Stablecoins Skyrocketing + Regulatory Lag = Risk

A stablecoin is a type of cryptocurrency that is pegged to a national currency (such as the US dollar), commodity (such as gold or real estate), or another cryptocurrency through an algorithm to stabilize its price. In essence, stablecoins serve as the tokenized version of fiat currency or other assets having a fixed value. Regardless of the mechanism used, either through fiat-controlled or crypto-collateralized means, a reserve is maintained as collateral, meaning that when stablecoin holders wish to cash out their token, an equal amount of assets is available for the exchange.

Advocates claim that stablecoins offer an attractive alternative to other cryptocurrencies such as Bitcoin, which may exhibit high volatility in price and exchange rates, thus making stablecoins more suitable for routine financial transactions. Decentralized finance platforms such as BlockFi and Celsius lend stablecoins to their customers because the value of the stablecoin tends to remain relatively stable between the time a customer gets approved for a loan and the cryptocurrency is delivered to the individual’s digital wallet. Additionally, stablecoin holders can avoid paying transaction fees to crypto exchanges such as Binance and Coinbase, which do not charge fees for currency exchanges in stablecoin. Proponents of stablecoins also claim that businesses and households can benefit from paying with stablecoin since the stablecoin infrastructure reduces cost and minimizes delays involved in sending and receiving remittances. Governments and regulators, however, continue to be wary of stablecoin, fearing the possibility of destabilizing runs, disruptions in the payment system, harm to consumers, and the implications of the concentration of economic power, and have thus begun to consider regulation.

Mechanics of Stablecoin

According to CoinMarketCap, stablecoin is currently a $163 billion subset in the crypto-ecosystem with roughly 200 varieties worldwide. Stablecoins use one of three methods to stabilize their value, but each carries its own inherent risk.

Fiat-controlled stablecoins: A reserve of a fiat currency or currencies is maintained as collateral to ensure the stablecoin’s value. In rare cases, collateral can also be accepted in the form of precious metals or commodities, such as crude oil. In principle, these reserves are to be maintained by independent custodians whose activities are audited. Examples include Tether and TrueUSD, which claim to be backed by US dollar reserves and are denominated at parity to the dollar. However, there are multiple concerns over these types of stablecoins. They are subject to regulatory risks resulting in adverse impact on the economic value of the cryptocurrencies, concerns over transparency of their reserve inventory, the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, as well as governance and operational risks.
Crypto-collateralized stablecoins: In theory, these are supposed to be backed by other cryptocurrencies and are over-collateralized due to the high volatility of the underlying cryptocurrencies. This means that the value of the cryptocurrency held in reserve must exceed the value of the stablecoins issued, nominally at a 150% collateral ratio. However, these stablecoins are also not immune to risk. For example, on 23 February, 2021, Tether and Bitfinex agreed to pay an $18.5 million fine to end a New York probe into whether they covered up $850 million in losses after failing to have sufficient funds in reserve. According to the New York attorney general’s office, they also agreed to halt trading activities with New Yorkers and to submit quarterly transparency reports.
Algorithmic stablecoins: These are typically under-collateralized, meaning they often do not hold independent assets in reserves to back the value of their stablecoins. Instead, they are stabilized by controlling supply and demand through coded algorithms. They rely on two tokens—one being stablecoin, and another a cryptocurrency that backs the stablecoin—so that smart contracts, which are self-executing with terms of agreement between the buyer and seller written directly into the code, can regulate the relationship between the two tokens. The code controls the execution of the agreement, i.e., regulating supply and demand, and the transactions are trackable and irreversible. Transactions are stored in a decentralized blockchain network. Recent developments illustrate the risk of algorithmic stablecoins. TerraUSD (UST) is a stablecoin with its price pegged to the US dollar, but without actual currency behind it. UST’s peg was its algorithmic link to Terra’s base currency, Luna. On 9 May, 2022, Luna lost more than $400 billion in value in crypto-market capitalization. When investors panicked and investors short-sold, it caused UST to depeg from the dollar. Luna’s currency devolved into a death spiral, causing other investors who earned interest via Anchor, Terra’s largest decentralized finance protocol, to quickly pull their money out, resulting in a “bank run.”

Current Regulatory Landscape

Regulators have begun to seriously consider the appropriate regulatory framework for stablecoin. According to the US Federal Reserve, stablecoins present risks to consumers, to the institutions and to the financial system more broadly. According to the Fed, and as illustrated by Terra/Luna, stablecoins are in need of policing because of their rapid growth in popularity and because “they are backed by assets that may lose value or become illiquid during stress, which makes them vulnerable to runs.” The Fed has also voiced a concern over the fact that the stablecoin sector is “highly concentrated with the three largest stablecoin issuers—Tether, USD Coin, and Binance USD—constituting more than 80% of the total market value,” leading to possible instability in the broader financial system¹. In addition, the “sudden mass redemption of cryptocurrencies could affect the stability of short-term credit markets if it occurred during a period of wider selling pressure in the commercial paper (CP) market, particularly if associated with wide redemptions of other stablecoins that hold reserves in similar assets.” Furthermore, “authorities are unlikely to intervene to save stablecoins in the events of a disruptive event, partly owing to moral hazard. Authorities could step in to support dealers and prime money market funds should stablecoin redemptions lead to or amplify a wider CP sell-off, pressuring market liquidity and impending new CP issuances.”

Furthermore, stablecoins raise a variety of consumer protection concerns, such as adequate disclosure and transparency of the reserves. Consumers should have information about backing mechanisms, the types of governance structures, the way the issuance is managed, and the redemption and technical choices that are made.

Regulators are particularly worried about systemic risk engendered when stablecoin’s market cap grows too large. Some politicians have called for regular audits of stablecoin issuers and imposition of bank-like regulations. Regulators will want to track companies issuing stablecoins to ensure the issuer actually has adequate reserves and that the entity is stable.

US President’s Working Group on Financial Markets Report

In November 2021, the President’s Working Group on Financial Markets (PWG) issued a report describing a proposed regulatory framework for stablecoin. The PWG noted that although stablecoins are primarily used to facilitate the trading of other digital assets, they could in the future be used more widely by households and businesses. The PWG recommended that Congress enact legislation to ensure that stablecoins are subject to a federal framework on a consistent and comprehensive basis, complementing existing enforcement authorities with respect to market integrity, investor protection, and illicit finance. Specifically, they recommend:

Requiring stablecoin issuers to be insured as depository institutions to mitigate risks to stablecoin users and to protect against stablecoin runs.
Require custodial wallet providers to be subject to appropriate federal oversight to address concerns about payment system risk. The PWG recommended that Congress provide the federal supervisor of a stablecoin issuer authority to require any entity that performs activities that are critical to the functioning of the stablecoin environment to meet appropriate risk-management standards.
Require stablecoin issuers to comply with restrictions that limit affiliation with commercial entities, thus alleviating concerns about systemic risk and concentration of economic power. Furthermore, the PWG encouraged Congress to consider implementing limits on issuer affiliation with commercial entities, and on the use of users’ transaction data by custodial wallet providers.

Additionally, the US Treasury stated its intent to continue to lead efforts within the Financial Action Task Force to encourage countries to implement international Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) standards, and to pursue additional resources to support oversight of domestic AML/CFT regulations.

Her Majesty’s Treasury Report

In April 2022, Her Majesty’s Treasury (HM Treasury) issued a report on the UK’s regulatory approach to crypto-assets, stablecoins, and distributed ledger technology in financial markets. The report confirmed the UK government’s intent to take legislative steps to issue or facilitate the use of stablecoin as a means of payment within the UK regulatory perimeter by amending existing electronic money and payments legislation. HM Treasury’s rationale was that stablecoins have the potential to become a widespread means of payment, driving customer choices and transactional efficiencies. The HM Treasury’s report includes proposals to:

Amend the Electronic Money Regulations 2011 and Payment Service Regulations 2017 to deliver a consistent framework to regulate stablecoin issuance and the provision of wallets and custody services.
Extend the applicability of Part 5 of the Banking Act 2009 to include stablecoin activities, especially in cases where the risks posed have the potential to be systemic, as well as to ensure that the threshold for Bank of England supervision is met. For entities authorized by the Financial Conduct Authority and recognized under the Banking Act, the Bank of England will be the lead prudential authority.
Extend the scope of the Financial Services (Banking Reform) Act 2013 to ensure relevant stablecoin-based payment systems are subject to competition regulation as overseen by the Payment Systems Regulator.

New York Department of Financial Services Regulation

On 8 June, 2022, the New York Department of Financial Services (NYDFS), which oversees regulated crypto-companies in New York, published a series of requirements for US dollar-backed stablecoin issuers operating in the state. This is the first guidance issued by a state regulator. NYDFS currently has regulatory authority over the issuers of three of the six largest, centralized, US dollar-backed stablecoins in circulation, which collectively account for approximately 13% of circulating US dollar-backed stablecoins globally. Their authority also extends to three of the 12 largest US “dollar-pegged” stablecoins in circulation, which account for about 12% of circulating US dollar-pegged stablecoins globally.

The intent of the guidance is to enhance consumer protection and institutional soundness. Under this guidance, all NYDFS regulated virtual currency businesses are required to receive approval from the NYDFS for any new products, including the issuing of stablecoins, and, in particular, US dollar-backed stablecoins licensed under 23 NYCRR Part 200 (a BitLicense) or chartered as limited purpose trust companies under the New York Banking Law. The “Guidance on the Issuance of US Dollar-Backed Stablecoins” outlines reserve, redemption, and disclosure requirements for US dollar-backed stablecoins issued by DFS-regulated virtual currency entities.

Reserve Guidance: Stablecoins must be backed by a reserve composed of US Treasury bills with less than three months to maturity, US Treasury notes, some types of US Treasury bonds, or reverse repurchase agreements that are collateralized by Treasury bills. This means that the market value of the reserve must be at least equal to the nominal value of all outstanding units of the Stablecoin at the end of each business day. These assets are segregated from the issuer’s operational funds, and regularly reviewed by an auditor.
Redemption Policy: Clear, conspicuous redemption policies must be implemented that allow the owner the ability to redeem stablecoin units from the issuer in a timely manner, which is characterized as no more than two business days from the time the issuer receives a “compliant redemption order.” However, there are exceptions to this requirement for “extraordinary circumstances” in which timely redemption would jeopardize the reserve’s asset-backing requirements or orderly liquidation of reserve assets.
Attestation Policy: The reserve must produce a monthly report, made available to the public and delivered to the NYDFS within 30 days following the end of the covered period. The report, which must be reviewed by a US-licensed CPA, requires an attestation as to management’s assertions on the last business day of the covered period, and at least one randomly selected business day during that period, with respect to:

“the end-of-day market value of the reserve, both in aggregate and as broken down by asset class;
the end-of-day quantity of outstanding stablecoin units;
whether the reserve was, at these times, adequate to fully back all outstanding stablecoin units;
whether all DFS-imposed conditions on the reserve assets have been met.”

Stablecoin issuers must demonstrate compliance with these regulations by 8 September, 2022, except for the annual attestation, which the issuers must complete in a reasonable time period as determined by the NYDFS. Furthermore, issuers must also obtain an annual attestation report, prepared by a CPA applying the standards of the American Institute of Certified Public Accountants, attesting to the management’s assertions concerning the effectiveness of internal controls, structure, and procedures for compliance with the requirements of the monthly attestation. The report must be delivered to the NYDFS within 120 days of the covered period, but does not have to be made public, as does the monthly CPA report.

What Does this Mean for You?

US and international regulators are increasingly looking to regulate the crypto space, especially in light of the TerraUSD/Luna fiasco. According to Treasury Secretary Janet Yellen, the TerraUSD/Luna crash was too small to threaten the whole financial system, but as she notes, stablecoins are “growing very rapidly, they present the same kinds of risks that we have known for centuries in connection with bank runs.” Nevertheless, the TerraUSD/Luna crash will likely lead to a demand for use of dollar-backed or over-collateralized stablecoins, as opposed to algorithmic-based counterparts. As stablecoins become widespread in the commercial/retail space, their associated risks grow. Entities with connections to stablecoins should, therefore, continue to monitor any new and developing regulations as they relate to stablecoins.

Call to Action

As regulations relating to stablecoin continue to evolve, Guidehouse will keep its clients apprised of regulatory changes pertinent to their businesses. Guidehouse can also help assess current compliance with regulations, frameworks, and guidance, and also serve to anticipate upcoming regulatory developments.

Special thanks to Laila Lapins for co-authoring this article.

¹^{Board of Governors of the Federal Reserve System, “Financial Stability Report.”}