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Recent headlines in the financial press have described the stunning collapse of stablecoin TerraUSD (UST). Largely invisible to mainstream investors before its implosion, UST was popular among crypto-asset enthusiasts and widely traded on crypto exchanges.
The creators of the UST promised that it could reliably maintain a one-to-one price link to the US dollar. However, for two weeks in May, UST lost its connection. Its value has fallen to about four cents on the dollar – despite efforts to keep it afloat. The rapid decline in the prices of UST and the related crypto-asset LUNA wiped out a staggering $42 billion in investor funds.
The UST collapse has sparked vigorous debate among regulators, investors, and crypto innovators about stablecoins, the appropriate regulatory response, and whether the UST saga could be a harbinger of future cryptocurrency-driven financial crises.
The debate is one that all compliance and risk professionals should understand, as it will shape the way financial institutions deal with cryptoassets for years to come.
Stablecoins: Institutional Gateway to Crypto?
Most cryptoassets — such as Bitcoin and Ether — are volatile and fluctuate in price. Accordingly, they serve primarily as high-risk speculative investments. Volatility often makes them unattractive for merchant payments, sending personal remittances, or other mass market use cases, and this can deter consumers from entering crypto markets.
Enter stablecoins, which aim to facilitate cryptocurrency adoption by reducing price volatility. Broadly speaking, there are two types of stablecoins: asset-backed and algorithmic.
Asset-backed stablecoins aim to maintain a fixed price by ensuring that they are fully insured. Their reserve funds may be fiat currencies such as the US dollar or the euro; other crypto-assets like Bitcoin or Ether; or physical commodities, such as gold. The most common stablecoins are fiat-backed coins pegged to the US dollar. These include Tether (USDT), USD Coin (USDC), Binance USD (BUSD) and Gemini Dollar (GUSD).
Algorithmically stable coins are not secured by reserves. Instead, they strive for price stability by relying on complex algorithms to regulate coin supply and demand. Popular algorithmic stablecoins include Dai, Neutrino USD and, until its collapse, UST.
At the time of writing, stablecoins have a combined market cap of more than $150 billion and are driving innovation across the crypto spectrum. Some proponents believe that stablecoins can increase financial inclusion among communities that are underserved by the banking sector. This is because they are more viable for use in payments and personal remittances than Bitcoin, although currently the use of stablecoins for payments and remittances is small.
Currently, stablecoins serve primarily as a vital bridge between the fiat and crypto ecosystems. Instead of constantly exchanging fiat currencies for volatile assets like Bitcoin and Ether, users can buy stablecoins and then exchange them directly on an exchange for a crypto-asset.
This has been key to the emergence of decentralized financial (DeFi) services – applications that rely on software to automate the delivery of financial services – as stablecoins allow users to reliably transfer funds to and from DeFi applications and serve as collateral in DeFi markets.
These features mean that stablecoins offer a promising entry into the crypto-asset world for corporations and financial institutions. Indeed, some are already exploring how to launch their own stablecoins.
The most high-profile of these efforts involved Meta — formerly Facebook — announcing in 2019 its plan to issue a stablecoin, Libra — later Diem — pegged to a basket of fiat currencies. The project aimed to bring crypto wallets to Meta’s two billion global users.
Regulatory scrutiny prompted Meta to shelve Diem, but other corporations are exploring similar initiatives for stablecoins that they hope can fuel innovative new products and services.
Regulators take note
But if stablecoins inspire imaginations in boardrooms, they have also caught the attention of regulators, who take a more skeptical view.
Project Diem has sparked alarm among policymakers that a major corporation could suddenly make a stablecoin available to billions of users, which some worry could undermine the macroeconomic policies of central banks.
In April 2020, the G20 called on leading economies to establish strong regulatory frameworks for stablecoins. This prompted the Financial Action Task Force (FATF) to release a report on stablecoins in September 2020. The organization highlighted several associated risks of money laundering and terrorist financing, including:
- pseudonymous transfers between illegal actors;
- peer-to-peer (P2P) cross-border transfers, which may enable money laundering, terrorist financing or sanctions evasion;
- layering of illegal profits where criminals can exchange stablecoins for other crypto assets;
- the ability of large corporations to launch stablecoins, which could cause the risk of systemic financial crime to proliferate.
The FATF has recommended that countries bring stablecoin issuers – as well as businesses that facilitate the issuance and trading of stablecoins – under AML/CFT regulation.
Since then, other watchdogs have gotten involved. In a February 2022 report, the Financial Stability Board (FSB) noted that asset-backed stablecoins could pose a risk to the broader financial sector if there was a rush to reserve funds invested in short-term money markets. Others – like New York’s attorney general – have expressed concern that some stablecoin issuers have failed to make honest disclosures about their reserves.
Other observers, meanwhile, flagged the risks associated with algorithmic stablecoins. They warned that investors may not understand the risks associated with these complex products, which can be anything but stable if the algorithms fail. The UST case brought these concerns to the fore when it failed the automated stabilization mechanism that was supposed to support it.
The European Union has addressed these issues through its proposed framework for markets in crypto-assets (MiCA). A comprehensive proposal for comprehensive regulation of cryptocurrencies across the bloc, MiCA sets the standard for stablecoin issuers serving the EU.
MiCA requires that issuers of asset-backed stablecoins maintain verified reserves and demonstrate that they have reliable stabilization mechanisms. It also provides token holders with strong redemption rights from issuers. Issuers of algorithmic stablecoins will have to establish a legal presence in the EU, disclose information about their operations in a white paper and warn consumers of the associated risks.
In the United States, regulators expressed their concerns in a November 2021 report released by the President’s Task Force on Financial Markets. The report recommends that stablecoin issuers be regulated as insured depository institutions. The US Congress is considering several proposals to bring stablecoin issuers under the supervision of banks.
Compliance response
As stablecoins are further integrated into the financial system, regulatory requirements will tighten, potentially significantly. Compliance teams should understand these requirements and take appropriate steps to mitigate risk.
Firms looking to launch their own stablecoins need to be aware of the rapidly evolving requirements in the EU and the United States and should be prepared to comply with rigorous disclosure, licensing and reserve requirements.
Stablecoin issuers must also ensure that they can identify the risks associated with money laundering and other financial crimes. Blockchain analytics solutions – which use data from ledgers that record stablecoin transactions – enable the detection of high-risk indicators associated with stablecoins and can facilitate the reporting of suspicious activity.
Similarly, financial institutions that provide custodial services for stablecoins – or that hold reserve funds for issuers – need to be alert to the risks of financial crime and should take advantage of blockchain’s monitoring capabilities to identify high-risk wallets and transactions.
Stablecoins may very well prove to be instrumental in enabling crypto-assets to become mainstream. Compliance professionals must now prepare for this emerging new face of finance.
Originally published by Thomson Reuters © Thomson Reuters.
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