Regulatory authorities have been increasing their attention towards the paradigm of stablecoins, and if designed well and appropriately regulated, stablecoins hold tremendous potential to transform our financial system by making payments more efficient, secure and instantaneous -- all of which can be tracked on a public ledger.
However, this transformation has largely been limited due to traditional regulations. While these assets may hold tremendous underlying benefits, they may pose risk to financial systems. Compliance with strict regulations in accordance with AML (Anti-Money-Laundering), KYC (Know Your Customer) and preventing their misuse have been at the essense of any regulation.
The most critical piece of crypto-markets regulation is the 400-page Proposal for a Regulation Of The European Parliament and The Council on Markets in Crypto-assets and amending Directive. If the Council of the European Union approves the proposed regulation, it will become E.U. law, and everyone in E.U. will have to follow it. However, because of the "Brussels Effect," there is a good chance these rules will become international standards.
The regulation is a few years away from coming into law, but it already affects the stablecoin market. Below, we analyze the regulation's effect on significant stablecoins, jointly constituting more than 86% of the stablecoin market, equal to $126 Bln at the time of writing.
- Fiat-backed stablecoins: USDT, USDC
- Yield-generating stablecoins: USD+ (Newcomer on the market)
- Algorithmic stablecoins: UST (‘TerraUSD’)
- CDP Stablecoins: DAI/LUSD
To avoid legal sanctions, it is important how this new legislation will affect each coin. If USDC and USD+ will benefit from the regulation, others might struggle to comply.
What are stablecoins?
Before we dive into how regulations affect the various types of stablecoins within the realm of cryptocurrencies, it is important that we understand stablecoins themselves. A stablecoin is essentially a class of cryptocurrencies that offers stability to its holders and is usually backed by a reserve asset. In recent times, there has been increased scrutiny regarding their “reserve assets” as regulatory authorities clawed down on their backing. This in turn has affected how they’re constituted under regulatory requirements.
Stablecoins intend to provide the best of both worlds to their holders: the ability to hold volatility-free fiat money as well as take advantage of instant processing of cryptocurrencies.
The following are the various types of stablecoins that are directly subjected to the recent regulations proposed.
USDT
Under the proposed regulation, USDT would fall under Title IV and be an 'Electronic money token,' which implies that Tether would have to get a banking license in the E.U., comply with KYC/AML standards globally, observe capital, liquidity and reporting requirements. If there is anything non-kosher with those reserves, it could be big trouble for USDT.
USDC
USDC would also be considered 'Electronic money tokens' and must obtain a banking license and comply with banking regulations. Compared to Tether, Circle has already disclosed its assets and adjusted investment policies towards more prudent standards; it plans to obtain a banking license in the U.S. and is prepared to comply. Most importantly, the regulation restricts the usage of stablecoins as a currency used to pay for goods and services to 'Electronic money tokens' only (more on this below). Overall, this means that not only USDC is poised to gain market share away from USDT massively, but it is also protected from decentralized stablecoins (UST, DAI, USD+, etc.) in the payments market.
USD+ (‘Overnight’)
The mechanics of USD+ are very similar to that of traditional money market funds, aka Vanguard or Fidelity. Because of its 'compliant mechanics', USD+ is essentially built to qualify as an 'asset-referenced token,' and would relatively easily receive Authorization under Article 19. An expected challenge would be proving that the yield generated by USD+ does not represent interest, which is prohibited as per Article 36, but instead profits from asset appreciation. But Overnight.fi has innovated in this matter by creating an interest rate benchmark called Polybor.
UST ('TerraUSD')
Regulated 'as is,' UST would meet the definition of 'Electronic money token' under Title IV: 'crypto-assets that reference only one official currency of a country,' in this case USD. It would be required to get a banking license, guarantee the claim and redeemability. More importantly, because of its seigniorage stabilization mechanics, complying with banking regulations would be non-trivial — all UST in circulation would be considered a liability with no asset to back it up. Simply put, from the E.U. regulator perspective, Terra Bank, if formed, would be short of $7.5 Bln of shareholder capital.
UST's best shot would be to move away from 'referencing one official currency' to 'referencing any value or right, or a combination thereof, e.g., USDC.' In this manner, UST could qualify as an 'asset-referenced token' as per Title III and would have an option to avoid getting a banking license by forming a legal entity in the E.U., Contribute equity to the amount of 2% of UST in circulation, Seek authorization under Article 19 of the regulation, and adjust its seigniorage mechanics away from burning Luna to maintaining 'reserve of assets' under Article 32.
If all this were not enough, UST as an 'asset-referenced token' would be restricted from 'being used widely as a means of exchange' under Article 19b. The restriction implies the limit of 1M transactions and/or 200 M EUR turnover per quarter. With Terra's vibrant payment ecosystem, including Chai and Memepay, UST would be in breach of this regulation as of day 1.
DAI ('Maker DAO')
I wish Maker DAO voted to go after 'Electronic money token' status as the process of E.U. licensing a DAO would be highly amusing to watch. Nevertheless, DAI's best chance would be to qualify as an 'Asset-referenced token' under Title III with much lighter requirements.
Under the scenario, CDP stablecoins' (DAI, LUSD, MAI, etc.) advantage over algorithmic ones (UST, FEI, etc.) would be the availability of collateral or the regulator availability of the reserve asset — making the regulation much easier to observe. Another positive is that DAI's core use case around financial transactions, not a 'means of exchange', which will be restricted.
The major challenge would stem from decentralized governance as the regulator requires a proper legal entity and governance somewhat resembling that of a public company/financial institution.
Finding the perfect balance between legitimate regulatory oversight and fintech innovation is crucial. We should ensure the proper safeguards so that stablecoins and all cryptocurrencies are for optimal use and investor protection.
The U.S. President's Working Group prepared a report on stablecoins in 2020 to comply with the legal and regulatory requirements. Treasury Deputy Secretary Justin Muzinich said, "The statement reflects a commitment to both promote the important benefits of innovation and to achieve critical objectives related to national security and financial stability..."
I am optimistic that appropriate governmental oversight worldwide will allow the industry to protect consumers and innovate within the financial industry.
About the author:
Max Ermilov is the Founder and CEO of Overnight, a decentralized protocol behind yield-generating stablecoin USD+. Overnight is Maxim's second business with the first being Mach49 Vostok, the Eastern European franchise of Mach49. Prior to founding Mach49 Vostok, Maxim had spent 17 years at BCG, most recently as Partner and Managing Director for the Financial Institutions sector. He also led the project to design and launch Tinkoff.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.