The recent collapse of stablecoin TerraUSD, or UST, and its sister token Luna, wiped out about $60 billion market cap in a matter of days. Investors were hurt. Treasury Secretary Janet Yellen called for stablecoins to be regulated, citing financial stability risks. Others argued this type of failure should be allowed as part of innovation.
The type of risks TerraUSD posed by an algorithmic-pegging mechanism—“death spiral” risks—was nothing new. Yet, these risks manifested due to a lack of regulatory framework on stablecoin. Why has stablecoin regulation been such a challenge in the US? The answer may lie in stablecoins’ mixed uses.
Stablecoins are digital tokens designed to maintain a stable value to a fiat currency or commodities. While they all have a fundamental objective of maintaining a stable peg to their reference assets, stablecoins differ materially in their design, use, and liquidity and risk profile based on their reserves.
Some stablecoins were designed to serve as a digital medium of exchange on decentralized exchanges to allow users to trade in and out of cryptocurrencies or arbitrage differences between exchanges. Others were designed for making quick and cost-efficient payments, managing short term liquidity like money market funds, or staking for 20%+ annual returns like risky bonds.
When these use cases are analyzed individually, most people understand which federal regulator should be in charge and what rules should govern. But today’s stablecoins, although designed with a primary use case in mind, often can be used for other secondary purposes described above. Therefore, stablecoins’ resemblance to multiple asset classes and their mixed uses have caused confusion in regulators and investors alike.
Are Single-Use Stablecoins Needed?
Are stablecoins going away? Unlikely. Stablecoins’ functions are desirable—some might even argue necessary—for decentralized protocols given the volatility of other cryptocurrencies. What could alleviate the regulatory confusion and propel stablecoins to the next milestone in the absence of a digital asset bill from Congress? One solution may be single-use stablecoins.
On its face, this may appear to be a step backwards, but industry experts agree that regulatory overhang has been a major obstacle to institutional adoption of stablecoins. Total stablecoin market cap was $180 billion just before the UST collapse—a significant number for a relatively new asset class—but dwarfed by the market cap of those asset classes that stablecoins are competing with or seeking to replace such as money market funds, which was recently approximately $4.5 trillion.
In managing their short-term liquidity, institutions clearly had not been eager to swap their 0.5% return for stablecoins’ 5%+ return even though some stablecoins are collateralized by high-quality assets that rival the underlying assets of certain money market funds. Regulatory uncertainty has been a primary reason behind such lack of institutional adoption—banks and asset managers have an obligation to safeguard client assets and cannot reasonably sweep client money to an instrument that lacks regulatory clarity for short-term liquidity purposes.
Given stablecoins’ progress to date, the industry should be sufficiently incentivized to look into single-use stablecoins to capture potentially greater institutional adoption. Imagine if an issuer created a dedicated money market fund stablecoin (MMF stablecoin). There should be little regulatory uncertainty as to who would regulate this instrument—the SEC—and what rules should apply—the federal securities laws and the Investment Company Act of 1940. An MMF stablecoin issuer would likely not have to be an insured depository institution.
The benefits of blockchain (e.g., faster settlement, greater transparency, potential ease of swing pricing implementation) would be an improvement over the traditional money market fund. And if an MMF stablecoin issuer wants to create another fiat-like payment stablecoin years later when it is ready to take on additional banking or money transmitter regulations, it could do that at its own pace with greater regulatory certainty, as the new product would likely not be integrated with its existing stablecoins.
To be clear, these single-use stablecoins need not sacrifice interoperability. One MMF stablecoin should be allowed to exchange with another MMF stablecoin on another blockchain or even with a payment stablecoin. But they do not all have to maintain a 1:1 peg at all times (e.g., institutional MMF stablecoins could be allowed to “break the buck” from time to time) because they serve different purposes, so their uses would all be optimized individually and regulated as such.
Today’s stablecoins make regulations harder than they should be. Single-use stablecoins will perhaps make it easier for regulators to apply existing rules, remove regulatory uncertainties faster, and help the industry achieve greater institutional adoption.
Some proponents of crypto argue these technologies are different, and the existing laws are too antiquated to address them. That may be true for a handful of applications—regulators may need to walk a fine line between ensuring investor protection and not imposing the full suite of regulatory burdens designed for mature financial products on these products and uses such that it stifles innovation. But the vast majority of blockchain applications achieve the same objectives as their predecessors, but more efficiently. The behaviors and incentives of those market participants are still identical as before, which existing US federal securities laws and financial regulations are adept at addressing.
If USTs were single-use stablecoins that were required to register as junk bonds, perhaps some retail investors would have been spared from losing their life savings.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Noah Qiao is a partner at Kirkland & Ellis LLP. He is a key member of the firm’s crypto advisory practice and has counseled clients on navigating the quickly-evolving crypto regulatory landscape. He is also an adjunct professor at Cornell Law School, where he teaches a class on crypto regulations.