Last week, the collapse of Silicon Valley Bank, where around 8% of Circle Internet Financial Ltd.’s USD Coin (USDC) reserves were deposited, caused the stablecoin to fall below its $1 peg, dropping to less than 85 cents before recovering. This event highlighted the importance of trust in the concept of money.

The idea that trust is the foundation of money has been discussed by economists Nobuhiro Kiyotaki and John Moore in a 2001 paper titled “Evil is the Root of All Money”. They argued that people accept and hold money because it helps society overcome the problem of broken promises. In other words, money serves as a trusted medium of exchange and store of value precisely because it represents a promise that the holder can rely on.

This concept is particularly relevant in the case of stablecoins, which are digital currencies designed to maintain a stable value relative to a real-world asset, such as the US dollar. Stablecoins like USDC are created by companies like Circle Internet Financial Ltd. that hold reserves of the underlying asset to back up the value of their digital tokens. This means that users of USDC can rely on the company’s promise to redeem their tokens at a 1:1 ratio for US dollars.

However, as last week’s events demonstrated, this promise is only as good as the trust that users have in the issuer of the stablecoin. When news broke that a significant portion of USDC’s reserves was held at a bank that had been shut down by regulators, users began to doubt whether Circle Internet Financial Ltd. would be able to redeem their tokens at full value. This led to a drop in the price of USDC, as holders tried to sell their tokens before they lost further value.

This episode shows that even a slight doubt about the stability of a currency can cause it to lose its status as a trusted medium of exchange and store of value. Money must be free of any doubt in order to maintain its claim as a reliable means of facilitating transactions and storing wealth.

In the case of stablecoins, the promise of 1:1 redemption is critical to their value proposition. Without it, they lose their claim to being an alternative to traditional fiat currencies. As the world becomes increasingly digitized, stablecoins are likely to become more important as a means of facilitating cross-border transactions and providing financial services to people who are unbanked or underbanked. However, for this to happen, stablecoins must maintain the trust of their users.

The events surrounding USDC’s drop below its peg highlight the need for greater transparency and accountability in the stablecoin market. Regulators must ensure that issuers of stablecoins hold sufficient reserves to back up their promises of 1:1 redemption and that they are able to meet these obligations even in the event of a bank failure or other adverse event. Users, meanwhile, must be vigilant in assessing the risks associated with holding stablecoins and must be prepared to withdraw their funds if they lose confidence in the issuer.

The recent turmoil at Silicon Valley Bank (SVB) has highlighted the vulnerability of stablecoins, such as USD Coin (USDC), which are used as a means of exchange in decentralized finance (DeFi). The collapse of SVB was caused by the bank’s overexposure to long-term interest rates, resulting in distrust among depositors, including many young start-ups and 60 Indian firms. Circle, which had its funds deposited with SVB, attempted to move them elsewhere but was unsuccessful. While deposits below $250,000 are insured, there is no such safety net for token holders, creating a regulatory vacuum that has prevented stablecoins from becoming “no-questions-asked” money.

Professors Gary Gorton of Yale School of Management and Jeffrey Zhang of the Federal Reserve has called for greater regulation and oversight of stablecoins. The recent collapse of SVB has raised doubts about Circle’s ability to redeem every USDC coin at par, but the fact that 77% of its backing assets are invested in short-term US Treasury debt should help to reassure investors. The bigger concern is the systemic risk posed by the emerging world of DeFi, which lacks the safety net of insured bank deposits.

Stablecoins, such as USDC, have been touted as a solution to the problem of broken promises in traditional finance (TradFi), but recent events have shown that they too are vulnerable to market turmoil. In contrast, central bank digital currencies (CBDCs) offer full sovereign backing and are less likely to be subject to the same risks. However, CBDCs are still in the experimental stage, and it is unclear whether they will be available on public blockchains. The collapse of SVB and the de-pegging of USDC have exposed the limitations of stablecoins and highlighted the need for greater regulation and oversight in the world of DeFi.