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Regulators are coming to stablecoins, but where should they start?

The word “stablecoin” can have a pleasant buzz – isn’t it nice to have something stable in volatile crypto? – but for critics they are nothing more than a ticking time bomb. Whether that’s true or not, the pressure to regulate stablecoins is growing. The United States and the European Union are nearing the formalization of their playbooks and have a history of financial regulation that stretches back to Washington and Brussels, as well as the Financial Action Task Force’s guidance on financial regulation saying the rest of the world will follow suit.

However, regulating stablecoins is not an easy task as such coins come in all shapes and sizes, making a one-size-fits-all solution a problem. The three largest stablecoins by market capitalization – Tether (USDT), USDCoin (USDC) and Binance USD (BUSD) – are all pegged to the US dollar. According to their respective developers, they are backed by reserves of greenbacks and various financial instruments to always keep their value at $ 1.

Tether has undergone regulatory scrutiny for profitability and reserves, prompting two other projects to disclose their respective supporting assets. The USDC disclosure, for its part, highlights a significant amount of commercial paper – not necessarily high quality or high liquidity – in their respective reserves. For many, the disclosure led to the conclusion that the company was operating as a bank rather than a payments company.

Other, lesser-known stablecoins use many alternative approaches. They can be tied to commodities like gold or oil, like Venezuela’s controversial Petro. More exotic options include carbon-linked coins such as UPCO2, crypto-asset-backed coins such as Dai, and perhaps least of all stablecoins such as Terra (UST) have no collateral and instead rely on algorithms to provide the To keep prices stable.

Of course, some might say that regulation will only slow down innovation, so governments should stay out of the crypto wave, but this argument lacks historical context. Before that, in the era of savage banking, private currency issued by rogue banks often cost buyers with worthless paper, making the greenback considered the only currency in the United States. The same logic applies to the 2008 money market fund crisis, when federal agencies introduced new rules to protect Regular Joes from longtime investors who made large sums of money on their investments.

As a society, we find time and again that consumers need to be protected from fraud or simply wrongful judgments by custodians, value transferors or provide similar services. We have put in place rules and regulations governing who can spend and redeem money, we have written a handbook for money processors who, if handled incorrectly, can create shock waves across the economy. Why shouldn’t we do the same with stablecoins, a market with a total capitalization of over $ 133 billion? It just doesn’t make sense to let a cryptocurrency bank’s sword of Damocles hang over the heads of investors and traders. So where do we start?

One-to-one approach

The best way to start regulating stablecoins is to establish rules and protocols to make sure they meet your needs. Christine Lagarde, Director of the European Central Bank, said in a recent interview that stablecoins must be supported by Fiat 1: 1, adding that the projects behind the issue of stablecoins candlesticks:

“[…] tested, monitored and managed so that consumers and users of such devices are really protected against possible misrepresentations. “

The EU has a long history of electronic money institutions (EMIs) that can issue and redeem digital euros, and these institutions return their digital euros using real euros held in a bank or, in some cases, a central bank. This could be an example of regulators in other jurisdictions seemingly going in the same direction.

Here we can draw parallels with capital requirements for banks or payment companies like EMI to ensure stablecoin users can exchange their funds for fiat at any time through the minted company. For reference, one of the most important ways banks make money is by lending other people’s deposits. The process should be simple to ensure that the bank has enough reserves to cover customers who might want to withdraw their funds, but not necessarily 1: 1 for all active deposits.

For a stablecoin issuer, selling their coins for fiat can technically be like receiving a deposit, but the question is what do they do with the money next? When she lends, she is engaged in banking. When it processes a transaction, it processes payment transactions. When it invests money in high-yield assets, technically it passes jobs on to a broker or works as a broker itself. Here, too, as a company, we have entrusted the management of these activities to the supervisory authorities.

Related: Stablecoins are being scrutinized: USDT stands for “Commercial Paper” -Tether

Accordingly, in the case of stablecoins, the regulatory authorities must first define transparency standards for issuers, which must define the financial activities they carry out, such as banks, goods and payment companies. Money market funds can be a good benchmark here. It is only reasonable to expect any stablecoin issuer to issue a report on their holdings, including the companies that have issued certain securities and their numbers, if any. Without this, there is simply no way for stablecoin users to be sure that their assets are actually worth.

For stablecoins tied to more exotic assets, the basic rule should be the same: they need to be able to demonstrate that the asset they claim is behind the coin. But there we jump straight into a deep, deep rabbit hole. For example, a commodity-backed stablecoin is de-jure, a commodity-based investment contract, and should be regulated as such, not in any way as “money”. And algorithmic stablecoins have a harder time integrating into the regulated world.

Outer edge

Algorithmic stablecoins are not as big as fiat-secured stablecoins. TerraUSD, which is pegged to the US dollar but technically has no underlying security, is the fifth largest stablecoin, according to CoinMarketCap, and the ETH-backed DAI is the fourth largest stablecoin. Tether makes up about half of the total market capitalization of stablecoins.

From a regulatory perspective, algorithmically secured stablecoins and cryptocurrencies are currently not as closely tied to the traditional financial system as those that hold conventional financial instruments in their reserves. Such coins are often fully integrated into the larger cryptocurrency ecosystem or its network. However, given the size and activity of these organizations – in essence, the transfer of value is not always subject to the rule of law – they, like other stablecoins, deserve to be the linchpin of regulators.

As an open and unchangeable ledger, the blockchain is open to audits and thus mostly to the smart contracts that drive such projects. Assuming an identity can be assigned to a wallet, transparency is not necessarily an issue. One problem, however, is at least potentially in stimulating the imagination of the units used for traditional financial processing while encouraging crypto projects to find solutions to comply with the rules of our society.

In theory, regulators could do whatever it takes to set a standard for integrating automated reports and audits into the code that powers the coins. In fact, something like this raises questions about a broader regulatory framework for such cryptocurrencies. Many governing bodies are also working on this playbook, but there is still a long way to go to complete it.

Related: Stablecoins pose a new dilemma for regulators as mass adoption emerges

With a clear focus on fiat-backed giants like Tether, the first task is to categorize them by activity (payments, banking, investments) and apply the necessary licensing requirements accordingly. Algorithmic stablecoins will most likely get into a regulatory limbo until the powers that be determined whether they’re commodities or even banned outright – either forcing them to choose between conforming to regulations or marginalizing.

Anyway, it is clear that stablecoins are facing a rude awakening from regulators around the world, and rightly so. With market capitalization soaring, stablecoins …

Annie

Championing positive change through finance, I've dedicated over eight years to sustainability and environmental journalism. My passion lies in uncovering companies that make a real difference in the world and guiding investors towards them. My expertise lies in navigating the world of sustainable investing, analyzing ESG (Environmental, Social, and Governance) criteria, and exploring the exciting field of impact investing. "Invest in a better future," I often say. That's the driving force behind my work at Coincu – to empower readers with knowledge and insights to make investment decisions that create a positive impact.

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