The capitalization of the stablecoin market has been booming for several years and represents more than 140 billion dollars, with a spectacular growth of 30 billion in 2021.This rapid development is attracting the attention of regulators who have repeatedly announced their desire to expand financial supervision since Facebook announced Libra in 2019.
Many discussions about the regulation are on their way, both in the U.S. and Europe, which will fundamentally transform the ecosystem. Tether’s setbacks and the debt crisis of real estate developer China Evergrande have renewed attention on the regulation claims of these stablecoins. A transparent regulatory framework will accelerate the development of stablecoins industry and democratize it in an even broader way, exploiting their full potential.
In this sense, Lugh wants to position itself as a pioneer and driver in the creation of a reliable euro stablecoin.
Why and how ?
The growing adoption of stablecoins is creating new financial risks that concern regulatory agencies. What are they?
Loss of value
A stablecoin seeks to approximate the value of a fiat currency through a various mechanisms that range from simple cash hoarding to the use of mathematically based algorithms. However, the stability of a token can be undermined by the use of illiquid reserve assets or assets whose prices may fluctuate. Operational risk related to cybersecurity and the protection of stored assets is also a concern.
A full-blown panic may ensue if a stablecoin does not allow for immediate redemption of a fixed amount of fiat currency. It prevents a bank run on a stablecoin that would ruin individuals and endanger the financial sector that regulators want to legislate. A stablecoin is only effective if its value can be trusted. So it seems crucial to use safe, liquid, and stable collateral to meet withdrawal demands, especially in a bear market.
In September, Billionaire investor Mark Cuban called for urgent regulation of stablecoins after losing money in what he called a “bank run” on the dollar stablecoin IRON. The token failed to withstand a massive sale of its native token, which was collateral. The stablecoin is worth almost zero dollars, and many users have been ruined.
“if account holders begin to have concerns that they cannot get money out, they might try and trigger a bank run.”
Lee Reiners, former supervisor at the Federal Reserve Bank of New York
Systemic risk
An unregulated stablecoin issuer could create a systemic risk if it fails. This risk would affect the entire economy, given the rapid growth of this sector. That’s why the DeFi boom has financial regulators worried since the summer of 2020.
States also seek to ensure healthy competition among these private issuers. Excessive concentration worries the authorities. If one stablecoin is widely adopted and prevents users from moving to other protocols by creating friction, it would threaten competition. Regulators are stressing the need for true interoperability between the various projects to protect users.
The traditional banking sector is also lobbying to encourage governments to act. Banks consider that these new protocols are subject to the same financial risks and should be subject to the same rules.
When you think that the banking industry is one of the most regulated globally, it is hard to see states not addressing this issue.
Stablecoins could one day become competitors to traditional payment networks. Governments will not allow unregulated stablecoins to flourish, as they could build a parallel fiat currency economy and jeopardize the entire economy if they fail.
U.S. regulation will kick in before 2023
Facebook’s 2019 announcement of the Libra launch was the initial catalyst that alerted policymakers. Since then, there has been a call for more regulation from both federal agencies and the Treasury. SEC Chairman Gary Gensler, FED Chairman Jerome Powell, and Janet Yellen have repeatedly shown interest in stricter regulation.
In November, a working group (PWG) composed of the SEC, the FED, the CFTC, and the Treasury published a report that stablecoin regulators will undoubtedly use. It contains many recommendations for Congress.
The report urgently calls on Congress to limit the issuance of stablecoins to insured depository institutions. In other words, if this recommendation were to be adopted as written, only stablecoin issuers with a banking license or charter could be allowed to continue operating. Legislative proposals such as the Stable Act (2020) have also required issuers to have deposit insurance.
« Stablecoins must be 100% backed by cash and cash equivalents, and this should be audited regularly. I am concerned that some stablecoins are not always fully backed by appropriate assets in a transparent manner. »
Pro-Crypto Senator Cynthia Lummis
Federal Deposit Insurance Corporation (FDIC) Chair Jelena McWilliams’ position is even more radical. She would like the only entities authorized to issue stablecoins outside the banking sector to offer 1:1 support. The Biden administration seems to be moving more and more in this direction Therefore, it would seem that stablecoins collateralized 100% with fiat will benefit the most from U.S. regulation. Indeed, if these stablecoins limit their reserves to cash or equivalents such as short-term Treasury bills, there is no risk of a “bank run”, and deposit insurance is unnecessary.
The PWG also recommends the creation of regulatory criteria for capital and liquidity requirements as part of a risk management policy. Systemically important entities could be subject to stricter prudential standards, as traditional too-big-to-fail banks are.
Finally, the myriad of rules that apply to the banking sector, such as deposit protection, anti-money laundering, terrorist financing, and mandatory audits, would also apply to issuers.
Regulation is imminent
Financial regulators seem to understand the value of stablecoins in a digitalized economy as a faster and cheaper means of payment. But since network effects could lead to massive adoption of stablecoins, the PWG calls for quick action. Therefore, a regulatory framework is likely to be established in 2022, before the midterm elections, or no later than 2023.
The agencies that participated in this report call on the Financial Stability Oversight Council (FSOC) to take emergency action if Congress does not quickly define this regulatory framework. Regulatory agencies have limited regulatory tools because stablecoins are not registered as bank deposits. Hence the importance of a Congressional vote.
“We are almost certain to see federal regulation of stablecoins in 2022”
Douglas Landy, partner at White & Case
Tether, the main target of American regulators
In 2021, we saw the beginnings of American regulation. Indeed, Tether was fined $41 million this fall because of misleading statements that dollars fully backed USDT. Tether’s reserves included unsecured claims and non-traditional currencies.
In this case, the regulation will allow for more transparency on the reserves of issuers and, therefore, judge the absolute solidity of a project, especially during a bear market. Unlike Circle (USDC) and Paxos (USDP), Tether was less close to American regulators. Tether’s opacity had fueled fears of financial risk on the crypto ecosystem for several years.
“To the extent that folks are operating outside the regulatory perimeter, but are supposed to be inside, we will bring enforcement actions”
Gary Gensler, Securities and Exchange Commission Chairman
The imminent arrival of a regulatory framework will therefore bring confidence and stability.
European regulation is on its way
Europe has always had more restrictive banking regulations than the United States. This is unlikely to change with stablecoins to protect consumers from the risks inherent in this technology.
The beginnings of this can be seen in the ECB’s announcement in 2021 that it will demand a right of veto over all stablecoin projects backed by the euro. Here again, there is a desire to converge the legislation of stablecoins to that of traditional banks.
The European Market in Crypto-Assets (MiCA) regulation to harmonize rules in the 27 member countries will allow a small number of regulated stablecoins issued by supervised institutions to be listed on regulated exchanges. It is expected to come into force before 2023, and the project is still being debated in Parliament.
The regulations clearly distinguish between algorithmic stablecoins and other tokens backed by fiat currency. Therefore, it is likely that the regulations will differ depending on the nature of the stablecoin. The latter will require the use of a regulated custodian. If these projects are not licensed, they risk being banned throughout the E.U.
Conversely, a project that is licensed in one E.U. member state will be able to develop in compliance throughout the European area without additional authorization. Regulation can also be a great opportunity for compliant projects.
MiCa would also require issuers to have a reserve equivalent to 2% of total reserved assets or €350,000 to guarantee the peg at all times. Larger projects with capitalization above €1 billion would likely face more stringent requirements. This capital fund would notably increase to 3% of their reserves.
Regulation will be global
In early 2021, the UK HM Treasury published a report recognizing the value of stablecoins in supporting economic growth. However, the government department conditions their development on applying strict regulation. In other words, in the U.K. too, regulated stablecoins have the most significant potential.
Japanese financial regulators are also looking into the subject of stablecoins. The Financial Services Agency (FSA) would like to adopt an aggressive regulation of stablecoins by restricting their issuance to banks and wire transfer companies. This bill would probably be proposed in 2022.
Finally, China is probably the country with the strictest legislation, as all stablecoins backed by the yuan were banned at the end of 2020. While it is improbable that European and American regulators will opt for this radical course of action, it nevertheless illustrates the willingness of states to regulate the use of their currency.
Unregulated stablecoins are threatened
The main risk for unregulated stablecoin is that centralized exchanges will delist it. This threat is greater as these platforms increasingly seek to comply with regulators. For example, Changpeng Zhao, the CEO of Binance, recently announced his willingness to work with regulators actively and that this strategy would be central by 2022.
We have seen in the past that unregulated stablecoins can suffer from unannounced decisions by states. For example, the New York Attorney General has banned USDT from circulating in his State. It is a sword of Damocles hanging over these tokens.
When you consider that about 20% of banks’ operating costs can be attributed to compliance, it is more likely that many stablecoin projects that have not incorporated the arrival of regulation will not be viable and will disappear. Unregulated stablecoins will eventually be available on offshore markets but will certainly not be used by traditional financial institutions. They could therefore be gradually marginalized and will have difficulties in obtaining liquidity.
In that sense, we could mention the opacity of certain decentralized stablecoin protocol that are growing outside of any regulatory framework. Algorithmic stablecoins, for example, remain very vulnerable and have not yet proven their reliability. Some unregulated tokens attempt to replace fiat collateral with mathematical mechanisms. These stablecoins tend to work in bull market, but those that have collapsed in times of stress are legion. Indeed, these tokens work when demand is high. Producing more tokens is enough to maintain the peg. The challenge is when demand is low. Because the protocol cannot guarantee tangible collateral, the price can fall to zero and ruin users. This is what happened to the FEI protocol last April.
Algorithmic stablecoins are far from offering an equivalent service to regulated stablecoins and are still in the experimental stage.
Hence, neglecting the regulators could not be a viable strategy when issuing stablecoins.
Promising regulated projects in the US: Paxos and Circle
In the United States, several regulated projects have emerged in recent years. We can mention the Pax Dollar (USDP), the Binance Dollar (BUSD), the Gemini Dollar (GUSD), and also the USD Coin (USDC). A few days ago, a consortium of American banks even announced the launch of a regulated $ stablecoin, the USDF.
Paxos (USDP)
USDP is a regulated stablecoin issued by Paxos and is 100% backed by dollars, which ensures a high level of reserve liquidity. Its market cap is over $1 billion. Paxos is a regulated company by the New York State Department of Financial Services (NYDFS). This oversight is in line with the ten recommendations for regulating stablecoins issued by the Financial Stability Board in 2020.
Paxos has chosen to separate the company’s assets from the reserves backed by the USDP issue following the rules imposed by the NYDFS. This choice allows disconnecting the company’s bankruptcy risk from the stability of the token. Some issuers hold reserves in their balance sheet without recording the receivable. They thus consider that the resources belong to them and that they can use these funds to make more or less risky investments, which harms the stability of the token.
Paxos believes that this regulatory advantage will encourage partnerships with companies to enter the crypto ecosystem. Facebook has integrated Paxos’ USDP into its Novi wallet. Mastercard has also announced the use of Paxos’ regulated infrastructure to support payments for U.S. users.
“regulatory framework should incentivize payments companies to integrate blockchain technology and stablecoins into their platforms”
Bank of America, November 2021.
In the age of crypto-assets and the digital economy, it seems highly likely that businesses will use regulated stablecoins. Their potential is, therefore, immense.
Circle (USDC)
Circle, the issuer of the USD Coin (USDC), has also chosen to work with regulators to create a trusted stablecoin. It is now the second most widely used stablecoin behind USDT, with a market cap of over $40 billion.
Fully backed by liquid assets such as cash and short-term U.S. Treasury bills, it is one of the world’s most trusted and liquid stablecoins. These backed assets are part of a list prescribed by US regulators. The prestigious auditing firm Grant Thornton certifies monthly that reserves back all USDC.
Circle made an early choice to work with regulators. USDC is subject to oversight by 46 regulatory entities under money transfer laws. The issuer is also registered with Financial Crimes Enforcement Network (FinCEN).
The choice to build a stablecoin in compliance with the regulations seems to be an excellent strategy for USDC, one of the most promising tokens today.
EURL : a reliable euro-backed stablecoin
At Lugh, we believe that the only way to provide users with transparency and a high level of security is to work with the regulators. That’s why, from the beginning, we took the gamble of building a reliable euro-backed stablecoin. Few € stablecoin projects can claim such high standards.
We are committed to ensuring transparency, security and reliability on our collateral. Our reserve is held on a bank account at Société Générale. Having such a partner allows us to benefit from the compliance experience of a major European bank. Our accounts are audited monthly by an international auditor, one of the largest audit firms in the world, to meet transparency requirements.
We have also chosen to rely on Coinhouse, one of the leading French Digital Asset Service Providers (DASP). The European regulatory regime is strongly inspired by the French classification established by the PACTE law in 2019. EURL is already considered a digital asset under this law. It gives us a considerable advantage over other projects that start from scratch on this legal ground.
We strongly believe that this framework will allow us to develop many corporate use cases and use our stablecoin into many payment railways of the future digital economy.
Feel free to read our latest article to learn more!
Yanis Adoul
