Stablecoins Are On A Collision Course With Regulators
Stablecoins are heralded as the glue holding the crypto market together. These digital assets enable channels that let crypto holders transfer value between two or more crypto networks without having to incorporate fiat-based transactions. More importantly, they provide crypto participants with an opportunity to momentarily escape the volatility of the crypto market. While all these factors have propelled the stablecoins market in the last couple of years, it has also attracted regulatory scrutiny that had in turn induced uncertainties regarding the future of stablecoins.
And so, it is important to examine the sustainability of the current stablecoin frameworks and how they can be modified, if need be, to adequately eliminate the current legal shortcomings. In this article, I will be focusing on the burgeoning stablecoin market and the ways it can adapt to the legal realities unfolding across the world.
Stablecoin: Stability amid volatility
The concept of stablecoin was introduced some 7 years ago with the hopes that it could serve as an anchor for the highly volatile crypto market. The idea that birthed this system was inspired by the need for crypto participants to access stability amid the uncertain crypto terrain. Seeing that stability can only be achieved by somehow replicating some of the characteristics of fiat currencies in the crypto space, developers and entrepreneurs began to issue coins tethered to the value of fiat.
More specifically, the issuers pegged the price of digital assets to that of fiat currencies by holding enough funds denominated in the target fiat currency. In other words, the idea is to have a stash of cash stored in a bank or a custodial service such that the fiat currency and the issued stablecoin can maintain a 1:1 relationship. For example, if 100 million units of a USD-pegged stablecoin were issued, there ought to be $100 million stashed somewhere.
While this is the premise that birthed stablecoin, recent revelations have shown that this is not always the case. Contrary to the long-held view that stablecoins are backed by cash, several stablecoin issuers have revealed that cash accounts for just a fraction of their reserves. More often than not, these services hold a combination of loans, commercial paper, and corporate bonds. According to skeptics, this revelation is even more reason to be wary of the susceptibility of stablecoins to risks. However, before I go into the implications of this diversified reserve framework, let us first discuss some of the compelling factors that have propelled these offerings in the last few years.
Why are stablecoins a popular choice for crypto participants?
As mentioned earlier, stablecoins bring much-needed stability to the crypto market. The volatility of digital assets is unprecedented and it exposes crypto holders to risks. At any moment, crypto holders can lose a significant chunk of their investment when the price of digital assets takes a plunge, which happens more often than not. To protect themselves, crypto holders usually make use of stablecoins, especially when they feel that the price of digital assets might fall abruptly. So, in a way, stablecoins offer crypto users an escape from the chaos that might be triggered by price fluctuations.
Another good thing about stablecoin is that it functions as an exchange channel for cryptocurrencies. Note that most digital assets are paired against stablecoins, especially USDT. This makes sense because digital assets are commonly priced in US dollars.
Frances Coppola noted that bitcoin has failed to take up the role of a medium of exchange because it is volatile and expensive. Coppola wrote:
“The crypto community has tried hard to convince the world that bitcoin, and to a lesser extent other cryptocurrencies, can fulfill all three functions better than any past or present currency or asset. But the way things are developing suggests that this battle has been lost. Bitcoin has become a major asset class and is showing signs of holding value over the long term. But although bitcoin maximalists like to insist that one bitcoin equals one bitcoin, the reality is that people tend to measure the value of BTC, and indeed all cryptocurrencies, in U.S. dollars. And despite recent attempts to improve bitcoin’s liquidity (through subdivision and layer 2 solutions), its high price and extreme volatility make it extremely risky as a medium of exchange.”
Coppola added that stablecoins has risen to fill the void because they are stable assets that function like fiat:
“So the U.S. dollar has become the numeraire of the crypto ecosystem, and bitcoin its premier reserve asset. But what is its principal settlement currency? It’s not the U.S. dollar. In the crypto ecosystem, dollars are far too scarce and illiquid to use as principal settlement currency. And it’s not bitcoin either, nor any other traded cryptocurrency. Right now, the principal settlement currency in the crypto ecosystem is tether. Tether, or rather Tether’s U.S. dollar token USDT, is a pure medium of exchange. It is, in effect, the crypto equivalent of a fiat currency. Its value is maintained at approximately 1 USDT to 1 U.S. dollar by means of open market operations performed by its issuer through a network of partner exchanges, somewhat akin to the Fed’s broker-dealer network. At the time of writing, over 65 billion USDT have been issued, more than twice as many as the next largest dollar-denominated stablecoin, usd coin .”
Apart from the medium of crypto settlement that stablecoin has already established as one of its strong suits, it is also being used as a payment medium. Crypto holders sometimes used stablecoin to circumvent the hurdles of transferring fiat across borders. Rather than wait for wire transfers to finalize, it is a lot faster to send money with stablecoins. In one of my past articles titled Wirecard, Paypal, and Stablecoin: The banes and strengths of crypto payment, I highlighted the growing importance of stablecoin in the ongoing digitization of payments. I wrote:
“One of the core challenges for crypto in the payment sector is its inherent volatility. Merchants and customers have to factor in price fluctuations whenever they want to adopt crypto as a payment option. To mitigate this flaw, we are witnessing the increased demand for stablecoins and their capacity to establish stability in an inherently volatile financial landscape. Luckily, the push for cashless societies plays into the crypto narrative and presents an avenue to propel crypto’s viability as a payment option.”
Another interesting use case is that stablecoins are popularly used to power interest-generating opportunities in the decentralized finance (DeFi) sector. Participants are borrowing stablecoin-denominated loans, depositing them as part of the capital requirements for earning yields from liquidity pools. The extensive use of stablecoins in the DeFi sector has contributed massively to the explosiveness of the stablecoin market which at the time of writing is worth $130 billion.
As such, it is safe to say that stablecoin has begun to replicate the functions of fiat in the traditional market in the crypto sphere. However, as effective as stablecoins have proved to be, they are backed by assets prone to inflation. Therefore, no one in their right senses would hold on to them in the hope that they would yield profit via price gains. In reality, the stablecoin lose their purchasing power in the long run. In contrast, the value of viable digital assets like Bitcoin has maintained an upward trajectory over the years. Coppola explained this better when he said:
“So USDT is extremely liquid, but its nominal yield is zero and it pays no interest. It’s a zero-coupon perpetual U.S. dollar bond, if you like. And its quantity is both potentially unlimited and controlled by an opaque, unaccountable entity. Now, of what does this remind you? Because USDT and USDC are pegged to the U.S. dollar, which is an inflationary currency, they have a negative real yield. So they are a terrible store of value. Absolutely no one holds these stablecoins as assets. To make money from stablecoins, you have to lend, trade or pledge them for something riskier. And that’s exactly what people do. USDT, and to a lesser extent other stablecoins, are cash collateral in crypto lending as well as settlement media in crypto trading.”
Tanvi Ratna aptly summarized all the use cases of stablecoin in an article published on Coindesk. He wrote::
“The current market cap of stablecoins has surpassed $108 billion as of July, representing ~7% of the total cryptocurrency market cap. Stablecoin providers are going beyond the utility of cryptocurrency trading. Their main benefits – namely, faster transaction speed, borderless payments, generally lower fees and eventually programmable money – already enable a multitude of other use cases today: remittances, micropayments, commercial payments, bank deposits and withdrawals, payroll, escrow, store of value, settlement, lending, wealth management, foreign exchange trading and powering decentralized applications. Being central to the development of DeFi, reserve-backed stablecoins such as tether (USDT, -0.05%) and usd coin (USDC) currently dominate in most decentralized exchange (DEX) trading pairs and lending markets. Besides DEXs, lending platforms and other DeFi applications rely on stablecoins like dai and USDC to mitigate volatility in crypto markets and attract more investors.”
Types of Stablecoins
Understandably, stablecoins are categorized based on the type of collateral that backs them. Considering the stablecoin frameworks existing today, we can say that there are 5 types of stablecoins.
Fiat-backed stablecoin
As its name implies, a fiat-backed stablecoin is a digital asset underpinned by cash stored somewhere. The US dollar is popularly adopted as the reserve of stablecoins due to its global reserve currency status. We have also seen some stablecoins that are backed by the euro and other local currencies. The good thing about this framework is that it is less technical as issuers only have to ensure that there is enough money in the bank to establish the price of their stablecoin.
Commodity-backed stablecoin
As an alternative technique, some issuers have chosen to take things up a notch by issuing stablecoins backed by commodities, including gold and other precious metals.
Crypto-backed stablecoins
Interestingly, cryptocurrencies like Bitcoin and Ethereum have been used as collateral to ensure that the price of some digital assets remains stable. Unlike the fiat and commodity-backed options, this technique is a lot more technical to manage as the value of the collateral usually fluctuates. Hence, it is up to the issuer to find the right strategy to ensure that the volatility of the cryptocurrency used as collateral does not cause the price of the stablecoin to swing wildly. Usually, these digital assets are overcollateralized stablecoins. This is different from what we have in fiat and commodity-backed stablecoins which usually maintain a 1:1 relationship. For instance, 10 million units of a USD stablecoin can be collateralized by $25 million worth of Ethereum. With this, the price of each stablecoin will only experience a wild swing only in rare situations where the price of Ethereum crashes astronomically such that the value of the collateral falls below the $10 million mark.
Algorithmic-based stablecoin
Unlike all the stablecoin frameworks highlighted so far, the algorithmic-based ones are not collateralized. Instead, a smart contract burns or mints more coins to ensure that the price of the token remains stable. When the price of stablecoin falls below the target price, the smart contracts burn some of the coins, while more coins are minted when the price is above the target price. Understandably, there are still a lot of improvements needed to make this framework sustainable. However, for now, there is every reason to believe that this algorithmic-based strategy might be the go-to choice for future stablecoin issuers.
In July, Kent Barton, head of research and development at ShapeShift, explained that the algorithmic stablecoins have the potential of becoming the next frontal in the stablecoin narrative. He wrote:
“The basic notion here is that if a stablecoin protocol has the ability to automatically manage supply by minting and burning assets in response to market conditions, it can ensure that the asset remains close to its peg. This can lead to less reliance on governance, as well as lower collateralization requirements.”
Mixed reserve stablecoins
In some cases, issuers hold a reserve containing two or more commodity assets and cash. The goal is to create a basket of assets to back the validity of the stablecoin. As seen in the reports of Tether and Circle, USDT and USDC fall into this category with their reserves containing a combination of cash, precious metals, and commercial paper.
Why are stablecoins on a collision course with regulators?
Like most concepts introduced with the help of crypto technology, stablecoin has come under intense scrutiny. The technology has generated a lot of headlines in the United States since a majority of the stablecoins circulating are tracking the value of the US dollar. In most of the arguments raised by regulators and skeptics alike, the lack of transparency and the chaos that could ensue due to the unregulated nature of the stablecoin market is being highlighted as reasons to implement a regulatory framework fast.
In a recent blog post, the IMF explained that the wild west nature of the stablecoin market could have a knock-on effect on the stability of the global economy. The blog reads:
“Stablecoins—which aim to peg their value usually against the US dollar—are also growing at lightning speed, with their supply climbing 4-fold throughout 2021 to reach $120 billion. The term “stablecoin,” however, captures a very diverse group of crypto assets and can be misleading. Given the composition of their reserves, some stablecoins could be subject to runs, with knock-on effects to the financial system. The runs could be driven by investor concerns about the quality of their reserves or the speed at which reserves can be liquidated to meet potential redemptions.”
The United States Securities and Exchange Commission Chair Gary Gensler also shares a similar view, having stated that stablecoins are one of the main enablers of the largely unregulated crypto market. Gensler stated:
“Stablecoins are almost acting like poker chips at the casino right now. We’ve got a lot of casinos here in the Wild West, and the poker chip is these stablecoins at the casino gaming tables.”
Gensler went further to state that the SEC will double down on its efforts to bring some level of structure to the crypto industry:
“I do really fear that we’ll keep bringing these enforcement cases, but there’s going to be a problem. There’s going to be a problem on lending platforms, on trading platforms. Frankly, when that happens, I think a lot of people are going to get hurt.”
Interestingly, a similar conversation is brewing in Europe, as Christine Lagarde, president of the European Central Bank (ECB) recently noted that several discrepancies indicate that stablecoins expose users to unprecedented risks. Lagarde stated:
“Stablecoins are pretending to be a coin, but in fact it’s completely associated with an actual currency. For instance, some of them are saying that they can be used for transactions, but the value will be exactly aligned to the dollar.”
Lagarde added that stablecoins ought to be backed 100% by fiat currencies as against the growing trend of combining a wide variety of backers:
“That needs to be checked, supervised, regulated so that consumers and users of those devices can actually be guaranteed against eventual misrepresentation. I think very recent history has shown that those reserve currencies were not always available and as liquid as they were intended to be.”
Notably, Lagarde was referring to the decision of Tether to spread their funds across a basket of assets. She then commented that it is important that the ECB meet the demand for digital forms of money by issuing a central bank digital currency (CBDC):
“If customers prefer to use digital currencies rather than have banknotes and cash available, it should be available. We should respond to that demand and have a solution that is European based, that is secure, that is available, and friendly terms that can be used as a means of payment.”
Noel Quinn, CEO of HSBC Group, the largest European bank, holds a similar notion regarding the stablecoin conversation. Like Lagarde, Quinn favors a digital currency backed by central banks rather than stablecoins. He wrote:
“CBDCs are one new form of digital money. The critical difference between CBDCs and other types of digital money, such as stablecoins and cryptocurrencies, is that the latter are both forms of private money. Private money itself is nothing new. Current commercial bank money is privately created and widely used. But commercial bank money is anchored by central bank money and closely regulated, reflecting its systemic importance. If stablecoins and cryptocurrencies are to become relied upon in the same way, they will also require regulation that is commensurate with the risks they create. Even then, only designs that are sufficiently well anchored to achieve price stability, and correspond with current approaches to financial crime prevention, are likely to be useful as a reliable and safe means of payment.”
According to Jane Thomason, stablecoins must scale a series of regulatory hoops to establish a transparent and secure financial product for users. Even more importantly, there is the need to incorporate standards across the stablecoins market. She wrote:
“There are hurdles to achieve this. Despite their name, stablecoins do not guarantee stability. There is a lack of uniform standardized taxonomy for stablecoins. The United States Federal Reserve has called for a comprehensive regulatory framework for stablecoins. Moreover, any solution would need to address consumer protection, financial stability and financial crime prevention. Furthermore, there will be regulatory challenges across diverse economies, jurisdictions, legal systems and different levels of economic development. These challenges would require harmonizing legal and regulatory frameworks governing data use and sharing, competition policy, consumer protection and digital identity.”
It is worth mentioning that supporters of strict regulations in the United States have likened this stablecoin trend to the free banking era that lasted between the 1830s to the 1860s. During this era, state-regulated banks freely issued private banknotes. This system was later deemed unviable due to the chaotic financial economy it induced. Left with no other choice, the federal government decided to harmonize the monetary system such that the entire nation would rely on a single banknote regulated at the federal level.
However, Nic Carter, partner at Castle Island Ventures, a public blockchain-focused venture fund, noted that this argument against the free banking system inspired by stablecoins does not hold. In his counterargument, Carter explained that there were other factors responsible for the chaos that trailed the free banking era of the 19th century. He wrote:
“Banks during that period were forced to hold risky state government bonds and were restricted from engaging in “branching” – meaning they couldn’t establish branches nationwide. This inhibited them from geographically diversifying their depositor base and from having free choice in their asset portfolio. It’s no wonder that bank failures were common. Neither of these peculiarly U.S.-based restrictions was present in genuine free banking episodes such as Canada. There’s also Scotland’s successful case study, chronicled by the aforementioned Selgin and White, alongside Kroszner and Dowd. The repeated omission of successful historical instances of free banking – Scotland, Canada, Sweden, and Switzerland – in which bank failures were uncommon, notes were mutually accepted by rival banks and traded at par, appears strategic.”
Carter added that the reason regulators have continued to reference this era is because it provides a strong narrative to sell the idea of CBDC:
“It’s no coincidence the anti-stablecoin contingent is generally fond of CBDCs and believes the state should not only control the issuance of money but also have the power to determine which transactions are valid. We do not have to speculate on this front: If you listen to central bankers, they invariably de-emphasize privacy in transactions and mention the necessary imposition of controls inhibiting activities that the government claims are illicit. This is sometimes euphemized as “balanc[ing] an individual’s right to privacy with the public’s interest in the enforcement of AML/CFT regulations” – despite the fact that physical cash has no inbuilt anti-money laundering/combating the financing of terrorism controls. I have yet to come across a central banker proposing a CBDC project with the precise and same qualities of privacy and transactional freedom as physical cash.”
Speaking of consumer protection, there is the possibility that stablecoin can eventually qualify for consumer protection provided by The Federal Deposit Insurance Corp. (FDIC). If this happens, it would only be because stablecoins are now considered to be under the scope of the United States’ banking rules. Coindesk, while quoting an anonymous source stated this would very much allow banks to issue stablecoins of their own. The anonymous source allegedly stated:
“This is all part of a process by which they are trying to bring stablecoins into the banking system in a responsible manner. It depends on what’s backing the stablecoins. If it’s backed by reserves at the Fed[eral Reserve] for cash then I think you just make the argument that it’s a deposit. If it’s backed by Treasurys [bonds], I think you’ll have a hard time treating it as a deposit.”
While reacting to this news, Todd Phillips, a former FDIC lawyer who is currently the director of financial regulation and corporate governance at the Center for American Progress, a Washington think tank, stated:
“The FDIC is probably looking at whether stablecoins can count as deposits or whether someone’s ownership of a stablecoin is a deposit at the stablecoin issuer[…] “One thing to remember is that each person has insurance of only up to $250,000. So, the stablecoin issuer would need to keep track of who is the current holder of their stablecoin and how many they own[…] The FDIC basically has one overriding mission,- which is to ensure the safety of the Deposit Insurance Fund, the DIF. If the FDIC were to insure a stablecoin, that insurance would come out of the DIF and the FDIC will want to be very sure that they are on legal footing and that whatever they do doesn’t risk the DIF.”
Phillip added that the tag “FDIC Insured” will offer stablecoin holders the type of protection they presently cannot access. And so, it is understandable that FDIC would take its time to consider all the facts before making a decision:
“The FDIC has strict rules as to which institutions may call themselves FDIC-insured or use the FDIC logo for advertising. Just as how the FDIC’s logo on a bank’s website allows savers to be confident that the bank is safe, insurance of particular stablecoins and permission to use the FDIC logo would provide clarity about which stablecoins, up to the insurance limit, will not lose value[…] I also imagine there are conversations going on between the four FDIC directors, since you need a majority of them to approve a new regulation,”
What does the increased regulatory scrutiny mean for stablecoins?
More transparency
The first thing that you need to know is that the increased scrutiny forces stablecoins to enable a more transparent operation. We have already seen this in action with the likes of Tether and CIrcle having no other choice but to reveal more details about how they manage their reserves. JP Koning, in an article published on Coindesk, unpacked the potential impact of increased transparency in the stablecoin market. He wrote:
“Up till now, attestation reports did not disclose much about the sorts of investments held to “back” stablecoins. And so the composition of stablecoin reserves has always been mostly a matter of conjecture and rumour. With Tether and Circle now providing attested information about the composition of their assets, and not just quantity, consumers finally know what that “something” is. In Tether’s case, its biggest reserve asset is commercial paper, most of it rated A-1 or A-2. And USDC’s preferred backing asset is cash and cash equivalents, with a big allocation to Yankee certificates of deposit. I suspect this new transparency will create beneficial knock-on effects for consumers. Equipped with more information, consumers can better shop around for the safest coins. To attract them, stablecoin issuers will have to demonstrate their backing assets are sound. That means the entire sector will be pressured to cleanse itself of dreck collateral.”
Koning added that the push for transparency will force stablecoin issuers to incorporate best practices:
“This process may even satisfy regulatory hawks, who have begun to circle the stablecoin sector with concerns about the possibility of stablecoin runs and contagion effects. In Tether’s case, we’ve already seen an improvement in asset quality. As one of the many conditions of a February legal settlement with the New York Attorney General, Tether was obliged to provide a quarterly breakdown of its investments to the public.”
More importantly, this means that stablecoins may need to spend more to audit their businesses. This will definitely put a strain on the operations of stablecoin issuers:
“The transparency wars will only make things more complicated for Circle, Tether and the rest. To begin with, regular attestations aren’t free. Auditors need to be paid. And the more complex the auditing requirements, the higher an auditors’ fee. Even worse, a transparency-induced competition to safety means lower revenue for issuers. A big portion of stablecoin revenue accrue from the interest income thrown off by a stablecoin’s backing investments, which issuers keep for themselves rather than paying out to their customers. A five-year corporate bond currently yields around 1.2% per year. With increased transparency, juicier assets such as these will be increasingly out of bounds for issuers. But the alternative, safe assets like Treasury bills and bank deposits, don’t yield much. These days they offer a miniscule 0.05% or so.”
KYC requirements for stablecoin users
Since transparency could become a critical requirement for stablecoin issuers, it is safe to say that it is only a matter of time before stablecoin holders are required to scale KYC checks. Like auditing, implementing KYC will inadvertently force stablecoin issuers to the brink, as the cost for incorporating such checks will eat further into their revenue.
Geopolitical competition
Ratna made a compelling argument centered around the effect of the ongoing push for stablecoin regulation in the United States. According to Ratna, this campaign may induce global competition, as other countries scamper to develop their own stablecoin framework. He wrote:
“Stablecoins might also not reduce to a monopoly of the Fed, if other countries retaliate. China, Russia and the European Union have all taken steps or voiced concerns to move past the dollar-dominant financial system. All three countries have also actively experimented with and regulated cryptocurrencies or built their own digital currency. It is very likely that if U.S.-bank or Treasurys-backed stablecoins emerge, these countries will issue stablecoins backed by their own currencies into the wider cryptocurrency market. Both CBDCs and private and public-private stablecoins denominated in different currencies could emerge as a counter to U.S.-centered regulation of stablecoins. A critical component of the cryptocurrency ecosystem could, hence, either become a shadow of the existing system or a battleground of intense geopolitical currency wars. In either case, in remaining a pillar of an independent financial cryptocurrency-based system, stablecoins face a considerable challenge.”
Conclusion
Stablecoin seems to be the next crypto sector on the regulatory hot seat. It remains to be seen how this regulatory campaign unravels and whether stablecoin will survive the onslaught and still manage to keep its free banking nature.
