How Can Stablecoins Scale to Reach the Next Milestone?
The recent collapse of the stablecoin TerraUSD, or UST, and its sister token Luna wiped out a market capitalization of around $60 billion in a matter of days. Investors have been affected. Treasury Secretary Janet Yellen has called for regulation of stablecoins, citing risks to financial stability. Others have argued that this type of failure should be allowed as part of innovation.
The type of risks that TerraUSD posed through an algorithmic indexing mechanism – “death spiral” risks – were nothing new. Yet, these risks have manifested due to a lack of regulatory framework on stablecoins. Why has stablecoin regulation been such a challenge in the US? The answer may lie in the mixed uses of stablecoins.
Stablecoins are digital tokens designed to hold a stable value against fiat currency or commodities. Although they all have the fundamental objective of maintaining a stable link with their reference assets, stablecoins differ significantly in their design, use, liquidity and risk profile depending on their reserves.
Some stablecoins were designed to serve as a digital medium of exchange on decentralized exchanges to allow users to trade cryptocurrencies or arbitrate differences between exchanges. Others were designed to make fast and cost-effective payments, manage short-term cash like money market funds, or bet on annual returns of more than 20% like risky bonds.
When these use cases are analyzed individually, most people understand which federal regulator should be responsible and which rules should govern. But today’s stablecoins, while designed with one primary use case in mind, can often be used for other secondary purposes discussed above. Therefore, the resemblance of stablecoins to multiple asset classes and their mixed uses has caused confusion among regulators and investors.
Are single-use stablecoins necessary?
Are stablecoins disappearing? Unlikely. The functions of stablecoins are desirable – some might even say necessary – for decentralized protocols given the volatility of other cryptocurrencies. What could alleviate regulatory confusion and propel stablecoins to the next stage in the absence of a digital asset bill from Congress? One solution may be single-use stablecoins.
At first glance, this may seem like a step backwards, but industry experts agree that increased regulation has been a major impediment to institutional adoption of stablecoins. The total market cap of stablecoins was $180 billion just before the collapse of the UST – a significant number for a relatively new asset class – but dwarfed by the market cap of the asset classes the coins are with. stablecoins are competing with or looking to replace, such as money market funds, which was recently around $4.5 trillion.
In managing their short-term liquidity, institutions had clearly not been keen on trading their 0.5% yield for the 5%+ yield of stablecoins, even though some stablecoins are backed by stablecoins. high-quality assets that rival the underlying assets of some money market funds. Regulatory uncertainty has been a major reason for this lack of institutional adoption – banks and asset managers have an obligation to protect customer assets and cannot reasonably transfer customer money to a an instrument that lacks regulatory clarity for short-term liquidity purposes.
Given the progress of stablecoins to date, there should be enough incentive for the industry to look into single-use stablecoins to capture potentially greater institutional adoption. Imagine if an issuer created a stablecoin dedicated to money market funds (MMF stablecoin). There should be little regulatory uncertainty as to who would regulate this instrument – the SEC – and what rules should apply – the federal securities laws and the Investment Company Act of 1940. An issuer of MMF stablecoins probably wouldn’t have to be an insured depository institution.
The benefits of blockchain (e.g. faster settlement, greater transparency, potential ease of implementing swing pricing) would be an improvement over the traditional money market fund. And if an MMF stablecoin issuer wants to create another fiat-like payout stablecoin years later when they are ready to adopt additional banking or money transfer regulations, they could do so at their own pace. with greater regulatory certainty, as the new product would likely not be integrated with its existing stablecoins.
To be clear, these single-use stablecoins don’t need to sacrifice interoperability. An MMF stablecoin should be allowed to trade with another MMF stablecoin on another blockchain or even with a payout stablecoin. But not all of them are required to maintain 1:1 parity at all times (for exampleinstitutional MMF stablecoins might be allowed to “break the ball” from time to time) as they serve different purposes, so their uses would all be individually optimized and regulated as such.
Today’s stablecoins make regulations harder than they should be. Single-use stablecoins may make it easier for regulators to enforce existing rules, remove regulatory uncertainty faster, and help the industry achieve greater institutional adoption.
Some crypto proponents argue that these technologies are different and that existing laws are too outdated to address them. This may be true for a handful of applications – regulators may need to distinguish between providing investor protection and not imposing the full set of regulatory burdens designed for mature financial products on those products and their uses in a way to stifle innovation. But the vast majority of blockchain applications achieve the same goals as their predecessors, only more efficiently. The behaviors and incentives of these market participants are always the same, something that US federal securities laws and financial regulations are able to address.
If USTs were single-use stablecoins that had to be registered as junk bonds, perhaps some retail investors would have been spared losing their life savings.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Noah Qiao is a partner at Kirkland & Ellis LLP. He is a key member of the firm’s crypto advisory practice and has advised clients on navigating the rapidly changing crypto regulatory landscape. He is also an adjunct professor at Cornell Law School, where he teaches a course on cryptography regulation.