Stablecoins Show the Problem With Crypto in 401(k)s

The continued decline in the market value of bitcoin has momentarily taken the wind out of the sails of crypto-mania. Any 401(k) plan fiduciary previously contemplating investing in or enabling plan investments in cryptocurrencies should use this opportunity to hit the pause button.

Fiduciary committees need to take a deep dive into the mechanics of cryptocurrency investments before they reach a prudence determination. Cryptocurrency is a virtual Rubik’s Cube of financial complexity. Buyers beware.

Cryptocurrencies are a non-centralized digital means of exchange that rely upon blockchain technology — digital money. The market value of most cryptocurrencies fluctuates daily, and the volatility in market price can be substantial. 

Not So Stable

In order to mitigate the challenges related to daily market volatility, and to facilitate efficient trading of a cryptocurrency, developers created a subcategory of cryptocurrency referred to as stablecoins. This form of cryptocurrency has its value pegged to another asset (dollars, gold, and sometimes other cryptocurrencies).   

Often, an investment in a cryptocurrency first involves the purchase of a stablecoin, and then the onward purchase of the underlying cryptocurrency. For example, investments in bitcoin are often facilitated by the purchases of tether — a stablecoin. Therefore, plan fiduciaries must understand the risks associated and the relationship between these two related but distinctly different investments.

Setting aside the price volatility attributable to the surge in popularity of cryptocurrencies, the claim that a stablecoin such as tether is pegged to the dollar requires focused attention. In fact, notwithstanding the dollar peg, in the past few months the value of tether dropped below $1 to 95 cents before rebounding to $1. Terra, another stablecoin, imploded below 30 cents. In other words, investors who were expecting to receive $1 per coin received only 95 cents per coin, or worse, 30 cents.  

Another Dollar-Pegged Investment

Pegging the value of an asset to the dollar is not a new concept. For decades, investors have transacted in money market funds at dollars per share. Unlike stablecoins, however, the dollar peg of money market funds does not rest simply upon the claim of a fund sponsor but is supported by a robust regulatory system.

At the heart of the investment/risk challenge for a dollar-pegged investment lies the discrepancy between the book value of the shares in the fund ($1 per share) and the fair market value of the underlying assets. Among the technocrats, this disparity in value is referred to as the deviation — i.e. the deviation between book and market value.

Detailed rules have been adopted related to the duration, credit quality and liquidity of money market funds so that the deviation remains in a manageable range, enabling investors to rely upon the book value of $1 per share.  

Back in the midst of the financial crisis, the Reserve Fund (a storied fund among money market funds) broke the buck. It was forced to be valued at 97 cents per share, rather than $1 per share. This event sent shock waves through financial markets. In response, the Securities and Exchange Commission tightened the rules around the underlying investments in money market funds. 

Compare the Reserve Fund’s valuation of 97 cents with the stablecoin valuations mentioned above of 95 cents and 30 cents. The difference is significant. In fact, for perspective, the money market rules allow a deviation of only 50 basis points ($0.995) before the fund is forced to break the buck, as in the case of the Reserve Fund.  

The commitment to maintain a stable value of $1/share for money markets takes significant resources, expertise and regulatory oversight. The $4.5 trillion of assets invested in money markets (as reported June 21 by the Investment Company Institute) stands as a testament to the well-deserved trust earned by the money market industry.

Fiduciary Process

With cryptocurrencies, on the other hand, there are no regulations related to the dollar peg of the stablecoins. In fact, tether resisted disclosure of the financial statements related to the collateral pools supporting the dollar peg until it was forced by a settlement with the New York attorney general’s office to issue attestation reports disclosing the holdings of the collateral pools.

Thus, 401(k) plan fiduciaries must demand continued transparency from all cryptocurrency sponsors before they open the floodgates of ERISA-qualified assets into this asset class. But transparency is merely a first step in building trust in this asset category.

When assessing the prudence of a cryptocurrency investment, they must take the disclosed data and run it through analytics that are similar to the requirements applicable to money market funds; assessing metrics related to the duration, liquidity and credit quality of the collateral pools, as well as the deviation between book and market values. 

Effectively, the rules pertaining to money market funds constitute best practices related to dollar-pegged investments. Before plan fiduciaries commit ERISA-qualified assets to cryptocurrencies, it would behoove them to ensure that best practices are being followed. 

Of course, the specific details do not have to be precisely the same as those pertaining to money market funds, but any metrics, at a minimum, should address the same principles reflected in the money market requirements. In fact, any analytic procedures used for stable value funds may be a good place to start.

No one knows what the future holds for cryptocurrencies. We may look back 10 years from now and cryptocurrencies may have been an exciting financial fad. On the other hand, cryptocurrencies may form the bedrock of the global monetary system. As of today, the future is unknown. But if the asset class is heading toward the latter, retirement plan fiduciaries can actually play a constructive role for the market as a whole.

Mitchell Shames is founder and managing director of Harrison Fiduciary.