Digital Assets Discussion: Stablecoins

In the shadow of TERRA/LUNA’s recent collapse, this Ropes & Gray podcast, hosted by asset management attorneys Melissa Bender and Charlie Humphreville, discusses stablecoins, how they are intended to operate and their importance to the overall digital assets markets. The podcast also covers potential regulatory developments that may impact stablecoins.

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Transcript:

Melissa Bender: Over the course of five days, $40 billion of assets was erased after the algorithmic stablecoin, Terra (or UST), lost its U.S. one dollar peg. As the price of Terra fell below its one U.S. dollar peg, investors purchased Terra on various exchanges (for less than a dollar) and tendered them for redemption. Each Terra token can always be redeemed for one dollar worth of the related native token, LUNA. This resulted in a massive number of LUNA tokens being issued—putting downward pressure on LUNA’s price—ultimately resulting in a feedback loop that saw the catastrophic meltdown of both Terra and LUNA. Between May 8 and May 12, the price of Terra fell from $1 to just $0.05, and the price of LUNA fell from $65 to fractions of a penny.

6Charlie Humphreville: What does this mean for the digital asset markets in general, or for stablecoins in particular? We will discuss that and more today.

Drawing on the perspectives of over 1,400 attorneys from all areas of our practice, we provide insight into essential considerations associated with crypto, digital assets and blockchain matters. I’m Charlie Humphreville, a counsel in the Boston office. Joining me today is my colleague Melissa Bender, a partner in our San Francisco office. On this episode, we will discuss stablecoins, their importance to the digital assets markets, and how they may be regulated in the future. There is a lot of ground to cover on this topic, so we’ve focused on what we think are the key and timely issues.

Melissa Bender: It probably makes sense to start by quickly laying out a definition of a stablecoin. Stablecoins are digital assets with a value that is intended to be pegged to that of another asset. For instance, the two largest stablecoins, and the third and fourth largest coins overall by market cap as of the date of this recording, Tether and USDC, are pegged to the U.S. dollar.

Charlie Humphreville: Stablecoins can, however, be pegged to the value of other assets. For instance, there are several gold-pegged stablecoins. Libra, then Diem, or the so-called Facebook coin, was intended to be pegged to a basket of world currencies.

Melissa Bender: And to keep stablecoins’ prices stable, they can typically be redeemed at their pegged value—so one Tether can be redeemed for one U.S. dollar.

Charlie Humphreville: But coins like Tether and USDC also keep their price stable by maintaining reserves, right?

Melissa Bender: That’s right. “Backed” stablecoins are issued by a centralized entity that holds equivalent assets on reserve for every outstanding stablecoin. Taking Tether again, because it is the largest and most well-known stablecoin, as an example—Tether’s issuer holds assets sufficient to back each Tether issued on a 1:1 basis. These assets are comprised primarily of cash, U.S. treasuries, corporate bonds, short-term commercial paper and other cash equivalents. An independent accountant issues a quarterly opinion confirming that these holdings equal or exceed the pegged value of issued and outstanding tether. Circle, the issuer of USDC, makes available a similar report from its accountants, issued monthly.

Charlie Humphreville: Algorithmic stablecoins, like Terra, however, work differently. Algorithmic stablecoins can derive their value in any number of ways. For instance, in a “rebase” model, if the value of the stablecoin increases above its peg, new coins are issued to each wallet in which the coin is held, thereby diluting the value back down to the pegged value. Or if the value of a coin drops below the peg, coins in all wallets are burned, thereby reducing the supply and increasing the value of the remaining coins. Terra, however, used what is often referred to as a “seniorage” model. In the seniorage model, the stablecoin is paired with a native staking token. In the simplest terms, the value of the stablecoin is maintained because it can always be exchanged for the pegged value worth of the native staking token. Put another way, $1 worth of UST (or Terra) was always redeemable for $1 of LUNA. In the case of Terra and LUNA, LUNA had an independent value because the LUNA blockchain was designed to permit defi applications, similar to the Ethereum and Solana blockchains.

Melissa Bender: One thing that made Terra a bit unique was that its founders had established a reserve of bitcoin (and certain other non-LUNA digital assets) in a foundation that was to be deployed in the event that Terra materially deviated from its peg. Essentially, the reserve’s assets could be sold and the proceeds used to buy Terra in the market to increase Terra’s price if necessary. The idea being that this would relieve some pressure otherwise put on the price of LUNA as a result of TERRA redemptions through the normal process.

Charlie Humphreville: That was over a billion dollars worth of bitcoin. And they were paying a 20% yield on Terra that was staked to the “Anchor Protocol” as a further incentive for investors to keep assets in Terra.

Melissa Bender: Right. But unfortunately, the reserves and yield were not adequate to stave off the meltdown we saw in early May.

Charlie Humphreville: So, some people might be asking themselves: Why do these things exist in the first place?

Melissa Bender: Right. First, the backed stablecoins don’t seem to align very well with the fundamental beliefs driving crypto. They are effectively centralized and rely heavily on legacy financial institutions. They require bank accounts and custodians. They are backed by traditional financial instruments. But algorithmic stablecoins haven’t had a great track record. It hasn’t been just Terra/LUNA. It was only last summer that another seniorage algorithmic stablecoin pair, IRON/TITAN, collapsed.

Charlie Humphreville: Nonetheless, stablecoins are crucial to the functioning of the digital assets markets. Tether is, by volume, the most traded coin on exchanges—by a large margin. In September 2021, for instance, 75% of all trades on exchanges involved a stablecoin. Many exchanges, particularly those located outside of the U.S., do not have the ability to hold fiat currencies (or at least not U.S. dollars) for their customers, so the only way for a trader to quickly de-risk on an exchange is to move to a stablecoin. It’s often the most efficient way to move assets on or off of an exchange, as many exchanges, including decentralized exchanges, have no “on ramp” for fiat currency. They cannot accept deposits or pay withdrawals in fiat currencies. And even if they could, the settlement times would be much longer than the time it would take to transfer, for instance, an ERC20-based stablecoin.

Melissa Bender: And algorithmic stablecoins aren’t likely to just go away, because they represent the true “defi” version of a stablecoin. As we noted, backed stablecoins require the assets backing the coins to be held “IRL.” Algorithmic stablecoins have the advantage of fully decoupling themselves from legacy financial institutions and relying solely on the blockchain. Obviously, challenges remain to ensuring the stability of these platforms.

Charlie Humphreville: But the failures of TERRA/LUNA, and IRON/TITAN, haven’t completely discouraged investors from utilizing algorithmic stablecoins. USDD, an algorithmic stablecoin on the TRON blockchain, launched in early May 2022, just as TERRA was collapsing, and with a model nearly identically to TERRA. By June 12, it was unable to maintain its peg, despite active support from the TRON Foundation. USDD’s market cap recently hovered around $700 million, so it poses a smaller risk to the crypto markets than TERRA.

So, what does the future for stablecoins look like?

Melissa Bender: That’s hard to say. Anyone with the ability to regulate stablecoins in the U.S. has expressed an interest, so it would be unwise not to expect some form of regulation in this space. Senator Toomey proposed the Stablecoin TRUST Act in April of this year, which would authorize the Office of the Comptroller of the Currency to create a specific license for stablecoin issuers. Senators Hagerty and Hollingsworth have a competing bill more focused on disclosure requirements. The most anticipated bill on crypto, however, has been the Lummis-Gillibrand Responsible Financial Innovation Act, which was publicly released by Senators Lummis, from Wyoming, and Gillibrand, from New York, on June 6. That legislation includes special rules applicable to “payment stablecoins” and their issuers. In this context, “payment stablecoins” are essentially “backed stablecoins.” The Responsible Financial Innovation Act would only permit depositary institutions, like banks, or other entities subject to oversight by a federal or state regulator, to issue payment stablecoins. The act would also mandate that the issuer of a payment stablecoin maintain at all times 100% reserves against its issued stablecoins, and would limit the instruments in which the reserves could be held. The act also lays out a detailed reporting and examination framework applicable to issuers.

Charlie Humphreville: From the executive branch, we had the President’s Working Group on Financial Markets issue a report and recommendations on stablecoins late last year. That urged Congress and various agencies to act to regulate digital assets generally, and stablecoins in particular, but suggested that FSOC (Financial Stability Oversight Council) could act in the absence of any more formal legislative or regulatory action. The report highlighted what it viewed as systemic risks raised by the use of stablecoins, as well as conflicts of interest for stablecoin issuers that also engaged in other commercial activities. The SEC has certainly shown an interest here, as well. Chairman Gensler appears to be seizing on recent market volatility as an opportunity to push for regulation in crypto generally, which would likely include rules impacting stablecoins. Commissioner Pierce, on the other hand, does not rule out regulation, but believes that there must be room for experimentation and failure. Treasury Secretary Yellen has also spoken about the need for a regulatory framework for stablecoins. The Fed has also been highly focused on stablecoins, and recently discussed risks associated with stablecoins in their May Financial Stability Report.

Melissa Bender: Overseas, the United Kingdom is considering granting the Bank of England authority to oversee stablecoin issuers, beginning with special administration rights in the event of the insolvency of a stablecoin issuer. Query how this proposed regime would have applied in the recent fall of TERRA—or would apply in the case of another failed algorithmic stablecoin.  Leaked documents out of the EU indicate the potential for even more restrictive regulation of stablecoins, for instance, limiting the permitted amount of a stablecoin in circulation.

I think it’s safe to say it’s less a question of whether there will be regulation, and more a question of when and by who.

Charlie Humphreville: Maybe the last topic to note, and one that could really fill an entire podcast, is central bank digital currencies (or CBDCs). Are they stablecoins?

Melissa Bender: In a sense, they feel like a stablecoin because they are intended to have a stable value tied to a fiat currency. However, it’s unlikely that CBDCs will, as a general rule, be traded on exchanges or available to serve the same role in the digital assets market currently served by stablecoins. Additionally, whereas stablecoins are private digital assets pegged to a currency, a CBDC actually holds the status of legal tender and is issued by a central monetary authority.

Charlie Humphreville: Obviously, we have yet to see the widespread rollout of these coins, so this is all speculation—but certainly something many are watching with interest.

Melissa Bender: That brings us to the end of the podcast. Charlie and I appreciate you tuning into this series. For more information on the topics that we’ve discussed today, other topics related to digital assets, or other similar topics of interest, please visit our Ropes & Gray website at ropesgray.com/cryptocurrency, where we have links to additional materials.

Charlie Humphreville: And don’t hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. Finally, you can subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.