There is no question that financial markets and regulators are currently working to manage turmoil in the cryptocurrency space.
Unfortunately, a recent string of high-profile bankruptcies and collapses of over 20 “stablecoins” whose peak market capitalisations were collectively over US$26 billion ($34.4 billion) has exposed many problems in the nascent ecosystem. Even one of the largest remaining stablecoin issuers — Binance — admitted to pooling company and client assets in issuing their stablecoins after the publication of a report written by one of the authors of this article.
Libertarians will argue this is a free market sorting out problems. But both regulators and regulated entities in the space are reasonably calling for more investigation and evaluation of how regulation can improve trust in the system.
Stablecoins are an asset class within the cryptocurrency space that seeks to replace traditional bank-centric payment systems with transactions on public ledgers. On the one hand, some regulators, like the New York Department of Financial Services, provide stamps of approval of sorts for these products.
Others, like the United States Treasury, have yet to clarify the regulatory frameworks. Interestingly, the federal government, including the United States Treasury and the Office of the Comptroller of the Currency, have not finalised their regulatory framework yet.
Designing a stablecoin
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Many extant stablecoins and proposed regulations aim to enforce what is known as “fully collateralised” stablecoins. This means that for every “stable” asset that is issued, there is one corresponding unit in reserve in a traditional bank account. Such an arrangement is similar to that many countries use to peg their local currency to a foreign one. These sorts of mechanisms are well-studied in international finance.
It may be worth considering whether the algorithmic nature of cryptocurrencies, embodied by the smart contracts which can be written on top of existing systems, introduce a new way to construct and manage stablecoins — assets whose origins trace back hundreds of years back to the gold standard.
Without taking an ideological stance, we can evaluate the role of regulation for this asset class from a technical perspective by studying the theoretical limits of proposed decentralised stablecoins. Importantly, none of our views rely upon the belief anyone involved is a bad actor. We find that the traditional financial solution, commonly called a “currency board,” is the only solution for provably stable cryptocurrency stablecoins.
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We are unaware of regulations that permit other designs and would encourage regulators to codify this requirement more firmly to help protect future users from being misled. Even after the failure of the “algorithmic stablecoin” UST in May 2022, similar products are still being developed. And consumers should know that no such design will get an official stamp of approval. That marketing tool should be taken out of service.
Implications for financial regulation
At the same time that current regulations permit only working designs, they do have other gaps. A provably stable stablecoin can still easily be repurposed to evade important regulations like a range of know-your-customer (KYC) and anti-money-laundering (AML) laws.
But the high degree of automation in cryptocurrency markets enables new routes around these regulations. For example, most people think of a stablecoin as representing US$1 on a blockchain with a corresponding bank account balance held by the issuer. But one can also lock one stablecoin into a “smart contract” on a blockchain and then issue a new one backed one-to-one by the old, a stablecoin-on-a-stablecoin.
So long as the licensed issuer is not the entity issuing this stablecoin-squared, there is no reason to expect the second coin to follow any particular KYC and AML rules. And most current rules do not cover this easy workaround.
This is where the combination of permissionless public networks and high levels of automation creates new regulatory problems. Let’s say we have a regulated stablecoin USDX, issued by a New York Department of Financial Services-licensed institution called “X” with all the required controls. What responsibility does X have if some other party called “Y” generates a USDY with a 1:1 USDX backing?
It is worth looking at extant regulations in traditional finance for banks. For example, if someone is going around selling “wrapped” certificates of deposit issued by Bank Z without the requisite licenses, that is clearly a problem for them. But if Bank Z knows about this and does nothing, then Bank Z, too, is complicit.
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This concept is similar to the principle in copyright law that you must pursue infringers to maintain your rights. It is not enough to shrug and say “they are wrong” — you must actively pursue infringers. Further, as the only working stablecoin design is the one best suited to this kind of misleading wrapping, this gap is likely to be exploited in practice.
And here, the low cost and permissionless nature of the ecosystem is a double-edged sword. Wrapping new stablecoins and wrapping the wrappers can be done very quickly and cheaply — making policing this behaviour ever more difficult and borderline impossible.
In practice, we have seen ample evidence of this behaviour even when there is an existing business relationship between X and Y. In several cases, a cryptocurrency exchange has entered into a marketing agreement with the regulated stablecoin provider to issue regulated, branded stablecoins with all the required KYC/AML controls. And then, the marketing partner went off and built a wrapped version of the token without those controls.
Without asserting that any of these parties have done anything wrong, we would still argue that the regulations are inadequate. What responsibilities does the regulated issuer have to surveil the market and protect its name? What must they do when confronted with the presence of this activity or inquiries about marketing materials that seek to represent the unregulated product as regulated? The time to tackle these policy questions is now.
Much of the debate in the cryptocurrency space involves absolutes. There are advocates for unbridled freedom and also those for extreme levels of surveillance. We seek to advance the debate on a more practical level by identifying gaps in existing rules that actively cause confusion in the market and demonstrate a clear possibility of causing consumer harm.
We now know some of the theoretical limitations of automated blockchain-based financial systems. It is past time for the different jurisdictions seeking to provide licenses in the space to patch holes in their regulatory frameworks.
Ben Charoenwong is an assistant professor of finance at the National University of Singapore Business School where he teaches international finance and conducts research on financial regulation. The opinions expressed are those of the writer and do not represent the views and opinions of NUS. Jonathan Reiter is co-founder of Data Finnovation