Calls for improved regulation of the crypto market continue to gain momentum – including for the facilitator of the crypto market: stablecoins. These crypto assets serve as an important crossover between the crypto universe and the “real” economy, which means they also provide a conduit through which shocks may be transferred from the crypto world to the “real” world and vice-versa.
The Weil restructuring team provides its observations on this expanding area of the financial landscape.
- Focus on regulation of crypto assets (including stablecoins) is appropriate as crypto assets increasingly become integrated into the “real” world economy.
- While some parallels might be drawn with financial products that played a role in triggering the Great Recession, stablecoins are new structures with their own complexities.
- The crypto world may be borderless, but insolvency and restructuring regimes are not – failure and restructuring of stablecoin and other crypto issuers will require a truly global, coordinated approach.
What are stablecoins?
Like so much of the blockchain universe, there is no agreed form of stablecoin, but the key advertised feature is consistent: a crypto asset that seeks to minimise volatility in its value.
Stablecoins are typically either asset-linked (with physical or financial reserves, such as Tether) or algorithm-based (such as Terra / Luna, the spectacular failure of which has been borne out in recent weeks). We focus here on the asset-linked type, which we consider has greater potential for ramifications in the wider economy.
The critical element of an asset-linked stablecoin is that the holders are entitled to redeem the coin for reserve assets at a specified redemption ratio—the most common form is a 1:1 redemption for fiat currency (e.g., one U.S. dollar for one stablecoin). Importantly, it is the issuer’s promise to complete the exchange together with the veracity of its reserves that underpins the holder’s faith in the 1:1 pricing.
Stablecoin issuers report holding reserves in forms other than physical currency, including investments in commercial paper, certificates of deposit, foreign cash and bank deposits, reverse repurchase agreements, money market funds and government bills. According to press reports, stablecoin issuers have become one of the largest classes of buyers of commercial paper. These alternative reserve sources add an interesting dynamic to the nascent cryptocurrency by creating a conduit between the crypto world and the “real” economy.
People generally acquire stablecoins to conduct more speculative trading in other cryptoassets or to store value during times of crypto market volatility. Many crypto currency platforms do not facilitate trading with fiat currency, and so participants must first acquire stablecoins (using fiat currency) in order to trade on those platforms. Platforms that do facilitate trading with fiat currency often take several days to process deposits or transfers of fiat, during which time trading opportunities in the crypto market may be missed. Stablecoins, on the other hand, facilitate rapid participation and settlement in the crypto market.
Stablecoins arguably also have day-to-day uses in the “real” economy as a means of direct payment. The UK’s Financial Conduct Authority (FCA) found that 27% of stablecoin owners used stablecoins to purchase goods and services. The UK Government believes that certain types of stablecoin have the potential to play an important role in retail and cross-border payments (including settlement), provided that appropriate standards and regulations are in place. Stablecoins can also serve as collateral for margin lending.
Risks with stablecoins
The core proposition of a stablecoin is that it reduces risk for the holder (compared to other crypto assets) and avoids wild swings in price common to other cryptocurrencies, like Bitcoin. However, it is worth considering whether stablecoin may in fact create new systemic risks (or recreate old ones).
As mentioned, the cornerstone of a stablecoin’s stability is the holder’s faith in their ability to redeem the stablecoin for the reserve. If this faith is undermined (for example because of serious concerns regarding the quality, amount or liquidity of reserve assets) then this may trigger a self-perpetuating “run” on the stablecoin – an example of this occurred in May 2022 when Tether’s price temporarily lost its US$1 peg following approximately US$3bn of redemptions in a single day.
A sustained “run” could have implications both within the crypto world (as has been borne out in recent weeks), as well as potentially more far-reaching consequences in the “real” economy. For example:
- Loss of value for the stablecoin holder. The supposed “stable” store of value is now worth less in the hands of the holder. This could be especially concerning if stablecoins become more widely used as a form of direct payment for goods and services.
- Impact on other cryptocurrencies. Stablecoins are used primarily to facilitate rapid transactions in other crypto assets (compared to using fiat currency). For example, digital asset analysts have suggested that Tether may be used for up to 70% of all Bitcoin trades. A run on stablecoins would severely reduce liquidity in the crypto markets, potentially triggering price declines across the crypto asset universe. One could argue that this is exactly what has occurred in recent weeks following the collapse of Terra / Luna and the short-lived Tether de-pegging.
- Less liquidity in the “real” economy. In June 2021, Tether had become one of the world’s largest investors in the U.S. commercial paper market, with holdings similar to some of the world’s largest traditional asset managers. A run on stablecoins may trigger selling pressure in the commercial paper market and / or prevent stablecoin issuers from participating in these markets, which could potentially create a large funding gap in the “real” economy, with less liquidity available for businesses to fund day-to-day operating expenditure like wages and utilities. It is possible that other market participants would fill this funding gap relatively quickly, causing only a temporary liquidity shock.
Parallels with 2007 – 2008
The potential risks inherent in stablecoins are not new to the financial markets. Both money market funds (MMFs) and structured investment vehicles (SIVs) have qualities similar to stablecoins, and both structures significantly contributed to the credit crisis in 2007 and 2008.
In simple terms, a MMF permits shareholders to redeem each share in the fund for one fiat currency (e.g., U.S. dollar). MMFs are closely regulated and may only hold reserves meeting certain criteria. The MMF immediately pays shareholders any interest or return it makes on the reserves.
Like the stablecoin issuers, MMFs are also major participants in the commercial paper and government bills market. The bankruptcy of Lehman Brothers on 14 September 2008 triggered a “run” on the Reserve Primary Fund MMF, with redemption requests totalling US$40 billion by the afternoon on 16 September 2008 (nearly 2/3 of total AUM). Reserve Primary Fund’s shares later “broke the buck” when its NAV dropped to $0.97 per share, triggering a wide-spread run on other MMFs as investors sought to withdraw their funds over fears that each share was no longer worth one U.S. dollar. Short-term liquidity in the commercial paper market effectively evaporated overnight, causing severe shock in the “real” economy. Businesses were no longer able to borrow funds to meet day-to-day operating expenses due to a lack of willing lenders. The “run” was only stemmed by the U.S. government extending “deposit insurance” to MMF investors to effectively underwrite their 1:1 redemption rights.
SIVs borrowed funds from the short-term commercial paper market and then on-lent those funds for mortgage backed securities with terms ranging from 15 to 30 years (profiting on the spread between the two rates).
Following the sub-prime mortgage crisis in 2007/8, SIVs were unable to roll over commercial paper borrowings due to a collapse in underlying collateral values. SIVs consequently had to liquidate assets and call upon sponsor credit lines to meet redemptions, with reverberations through the wider financial markets.
These “borrow short / lend long” issues could similarly arise with stablecoin issuers, where on demand deposits have been used to fund longer term paper – creating selling pressure in the event of substantial redemptions.
Key difference from old structures
One key difference between the MMF and SIV structures of 2007/8 and stablecoin products is the ability for stablecoin issuers to gate redemptions if required due to the illiquidity, unavailability or loss of any reserves held by the stablecoin issuer supporting the value of the stablecoin. However, this is likely only a last resort to facilitate an orderly liquidation of assets, rather than a permanent solution, given that confidence in the stablecoin would be completely eroded by the act of suspending redemptions.
The courts have so far managed to fit cryptoassets into established case law principle. Yet, in some cases, the courts have sidestepped certain issues and may start reaching different conclusions across jurisdictions. A lack of global uniform rules and diverging views in relation to the proper law and regulation of an item existing in all places at once will most likely constrain stablecoin’s ability to be a functional tool in commerce. That issue has in part been a catalyst for the UK Government to seek to make the UK a leading hub for dealing in cryptoassets through new crypto regulatory frameworks, resulting in two recent public consultations led by HM Treasury.
In April 2022, HM Treasury announced its intention to make stablecoins a means of payment in the UK regulatory perimeter through a raft of legislative amendments. HM Treasury says, taken together, the “changes will create the conditions for issuers and service providers of stablecoins used as a means of payment to operate and grow in the UK, in line with the government’s firm commitment to place the UK’s financial services sector at the forefront of crypto asset technology and innovation.”
In May 2022, HM Treasury followed with a further consultation on a proposed framework insolvency regime to apply to systemically important crypto asset issuers (including stablecoin issuers). The primary objective of the framework is to align with the UK’s existing Special Administration Regime (SAR) to ensure the continuity of services provided by systemically important companies. If Treasury’s proposed approach is enacted, a further objective will be added that administrators transfer the coins to another stablecoin issuer or return them to the users (in the case of a systemic digital asset firm). Bringing crypto asset issuers within the ambit of the SAR would place the Bank of England as the appropriate lead regulator of stablecoins, over the Financial Conduct Authority (although there would be some regulatory overlap). It is proposed that the Bank of England be required to consult with the FCA before it seeks a special administration order for stablecoin issuers subject to regulatory requirements imposed by both the Bank of England and FCA, or directs administrators with regard to the regime’s objectives.
It is likely these two consultations are only the start to the UK’s regulatory roadmap for crypto assets. There are other issues that will require careful consideration, such as classifying and applying appropriate regulations to the broad array of cryptocurrency and crypto asset business models. For example, crypto exchanges offer trading and “wallet” services having similar features to other regulated custodians of financial instruments, but there is no equivalent “Client Asset Sourcebook” (CASS) rules that apply to them. Without uniform rules, whether or not the crypto exchanges hold any given crypto assets on trust for the user may be uncertain. Clarity on these issues is vital in the event of insolvency as administrators and liquidators try to untangle an already abstruse asset class.
In addition, local regulation seems necessary, but given stablecoins (and crypto assets more generally) are a form of “borderless” asset, there is scope for overlap and inconsistency between applicable regulatory regimes in different jurisdictions. It remains to be seen which regulatory regime(s) across various jurisdictions will apply and how any inconsistencies may be resolved.
While some parallels can be drawn to the credit crisis experienced in 2007/8 (and structures like MMFs and SIVs), cryptocurrency and stablecoin structures are new and will likely present unique challenges. Significant questions remain as to how these new structures will fare in their own crisis – although developments over recent weeks in the crypto universe suggest that the answer may become clearer in the near term.
Increasing regulation of the crypto market, and in particular stablecoin issuance, is inevitable as the crypto market grows and becomes increasingly mainstream. This is a sensible approach as it should help to promote stability and trust in the crypto markets.
Legal frameworks (including insolvency regimes) that would apply in the event of an insolvency or restructuring of a crypto issuer are jurisdiction-specific, but cryptoassets themselves are not. With crypto issuers incorporated in jurisdictions like BVI and Hong Kong, assets held with banks from Singapore to the Bahamas, claims against commercial paper issuers in the U.S., Europe, China and Latin America, creditor claims evidenced through various crypto blockchains, and terms of service that attempt to limit creditor coordination, it is clear that a truly global, coordinated approach will be required to successfully restructure or liquidate these vehicles in the event of a failure.
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