Stablecoin stability and regulation

TerraUSD debacle

In early May 2022, the stablecoin TerraUSD (UST) suddenly crashed, losing its peg to the US dollar.

I define “stablecoin,” a term without a clear consensus definition, as a store of value and/or medium of exchange that aims to maintain parity with a fiat currency and is used on a permissionless blockchain. I classify stablecoins as fiat-backed, crypto-backed or algorithmic based on the mechanism by which they seek to maintain a stable value. Fiat-backed stablecoins are backed by safe financial assets such as bank deposits or government bonds and guaranteed by their issuer to be redeemable on demand. Crypto-backed stablecoins aim to maintain a stable value through overcollateralization with cryptoassets in accord with an issuance protocol. Algorithmic stablecoins rely on arbitrage against other cryptoassets to maintain a stable value.

UST was an algorithmic stablecoin. Specifically, it was structured to maintain a stable value through arbitrage against LUNA4), a second cryptoasset governed by the Terra issuance protocol. The Terra ecosystem attracted capital inflows by developing various UST-based services, including the Anchor lending/borrowing protocol, which offered a 20% APR to lenders. However, whales drove down UST’s value by liquidating their holdings. In response, arbitrageurs exchanged UST for LUNA, leading to massive LUNA issuance. In other words, the mechanism that was intended to maintain a stable exchange value between UST and LUNA ended up triggering a hyperinflationary death spiral.

Regulatory approaches

Countries around the world are building stablecoin regulatory regimes that revolve mainly around stabilization mechanisms and AML/CFT compliance. Specific approaches vary among countries. Japan was an early mover in the space, regulating stablecoins ahead of the eurozone and US with a 2016 amendment of its Payment Services Act. Japan initially regulated stablecoins as “currency assets,” not cryptoassets, until stablecoins were redefined as “electronic payment instruments” earlier this year by another amendment to the Payment Services Act. This latest amendment has enabled issuers and intermediaries to be regulated separately in light of actual practices in stablecoin ecosystems. While stablecoins are assumed to be backed by financial assets, particularly bank deposits, issuers cannot reasonably expect to earn an appreciable return on such collateral with domestic interest rates as low as they are today across their entire term structure. Intermediaries are permitted to provide value transfer services. Doing so at commercial scale, however, entails more than a few challenges, including of course compliance with AML/CFT requirements.

The EU’s regulatory approach is to lump stablecoins together with other cryptoassets under its yet-to-be-finalized Markets in Crypto-Assets (MiCA) directive unveiled in 2020. In late June 2022, the EU Council presidency and European Parliament finally reached a provisional agreement on MiCA. Under MiCA, cryptoassets that seek to maintain a stable value by referencing a single fiat currency are defined as “electronic money tokens.” In contrast, cryptoassets that reference a basket of fiat currencies, one or more commodities and/or one or more other cryptoassets are defined as “asset-referenced tokens” (ARTs). MiCA has separate sections devoted to ARTs and electronic money tokens, neither of which would be able to be issued or circulated within the EU without prior regulatory approval. Other matters addressed in detail by MiCA includes issuers’ obligations, collateralization and a prohibition against interest-bearing tokens. The process of effectuating new regulations in the EU normally involves publication of regulatory technical standards in addition to finalization of the regulations’ text. Cryptoasset issuers and service providers consequently still do not have complete clarity on MiCA’s details.

The US has yet to adopt regulations pertaining solely to stablecoins. Stablecoins have so far been issued and used in the US pursuant to federal AML/CFT laws and state laws governing stablecoin issuance and circulation. In response to the stablecoin market’s recent explosive growth, the President’s Working Group on Financial Markets issued a November 2021 report recommending legislation requiring stablecoin issuers to be insured depository institutions.

Under a bipartisan bill introduced in the U.S. Senate in June 2022, the month after TerraUSD imploded, digital assets, defined as natively electronic assets that are recorded using distributed ledger or similar technology, would be classified in three categories: (i) virtual currencies, (ii) payment stablecoins or (iii) other securities and commodities. Additionally, the bill assumes that only depository institutions would be permitted to issue or redeem payment stablecoins and conduct activities incidental thereto. The Office of the Comptroller of the Currency, which has supervisory authority over federally chartered banks, would be charged with deciding whether to grant depository-institution status to trust companies already active as stablecoin issuers and state-licensed stablecoin issuers/service providers in the aim of ensuring adequate market competition. The bill appears to endorse the view that entities that perform bank-like functions such as providing payment instruments should be regulated like banks. Lastly, virtual currencies include digital assets intended to trade at a stable value (relative to a fiat currency), like the aforementioned crypto-backed and algorithmic stablecoins. How US regulators decide to treat such virtual currencies bears watching going forward.