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The State of Stablecoin Regulation

The US, Canada, and some European Commission countries have voted to kick Russia off the SWIFT messaging system for its invasion of Ukraine. These new sanctions will isolate the Bank of Russia and its economy from the global financial system.

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is based in Brussels, but it is policed in New York. 95% of all SWIFT’s USD payments are settled in New York. SWIFT works alongside CHIPS or the Clearing House Interbank Payments System that also settles over $1.8 trillion in claims from banks.

Consequently, a ban from the Swift network will alienate the Central Bank of the Russian Federation from its international reserves till these countries deem it fit to lift these sanctions. Russia now joins a list of pariah countries whose financial systems have also undergone the SWIFT sanction process, aka the “nuclear option.”

The economies of North Korea, Iran, and Venezuela have at one time gone into shock as a result of the SWIFT messaging system isolation sanctions. Russia, however, would be the largest economy to undergo the dollarization effect of a sanctioned central bank.

Stablecoin usage could, however, thwart a full-on collapse of the country’s financial system. Pundits predict that in the future, stablecoins and their regulated counterparts, the Central Bank Digital Currency (CBDC), could offer countries like Russia a viable alternative in international trade.

As an illustration, Beijing is on track, laying down a CBDC framework that will further isolate it from the SWIFT messaging system. In addition, China is building its CHIPS alternative, CIPS or Cross-Border Interbank Payment System, to settle international banking claims in yuan.

The yuan, however, only clears 3% of the world’s international payments. In contrast, 40% of the all-international payments are dollar-denominated. To this end, China has built the e-CNY and the digital yuan for domestic and eventual cross-border use.

Should China find itself in Russia’s position, it could leverage the e-CNY and USD-backed stablecoins to go around SWIFT sanctions. Stablecoin payments do not have settlement risks. To this end, China could sell Chinese goods to the rest of the world by simply converting its digital yuan to USD-backed stablecoins. It will then settle its international payments via the e-CNY.

Stablecoins are the first digital asset protocols to challenge the USD, CHIPS, and SWIFT trifecta, the key pillars that weaponize the traditional banking system. To this end, regulators are calling for legislation that reigns in their massive growth and influence over the financial sector.

Stablecoin market growth

The stablecoin market has grown in leaps and bounds as more crypto investors leverage them in stable value transfer within the crypto ecosystem. Currently, they are the sector’s hottest post, ballooning in size to a $180 billion market capitalization.

Analysts attribute this growth to crypto traders who now prefer to swap volatile cryptocurrencies for stablecoins rather than fiat cash. This is because stablecoin holdings are easy to access and do not incur conversion costs.

Consequently, most investors no longer take out liquidity from the crypto ecosystem but use stablecoins as a flight to relative safety as they wait out market volatility. For example, Tether (USDT), a centralized USD-backed stablecoin, has over $80 billion market cap. Circle’s USD coin, on the other hand, has a $47 billion market cap.

The USDT’s $80 billion market cap is now higher than the sum of the top 50 FDIC-insured commercial banking institution’s deposits as per June 2021 data.

Regulators have noted that billions worth of USD equivalent coins are exchanging hands daily and bypassing the US banking system, escaping their “regulatory and oversight framework.”

Therefore, the Federal Reserve Board of Governors says that the growing use of stablecoins could eventually fragment the current financial system via a “run on the bank” event.

To this end, in late 2021, the President’s Working Group on Financial Markets tabled a report to Congress asking them to pass bank-like legislation for stablecoin issuers.

The working group, consisting of top US regulators, cited the reasons below as causes of the push towards stablecoin regulation.

  • Stablecoins could face the risk of loss of value
  • They have payment system risks
  • They have risks of scale

Why legislators want to regulate the stablecoin market

  1. Risk of loss of value

The PWG Report defines stablecoins as digital assets whose design maintains a stable value in reference to a national currency or other assets. Unlike FDIC-insured USD deposits, stablecoins do not have laws that enforce the right of immediate redemption.

They also do not have any insurance or holder entitlement to preference should there be a resolution hearing. To this end, the PWG says that should stablecoin assets lose value in a period of stress, they could easily become illiquid.

This is because most of them do not have adequate reserve asset safeguards. Tether, for instance, paid a $41 million fine to the US Commodity Futures Trading Commission for misleading the public on the state of USDT dollar backing.

Between 2016 and early 2019, Tether told USDT holders that an equivalent USD in its reserves fully backed each token. However, Tether later admitted that only 76% of USDT in circulation had “cash and cash equivalents” backing.

Then, only 74% of USDT had actual USD backing. The world’s second-largest stablecoin, the USDC, has 61% USD cash backing and 9% commercial paper backing. The regulated Gemini Dollar (GUSD) has the most transparent model of all USD-backed stablecoins. It has a $251 million market cap, and all its GUSD is fully backed by USD stored in FDIC-insured accounts.

Circle, however, is pro-regulation. It is, for instance, pursuing a bank charter to support its stablecoin service. To this end, Circle has filed its banking charter with the Securities and Exchange Commission.

Jeremy Allaire, its CEO, has said, “We are fully supportive of the call for Congress to act and establish federal banking supervision for stablecoin issuance. The rapid scaling and strategic importance of this to dollar competitiveness in the age of crypto and blockchains is critical.”

The PWG, therefore, warns legislators of a Great Depression-like bank run on stablecoin issuers should these assets undergo extreme price incidences. The group, therefore, recommends that fiat-backed stablecoins issuance should be relegated to insured depository financial institutions.

2. Payment system risks

The PWG also cited custodial wallets as an operational risk requiring federal oversight. Regulation would prevent misuse of user deposits and protect their transaction data.

3.The concentration of economic power

The regulators also pointed out that rising stablecoin use could cause an excessive concentration of power on a single asset. They, therefore, propose that Congress should enact laws that enforce authority over stablecoin issuers whose assets could balloon to levels that affect the critical functioning of the economy.

Regulation will also promote stablecoin interoperability between stablecoins and other payment systems.

The state of stablecoin regulation in the US

Despite the current regulatory sentiment and calls for tough stablecoin governance, stablecoins are still largely unregulated in the US. That said, the President’s Working Group on Financial Markets has passed its report to Congress, asking it to legislate stablecoin oversight.

The group has also laid the groundwork for federal regulation, should Congress choose not to provide roles for stablecoin regulation. As it stands, the US has too many agencies seeking oversight, an act that could delay laws for longer.

Possible outcomes of stablecoin regulation in the US

  1. Regulation as Systemically Important Financial Institutions (SIFIs).

As per Brooking’s research, stablecoin issuance could undergo a review from the Financial Stability Oversight Council (FSOC). The FSOC could cite the Dodd-Frank Wall Street Reform and Consumer Protection Act.

This law will enforce regulation of stablecoin payment activities on the merit that they are, or are “likely to become, systemically important.” Consequently, stablecoin issuers could be subject to Federal Reserve supervision as Systemically Important Financial Institutions (SIFIs).

In the past, non-bank institutions such as General Electric Capital Corporation, MetLife, American International Group, and Prudential Financial have earned the SIFI designation. That said, they are no longer SIFIS, and no other non-bank institution in the US has the SIFI title.

2. Regulation as financial market utilities (FMUs)

The FSOC could also designate stablecoin issuers as FMUs or financial market utilities Under the Dodd-Frank act. FMUs are subject to higher compliance and banking supervisory provisions. For example, the Chicago Mercantile Exchange, the Clearing House Payments Company, and the National Securities Clearing Corp are FMUs.

The FSOC would, however, have to identify and prove that stablecoins have activities that it deems as “systemically important payment, clearing, and settlement (“PCS”) activity.”

3. Regulation as securities

Gary Gensler, the Securities and Exchange Commission chair, has also proposed the regulation of stablecoins as money market funds or securities. Stablecoins, however, are payment devices, and classifying them as securities would preempt the FSOC classification of stablecoins as systemically important payment, clearing, and settlement (PCS) networks.

4. Stablecoin issuance relegation to banks

The Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act could force stablecoin issuers to obtain banking charters. The Tlaib, García, and Lynch STABLE Act would also enforce banking regulations on stablecoin issuers and place their operations under the oversight of the FDIC and the FED.

Consequently, centralized stablecoin firms would have to maintain reserves as per Federal Reserve regulations, ensuring that their tokens are readily converted to USD.

The state of stablecoin regulation in Asia

The stablecoin regulation sentiment in Asia varies as per jurisdiction. China, for instance, has a ban on crypto-asset development, while India has not enacted any stablecoin regulation laws.

Singapore and Hong Kong are developing their stablecoin regulatory frameworks. Japan, however, is going to limit stablecoin issuance to wire transfer services and banks. It is also releasing the yen-based DCJPY cryptocurrency.

The state of stablecoin regulation in Europe

The US’s stable coin regulation push may lack a coherent narrative, but Europe has embraced a laser-focused approach. In late November 2021, the European Council released the Markets in Crypto Assets (MiCA) proposal, highlighting stablecoin issuers.

The MiCA framework proposes that all stablecoin issuers have e-money or credit institution licenses. To this end, any EU-based stablecoin firm will require an EU member state banking license. It will also have to offer genuine transparency of operations.

The MiCA framework does not affect CBDCs or security tokens. However, its comprehensive bill could raise the stablecoin barrier of entry through over-regulation. Below are some of the Mica bill’s proposals.

  • Stablecoin issuers should publish a regulator-approved white paper 20 days before token issuance. However, as per the EU Commission’s impact assessment, white paper publishing could cost stablecoin issuers up to $87,000 per project due to the EU legal advice costs.
  • Crypto service providers should obtain licenses from EU-based regulators to operate in EU countries. One-off compliance costs for stablecoin issuers could go as high as $19 million. These projects will also pay ongoing compliance of up to $28 million.
  • As per MiCA rules, stablecoin issuers will require capital funds deposits of $400,000 or €350,000. Larger projects will maintain at least 2% of their reserve assets as capital fund deposits.
  • Significant issuers that cross the €1 billion market cap will hold 3% of their reserve assets in untradeable capital funds format.

The MiCA framework targets three sets of asset-referenced tokens.

  • Stablecoins such as Libra, whose backing is a basket of currencies.
  • E-money tokens that peg their value to fiat currencies.
  • Utility tokens that function as a native transfer of value within a blockchain network.

Why PAR will thrive as stablecoin regulation takes over

The MiCA framework and the PGA proposal target stablecoins that operate under the 1:1 real currency backing. Unlike Mimo Protocol’s PAR, which is crypto-backed and has an algorithmic peg to the EURO, stablecoins such as USDC or USDT are heavily reliant on cash reserves.

Therefore, they could cause a currency crisis should their reserves run low as they absorb other assets to cover their positions. Tether, for instance, would have to liquidate its commercial holdings at a discount to access adequate USD to cover its operations.

The PAR stablecoin is an algorithmic, crypto-backed stablecoin that tracks the value of the Euro. On top of that, PAR is censorship resistant since it is fully decentralized. PAR is highly scalable since its code runs its demand and supply sides. It will thrive as unfriendly stablecoin laws affect the operations of centralized stablecoins.

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