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  • Writer's pictureLeo Wong Chin Wai

Regulation on Stablecoins, a Boon or a Bane.

Updated: Aug 23, 2022

Stablecoin is a cryptocurrency with an additional economic structure aimed at stabilizing prices and purchasing power. The most popular reserve asset for stablecoin is one US dollar. Stablecoins have a combined market cap of more than 170 billion and the market value of existing stablecoins (USDC, USDT, Dai, etc.) reached USD 14 bn in August 2020. The stablecoins sector continues to grow rapidly and will increase the exposure of different risks that vary significantly according to their designs and are often poorly understood. No matter if you are a veteran or a freshman in the crypto space, this article will be useful for you to revise the basis behind the stable assets that you are trading every day, the categories, and the risks behind respectively. The second part of the article will mention the coming regulation by policymakers and discuss whether this would be a boon or a bane.

Custodial or Non-custodial stablecoins

There are two major classes of stablecoins, custodial and non-custodial. Custodial or trusted by off-chain collateral assets, like fiat dollars, sit in the bank and require the trust of third parties. Noncustodial, aka decentralized stablecoins are fully unchained and backed by smart contracts in economics, with no trusted parties.

Custodial stablecoins are issued by central administrators and backed by collateral held in a bank or other institution. Custodians hold a combination of assets, currencies, bonds, commodities, etc off-chain, allowing the issuer to offer a digital token of a reserved asset. These are usually fully collateralized from one dollar of the asset to one dollar stablecoin. Custodial stablecoins represent the vast majority of total stablecoins volume, and they are known as stable and reliable, provided by the issuers' trust and transparency. The industry standard is circled and widely adopted by regulatory stablecoins - USDC. There are three types of custodial stablecoins:

  1. Reserve fund: 100% reserve ratio in which stablecoins are backed by the unit assets held by custodians.

  2. Fractional reserve fund: this stablecoin is backed by a mix of both reserve assets and other capital assets.

  3. Central bank digital currencies: a digital form of central bank money that is widely available to the general public. CBDC is in its nascency today, with only 9 countries and territories having launched them, many of them small.

Custodial stablecoin has three major risks:

  1. Counterparty risk: fraud, debts, government seizure, etc.

  2. Censorship risk, operation block by regulators, etc.

  3. Economic risk: off-chain assets go down in value.

Each can result in a stablecoin value going to zero.

Next, non-custodial stablecoins achieve by creating an economic structure on blockchain and utilize smart contracts. They consist of autonomous self-executing protocols running on public blockchains that seek to produce a dollar peg token without relying on a trusted third party.

  1. Exogenous collateral: the stablecoins are backed by assets that have been used outside the stablecoin system. The most prominent stablecoin category is the Maker DAO protocol and its DAI stablecoin, which is backed by several crypto assets like ETH. Instead of being held by custodial issuers, assets are held by non-custodial smart contracts on the blockchain. Since those assets are volatile, over-collateralization is required to maintain stability.

  2. Endogenous collateral: asset created to be collateral for the stablecoins. Examples include Synthetix, whose token (SNX) is collateralized as sUSD stablecoin. Such a system protects from price risk, which absorbs losses when stable coin demand is low and the supply will be contracted; while receiving newly minted stablecoins when demand is high and the supply will be expanded.

  3. Implicit collateral, aka algorithmic. These are stablecoins without explicit collateral instead use market mechanisms to adjust the price to stabilize the price. This brings us to UST, trying to be everything at once, decentralized, stable, and perfectly efficient while having no collateral at all. We have explained why algorithmic stablecoins are never stable, you can learn back here.

Noncustodial stablecoins have five major risks:

  1. Collateral: effects from deleveraging-like processes on collateral like assets, causing the value less than the issuance

  2. Data feeds & governance perimeter failure, which the system can’t price itself.

  3. Base layer risks from mining incentives

  4. Smart contract coding and hack risks to its insolvency.

  5. Censorship and counterparty risk.

Each can result in stablecoin value going to zero.

Regulatory context on stablecoins:

After the collapse of UST stablecoin, which resulted in billions of dollars of lost value and led to a wider blockchain and cryptocurrency ecosystem breakdown, the question everyone is discussing right now is what policymakers would or should do. The Fed has been consistently warning that the redemption risk and other vulnerabilities would be exacerbated by a lack of transparency regarding the riskiness and liquidity of assets back in stablecoins. In addition, the increased use of stablecoins to meet marginal requirements for leverage trading and other cryptocurrencies may further amplify the volatility in demand for stablecoins to heighten redemption risks. In addition to the risks to financial stability, Stablecoin raises many other regulatory and supervisory concerns, especially concerning market integrity and consumer/investor protection. Market manipulation, fraud, and consumer abuse are still rampant in this area. In fact, without regulation, stablecoin issuers make a profit by investing in high-yielding or illiquid assets or lending funds or assets to stablecoin holders while paying them at low or no interest - this may also be the 'master plan' of Do Kwon from the beginning.

Stablecoins present a significant opportunity for us to risk getting them wrong as a matter of policy. The Fed went on to note that “the president working group on financial markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency have made recommendations to address prudential risks posed by stablecoins. Besides, the President’s Executive Order and Ensuring Responsible Development of Digital Assets has tasked various agencies with considering digital assets regulatory development. Two months ago, US president Biden issued an executive order to identify crypto opportunities and risks, as well as responsibilities of analyzing them and calling for written reports. That work is ongoing and will be critical for the next steps and congress and across the administration. Regulators also responded quickly to the Terra chaos and re-emphasized why stablecoin and decentralized finance regulation is required. United States Treasury Secretary Janet Yellen said there is an imminent need for a regulatory framework regarding the risks that stablecoins are not at scale right now and the financial stability concerns they could bring out in the future. She also mentioned payment stablecoins and their arrangements are subject to federal prudential framework on a comprehensive basis, requesting lawmakers to develop a “consistent federal framework” on stablecoins, a bi-parties consensus in Congress, and adopt new regulations that are fit for purpose to address risks.

When regulating stablecoin, the starting point must be an appropriate registration or licensing system that allows appropriate information and monitoring, combined with regulatory requirements. It is essential to build systems to collect data on such instruments, thus authorities should combine this with the information-sharing practice between the authorities, as they may have crossed their borders. Information is a central function of regulation, both in terms of improving market functionality and efficiency, as well as in terms of market integrity, customer and investor protection, or oversight for discreet purposes. Direct automated delivery of data as a digital payment system and market licensing or registration requirements provides an important opportunity to better utilize technology to meet regulatory and regulatory goals and reduce the costs of market participants. Without data and oversight, potential risks to financial stability can be overlooked. Without proper thresholds and higher regulatory requirements, it could let unethical issuers produce a new product that can rapidly evolve into global stablecoins, posing significant risks to financial stability.

At the same time, authorities are actively designing the Central Bank Digital Currency (CBDC). It can perform these functions even more effectively than privately developed stablecoins. The CBDC enjoys the support of the central bank and does not face the same conflict of interests regarding asset conservation and stabilization mechanisms. Their value is fixed by design to the currency they are associated with and can eliminate fluctuations in value. The question is how can the CBDC be designed to provide robust interoperability with new decentralized finance solutions. Many improvements to existing payment systems may offer alternatives or complement stablecoin and the CBDC. Well-designed public-private initiatives, especially Fast Retail Payment Systems (FPS) supported by public digital identity (ID) infrastructure, have already significantly increased payment speed, availability, and universal access in many countries and they keep improving.

While there is agreement among certain federal entities and legislators that establishing a stablecoin regulatory is necessary, there is not yet a consensus on what form it should take. On one hand, there are calls for Congress to act promptly to ensure that payment stablecoins are subject to appropriate federal prudential oversight on a consistent and comprehensive basis. Those demands always add that the legislation should limit stablecoin issuance, and related activities of redemption and maintenance of reserve assets, to entities that are insured depository institutions. On the other hand, Senator Toomey, the Ranking Member on the Senate Banking Committee, who issued draft legislation in April that would establish a new regulatory framework for stablecoins, has expressed the view that while increased regulation is necessary, stablecoin issuance should be allowed in three following circumstances:

  1. A money transmitting business or any other person that is authorized by a State banking or similar authority to issue stablecoins;

  2. A national limited payment stablecoins issuers; or

  3. An insured depository institution.

Ready or not, here it comes and this will move from urgent to urgent-urgent. Regulation will play a key role in shaping the stablecoin sphere. As the use of, and uses for, stablecoin continue to develop and grow it will be important to monitor how various federal agencies and legislators determine how best to develop stablecoin regulation. The real question for policymakers is who is going to be willing to put in the time, put aside their priorities, and see the difference and distinctions they are trying to draw. The hopeful thing is there is a pretty common sense of agreement on how to regulate custodial stablecoins. No one in this industry would not like to know more rather less information about where the reserve assets of the big custodial stablecoins are held, in what instruments, how much, all of that stuff. Transparency has been increasing as a matter of course, but full out-of-station reserve backing seems obvious as part of any other stablecoins legislation. To strengthen global dollars, promoting stablecoins should be a top national priority, not even mentioning the benefits of inclusion, efficiency, competitiveness, and more. It is time for deep strategic thoughts and deliberate action to monitor and assess risks from stablecoins, and to address risks to the economy, consumers, and the financial system.

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