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Regulatory Concerns Could Dampen Investor Excitement for Stablecoins


Stablecoins, a class of digitial asset touted as being more constant in their value than other cybercurrencies, have become increasingly popular in recent years. But recent market declines in the past couple of months have turned the spotlight on the quality of the assets backing the values of stablecoins. The quality of major stablecoin providers’ financial reporting has also been questioned, especially in light of regulatory scrutiny and enforcement actions.

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On June 27, 2022, SEC Chair Gary Gensler expressed concerns over crypto and stablecoin disclosures and the need for enhanced regulatory protection for investors (CNBC, SEC Chair Gary Gensler discusses potential crypto regulation and stablecoins, June 27, 2022, https://cnb.cx/3PJBCjn). The lack of adequate authoritative guidance for the accounting and disclosure of crypto and stablecoin transactions has led to fundamental problems in the consistency, comparability, and representational faithfulness of financial reports. Critical accounting procedures (e.g., segregation of funds, timely reviews, third-party verification) are very much the exception. The quality and quantity of assets backing stablecoins remain an open question.

The summer of 2022 saw the price collapse of the then–third-largest stablecoin TerraUSD (Vicky Ge Huang, “Tether Cedes Territory to Rival Stablecoins as Crypto Investors Diversify,” WSJ, June 9, 2022, https://on.wsj.com/3zmjJBN). The crypto asset class has fallen 67%, from a total market capitalization of around $3 trillion in November 2021 to under $1 trillion as of June 2022 (Paul Vigna, “Bitcoin Price Dips Below $21,000 as Crypto Firms Announce Layoffs,” WSJ, June 14, 2022, https://on.wsj.com/3v1DbkQ). Bitcoin, the largest and likely oldest crypto asset, lost 70% of its value in this same period (from approximately $68,000 to $20,000 per unit). As of June 2022, the number of crypto bankruptcies was growing (Three Arrows Capital, Celsius Holdings, Voyager Digital) and counterparties in the crypto field have been under increasing stress (“Crypto bankruptcies spread through digital asset landscape as cheap money dries up,” CNBC, July 15, 2022, https://cnb.cx/3cx4f5c).

This article examines the growth of stablecoins and the multitude of underlying accounting, governance, and regulatory issues they present. We will focus on U.S. regulatory concerns, while addressing the need for coordinated international regulation. Although the U.S. government’s oversight of stablecoins currently has regulatory gaps, as described in the President’s Working Group on Financial Markets (PWG) Report, there is increasing U.S. and international regulatory scrutiny of this new asset class. Those investing in stablecoins can lack basic investment protections and disclosures that investors expect, especially in the United States.

PWG Concerns

In November 2021, the PWG, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) issued their Report on Stablecoins, which stated the following:

Stablecoins are digital assets that are designed to maintain a stable value relative to a national currency or other reference assets. Today, stablecoins are primarily used in the United States to facilitate trading, lending, or borrowing of other digital assets, predominantly on or through digital asset trading platforms. (https://bit.ly/3PuBBQS)

 

In response to the release of the PWG Report, U.S. Treasury Secretary Janet L. Yellen expressed her concerns over the current regulatory oversight system:

Stablecoins that are well-designed and subject to appropriate oversight have the potential to support beneficial payments options. But the absence of appropriate oversight presents risks to users and the broader system. Current oversight is inconsistent and fragmented, with some stablecoins effectively falling outside the regulatory perimeter. (https://bit.ly/3PM300o)

 

Although stablecoins may offer potential beneficial payment options, there are areas of significant regulatory concern. The 2021 PWG Report identified three major areas: 1) risks to stable-coin users (including runs on stable-coins), 2) payment system risk, and 3) systemic risks and concentration of economic power.

The 2021 PWG Report noted that “Congressional action is urgently needed” in these areas and that regulators need to take steps that will increase investor protection, ensure market integrity, and address illicit finance concerns. The PWC Report called for Congress to “act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.”

Stablecoins

Stablecoins are often marketed and sold on the premise that they maintain a fixed value and are fully backed by underlying assets (e.g., 1 coin equals $1). They are a primary means to settle trades in the virtual currency domain and facilitate transactions using different fiat currencies (e.g., U.S. dollars, euros, British pounds, yen). They facilitate virtual currency exchanges that often face significant banking restrictions.

The growth of stablecoins is an ongoing concern to U.S. government officials, with regulators openly questioning their financial stability and veracity of their disclosures.

The PWG Report observed that many stablecoins offer the promise or expectation that they can be readily redeemed at par value. Stablecoins are often categorized as such because they are supported by reserve assets. The quality of reserve assets varies by the particular stablecoin and ranges from higher-quality U.S. Treasury bills to riskier commercial, corporate, and municipal assets, even including other digital assets or some combination. In the case of TerraUSD’s stablecoin collapse, it was not directly backed by a reserve, but by an algorithmic link to Luna, its “sister token” (Paul Vigna, “Cryptocurrency TerraUSD Falls to 11 Cents, Creator Announces Rescue Plan,” WSJ, May 16, 2022, https://on.wsj.com/3Otjs4m). Another inconsistency with stablecoins revolves around redemption rights. They vary from minimum redemption amounts, up to seven-day postponements, suspensions, to no direct right of redemption. In contrast, U.S. demand deposits that are federally insured (typically up to $250,000) are subject to regulatory supervision and regulations that protect depositors.

Exhibit 1 lists the largest stablecoins by total market capitalization as of July 16, 2022. It is clear by their trading symbols that many stablecoins are geared to the U.S. dollar (e.g., USDT, USDC, BUSD). The largest stablecoin is Tether, issued by Tether Limited, a Hong Kong–based company controlled by Bitfinex. In 2021, Tether entered into settlement agreements with the Commodity Futures Trading Commission (CFTC) for $41 million and with the Attorney General of the State of New York (NYAG) for $18.5 million regarding the misleading claims that each Tether token was backed by $1 U.S. (https://on.ny.gov/3B8XHDX). Tether’s staggering growth has continued mostly unabated despite the settlements. From January 2020 to January 2022, Tether’s total value grew from $4.1 billion (James Mackintosh, “Tether Sheds Light, but Not Enough, on Its $63 Billion Reserves,” WSJ, August 12, 2021, https://on.wsj.com/3v7OesV) to $78 billion. As of July 16, 2022, Tether was valued at $66 billion. The timeline of events leading to Tether’s NYAG settlement agreement, presented in Exhibit 2, reveals troubling accounting safeguards.

Exhibit 1

Largest Stablecoins as of July 16, 2022 (mid-day)

 Name; Symbol; Price; Market Cap (billions) Tether; USDT; $.9998; $65.86 USD Coin; USDC; $1.000; $54.83 Binance USD; BUSD; $.9982; $17.55 Dai; DAI; $1.000; $7.01 TrueUSD; TUSD; $.9999; $1.22 Source: https://coinmarketcap.com/view/stablecoin/

Exhibit 2

Tether Timeline, 2014–2020

 2014 to February 2019; From Tether's inception in 2014 until late February 2019, Tether represented that every outstanding tether coin was “backed” by, and thus should be valued at, $1 U.S. March 2017; Wells Fargo stopped servicing wire transfers from Bitfinex and Tether accounts. June 2017; Bitfinex and Tether engaged a U.S. accounting firm to audit both companies. These audits were never completed. August 2017; Bitfinex restricted U.S. based users from its trading platform, but U.S. based businesses were still allowed access. Late Summer 2017; Online reports asserted that Tether lacked the sufficient cash to back one coin for $1. September 15, 2017; On the morning of Sept. 15, Tether deposited $382 million into the Puerto Rico–based Noble Bank (funds were transferred from Bitfinex's account at Noble Bank). This was the same day as the auditor's statement on Tether's cash memorandum (transparency update). September 30, 2017; The “misleading” transparency update was released. May 2018; Bitfinex could not access $1 billion in funds from a Panama-based entity, Crypto Capital. Reasons given to Bitfinex were tax complications, compliance personnel at banks, bankers on vacations, faulty wire instructions, and Polish government corruption. Summer 2018; Bitfinex borrowed $400 million from Tether. This would grow to at least $625 million. August 2018; Bitfinex announced that all U.S. individuals and entities were barred from its trading platform. October 2018; Bitfinex and Tether ceased business with Noble Bank and started banking with Deltec Bank and Trust. Nearly $500 million was deposited into the Bitfinex account from Tether after Deltec confirmed Tether had $1.8 billion in deposits. November 2018; Tether lacked dollar-for-dollar backing due to the deposit into Bitfinex to make up for Crypto Capital taking funds. February 2019; Tether changed its reserve representation to account for other assets, including receivables from affiliated entities. April 24, 2019; The NYAG filed proceedings with the N.Y. Supreme Court under section 354 of the Martin Act. February 18, 2021; An $18.5 million settlement with the NYAG prevented them from trading Bitfinex and Tether with New York persons or entities. Bitfinex still cannot access its Crypto Capital funds.

The growth of stablecoins is an ongoing concern to U.S. government officials, with regulators openly questioning their financial stability and veracity of their disclosures. As SEC Chairman Gensler told Congress in May 2021:

Tokens currently on the market that are securities may be offered, sold, and traded in non-compliance with the federal securities laws. Furthermore, none of the exchanges trading crypto tokens has registered yet as an exchange with the SEC. Altogether, this has led to substantially less investor protection than in our traditional securities markets, and to correspondingly greater opportunities for fraud and manipulation. (https://bit.ly/3czvtYY)

 

U.S. Regulatory Concerns

In July 2021, Treasury Secretary Yellen, in convening the PWG on stablecoins, observed, “Bringing together regulators will enable us to assess the potential benefits of stablecoins while mitigating risks they could pose to users, markets, or the financial system.” In August 2021, SEC Chair Gensler raised concerns that stablecoins “sidestep a host of public policy goals” and are potentially subject to SEC oversight as a security. In his testimony, Gensler specifically highlighted four major areas of concern:

  • If stablecoins are securities, they fall under SEC investor protections.
  • Approximately three-quarters of crypto trades use stablecoins and other tokens.
  • U.S. investors can sidestep U.S. restrictions on crypto investments and trading by utilizing virtual private networks, which some unregulated foreign exchanges appear to be encouraging.
  • Legislative authorities should prioritize crypto trading, lending, and decentralized finance (Defi) platforms. (Ethereum, the second largest crypto currency, touts its Defi as an “open alternative to the current financial system,” per its website.)

Gensler sees crypto as not having enough investor protections and likened the crypto environment to the Wild West. In his view, stablecoins backed by securities “are subject to the securities laws and must work within our securities regime” (https://bit.ly/3PMiz84). Token-related cases involving fraud and investor harm are an SEC priority, and dozens of complaints have been brought against firms and individuals in this area. In an enforcement action (In the Matter of Poloniex,https://bit.ly/3RKMTBQ) against a trading platform that failed to register, the SEC noted that the coins exchanged on that platform were “investment contracts” and would be interpreted as securities under SEC v. Howey [328 U.S. 293 (1946)].

Concern exists government-wide. In June 2021, Boston Federal Reserve President Eric Rosengren stated: “There are many reasons to think that stable-coins—at least, many of the stable-coins—are not actually particularly stable” (Paul Vigna, “Risks of Crypto Stablecoins Attract Attention of Yellen, Fed and SEC,” WSJ, July 17, 2021, https://on.wsj.com/3cwAX6O). In a June 2021 presentation, Rosengren highlighted Tether as one of the “financial stability challenges” to the U.S. banking system (Marc Hochstein, “US Fed Official Calls Tether a ‘Challenge’ to Financial Stability,” Yahoo, May 25, 2021, https://yhoo.it/3z4Gw42). Uncharacteristically, the Federal Reverse President mentioned Tether specifically.

Not everyone is on board with the need or the nature of regulation. In public statements, SEC Commissioner Hester Peirce has questioned the “enforcement guns blazing” approach to crypto and some market participants are concerned that regulation will stifle emerging financial technologies (In the Matter of Poloniex).

Tether Settlement Agreements

In October 2021, the CFTC reached a $41 million settlement with Tether and its affiliated companies (“CFTC Orders Tether and Bitfinex to Pay Fines Totaling $42.5 Million,” https://bit.ly/3RKMTBQ). With no admission of guilt, Tether allowed for the entry of conclusions of fact and agreed to pay $41 million to the CFTC for the resolution of all claims. The findings of fact were damning to Tether:

  • Statements that Tether stablecoins were backed completely by fiat currency were false,
  • Reserves were not routinely audited, and
  • The two “bank reviews” of their reserves were staged by Tether, which had notice of the reviews and shifted funds to prepare for them.

The CFTC asserted jurisdiction over the stablecoins as a commodity under section 6 of the Commodity Exchange Act but noted that neither Tether nor any of its affiliates had registered with the CFTC.

Earlier, in February 2021, Tether, Bitfinex, and the NYAG had entered into a settlement agreement. More damning evidence was produced as part of that settlement. Tether and Bitfinex are affiliated entities controlled by the same small group of individuals (one of whom is a New York resident). While Tether and Bitfinex admitted no liability, the findings made by the NYAG clearly show that the representations made were false from their inception in 2014 until 2019, with at least $875 million in funds not accessible.

In late February 2019, Tether updated its cash reserves disclosure to:

Every tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, ‘reserves’).

 

In July 2022, the Tether website contained limited reports on their asset holdings. These classes are broad, as shown in Exhibit 3. As of publication, the authors could not find a list of Tether’s individual holdings on its website, in contrast to U.S. audited money market funds that list individual holdings. Although Tether charges fees, its interest on $66 billion in deposits remains unaddressed (as of July 2022).

Exhibit 3

Tether’s Asset Breakdown, as of March 31, 2022

 Reserves Breakdown Other Investments (including Digitial Tokens); 6.02% Secured Loans (None To Affiliated Entities); 3.82% Corporate Bonds, Funds & Precious Metals; 4.52% Cash & Cash Equivalents & Other Short-Term Deposits & Commercial Paper; 85.64% Cash & Cash Equivalents Breakdown & Others Non-U.S. Treasury Bills; 0.41% U.S. Treasury Bills; 55.53% Reverse Repurchase Agreements; 0.15% Cash and Bank Deposits; 5.81% Money Market Funds; 9.63% Commercial Paper and Certificates of Deposit; 28.47% Source: https://tether.to/en/transparency, July 16, 2022

In August 2021, The Wall Street Journal reported that Tether had made more detailed asset disclosures and that U.S. Treasuries were now 24.3% of their holdings (up from 2.23% in March 2021). Tether has numerous stated risks on its website (e.g., government and banking restrictions, securities breaches, liquidity). In late June 2021, it was reported that the U.S. Department of Justice was investigating Tether for possible bank fraud (“DOJ reportedly investigates crypto company Tether for possible bank fraud,” CNBC, July 26, 2021, https://www.cnbc.com/2021/07/26/doj-reportedly-probes-crypto-company-tether-for-possible-bank-fraud.html). In August 2021, the second-largest stablecoin, USD Coin, announced that its coins will be backed by U.S. Treasuries and cash moving forward (“The world’s second-largest stablecoin is undergoing a massive change,” CNBC, August 23, 2021, https://cnb.cx/3OmMRgB). The potential of impending regulations may be encouraging stablecoin providers to take preemptive actions. The 2021 CFTC and NYAG settlement agreements may have raised questions from investors. Whatever the case, stablecoin providers seem to be trying to reassure the market.

Parallels to 2008 Money Market Crisis

As seen in 2008, when the Reserve Primary Fund “broke the buck” due to Lehman Brothers Holdings (Diya Gullapalli, Shefali Anand and Daisy Maxey, “Money Fund, Hurt by Debt Tied to Lehman, Breaks the Buck,” WSJ, September 17, 2008, https://on.wsj.com/3PktMNr), investors’ confidence can quickly erode and lead to a run not only on a particular fund, but on most money market funds. Ironically, the reserve, a cash management company, formed the first money market fund in 1972 (Stephen Miller, “Co-Inventor of Money-Market Account Helped Serve Small Investors’ Interest,” WSJ, August 16, 2021, https://on.wsj.com/3yVbQ57). A close examination of Tether’s cash reserves as of March 2022 would not give investors much confidence in the underlying assets if major cash outs of tethers were to begin.

As some market commentators have observed, the real test of Tether’s ability to honor its “one tether for $1” pledge will occur when investors attempt to liquidate in short order a couple of hundred million or even billions in tethers. Tether was able to redeem $10 billion in coins in May 2022, but temporarily saw its peg to the $1 go as low as $.95 (WSJ, June 9, 2022). In June 2021, it was reported that the U.S. Department of Justice was investigating Tether for possible bank fraud (CNBC, July 26, 2021). As the 2021 PWG Report stated: “If users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system.”

International Reach

The largest crypto trading exchange, Binance Holdings, Ltd, demonstrates the global reach of virtual currencies. Binance USD is the third-largest stable-coin. At midyear 2021, Binance averaged $75 billion in daily transactions. Binance was initially founded in China in 2017 but currently has no official headquarters. Changpeng Zhao, the founder, has stated: “We are committed to being compliant with appropriate local rules wherever we operate” (Alexander Osipovich, “Binance Pulls Plug on Digital Stocks Amid Regulatory Scrutiny,” WSJ, July 16, 2021, https://on.wsj.com/3B54izm). Binance is currently under investigation by the U.S. Department of Justice and the IRS regarding money laundering and tax issues (Tom Schoenberg, “Binance Faces Probe by U.S. Money-Laundering and Tax Sleuths,” Bloomberg, May 13, 2021, https://bloom.bg/3PHKKVR).

Regulatory Difficulties

Despite cryptocurrencies’ efforts to legitimize themselves with stablecoins, significant and troubling regulatory issues remain. Given the disclosures made in the 2021 CFTC and NYAG settlement agreements and the statements made by Tether on its website, one wonders why investors flock to the asset. The answer is simple—higher returns. With interest rates yielding around 1% or less, the possibility of earning 12–25% or more overwhelms the glaring red flags in the eyes of many investors.

Several virtual currency exchanges even offer more than 100–to-1 leveraging on crypto positions (Dave Michaels, Caitlin Ostroff, and Elaine Yu, “Cryptocurrency’s Surge Leaves Global Watchdogs Trying to Catch Up,” WSJ, August 23, 2021, https://on.wsj.com/3B8MEe8). This leaves the markets to deal with exponential growth and extreme volatility, which could significantly impact the economy if (or, cynically, when) the house of stablecoins collapses. Regulation is needed, but would be problematic based on current circumstances. As the 2021 PWG Report stated:

These market integrity and investor protection risks encompass possible fraud and misconduct in digital asset trading, including market manipulation, insider trading, and front running, as well as a lack of trading or price transparency. Where these activities involve complex relationships or significant amounts of leverage, there may also be risks to the broader financial system.

 

Despite cryptocurrencies’ efforts to legitimize themselves with stablecoins, significant and troubling regulatory issues remain.

Regulation is based on the power of jurisdiction, the authority a nation has to set rules and enforce them. Jurisdiction, in turn, is based on a nexus of contact: the nationality of a company, assets deposited, incorporation situs, where taxes are paid, where business is conducted, and where principals reside. All these criteria are amorphous in the crypto world; note that Binance has no stated national identity and usually falls outside of U.S. jurisdiction. It is often unclear which national authority has any regulatory power over cryptocurrencies.

Proceed with Caution

Stablecoins are often how other virtual currencies are settled. They have significant risk factors and, like the virtual currencies they bolster, generally lack regulatory oversight in the United States and internationally. Investors should proceed with extreme caution, as virtual currency claims have at times not reflected reality, as revealed in the 2021 CFTC and NYAG settlement agreements and TerraUSD failure. The 2022 mid-summer bankruptcy and or collapse of some major crypto players highlighted that investors have little chance of recovering lost funds.

Stablecoins are a growing asset class that often escapes regulation because they can operate without a national identity and take full advantage of international jurisdictional loopholes. Through virtual private networks, investors can also sidestep restrictions imposed on them (for example, U.S. and N.Y. residents investing in Tether). As with all digital assets that easily cross borders, regulation will be ineffective without international cooperation. Enhanced authoritative guidance in accounting and disclosures is imperative if investors are to be able to rely on the financial reports of these digital assets.



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