Regulatory Response to Stablecoins and the Terra Collapse

In the crypto sphere, stablecoins represent a bridge between cryptocurrencies and fiat/assets with stable value, designed to protect investors from the volatility of cryptocurrencies. 

There are four main stablecoin types based on the underlying collateral structure:  

• fiat-backed (pegged to a fiat currency such as Tether, USD Coin, Gemini Dollar, holding a reserve of fiat-denominated assets with a value in a 1:1 relationship with the value of the stablecoin), 
• commodity-backed (have as collateral precious metals or crude oil, such as Paxos Gold), 
• crypto-backed (over-collateralized by other cryptocurrencies – the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued – such as MakerDAO’s DAI, pegged to the U.S. dollar and backed by ETH and other cryptocurrencies worth 150% of the DAI stablecoin in circulation), 
• algorithmic. 

Unlike the first 3, which hold reserve assets unlikely to lose their value, the algorithmic stablecoin uses different methods to control the supply or value of the stablecoin, such as minting or burning of coins, rebasing, and arbitrage. 

Usually an algorithm is used to maintain a consistent value by linking two coins and adjusting their price depending on the supply and demand of investors. 

This very mechanism was the basis of the TerraUSD (UST) – LUNA link, where UST is the stablecoin and LUNA the balancer token. In this relationship, TerraUSD was to maintain its value at $1 per coin, however the peg was broken in mid-May and has continued to plummet in value, reaching a new all time low on June 12th of $0.008. Following the crash which saw the market cap of the stablecoin drawdown from ~$45 billion to ~$85 million, the TerraUSD protocol was rebranded to TerraClassicUSD (USTC).

The situation reflects a classic ‘run-like’ scenario where the main influencing factor of the de-pegging was the sizeable UST withdrawals from Anchor, a decentralized lending protocol, established by Terraform Labs, in which UST holders could park their UST for a reported 20% annual percentage yield.  

In June 2021, there was an identical incident involving Iron Titanium. The algorithmic stablecoin Iron is structured using TITAN and USD Coin and when TITAN’s price collapsed, Iron was trading off the peg by more than a quarter.  

Following these events, financial stability concerns were expressed due to the contagion effects this situation might have on the crypto ecosystem’s interconnectedness with the traditional financial system. 

Regulations around stablecoins have a long way to go for this asset class to be properly regulated. Nevertheless, improvements are being made and such incidents only speed up the process. 

US Stablecoin Transparency Bill and NYSDFS Guidance

The US has taken steps in regulating stablecoins since November 2021 with the issuance of the Report on Stablecoins and most recently, in March and May 2022, the US introduced two bills (H.R. 7328 and S. 3970) cited as the ‘Stablecoin Transparency Act’ on reserve disclosure and composition, requiring a stablecoin issuer ‘to hold all reserves associated with each fiat currency-backed stablecoin they issue in (1) certain government securities; (2) fully collateralized security repurchase agreements, and (3) U.S. dollars or other nondigital currency. 

On June 8, the New York State Department of Financial Services issued a guidance note on stablecoins overviewing:

• Redeemability of such stablecoins;
• Asset reserves that the back such stablecoins (the “Reserves”)
• Attestations concerning the backing by these Reserves

G7, IMF, World Bank, OECD and FSB Meeting

Between May 18 and May 20, 2022, a meeting was held between the G7 Finance Ministers and Central Bank Governors, heads of the International Monetary Fund, World Bank Group, Organisation for Economic Cooperation and Development and the Financial Stability Board (“FSB”) where the G7 expressed its support to the  work done ‘by the Financial Stability Board (FSB) to monitor and address financial stability risks arising from all forms of crypto-assets, and welcomes increasing global cooperation to address regulatory issues associated with the use of crypto-assets, including in cross-border payments.  

Following recents events with Terra – LUNA ‘the G7 urges the FSB, in close coordination with international standard-setters, to advance the swift development and implementation of consistent and comprehensive regulation of crypto-asset issuers and service providers, with a view to holding crypto-assets, including stablecoins, to the same standards as the rest of the financial system. In particular, the G7 calls for rapid implementation of the Financial Action Task Force (FATF) ‘travel rule’ and stronger disclosure and regulatory reporting, for instance, as regards reserve assets backing stablecoins. We reaffirm that no global stablecoin project should begin operation until it adequately addresses relevant legal, regulatory and oversight requirements through appropriate design and by adhering to applicable standards. The G7 remains committed to high regulatory standards for global stablecoins, following the principle of same activity, same risk, same regulation.’ 

Bank of England’s Stablecoin Failure Management Proposal

In late May the Bank of England (BoE) published the consultation paper ‘Managing the failure of systemic digital settlement asset (including stablecoin) firms’ in which the institution noted that “The failure of a systemic digital settlement asset firm could have a wide range of financial stability as well as consumer protection impacts” which “could be both in terms of continuity of services critical to the operation of the economy and access of individuals to their funds or assets.”

The BoE is considering the Financial Market Infrastructure Special Administration Regime (FMI SAR) to be the primary regime for Digital Settlement Asset (DSA) firms. The BoE is seeking responses to its proposals to:

• “Appoint the FMI SAR as the primary regime for systemic DSA firms
• Establish an additional objective for the FMI SAR focused on the return or transfer of customer funds, similar to that found in the PESAR, to apply solely to systemic DSA firms 
• Be given the power to direct administrators of, and to introduce further regulations in support of the FMI SAR 
• Consult with the Financial Conduct Authority prior to seeking an administration order or directing administrators where regulatory overlaps may occur”

The public has until the 2nd of August 2022 to respond to the paper.

Japan FSA’s Revised Fund Settlement Law

On June 3rd, Japan’s parliament passed a landmark bill – revising the Fund Settlement Law – clarifying the legal status of stablecoins, defining them effectively as digital money.

The new law – to be in force from 2023 – states that a number of stipulations must be met by stablecoin issuers in the country. Firstly, the asset must be linked to the yen or an alternative legal tender as well as guaranteeing the holders the right of redemption of the assets held at face value.  

Only licensed banks, registered money transfer agents and trust companies are able to issue stablecoins according to the legal definition. The revised Fund Settlement Law does not address existing asset-backed stablecoins such as Tether from overseas issuers, or their algorithmic stablecoins.

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