Regulators are coming for stablecoins, but what should they start with?
The word “stablecoin” may have a pleasant ring to it — isn’t it nice to have something stable in the volatile cryptoverse? — but for critics, they are nothing short of a ticking time bomb. Whether that’s true or not, the push for regulating stablecoins is gaining momentum. The United States and the European Union are getting closer to formalizing their playbooks, and given the history of financial regulation emanating from Washington and Brussels, as well as the Financial Action Task Force’s guidelines on crypto over the past few years, it’s safe to say that the rest of the world will be following suit.
That said, regulating stablecoins is no easy task, as such coins come in all shapes and sizes, which makes a one-size-fits-all solution a problem. The top three stablecoins by market cap — Tether (USDT), USDCoin (USDC) and Binance USD (BUSD) — are all pegged against the U.S. dollar. According to their respective developers, they are backed by reserves of greenbacks and other various financial instruments to keep their value at $1 at all times.
Tether has already found itself under legal scrutiny over the viability and sources of its reserve, prompting the other two projects to reveal their respective supporting assets. USDC’s disclosure, for its part, shed light on a substantial amount of “commercial paper” — not necessarily high-quality or highly liquid — in its respective reserve. For many, the revelation led to the conclusion that the company is acting like a bank, not a payment business.
Other, more obscure stablecoins utilize a plethora of alternative approaches. They can be pegged to commodities, such as gold or oil, as with Venezuela’s controversial Petro. More exotic options include coins linked with carbon credits, like UPCO2, coins backed by crypto-assets, like Dai, and, perhaps rarest of all, stablecoins like Terra (UST) that have no collateral at all and instead rely on algorithms to keep their prices stable.
Of course, some might say that regulation will only slow down innovation, so governments should stay out of the crypto lane, but this argument is missing historical context. Way earlier, in the wildcat banking era, private currencies issued by rogue banks would often leave people buying in with worthless papers, so the greenback was enshrined as the only national currency of the United States. The same logic applies to the 2008 money market fund crisis when the federal authorities put new rules in place to protect the Regular Joe from big-time investors pulling in large sums from those.
Time and time again, we, as a society, determined that consumers need protection from scams or simply bad judgment by those who custody, transfer value or provide similar services. We implemented rules and regulations to govern who can issue and redeem what we consider money, we wrote the playbook for those handling money in amounts that can send shockwaves across the economy if mishandled. Why shouldn’t we do the same with stablecoins, a market with a total cap of over $133 billion? There is simply no point in keeping the Damocles sword of a crypto bank run hanging over the heads of investors and traders. So where do we start?
The one for one approach
The best way to begin regulating stablecoins is to set up the rules and protocols that ensure they live up to their claims. Christine Lagarde, the European Central Bank chief, said in a recent interview that stablecoins must be backed with fiat 1:1, adding that projects behind issuing any stablecoins should:
“[...] be checked, supervised, regulated so that consumers and users of those devices can actually be guaranteed against eventual misrepresentation.”
The EU has a long history of Electronic Money Institutions (EMIs), which can issue and redeem digital euros, and those institutions back their digital euros with real euros held in a bank, or in some cases, the central bank. This could set the example for regulators in other jurisdictions, who seem to be heading in the same direction.
Here, we could draw a parallel with capital requirements for banks or payment companies, like EMIs, to ensure that stablecoin users can trade their coins for fiat at any given moment via the company that minted those. For reference, one of the key ways banks make money is by lending the money deposited by others. The process needs regulation simply to make sure the bank has enough in its stash to pay off clients who may want to withdraw their money, but not necessarily a 1:1 ratio for every active deposit.
For a stablecoin issuer, selling its coins for fiat may be technically akin to taking in a deposit, but the question is what does it do with the money next? If it lends, then it is engaging in banking activities. If it processes a transaction, then it’s handling payment activities. If it puts the money into high-yield assets, then it is technically transmitting orders to a brokerage or working as a broker, itself. Again, for context, we, as a society, granted governance of these activities to regulators.
Appropriately, with stablecoins, regulators must first establish the transparency standards for the issuers, who must identify the financial activities they are engaged in, much the same way banks and payment companies do. Money market funds could be a good benchmark here. It is only reasonable to expect every stablecoin issuer to issue reports on their holdings, including, whenever appropriate, entities that issued specific securities and the amounts thereof. Without this, there is simply no way for stablecoin users to be sure that their assets hold the actual value.
For stablecoins pegged against more exotic assets, the fundamental rule must be the same: They must be able to prove that whatever assets they claim are behind the coin are there. But that’s where we jump right into a deep, deep rabbit hole. A commodity-backed stablecoin, for example, is, de-jure, a commodity-based investment contract, and needs to be regulated as such, not as “money” in any sense. And algorithmic stablecoins have an even harder time fitting into the regulated world.
The outer rim
Algorithmic stablecoins are not as massive as ones collateralized with fiat. TerraUSD, pegged to the U.S. dollar, but technically lacking underlying collateral, is the fifth-biggest stablecoin, and ETH-backed DAI is the fourth-largest stablecoin, according to CoinMarketCap. Tether makes for about half of the total market cap for stablecoins.
From a regulatory standpoint, algorithmic and crypto-backed stablecoins are not currently as closely intertwined with the traditional financial system as those that hold conventional financial instruments in their reserve. Such coins are usually fully plugged into the larger crypto ecosystem or their networks. That said, given the size and activities of these organizations — effectuating the transfer of value, in essence, not always in line with jurisdictional laws—they are as worthy of regulators’ crosshairs as other stablecoins.
As an open and immutable ledger, blockchain is open for auditing, and so, more often than not, are the smart contracts powering such projects. Assuming identity can be attached to wallets, transparency is not necessarily an issue. What is an issue, though, at least potentially, is firing up the imagination of entities used to dealing with traditional finance and simultaneously encouraging crypto projects to find solutions for complying with the regulations that govern our society.
In theory, regulators could go all the way to establishing a standard for incorporating automated reports and audits into the code powering the coins. In practice, doing something like that begs the question of a larger regulatory framework for cryptocurrencies as such. Multiple regulators are working on this playbook too, but there is still a way to go before it is completed.
Given the apparent focus on the fiat-collateralized giants like Tether, the first order of business will be to categorize them according to activities (payment, banking, investment) and apply the requisite licensing requirements accordingly. The algorithmic stablecoins will most likely be put into regulatory limbo until the powers that be determine whether they are commodities or not, or even get outright banned—either of which will force them into a choice between adapting to regulations or being marginalized.
Whichever way things go, it is clear that stablecoins are in for a rude awakening from regulators across the world, and rightfully so. With their market cap soaring, stablecoins are now one of the key pillars for the crypto ecosystem as such. By embracing regulation, the crypto community will simply make sure that this colossus does not have feet of clay.
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