Supervision takes the first step, stablecoin minting and redemption need to be transparent

Produced by | Bai Ze Research Institute

If crypto assets are the engine, then stablecoins are like its piston. Over the past seven years, stablecoins have grown into the main pillar of the entire crypto ecosystem. It is more like a tool for introducing new funds, managing and increasing liquidity, and pricing crypto assets.

According to Coingecko data, the total market value of the stablecoin market has reached $150 billion. Among them, the two major US dollar stablecoins USDT and USDC still occupy the main market share, with the circulating supply of USDT exceeding $73.4 billion and the circulating supply of USDC exceeding $37.2 billion. Looking back at history, when Bitcoin reached the price of $20,000 at the end of 2017, USDT only had a market value of $1 billion, but now it is an important stablecoin with a market value of more than $70 billion.

Recently, Sherrod Brown, chairman of the U.S. Senate Banking, Housing and Urban Affairs Committee, has sent inquiry letters to major stablecoin issuers and exchanges, including Coinbase, Gemini, Circle, Tether, Paxos, TrustToken, Binance USD, etc., calling on stablecoin issuers to disclose the stablecoin issuance process before December 3, and provide basic information about the purchase, exchange and minting of stablecoins, as well as the number of tokens in circulation and the frequency with which users exchange them for US dollars.

Ronw Hammond, director of government relations at the Blockchain Association, said the move was likely a sign of things to come before the Senate Banking Committee.

Jeremy Allaire, CEO of USDC issuer Circle, was one of the few to publicly respond to the letter. He expressed his willingness to work with Brown and clarified his concerns: "We look forward to working with you to ensure that consumers are appropriately protected."

Stablecoins face the strongest regulatory wave

The inquiry letter was issued after the release of the Stablecoin Report by the President’s Working Group on Financial Markets earlier this month. Brown publicly stated after the letter was issued: “The Stablecoin Report highlights the risks that the rapid growth of stablecoins poses to households and the economy. We must work to ensure that any new financial technologies comply with all laws and regulations that protect investors, consumers, and markets, and ensure that they compete on a fair basis with traditional financial institutions. I look forward to working with financial regulators to promote innovation in the financial system.”

In the United States, calls for stablecoin regulation have been going on for months. In July, SEC Chairman Gensler suggested that stablecoins could be regulated as securities, and Treasury Secretary Janet Yellen expressed concerns about stablecoins, urging lawmakers to "act quickly" to develop a regulatory framework to govern the crypto industry. In September, Gensler told the Senate Banking Committee that many crypto assets, including stablecoins, should be securities. According to Bloomberg, Gensler has been the SEC's leading force in calling for stablecoin regulation.

In the Stablecoin Report, the President's Working Group on Financial Markets, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) believe that stablecoin issuers should become "insured depository institutions", comply with requirements for capital and liquidity standards, and be included in the regulatory system like banks. Secondly, operators of crypto custodial wallets should also take the initiative to supervise entities that play an important role in the operation of stablecoins. In addition, the affiliation between stablecoin issuers and commercial entities should be limited to encourage competition and interoperability between different stablecoins.

How to understand "insured depository institutions"? Think of it this way. If stablecoins are widely accepted by the mainstream and are used for household or business payments, if the crypto market falls, there may be a large amount of funds that need to be redeemed for legal tender, or even congestion, similar to a bank run, which may force issuers to sell assets at a low price, which may put pressure on the financial system. Therefore, the legislature should make laws that only banks insured by the Federal Deposit Insurance Corporation (FDIC) have the right to issue stablecoins, and the FDIC should ensure that stablecoin issuers provide sufficient reserves to meet users' withdrawal requests.

Although the Stablecoin Report does not have legally binding attributes, in terms of the regulation of stablecoins, the report points out that within the enforcement scope of the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), stablecoins need to comply with federal securities laws, commodity exchange laws and other relevant regulations.

The Financial Action Task Force (FATF), a global anti-money laundering and counter-terrorist financing (AML/CTF) standard setter, released an updated guide on crypto assets and crypto asset service providers (VASPs) at the end of October to guide countries on how to implement their respective crypto regulations. In the updated guide, FATF believes that countries should take appropriate measures to manage the ML/TF (money laundering and terrorist financing) risks of stablecoins, especially those with larger scale.

In early October, a joint report published by the Bank for International Settlements (BIS) Committee and the International Organization of Securities Commissions (IOSCO) stated that regulators in various countries should strengthen their review of the risks that stablecoins may pose to the financial system, and made recommendations to various countries on regulating laws and regulations: Several factors can be considered to determine whether stablecoins are compliant, such as governance, risk management and liquidity of fund settlement.

Jason Wincuinas, senior editor at The Economist, said:

“Regulation of the crypto market is long overdue. As more institutions are attracted to decentralized finance (DeFi) and other native digital projects, the fate of these projects is intertwined with the fate of broader economic entities. Stablecoins are the backbone of the crypto market, and unclear regulation could undermine the stability of stablecoins. Regulators should also value each stablecoin based on its value.”

Stablecoins need to be transparent

Sherrod Brown, chairman of the U.S. Senate Banking, Housing and Urban Affairs Committee, mentioned at the beginning of this article, hopes that stablecoin issuers will provide various information as soon as possible to make the issuance of stablecoins as transparent as possible, which indicates that regulators may have taken the first step.

In a letter to Circle that has been made public, Brown expressed concerns about the lack of transparency surrounding stablecoins and questioned their minting and redemption processes.

According to the USDT investigation report published this month by the investigation firm Protos, the company spent several months cataloging and investigating every Tether-related USDT transaction from 2014 to October 31, 2021, across the eight blockchains it currently exists on: Omni (Bitcoin), Liquid (Bitcoin), Ethereum, Tron, Bitcoin Cash, EOS, Solana and Algorand.

The survey results show that Tether has issued a total of $108.9 billion in USDT (not representing market value, as some USDT has been recycled), providing 89.2% of the issued USDT to "market makers", 8.5% to trading funds and other companies, and only 2.3% to individual investors. Among them, Alameda Research (FTX's parent company) and Cumberland Global (a subsidiary of global financial trading giant DRW) are the largest market makers for USDT. These two companies have received at least $60.3 billion in USDT, accounting for 55% of the USDT provided to market makers. In addition, funds/companies such as Three Arrows Capital and Delchain are also the dominant forces in USDT.

But Tether's stablecoin issuance process remains opaque, and no one knows exactly how Tether works or which companies' commercial papers constitute the reserve assets backing USDT. Tether lends its USDT in the form of overcollateralized loans (BTC/ETH), but has never officially disclosed how these operations work.

In fact, Tether has been doing its best to obfuscate the services it provides to the crypto industry in the past, with some rumors suggesting that Tether offers discounts when issuing large quantities of USDT, but in its research, Protos did not find any clear evidence of discounts on USDT purchases.

To sum up, Tether's USDT alone did not achieve clarity at the time of issuance, which may be why Brown wants the stablecoin issuer to provide information as soon as possible.

Stablecoin duo caters to regulation

As the regulation of stablecoins by various countries is imminent, the attitudes of the two stablecoin giants USDT and USDC are still very clear, that is, to actively embrace regulation, but they have adopted completely different approaches.

After the release of the Presidential Working Group on Financial Markets’ Stablecoin Report, USDC issuer Circle was the first to respond, announcing its support for the proposals in the report and believing that this move will promote the development of the crypto ecosystem, so Circle is upgrading USDC to adapt to the fundamentals of banking, payment and capital markets. For example, for the “insured depository institution” proposed in the Stablecoin Report, although Circle has not yet applied to become a nationally chartered bank, if policymakers stipulate that only FDIC-insured banks can issue stablecoins, the company will choose FDIC insurance as soon as possible to prepare for USDC.

Jeremy Allaire, CEO of Circle, said in an interview with the media: "We support the Stablecoin Report. We think it represents a significant step forward in the development of the crypto industry, and we hope this is a process that is closely coordinated with regulators."

At the same time, Tether is determined to abandon the past, face the future, and support regulation. Tether accepted a $41 million fine from the Commodity Futures Trading Commission (CFTC) earlier this year. Recently, in order to comply with the FATF's crypto travel regulations, Tether has been testing new platforms Notabene and Shyft (creating a distributed, smart contract-based compliance system for crypto service providers).

Small Thoughts

Before policymakers work to understand stablecoins and introduce a clear regulatory framework, it is imperative that stablecoin issuers lead by example and take the lead.

Finally, let me quote Saule Omarova, director of the U.S. Office of the Comptroller of the Currency and professor at Cornell Law School: "With appropriate increased regulation of crypto assets and stablecoins, this [crypto revolution] will benefit our already dysfunctional financial system."