What are Stablecoins?
Of all “crypto” in existence, stablecoins are among the most useful monetary tools in a world of inefficient and expensive legacy financial systems. A stablecoin is a cryptographic token that is designed to be, well, “stable” in value relative to an external benchmark. Most, though not all stablecoins, are pegged to the United States dollar. The mechanism by which the coins maintain this peg vary:
Fiat-backed stablecoins are created and issued by a central organization, which organization then backs the stablecoin with reserve assets. One example is USDC (United States Dollar Coin, need it be spelled out), which is backed 1:1 by “conservative” dollar-denominated assets that are themselves designed to hold their value. Circle, the organization that created and issues USDC, maintains principally cash and United States government debt as the backing for every USDC coin issued and outstanding. They permit redemption of USDC coins for dollars, and USDC can also be sold for United States dollars on crypto exchanges. In keeping with the recent trend demanding proof of reserves, the accounting firm Grant Thorton publishes monthly “attestation reports” of the amount of fiat money that Circle holds to back USDC. See https://www.centre.io/usdc-transparency. The idea behind maintaining these reserves is that USDC users can be confident in using the tokens essentially in place of dollars across the networks that support it. These networks are faster, cheaper and more efficient than their legacy counterparts.
Crypto-backed stablecoins are also intended to maintain a $1 United States dollar value per token, but instead of relying on a central issuer to store the reserve, crypto-backed stablecoins use smart contracts to secure assets as collateral. To account for the unpredictable volatility of the cryptocurrency market, many decentralized crypto-backed stablecoins like MakerDAO’s DAI token are over-collateralized. This requires, for example, that a given borrower send 200% of the amount of DAI to be borrowed to the MakerDAO smart contract, typically in the form of Ethereum (ETH). These smart contracts are fair and automatic in their execution – if the ETH sent to the contract falls to a given liquidation point in dollar terms it is liquidated without preference to any one borrower over another. This engenders confidence in the value of DAI, even though its backing (ETH) is significantly more volatile than the US dollar.
An algorithmic stablecoin is a type of cryptocurrency that aims to maintain a stable value by controlling the supply of coins using algorithms, and by relying on supply and demand principles to maintain the $1 peg. Typically, algorithmic stablecoins have a “companion” coin into which the stablecoin is convertible on a 1:1 basis, and the assumption is that this companion coin is valued at $1 or more by market participants for its utility as a payment instrument or for whatever other reason. As such, algorithmic stablecoins don't rely on reserve assets but rather use a computer program or smart contract to control and regulate the supply of each coin in the pair. This is done by “minting” one of the coins in the pair and “burning” the other every time a market participant does an exchange. The assumption is that people will keep the value of the coin close to or at the $1 peg through arbitrage (that is, human nature dictates that a rational person would want to mint the undervalued coin in the pair [for subsequent sale at a profit] and burn the overvalued one, keeping the equilibrium).
In the aftermath of the collapse of TerraUSD (UST), however, this model has come under considerable strain. In the case of UST, an attacker essentially overwhelmed the mint/burn mechanism that was designed to keep the token stable at $1. He, she or they burned a massive amount of UST at once (under suspicious circumstances) which, according to the smart contract, minted the companion coin LUNA in an equal amount. LUNA was at its peak valued at close to $115.00, but this flood of supply panicked the market and drove its price off of a cliff. Because LUNA was always exchangeable 1:1 with its stablecoin – UST – the value of UST lost its $1 “peg” as LUNA crashed, with both ending up close to $0. This failure in the arbitrage mechanism and supply / demand balance was known as a “death spiral”, that is, the market no longer believed that LUNA, or its companion, were worth $1, and discarded them both.
Why are Stablecoins Important?
Stablecoins are important for the same reason that any form of money is important – they are a means of exchanging value. The rationale is as old as money itself – at one point human beings traded goats for chickens, or corn for wheat, until they came up with a symbol of value (once shells, now paper and digital entries in a database) that could be exchanged in lieu of the actual goods. So it is with stablecoins in the crypto sphere. In other words, instead of having to trade your Bitcoin directly for Ethereum (which you can certainly do – goats for chickens) you have the option instead to transact in the form of a stablecoin. This is especially powerful when you think in terms of international trade. If you earn pesos but want to buy something priced in dollars, a neutral representation of value, here, a stablecoin, can be used by both parties to buy and sell the goods instead of worrying first about getting your hands on the “right” currency for the market in which you want to trade.
Why are Stablecoins Controversial?
Stablecoins are controversial to some, for several reasons. The first relates to consumer protection, confidence and market integrity. It makes sense for there to be standards or rules around what makes a coin “stable”. In the case of fiat-backed stablecoins, the issuer should have to establish the existence of the reserves in a transparent manner according to standards that can be easily understood and compared against other issuers and coins.
The mere existence of crypto-backed and algorithmic stablecoins is controversial to others. Some doubt the sustainability and market value of even the largest cryptocurrencies. If this is the case, no cryptocurrency could ever serve as good collateral, even where a coin is backed 2:1 or more by another form of crypto. The LUNA debacle, too, fundamentally puts the algorithmic stablecoin model (at least as it is currently conceived) in doubt.
Some go a step further, and dislike stablecoins for their disruptive potential. A great deal of the legacy financial system is rent seeking, that is, fueled by transaction fees for moving or exchanging different forms of money. A more efficient competitor – a neutral medium of exchange good across national borders – threatens this model. Some in government and supranational bodies don’t like the idea of any form of “money” that cannot be surveilled, and, consequently, controlled, although there is some justification for concern over the use of stablecoins for money laundering and other criminal activity.
Survey of Potential Stablecoin Legislation
There has over the past several years been multiple proposals advanced in both the United States House of Representatives and the Senate concerning the regulation of “stablecoins”. What follows is a digest of the outstanding United States legislation to date, specifically, the sections of pending legislation that define “stablecoins”. As of today none of the following Bills have become law and will be subject to considerable change, or rejection, as they go through the legislative process. (Emphasis and formatting, where used, is our own).
H. R. 5197 - Managed Stablecoins and Securities Act of 2019
“(20) The term ‘managed stablecoin’ means a digital asset that—
“(A) is not a security registered under section 8(a) of the Investment Company Act of 1940; and
“(B) satisfies one or more of the following:
“(i) The market value of such digital asset is determined, in whole or in significant part, directly or indirectly, by reference to the value of a pool or basket of assets, including digital assets, held, designated, or managed by one or more persons.
“(ii) One or more holders of such digital asset, directly or indirectly, are entitled to obtain consideration or other assets, including other digital assets and any sovereign currency of a foreign government or the United States, in exchange for the digital asset, the amount of which payment is determined, in whole or in significant part, directly or indirectly, on the basis of the value of a pool or basket of assets, including digital assets, held, designated, or managed by one or more persons.”
Comment: This bill has among the broadest definitions of a “stablecoin”, here, a “managed stablecoin”, in that it is principally concerned with whether the instrument references an external source – here, a “pool or basket of assets, including digital assets” managed by a third party – for its value. The Bill’s language is not restricted to US dollars or any other specific benchmark or form of collateral, and does not include a redeemability requirement.
H. R. 6154 - Crypto-Currency Act of 2020
(9) RESERVE-BACKED STABLECOIN.—The term “reserve-backed stablecoin” means a digital asset that—
(A) is a representation of currency issued by the United States or a foreign government;
(B) rests on a blockchain or decentralized cryptographic ledger; and
(C) is collateralized on a one-to-one basis by such currency, and such currency is deposited in an insured depository institution.
Comment: A “Reserve Backed Stablecoin” referenced here, is a “representation of currency” and is collateralized “on a one-to-one basis” with currency. Notably, this legislation requires that a stablecoin be backed by reserves held in an “insured depositary institution”, a superior form of protecting the assets backing the stablecoin.
H. R. 8827 - Stablecoin Classification and Regulation Act of 2020
“(aa) Definitions Related To Stablecoins.—
“(1) STABLECOIN.—The term ‘stablecoin’ means any cryptocurrency or other privately-issued digital financial instrument that—
“(A) is directly or indirectly distributed to investors, financial institutions, or the general public;
“(i) denominated in United States dollars or pegged to the United States dollar; or
“(ii) denominated in or pegged to another national or state currency; and
“(C) is issued—
“(i) with a fixed nominal redemption value;
“(ii) with the intent of establishing a reasonable expectation or belief among the general public that the instrument will retain a nominal redemption value that is so stable as to render the nominal redemption value effectively fixed; or
“(iii) in such a manner that, regardless of intent, has the effect of creating a reasonable expectation or belief among the general public that the instrument will retain a nominal redemption value that is so stable as to render the nominal redemption value effectively fixed.
Comment: In this legislation a “stablecoin” is either denominated in or pegged to the United States dollar or another national or state currency. This legislation speaks to the concept mentioned above, that is, part of what makes a stablecoin as much is the general public’s perception that it will maintain a fixed value in nominal terms.
S. 4356 - Lummis-Gillibrand Responsible Financial Innovation Act
“SECTION 9801. Definitions
“(5) PAYMENT STABLECOIN.—The term ‘payment stablecoin’ means a digital asset that is—
“(A) redeemable, on demand, on a 1-to-1 basis for instruments denominated in United States dollars;
“(B) defined as legal tender under section 5103 or under the laws of a foreign country (excluding digital assets);
“(C) issued by a business entity;
“(D) accompanied by a statement from the issuer that the asset is redeemable, as specified in subparagraph (A), from the issuer or another identified person;
“(E) backed by 1 or more financial assets (excluding other digital assets), consistent with subparagraph (A); and
“(F) intended to be used as a medium of exchange.
Comment: The Lummis-Gillibrand Bill is a bipartisan effort that has received considerable attention for its comprehensiveness and for reflecting a good understanding of the underlying digital assets. In this case, the definition of a “payment stablecoin” provides that it is redeemable on demand for fiat currencies or other “financial assets” securing its value. This redemption mechanism makes this Bill’s definition of a stablecoin broader, in that it would incorporate instruments that are backed by more than solely United States dollars.
H. R. 4741 - Digital Asset Market Structure and Investor Protection Act
“(c) Digital Asset Fiat-Based Stablecoin Defined.—In this section, the term ‘digital asset fiat-based stablecoin’ means a digital asset (as defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) that is, as determined by the Secretary of the Treasury, tied, pegged to, or collateralized substantially by—
“(1) the United States dollar or;
“(2) one or more fiat currencies.”
Comment: This take on stablecoins is interesting in that it considers digital assets to be stablecoins where they are collateralized “substantially” by the United States dollars or other fiat currencies. This begs the question of what other types of assets should (or must) back such stablecoin, which could include government debt (as is the case with USDC), or perhaps other forms of collateral (as in the case with USDT, which is backed in part by riskier assets, such as commercial paper).
H. R. 8498 – To establish reporting requirements for persons who issue fiat currency-backed stablecoins, and for other purposes.
SECTION 1. FIAT CURRENCY-BACKED STABLECOINS.
(a) In General.—The term “fiat currency-backed stablecoin” means a fiat currency-backed digital asset—
(1) that maintains price stability by backing the value of such digital asset to a non-digital currency that is denominated in the same currency as such digital asset is issued; and
(2) is redeemable on a one-to-one basis in the denominated currency to which the digital asset is backed.
(b) Treatment As A Security Or Commodity.—A fait currency-based stablecoin is not a security (within the meaning given the term in section 3 of the Securities Exchange Act of 1934) or a commodity (within the meaning given the term in section 1a of the Commodity Exchange Act) and may not be regulated as such by the Securities Exchange Commission or the Commodity Futures Trading Commission.
Comment: This legislation does not have a popular name at the time of this writing. The legislation resembles many of its peers in that a “fiat-backed stablecoin” references the nominal value of the fiat asset that backs it, and is redeemable for the same. Here we see evidence of the jurisdictional tug-of-war between the SEC and CFTC in identifying which assets are securities, which are commodities, and which, as would be the case under this definition, are neither.
S. 3970 – Stablecoin Transparency Act
Identically introduced in the House of Representatives under the same name, as H. R. 7328
SEC. 2. STABLECOIN ISSUER REQUIREMENTS.
(a) Definitions.—In this section:
(1) FIAT CURRENCY-BACKED STABLECOIN.—The term “fiat currency-backed stablecoin” means a fiat currency-backed digital asset—
(A) that maintains price stability by backing the value of the digital asset to a nondigital currency that is denominated in the same currency in which the digital asset is issued; and
(B) is redeemable on a one-to-one basis in the denominated currency to which the digital asset is backed.
Comment: This language is almost identical to H. R. 8498. Here a “fiat-currency backed stablecoin” is denominated in the same currency in which the digital currency is issued.
H.R.7614 - Digital Commodity Exchange Act of 2022
``(52) Digital commodity.--
``(A) In general.--The term `digital commodity' means any form of fungible intangible personal property that can be exclusively possessed and transferred person to person without necessary reliance on an intermediary.
``(B) Exclusions.--The term `digital commodity' does not include any asset that conveys--
``(i) an equity or debt interest in a company, partnership, or fund;
``(ii) a profit or revenue share derived solely from the managerial efforts of others;
``(iii) an entitlement to any interest or dividend payment.
Comment: While the Digital Commodity Exchange Act of 2022 doesn’t contain the term “stablecoin”, the broad scope of what is a “digital commodity” could potentially include stablecoins. Notably, this definition carves out digital assets that are more akin to securities, including those that convey equity, debt, profit, revenue or dividend interests (as do stocks, notes and other types of “investment contracts”).
Stablecoin Transparency of Reserves and Uniform Safe Transactions (TRUST) Act or Stablecoin TRUST Act of 2022
(9) PAYMENT STABLECOIN.—The term ‘‘payment stablecoin’’ means a convertible virtual currency that—
(A) is designed to maintain a stable value relative to a fiat currency or currencies;
(B) is convertible directly to fiat currency by the issuer;
(C) is designed to be widely used as a medium of exchange;
(D) is issued by a centralized entity;
(E) does not inherently pay interest to the holder; and
(F) is recorded on a public distributed ledger.
Comment: This legislation (which is unnumbered at the time of this writing) tracks the fundamental characteristics of stablecoins, which, as mentioned above, include their utility as a medium of payment, convertibility into fiat currency, central issuance and use of public blockchains.
S.5340 - Stablecoin Regulatory Framework Act of 2022
The Stablecoin Regulatory Framework Act of 2022 was introduced on 12/21/2022 to create a federal framework for stablecoin issuers. The bill would require stablecoin issuers to hold 100% reserves for each fiat currency-backed stablecoin they issue. It also imposes reporting requirements to ensure that issuers remain compliant with the framework. It requires issuers to develop a cybersecurity program to ensure the safety of the assets backing the stablecoin. The legislation includes consumer protections concerning the clear disclosure of fees and other key terms, and rights to access and move assets.
The text of this Bill was unavailable at the time of this writing, so it is unclear how “stablecoins” are defined therein.
It will be fascinating to see not only how stablecoins are ultimately defined, but also who will be charged with regulating them, and how. In general, we should hope that the rules as eventually adopted will focus on market integrity and robust collateralization of anything marketed as a “stablecoin”.
Ari Good, JD LL.M. is a blockchain lawyer serving the needs of financial services and payments companies, cryptocurrency exchanges and token issuers. His experience ranges widely from international tax law and corporate planning to securities law and financial services compliance.