Not All Stablecoins Are Created Equal – Or Stable

This week’s DC Blockchain Summit from the Chamber of Digital Commerce included a timely panel discussion on stablecoins given the recent Terra Luna stablecoin implosion as well as yesterday’s testimony in front of the House Financial Services Committee by Federal Reserve Vice Chairwoman Lael Brainard.

The Chairwoman was hopeful telling lawmakers that stablecoins and a central bank digital currency (CBDC) could provide a “safe” government-backed settlement layer and “would actually facilitate and enable private sector innovation.”

Panel participants for “Stablecoins and the Future of Money” included:

Are stablecoins innovative?

Moderator Stephen Palley of law firm Anderson Kill led things off by wondering aloud whether stablecoins are truly an innovation.

Caitlin Long, Founder and CEO of Custodia Bank and a well-known, Wyoming-based cryptocurrency advocate, began by saying that they are innovative but not truly crypto. She clarified: “They are not truly crypto in the sense that anything that touches the US dollar – so I’m talking about any sort of backed version of a stablecoin – ultimately has to clear through the Federal Reserve and therefore they’re not decentralized meaning they may be issued on blockchain-like rails, but they are not decentralized. They have an issuer and anything that has an issuer by my definition isn’t decentralized. Ergo, it is quasi-crypto, but not actually crypto.”

Citing the ability of stablecoins to move money faster and cheaper and to more people, Paul Wong of Stellar Development Foundation said he believed the technology is exciting, but there still was a gap in the existing legal regulatory framework for payments and financial instruments.

Jason Somensatto, Acting Director, LabCFTC, speaking on his own behalf (rather than the CFTC) seemed to concur suggesting there is a prudential regulation hurdle that needed to be overcome and hoped Congress would potentially address it.

Finally, Paul Balzano from the House Committee on Agriculture (disclaimer) speaking exclusively for himself believed stablecoin technology showed promise: “The ability to transfer value between people electronically without an intermediary is exciting. That’s different. (…) The challenge of stablecoins is that there are so many different kinds: from asset-backed stablecoins to algorithmic stablecoins and everything in between. Trying to figure out which which one of those things is useful makes it a little more difficult.”

The 3 types including algorithmic

Turning to the types of stablecoins, Ms. Long identified three groups:

    • Fiat-collateralized stablecoin – Backed by assets, which should be “liquidatable” if there’s a run on the stablecoin. She asserted that there’s a huge question about that and used the Terra Luna collapse as an example which occurred within a span of hours. None of the assets that are currently backing US dollar stablecoins can be liquidated that fast including T-bills which can’t be liquidated until the next day., according to Ms. Long, who added that this could introduce systemic risk into the banking system as it gets involved in crypto.
    • Crypto-backed stablecoins
    • Algorithmic stablecoins – Terra Luna is the eye-opening example here, of course.

Stellar’s Wong suggested algorithmic stablecoins aren’t actually stablecoins because it’s not clear if they’re backed. He added, “We really need to be careful in terms of how we define it. We broadly use stablecoins to label a bunch of assets that are not actually stable.” Custodia Bank’s Long interjected, “They’re CDOs. Algorithmic stablecoins – or the latest version of CDOs – this is the instrument that blew up the financial system in 2008.”

House Ag committee staffer Paul Balzano appeared to concur with his fellow panelists, “To the extent they’re not stable, it’s hard to call them stablecoins. If they’re not useful, and they’re not going to remain stable then who’s going to use them and why? And that’s a real challenge as we think about how to regulate. ”

What is the regulator’s role?

Mr. Somensatto, the Acting Director at LabCFTC, offered his own personal view, “The way I like to approach it from a regulatory perspective is to try to strip away some of the technology. What do you have when you’re holding a stablecoin? With the models that promise redemption at par, it’s probably a little bit easier to swap that into traditional legal thinking. A lot of stuff that gets talked about – like collateralized or uncollateralized algorithmic stablecoins – from the customer’s perspective it is, ‘What do I have in my hand?'”

Mr. Balzano responded, “From a Congressional perspective, it’s similar to a regulatory perspective. You have constituents and we are trying to think about how do we create regimes that protect people. But, it’s hard to figure out the right way in which you can look at an algorithmic stablecoin and think about how do we regulate that and how do we put rules in place that a regulator can implement for us to protect consumers?”

With stablecoins already providing an important function within the Stellar Network, Mr. Wong believe there was plenty value to the format. He added, “[Stella has] 20, operational or planned Fiat-based assets on the network. Those assets cover currencies supporting more than 50% of global GDP…. The reason why I wanted to share that is because stablecoins serve a functional value. And there is a lot of potential value in this space. We just need to realize that potential.”

The Unbanked

Ms. Long pointed to how the ‘unbanked’ today understand how to use the wallet infrastructure on their cell phones. “They’re getting there on their own,” she said. “With Bitcoin and the Lightning Network, we really are seeing unbanked people starting to get access to financial services in the world that have not. But, vis a vis the US dollar – that’s different because these are issued by banks, the Fed controls the US dollar and anything that’s an actual US Dollar as opposed to a derivative that’s trying to track the US dollar is going to come inside the banking system. And the biggest reason why there are so many unbanked has to do with Know Your Customer Anti-Money Laundering-type rules where some folks who don’t even have identification can’t qualify to get access to a bank account.”

The role of banks

Ms. Long offered her view of the role of banks in the connection with stablecoins, either regarding issuance or facilitating transfer.

For one thing, she disagreed with the President’s Working Group’s recommendation to have insured depository institutions issue these. She said, (and pointing to herself) “Being in the weeds of how the payment systems actually work – that would be a disaster for the insured depository institutions because the moment there’s a run on one of the stablecoins, it actually does become contagion into the insured system, which would ultimately create the financial stability risks that the regulators are trying to avoid.”

Citing a recent collaboration on an article with Dr. Manmohan Singh of the International Monetary Fund for financial risk publication, she shared the three different options they laid out:

    • Stablecoins and insured depository institutions.
    • Banks that issue Stablecoins backed by cash on deposit at the Fed.
    • Banks that issue Stablecoins backed by T-bills and other high quality liquid assets.

Ms. Long added, “[The editors] came back to us and said, ‘Cut out that first one. Everyone understands we don’t want insured depository institutions to be issuing these and focus on the second two.’ And we ended up explaining that due to the liquidity risks due to settlement mechanics of T-bills, it’s dangerous even to have T-bill-backed stablecoins because T-bills settle in a day and you could have a run in the span of hours and that could very easily turn into contagion for the financial system. So we’ve been consistent all along saying it needs to be a special purpose bank charter that has direct access to the Fed.”

Why a bank instead of a non-bank? Ms. Long said, “It’s because you have to be a depository institution under the Federal Reserve Act to be able to bank at the Fed. That’s been established for decades.” She explained:

“And I suppose Congress could change that if it wanted to. But I don’t think the Fed would want that. Why? Because it doesn’t want the credit risk of facing a non-bank. Banks are examined once a year, non-banks maybe once every three years. Banks have higher Bank Secrecy Act AML CFT standards than non-banks do. And banks are far better capitalized than non-banks. I think the Fed would fight that tooth and nail regarding changing the access to the Fed to include non banks.”

“What Wyoming did is we understood all this literally four years ago and set up a special purpose bank charter. We were definitely ahead of our time. And the whole idea was how – in the settlement mechanics – do you make sure that you don’t touch off a bank run in the traditional financial system, where the liquidity provision is very geared towards the term structure of the liabilities of banks.”

“How often do people all go and withdraw their deposits at the same time? Fedwire settles in hours, ACH settles in days. We’re talking now about stablecoins settling in minutes. That’s going to change the liquidity needs of the financial system if the banks get involved. You have to have a particular type of bank that refences this risk, so it doesn’t end up spilling into the capital markets or to the insured depository system, but it gives access to the Fed, which already has real-time payment and monitoring capabilities. That’s the obvious answer. And it’s been something that we’ve been talking about for years. (…) And so the world is definitely moving to where Wyoming was and so I would posit there is no regulatory gap. The Fed has had the ability to approve this for 19 months and it hasn’t. So the fact that a lot of people lost a lot of money in Terra Luna, I would posit, ‘What would have happened if the Fed had approved a bank to issue a digital dollar 19 months ago?’ The market would be a lot different and you would not have had so many people be scammed.”

Is a new regulator needed?

Mr. Balzano thought that between the SEC and CFTC there was “adequate authority with smart people who can address the markets. Stellar’s Paul Wong was unequivocal saying, “We should be regulating activity and not technology” adding that the U.S. has more regulators than anywhere in the world.

LabCFTC’s Somensatto offered his personal view saying as what he termed a “side comment” about the idea of a special separate crypto regulator, “Who is dying to join a regulator focused on crypto? We have enough talent trouble to think about some of these issues as it is.” He believed there was already a system in place which covers and focuses on these risks adding, “To the extent to which a new technology level risk exists, I still don’t think that like leads you to the conclusion that you want a new regulator.” From a markets regulator perspective, he pointed out that there’s a heavy reliance on self-regulation as the exchanges themselves are regulators within these market systems providing surveillance and cybersecurity oversight.

On self-regulation

Taking the bait, Mr. Palley asked the panel if there was a place for formal self regulation, i.e. a self regulatory organization (SRO) for stablecoin issuers.

Ms. Long quickly chimed in:

“I don’t think so. Again, it all comes back to what is a stablecoin? A stablecoin is trying to actually be redeemable for a US dollar or the equivalent amount thereof and that’s touching the banking system. The US Dollar is a fiat currency that’s issued by a central bank and the banks that are licensed to issue dollar. A self regulatory organization is not going to be able to get access to that. And again, it comes back to… if you buy the conclusion that even high quality, liquid assets don’t settle fast enough and in order to truly ringfence the risk, there’s one and only one type of backing for stablecoins that truly ringfences the risk, and that’s cash on deposit at the Fed.”

“Now we’re back to, ‘OK, who gets access to fed master accounts?’ And, I’m in the middle of that [at Custodia Bank] and we’re at 19 months and counting.” Speaking of her own bank’s challenges, she said, “In the State of Wyoming, when the structure of the Wyoming Special Purpose Depository Institution was proposed in 2018, there was a provision in the initial draft of the bill that required the Attorney General of Wyoming to sue the Fed if the Fed did not grant master accounts to validly targeted Wyoming Special Purpose Depository Institutions. And I was not privy to this phone call, but the Fed called the state of Wyoming and asked for that provision to be removed from the draft bill. And there was a gentleman’s agreement that was made at the time to remove that provision from the draft bill. The reason is that the Fed had said it had just litigated that issue, it had been appealed up to the appellate court in the 10th circuit, and they lost. They don’t didn’t want to litigate it again, and they said ‘We will work with the state of Wyoming.’ Senator Lummis alluded to this in her Wall Street Journal editorial. There were hundreds of meetings between the Federal Reserve and the state of Wyoming. We did not do this in a vacuum. And then when somebody actually got chartered and applied, the door got slammed shut. So either the door is going to be reopened in a friendly way or maybe this doesn’t end so friendly.”


Finally, Mr. Palley turned the discussion to privacy and whether there should be a safe space from a regulatory standpoint for people to transact using cryptocurrency stablecoins privately and not have to worry about FinCEN, the Bank Secrecy Act and so on.

Asked for his congressional point-of-view, Mr. Balzano was sympathetic, “I assume everyone here would would agree that they would prefer that their financial life have a measure of privacy to it. I think most people in Congress would probably prefer the same thing as well. I think the challenge is, how do you do that in a way that preserves maybe a small safe space but doesn’t open the door for all the sorts of illicit financing and terrible things that people can do with money, [and therefore] allow them to walk through the same door. That’s a technical challenge and I don’t know how to solve it. But that’s the thing I think we do need to think about.”

Stellar’s Wong offered on privacy, “One of the things I’ve learned from my engineering team is technology can do whatever we want it to do. We just need guidance.”

Offering a dose of reality, Ms. Long suggested that anything that touches the actual US dollar or has a centralized issuer is not going to be able to escape AML KYC requirements – and therefore privacy will be a challenge. But she added, “The truly decentralized parts of this sector are never going to be able to have those requirements enforced upon them. And so the regulators should focus on the place where they could successfully regulate.”