Regulators want to regulate stablecoins, but where do they start?

Stablecoins are like a curiosity in the crypto room. It is quite interesting that in the volatile digital currency world there is a currency of stable value. But for critics they are nothing more than a ticking time bomb. Whether that’s true or false, calls for stablecoin regulation are heating up. The US and European Union are nearing formalization of their regulation and with a history of financial regulation dating back to Washington and Brussels, as well as the Financial Task Force’s guidelines on cryptocurrency deaths in recent years, it is safe to say that the rest the world will follow suit.

On the other hand, one has to understand that regulating stablecoins is not an easy task as such coins come in different colors. This makes a one-size-fits-all solution a dilemma. The three best stablecoins by market capitalization USDT, USDC and BUSD are all pegged to the US dollar. According to their developers, they are backed by the greenback and support various financial instruments to always keep the value at $ 1.

Tether is under regulatory scrutiny for profitability and reserves, prompting the other two projects to disclose their respective backing assets as well. The USDC disclosure indicates that there is a significant amount of commercial paper – not necessarily high quality or high liquidity – in reserve. For many, the reveal led to the assumption that the company operated 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. There are also other exotic options like coins linked to carbon credits (e.g. UPCO2), coins backed by cryptocurrencies like Dai, and perhaps least of all stablecoins like Terra (UST). .

Of course, some might say that regulation will only slow down innovation, so governments should stay out of the crypto wave, but this argument is flawed given the historical context. Before that, during the banking turmoil, private currencies issued by rogue banks often resulted in shoppers buying worthless banknotes, keeping the greenback as currency, the only national currency in the United States. The same logic applies to the money market fund crisis of 2008, when federal authorities introduced new rules to protect ordinary people from the long-time investor who made a lot of money from it.

Time and time again, society finds that users need to be protected from fraud or simply poor judgment by custodians transferring value or providing services. Authorities in the United States and many other countries have put in place rules and regulations to regulate who can spend and redeem as money, and they have also written guidelines for traders. Money handling with numbers can create shock waves across the economy, if it’s done wrong. Why hasn’t anyone done the same with stablecoins, a market with a total capitalization of over $ 140 billion? There was just no reason to stop a crypto bank from pushing investors and traders into the situation. So where do we start?

1: 1 approach

The best way to start regulating stablecoins is to put in place rules and protocols to make sure they work as per your requirements. Christine Lagarde, President of the European Central Bank, said in a recent interview that stablecoins must be supported in a 1: 1 ratio by Fiat and stablecoin issuance projects “… should be checked, monitored and managed so that users and users of such devices” really should prevent misrepresentation can be guaranteed “.

The EU has a long history of e-money institutions (EMI) that can issue and redeem digital euros. These institutions exchange their digital euros for real euros that are 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.

This is where we can compare the capital requirements for a bank or payment company like EMI to ensure stablecoin users can exchange their coins for fiat at any time through the company that minted them. One of the most important ways banks make money is by lending other people’s deposits. This process should be simple to ensure that the bank has enough reserves to pay the customers who want to withdraw, but not necessarily 1: 1 for all active deposits.

For a stablecoin issuer, technically selling the coins for fiat can be the same as withdrawing the deposit, but the question is what do you do with the money next? When it comes to lending, it is banking. When processing transactions, it is based on payment processes. Technically, if you want to buy high-yield assets, you have to pass orders to a broker or work as a broker. In this context, too, the company has entrusted the management of these activities to the governing body.

In the case of stablecoins, the supervisory authorities must first set a transparency standard for issuers so that they can clearly identify the financial activities they carry out, just like banks and payment companies. Money market funds can be a good benchmark here. It only makes sense for every stablecoin issuer to report on their holdings, including the companies that have issued certain securities and the amount. Without this, there is simply no way for stablecoin users to be sure that their assets will have actual value.

For more exotic asset-linked stablecoins, the basic rule should be the same: they must be able to demonstrate that they are backed by the asset they claim to be. But that brings us to another difficulty. For example, a regulated commodity-backed stablecoin, a commodity-based investment contract that should be regulated as such, is in no way “money”. And algorithmic stablecoins have a harder time integrating into the regulated world.

Non-fiat stablecoins

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. USDT now accounts for roughly half of the total market capitalization of stablecoins.

Stablecoin Market Cap | Source: CoinGecko

From a regulatory perspective, algorithmically secured stablecoins and cryptocurrencies are currently not as closely linked to the traditional financial system as those that hold conventional financial instruments in their reserves. Such coins are often only used within the larger cryptocurrency ecosystem or their network. Given the size and performance of these organizations – but essentially the transfer of value is not always regulated – they deserve to be kept on the radar.

As an open and immutable ledger, the blockchain is public for audits and therefore such projects are often supported by smart contracts. Assuming an identity can be associated with a wallet, transparency is not necessarily an issue. Although it may be a problem that arouses interest in companies handling traditional finances while encouraging crypto projects to find solutions to suit our social distribution.

In theory, regulators could try to set standards for integrating automated reports and audits into the code that powers the coin. In fact, this begs the question of a larger regulatory framework for cryptocurrencies. Many regulators are also working on this aspect, but it is far from finished.

With a clear focus on fiat-backed giants like Tether, the first agenda is to categorize them by activity (payments, banking, investments) and apply the required permits accordingly. Algorithmic stablecoins will most likely get into a regulatory limbo until authorities decide whether they’re commodities or even banned altogether – both of which will force them to choose between conforming to regulations or marginalizing them.

Anyway, it is clear that stablecoins are facing strong warnings from regulators around the world. With market capitalization skyrocketing, stablecoins are one of the …