The world is facing a banking crisis not seen since 2008, with no end to the uncertainty in sight.  While depositors and tech companies have been highlighted as victims of this uncertainty, another casualty of the crisis has been cryptocurrency companies — especially those dealing with stablecoins.

Stablecoins are a type of digital currency designed to be tied to the value of a government-backed currency.  Most stablecoins aim to be pegged to the U.S. dollar, but other coins also aim to be on par with currencies like the Euro.

Stablecoins are used for a variety of purposes.  They allow for low-fee instantaneous transactions across borders, and they can act as an escape valve for residents living in nations dealing with hyperinflation, allowing them to store their wealth in something more predictable.

Stablecoins have relied on a variety of methods to keep their value tied to their preferred government-backed currency, but the most popular stablecoins have relied on holding either cash or government bonds at banks.

The recent banking crisis has highlighted the risk inherent in this system — namely, that banks are still susceptible to runs as the cash held on deposit is often lent out for other ventures.  Silicon Valley Bank, for example, held $3.3 billion of the USD stablecoin's cash reserves, causing the coin to break its price match with the dollar for nearly three days.  Additionally, recent actions by the federal government are attempting to decouple the traditional banking industry from cryptocurrency, leading to more risk for cryptocurrency firms.

When the Federal Deposit Insurance Corporation closed Signature Bank, all the firms' assets were transferred to New York Community Bancorp's Flagstar Bank — that is, all assets except for cash deposits of companies in the cryptocurrency sector, nearly $4 billion in total.  This comes on the heels of a Senate letter to Silvergate Bank, a major banking service provider to the cryptocurrency sector, which brought so much regulatory uncertainty that the bank ended up closing, though all depositors were paid back in full.

Given both the federal government's desire to keep crypto outside the banking system and the current instability of the very same banking sector, it raises the question whether banks holding deposits are helpful or harmful for the future of stablecoins.

Currently, stablecoin regulation remains a top priority of Congress, specifically of Committee on Financial Services chair Patrick McHenry of North Carolina, who has proven himself to be a leader in the cryptocurrency space.  As his committee addresses this issue to provide much needed regulatory clarity to stablecoins, it should consider alternative methods for keeping stablecoins stable.

Possible solutions include holding currency or other similarly liquid government-backed securities at a financial institution that doesn't engage in lending.  For example, Custodia Bank, an institution that is licensed under Wyoming's Special Purpose Depository Institutions, wants to hold $1.08 for every $1.00 of deposits on record at the bank.  These excess reserves could assure consumers that their stablecoins are safe.  Unfortunately, the Federal Reserve has yet to approve Custodia Bank for a Fed account, so this option remains off the table for now.

Another option to ensure the stability of stablecoin would be to use open decentralized finance protocols and allow for self-custody of stablecoins.  With an appropriately open blockchain, consumers could view the backing of the stablecoin without need for a third party such as a bank.  This could prevent the very type of risk that happens with both centralized crypto exchanges and banks.    

The Biden administration has made it clear it wants to separate traditional banking from the innovative digital currency sector.  That shouldn't preclude innovation in the space.

As Congress tackles stablecoins, it should do so by allowing innovation not only in how stablecoins are sent between people, but also in methods used to keep the currency stable.  If the last few weeks have shown anything, it's that banks are not the only solution.  In fact, they may be part of the problem.

Eric Peterson is the policy director of Satoshi Action Fund and a contributor to Young Voices.  He currently lives in New Orleans.

Image: Pixabay,  vjkombajn.