Stablecoins have proven to be an invaluable asset in the cryptocurrency world and are quickly becoming the backbone of the space.
Defined by the U.S. Department of the Treasury as “digital assets that are designed to maintain a stable value relative to a national currency or other reference assets”, the features of sound money (medium of exchange, store of value, unit of account) appear to have been successfully transplanted into cryptocurrency.
It certainly looks like the perfect marriage — we now have cryptocurrencies of wide acceptance and price-stability, which at the same time boast the speed, lower costs, and financial inclusion that distributed ledger technology brings.
However, being relatively new and having burnt so brightly and quickly, stablecoins have (as with anything crypto-related) brought about their own set of issues. Governments and regulators have only just begun to outline these problems and draw up action plans for them. Apart from large financial risks, legal complications are also on the rise. The pace and scale at which cryptocurrencies and stablecoins have developed now require all parties involved to pay full attention to the pitfalls in order to chart the best way forward.
Financial Risks of Stablecoins
Stablecoins come in various forms, though they mostly fall under 4 categories: fiat-collateralized (e.g. USDT, USDC), crypto-collateralized (e.g. DAI), algorithmic (e.g. UST), and commodity-collateralized (e.g. PAXG). No matter the type, the sanctity of a stablecoin naturally lies in its ability to remain properly pegged to its reference asset. Failure by a stablecoin to do so will almost certainly see its demise.
Loss of Value
With peg failure, holders of a stablecoin can expect to bear substantial loss. What recently happened with Iron Finance is likely the most high profile example, with its TITAN token falling from a high of $65 to almost zero. More than $2 billion was lost in the total value locked in the protocol as design flaws around the lack of a stabilizing mechanism were exposed. Even sophisticated investors like Mark Cuban were not spared in what the Iron Finance team described as “the world’s first large-scale crypto bank run”.
Wider Impact on Market
Aside from investors incurring losses when a stablecoin fails, greater adverse effects can also ripple throughout the rest of the market.
One need only look at the recent troubles faced by Tether (USDT) to imagine the scale of a potential fallout. Issued by Tether Limited, an entity controlled by owners of the Bitfinex exchange, much controversy has surrounded whether USDT is fully backed by reserves. Just last month, the U.S. Commodity Futures Trading Commission found that “Tether misrepresented to customers and the market that Tether maintained sufficient U.S. dollar reserves to back every USDT in circulation with the ‘equivalent amount of corresponding fiat currency’ held by Tether and ‘safely deposited’ in Tether’s bank accounts”.
At the time of writing, USDT is ranked 4th in terms of market cap across all cryptocurrencies, sitting at around US$73 billion. Amongst the stablecoins, it sits a comfortable 1st. Given its large total value and widespread use, a run on USDT would certainly have far-reaching consequences.
Regulators are therefore scrutinizing stablecoins, and for good reason. Speaking at the 2021 edition of the Singapore FinTech Festival, Managing Director of the Monetary Authority of Singapore (“MAS”) Ravi Menon raised concerns on stablecoins issued by private entities:
“But are capital market rules sufficient to ensure reserve backing is really there behind these stablecoins? We don’t know. Stablecoins can potentially pose financial stability risks. For example, if there is a run on a significant issuer of a stablecoin, there could be contagion risks to financial markets should the reserve assets be rapidly liquidated.”
Some believe that a USD Central Bank Digital Currency (“CBDC”) could be the answer to the USDT problem. U.S. Federal Reserve Chair, Jerome Powell, stated in September that the U.S. central bank is “working proactively to evaluate whether to issue a CBDC and, if so, in what form”.
Potential Threat to National Financial Systems
But a USD CBDC may not be music to everyone’s ears. Taking an even broader view, stablecoins (CBDCs or otherwise) could also pose threats at a national level to governments, specifically the financial systems built upon the fiat currency issued by their central banks.
As recently recognized by the MAS in its report considering the issuance of a CBDC in Singapore:
“While it remains a tail risk for now, a scenario where foreign currency use picks up significantly in Singapore, cannot be ruled out. Large global platforms utilising a foreign digital currency as the medium of exchange could offer cheaper, faster and more seamless transactions, thereby attracting merchants and consumers in Singapore to switch into it. Moreover, there are means by which BigTech companies could leverage their commercial or social media platforms and networks to actively scale adoption of their preferred non-Singapore dollar digital currency… Policymakers globally are increasingly recognising the risks that new forms of digital money could pose to the monetary and financial stability of smaller, open jurisdictions.”
Legal Risks of Stablecoins
Further to financial dangers surrounding stablecoins, regulators are also concerned about a variety of legal issues.
Recently, the President’s Working Group on Financial Markets (“PWG”) in the U.S. led a study on stablecoins, highlighting several hazards (both legal and financial) and suggesting courses of action to manage them. Reading the resulting report in full is recommended for a comprehensive understanding of the risks. The next few sections of this article pulls out the key legal concerns.
Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT)
From a compliance perspective, AML and CFT concerns are rife throughout the cryptocurrency space. Stablecoins naturally pose the highest risk.
Given the scale and speed at which stablecoins develop and continue to be adopted, risks are amplified due to gaps created by an “uneven implementation of global international AML/CFT standards developed by the FATF”:
Illicit actors can exploit these gaps by using services in countries with weak regulatory and supervisory regimes to launder funds, store proceeds of crime, or evade sanctions in stablecoins or other digital assets.
To combat this, the PWG calls on the FATF to actively engage member countries to effectively implement its standards. It would also be important to bring about “mass adoption of a well-regulated and supervised stablecoin with strong AML/CFT protections”. This is of course a lofty ambition, and one that may not occur in the near future. Whilst a USD CBDC may well fit this bill, Jerome Powell has mentioned that it is “more important to do this right than to do it fast”.
Anti-Competition
With each year, there is increased scrutiny on anti-trust and competition laws around the world. It seems these concerns are also applicable to stablecoins. The PWG report highlights the dangers of “excessive concentration of economic power”, particularly where a stablecoin issuer is tied to a commercial entity, with potential “detrimental effects on competition” and “market concentration in sectors of the real economy”.
Anti-competitive effects could also present themselves should there be “undue frictions or costs in the event [users] choose to switch to other payment products or services”. A lack of interoperability between different stablecoins would only serve to exacerbate the problem.
The PWG suggests limiting the affiliation of issuers with commercial entities, and for regulators to require implementation of interoperability standards between stablecoins. Another proposal involves restrictions on the use of user transaction data on providers of custodial wallets.
Lack of Regulation
Above all, the PWG observes that “stablecoin arrangements are not subject to a consistent set of prudential regulatory standards”. The number of players involved in a particular stablecoin arrangement, together with operational complexity, make things even more difficult for regulators. The report makes an obvious point:
[A] consistent and comprehensive regulatory framework is needed both to increase transparency into key aspects of stablecoin arrangements and to ensure that stablecoins function in both normal times and in stressed market conditions.
Moving Forward
Stablecoins, particularly fiat-collateralized ones, appear to go directly against the rallying cry of decentralisation. Yet, they have become firmly embedded in the cryptocurrency ecosystem and will continue to serve as an important bridge between the old and new financial worlds.
Lawmakers and regulators will have to remain nimble for their jurisdictions to stay on course. In Singapore, the MAS is currently reviewing whether the existing regulatory framework around the Payment Services Act remains suitable in the stablecoin context. Part of the review examines the “scope of e-money and [Digital Payment Tokens], and whether their definitions remain appropriate in view of the emerging class of stablecoins”.
The country’s approach is a forward-looking one that is also careful and considered. MAS Chairman, Tharman Shanmugaratnam, holds the view that “the future will be one where regulated stablecoins will have a useful role in a traditional payment system that innovates and becomes more inter-operable across borders for cheap, fast and instant payments.” Managing Director Ravi Menon shares a similar sentiment — “[w]e have to approach… with flexible regulatory chains which will allow us to harness its potential benefits but can be tightened quickly if the beast threatens to breath fire.”
As the cryptocurrency world furiously marches on, commercially sensible legislation will be key. It is of course difficult to strike the right balance, but the growing stablecoin phenomenon means it requires immediate attention. Legislators now face the unenviable task of having to do it both right and fast.