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Seen by many as a tame part of the crypto space, regulation around stablecoins is slowly moving forward.
Ever since the idea and concept of stablecoins made it to mainstream financial conversation, these seemingly boring types of cryptossets have proven to be just as difficult to regulate as more volatile assets such as bitcoin or non-fungible tokens. In both the House of Representatives and the U.S. Senate there have been multiple bills proposed seeking to set regulations and guidelines for stablecoins; none have made it much past committee discussion, much less being voted into law.
Headlines and market sentiment, as always, are playing a part in the difficulty that regulators and policymakers have faced. TetherUSDT, despite remaining the largest and most used stablecoin in the world, has only recently taken decisive action to improve the quality and timeliness of financial reporting. Paxos, a major stablecoin issuer, including the issuance of BUSDBUSD, is facing down potential SEC lawsuits, as well as enforcement actions taken by the New York state banking regulator. Even USDCUSDC issued by Circle, seen by many in the space as the most transparent stablecoin issuer, came under scrutiny after a short-lived depegging following the collapse of Silicon Valley Bank, where Circle had over $3 billion on deposit.
With stablecoins continuing to grow in importance, and major financial institutions like JP Morgan issuing versions of these instruments – albeit under different names like “deposit” tokens – the following needs to be asked? Why are financial instruments that are seemingly so simple in nature, often drawing comparison to money market funds (a well-regulated and transparent space) – proving so challenging to achieve any kind of consensus on?
Let’s take a look.
Surprising complexity. The appeal of stablecoins to many investors and entrepreneurs is that these cryptoassets are connected to an external asset, which in most cases is the U.S. dollar. Despite claims that de-dollarization is well underway, the fact remains that the dollar is the global reserve currency, and far out paces any other currency for international transactions.
Several questions come to the forefront when attempting to assess stablecoins, and specifically stablecoin issuance as a viable business model. How much does it cost the issuer to maintain the peg that is advertised? Similar to a currency pegged to another currency, maintaining that peg incurs costs for the organization. Additionally, how simple is it for users/investors that have purchased the stablecoin to exit that position? Many investment vehicles have black-out periods, or other limits of withdrawals, but for a cryptoasset seeking to supplement (and possible supplant) existing currencies, this process needs to always operate smoothly.
Reserve reporting. If one matter quickly became apparent during the crypto collapse that was punctuated with the failure of FTX, it was that the reporting and disclosure rules around cryptoassets were woefully lacking. No authoritative crypto-specific auditing standards have been issued to date in the United States, with very limited financial accounting guidance due out during 2023. Facing this gap, with standard-setters attempting to catch up and the private sector racing ahead, the idea of proof-of-reserves rapidly gained acceptance in the marketplace. The idea behind this reporting framework was to present a report, prepared by an independent third party, of the assets held at either the issuer of a stablecoin or a crypto exchange. A simple idea, but one that seemed to hold significant promise for the space.
Following the collapse of FTX, and the revelations that this alleged fraud was able to be completed even with audits having been conducted, questions quickly began to be asked about the validity of proof of reserves. Specific issues that have been raised, and that ultimately undermined the usefulness of proof-of-reserves include that 1) these reports only presented a snapshot of the assets in question, 2) there is limited comparability between different reports issued by different preparers, and 3) allegations of balance sheet window dressing (moving funds between accounts and wallets) were made against some firms who embraced proof-of-reserves.
Long story short, the rapid ascension of proof-of-reserves as an audit substitute was only matched by how quickly the concept fell out of favor with regulators, practitioners, and investors alike.
Systemic issues. One of the largest policy issues that are related to stablecoins is how these instruments will connect to the existing financial system, and this question has led to vigorous debates and opinions on both sides of the issue. With regulation still lacking, individual regulators such as the SEC have cracked down on some organizations in the space, such as Paxos, while entities like Tether have continued to operate even with a track record of legal issues and settlements.
Since so many stablecoins are backed and/or supported by the U.S. dollar, these instruments are already connected with the traditional banking system. A common refrain by some policymakers is that the implementation and utilization of stablecoins presents a systemic risk issue to the banking system; this misses the point. A fully reserved and crypto-first banking option has already been developed, put forward for review, and would avoid the potential of bank runs that had experienced during 2023.
For example, regulators and investors should take a fresh look at the business model and proposition put forward by Custodia to see 1) how close the U.S. to having this become a reality, and 2) how stablecoins and fully reserved deposits could play an important role in de-risking financial institutions.
Stablecoins are a simple idea with difficult regulatory questions, and that is all the more reason to proactively work on them.
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