Bankless: Will regulators declare war on all stablecoins?

Declaring war on stablecoins?

A flurry of regulatory enforcement and crackdowns has dominated crypto news lately. Who could be the next target? Stablecoins.

Specifically, U.S. institutions are going after Binance’s (Paxos-issued) BUSD and Terra’s (once stablecoin) UST.

Following the joint crackdown by the U.S. Securities and Exchange Commission (SEC) and the New York Department of Financial Services (NYDFS) on BUSD, a Fox Business reporter began spreading rumors last week that Circle’s USDC was facing similar regulatory enforcement.

Those rumors later proved to be unfounded, with Circle’s chief strategy officer Dante Disparte announcing that the stablecoin issuer had not received any notification from the SEC that it would open a regulatory investigation into USDC.

Still, the rumors that have fueled unease in crypto circles reveal a real, widespread concern: that federal agencies are about to launch an eventual, full-scale regulatory assault on stablecoins, and that everything is just beginning.

So, does the SEC want to declare all stablecoins securities? Or is it just cracking down on a few unscrupulous entities?

Paxos Alerts

As previously reported, Paxos has been ordered to stop issuing BUSD.

It is worth noting that the order does not extend to Paxos' internal Pax Dollar (USDP). In addition, neither the domestically-based USDC nor the Hong Kong-based USDT are the targets of this round of regulatory enforcement. In addition, there is currently no indication that the SEC is investigating decentralized stablecoin providers such as Maker (DAI) or Frax Finance (Frax), both of which are mainly backed by USDC.

Have Binance and CZ become regulars on the regulators’ naughty list? Maybe…

While I don’t want to alarm anyone by calling a spade a spade, it is certainly worth keeping an eye on how the BUSD crash plays out, especially as concerns continue about Binance’s use of BNB on its balance sheet.

Reports questioning the relationship between Binance and Binance US have begun to pour in, with Reuters reporting on Thursday that “Binance secretly accessed a bank account belonging to a purportedly independent U.S. partner and transferred significant amounts of funds from the account to trading firm Merit Peak Ltd.”

Merit Peak Ltd. is a market maker for Binance US, which is run by CZ. Between January and March 2021, Binance transferred more than $400 million from Binance US to Merit Peak through Silvergate Bank, another cryptocurrency company targeted by regulators. Company information viewed by Reuters showed that Binance US executives were concerned about these outflows from Silvergate accounts because they occurred without their knowledge.

Despite claims that Binance US is “completely independent,” the Silvergate transfer raises new questions about Binance’s relationship with its subsidiaries, even though Binance is not licensed to operate in the United States.

When it comes to BUSD, regulators seem to favor a two-pronged approach to cracking down on stablecoins.

One of them was a Wells notice on February 3, informing Paxos that the SEC was considering taking action to treat BUSD as a security and that the company should register its offering under the federal securities laws. Unexpectedly, Paxos issued a statement saying that the stablecoin issuer "strongly disagrees with the SEC's opinion that BUSD is not a security under the federal securities laws."

Additionally, the NYDFS stepped in, ordering “Paxos to cease minting Paxos-issued BUSD due to several unresolved issues related to Paxos’ oversight of its relationship with Binance.”

Did regulators catch us off guard and classify the $16 billion backing BUSD as falling under the purview of the RICO Act? Thankfully, no.

The SEC’s Wells Notice informed Paxos that the SEC is considering filing a lawsuit against the company, alleging that BUSD is a security and requiring Paxos to provide additional substantiation as to why BUSD is not a security.

NYDFS has notified Paxos to stop minting new BUSD.

The stablecoin remains regulated by the NYDFS, and Paxos is still required to maintain 1:1 backing and process exchanges for all customers in "good standing." In addition, the regulatory action does not affect any NYDFS-licensed entity's BUSD listing or exchange. BitLicense recipient Coinbase continues to offer BUSD to U.S. consumers.

Paxos said that while they will no longer issue new BUSD tokens, all existing tokens will remain fully backed and redeemable until at least February 2024.

Do Kwon and Terra Bunch

For nine long months, the crypto space has been waiting for U.S. regulators to take some form of regulatory enforcement action against the perpetrators of the largest Ponzi scheme in crypto.

On Thursday, the SEC finally filed its lawsuit against Do Kwon and Terraform Labs.

Compared to the Wells notice sent to Paxos, which is like a request for a response, the SEC's complaint is a formal document filed with the court, marking the start of the US legal process. It is very likely that Terraform Labs and Do Kwon received the Wells notice before the lawsuit was filed, but it is not clear whether anyone from Terraform Labs responded, and we all know that Kwon is not easy to find...

The complaint classifies LUNA, as well as Mirror Protocol’s governance tokens MIR and mAssets, synthetic tokens designed to track the performance of U.S. stocks, as securities and security-based swaps. The SEC applied the Howey Test and concluded that these Terra ecosystem assets all qualify as investment contracts.

To be classified as an investment contract, an asset must meet the following four criteria:

(1) Monetary investment

(2) Joint Enterprise

(3) Reasonable profit expectations

(4) From the efforts of others

While there are various types of securities, Howey and the corresponding “investment contract” label are most applicable to most crypto assets.

Generally speaking, the consensus about stablecoins is that they are not investment contracts !

Why?

Stablecoins generally fail to meet Howey’s third criterion: no rational person expects to make a profit when buying a stablecoin pegged to the dollar. There is no benefit: for every stablecoin redeemed, one dollar is paid pro rata!

But the SEC’s enforcement actions against Terra and, in particular, UST make it clear that they believe some stablecoins do qualify as investment contracts.

They argue that Terra’s role in establishing the anchoring protocol and subsidizing earnings results in UST buyers holding a reasonable expectation of profits that come from the efforts of others.

As the SEC states in the complaint, the Anchor Protocol was designed, developed, and supported by Terraform Labs and Do Kwon, and “defendants touted these efforts in monthly updates to investors, including their efforts to build front-end user access and back-end functionality to facilitate user access to the protocol through third-party crypto-asset financial services, as well as to fund and manage the Anchor Protocol ‘yield reserve’ for paying interest in UST to investors.”

When the anchor revenue fell below the revenue needed to pay UST’s advertised returns, “Terraform and Kwon sought to ensure that the anchor protocol had sufficient reserve assets to pay investors the interest they were promised and continue to attract UST/anchor protocol investors.”

The SEC highlighted multiple instances where Terraform supported these anchored returns, including:

Terraform provided $70 million of UST in July 2021.

Luna Foundation Guard (LFG) provided $450 million of UST in early 2022.

In addition, Do Kwon even tweeted that he strongly supports the anchoring protocol.

Remember when Terra gifted LFG billions of dollars in UST to defend the peg?

I think it is fair to say that the subsidy for the peg’s gains, combined with LFG’s aggressive defense of the peg, looks a lot like evidence of a rational expectation of profits based on the managerial efforts of others…

Summarize

At present, it is unclear why the SEC and NYDFS are keen to investigate BUSD issued by Paxos.

Regulators appear to be looking for ways to fight Binance, and this could be their best move forward. Both Binance and Binance US have irritated other regulators, including the U.S. Department of Justice (DOJ) and the U.S. Commodity Futures Trading Commission (CFTC), who are both upset by Binance’s alleged money laundering, tax evasion, sanctions evasion, and improper offering of crypto derivatives to U.S. citizens.

However, what is known is that (at least for now) US regulators have not taken direct action against USDC, USDT, TUSD, USDP, GUSD, or any other centralized stablecoin provider! They also seem to be ignoring DAI, FRAX, and other (less high-profile) decentralized stablecoins.

The difference between a product like UST and the above products is that the success of the product requires the participation of a centralized management company. UST investors actually rely on a certain combination of Do Kwon, Terraform Labs, Luna Foundation Guard, and subsidized income for every step of the anchoring agreement!

Luna may be an easier target for regulators since many of the crimes appear to have been carried out on Twitter, but to crack down on BUSD, regulators either have to expect something to go terribly wrong or just move on to the next most vulnerable target as they aim to crack down on stablecoin issuers.

While the FUD (doubt, confusion, and fear) of all stablecoins is a bit too much in the opinion of this author, there are definitely some bad vibes coming from certain corners of the industry. As always, it is very important to continue to do your research, especially in such a dynamic market. Crypto assets in general are risky, and you can also practice best practices by avoiding assets that are actively targeted by regulators!