Stablecoins: Legal Issues and Regulatory Options (Part 1)

"In 2008, the pseudonymous Satoshi Nakamoto released a white paper describing a peer-to-peer system of electronic cash. The product of that paper—Bitcoin—now boasts a market capitalization of roughly $600 billion. Other cryptocurrencies amount to more than $700 billion, bringing the overall crypto ecosystem in line with the GDPs of many large countries.

Despite this meteoric rise, cryptocurrencies have yet to exhibit a defining feature of cash: widespread useas a medium of exchange. One reason for that failure is volatility. Most cryptocurrencies have exhibited wild fluctuations that may make them unattractive instruments for day-to-day purchases of goods and services.

Enter stablecoins—cryptocurrencies whose value is pegged to a reference asset like the U.S. dollar. While stablecoin issuers attempt to maintain these pegs in different ways, most of the regulatory attention has focused on coins that are putatively backed with reserves of assets denominated in fiat currency. Often, those assets underwrite an issuer’s commitment to redeem its stablecoins for a fixed value upon demand.

That structure raises familiar risks. Like banks and money market mutual funds (MMFs)—the principal sources of private money—stablecoin issuers are vulnerable to runs if their customers lose faith in the adequacy of the assets backing their demandable liabilities. Unlike banks and MMFs, however, most stablecoin issuers are not subject to federal regulations and protections designed to instill faith in those liabilities, such as deposit insurance and portfolio restrictions.

Policymakers have taken notice. In November 2021, the President’s Working Group on Financial Markets recommended that Congress enact legislation limiting stablecoin issuance to insured depository institutions. Other commentators have advocated different regulatory strategies, ranging from a bespoke federal licensing regime to an outright ban on stablecoin issuance.

This Legal Sidebar—the first part of a two-part series—provides an overview of the existing regulatory framework governing stablecoins. The second part discusses proposals for legislative reform of that framework. Both parts focus on stablecoins that are ostensibly backed one-to-one with reserves of fiat-denominated assets. For a discussion of algorithmic stablecoins, which instead aim to maintain their pegs using algorithmically determined supply adjustments or arbitrage mechanisms involving other cryptocurrencies, see CRS Insight IN11928, Algorithmic Stablecoins and the TerraUSD Crash, by Paul Tierno, Andrew P. Scott, and Eva Su.
Stablecoins

Algorithmic Stablecoins and the TerraUSD Crash

"What Are Algorithmic Stablecoins?

Stablecoins are a type of cryptocurrency that aim to maintain a stable value. There are several classes of stablecoins that each use different methods to try to achieve this, one of which is algorithmic stablecoins. While no precise definition captures all of their features, algorithmic stablecoins typically use an algorithm or smart contract to manage the supply of tokens and guide their value to some reference asset (for example a fiat currency, such as the U.S. dollar). Algorithmic stablecoins generally do not attempt to achieve value by holding a reserve of fiat-denominated assets with a value in a 1:1 relationship with the value of the stablecoin. Instead, algorithmic stablecoins use different mechanisms to control the supply or value of the stablecoin, including the minting or burning of coins, rebasing, and arbitrage.

What Happened with TerraUSD?

TerraUSD (UST) stablecoin uses an arbitrage mechanism typical of some algorithmic stablecoin arrangements consisting of two coins or tokens: the stablecoin, in this case UST, meant to maintain a stable value or “peg,” and a balancer token, in this case,LUNA, the value of which can fluctuate. An algorithm manages the relationship between these two coins to attempt keeping the stablecoin pegged to the reference. If strong demand pushed the price of UST above its peg, arbitrageurs could buy $1 worth of LUNA, trade it for 1 UST (worth more than $1) and sell UST for a gain. If UST falls below $1, someone can buy $0.99 worth of UST and trade it for $1 worth of LUNA. In both instances arbitrageurs net a profit and ostensibly maintain the peg. Over the past week, UST llost its peg to the dollar (Figure 1), and both UST and balancer coin LUNA were dropped from various cryptocurrency exchanges. UST hit a low of $0.12 at 9 a.m. on May 16, 2022..."
Stablecoins