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Legal Limbo: Stablecoins and Regulation

By Simone D. Casadei Bernardi

Bringing the stability of fiat to cryptocurrency, stablecoins represent safe harbour in a volatile market—allowing traders to instantly hedge without transferring to fiat, and enabling the use of crypto for transactions without fear of price fluctuations.

Simone D. Casadei Bernardi

For exchanges, stablecoins allow them to effectively function as blockchain-based banking platforms, without needing to engage with legacy financial institutions or deal with the compliance responsibilities of fiat onramps.

But as a crossover between fiat and crypto, stablecoins represent a challenge for regulators, which are gradually turning their attention to this new class of digital asset and beginning to erect a legal framework for their use.

The action is led by Japan—the only country to have classified bitcoin as legal tender—which decreed in October 2018 that stablecoins are not to be considered virtual currencies under the law because they are anchored to fiat.

In the US, stablecoins are on the radar of federal regulators like the SEC, CFTC, and FinCEN, which have issued guidance suggesting that the way stablecoins are regulated depends on the mechanism they use to maintain stability—with algorithmic stablecoins and collateralised stablecoins requiring different approaches.

Collateralised Stablecoins

Most commonly, the value of stablecoins is secured by a stockpile of real-world assets. These remain locked away in a vault, and blockchain-based assets are issued in their place at a 1:1 ratio.

As it resembles the traditional model of debt-based fiat, this model has provoked criticism from crypto purists for being at odds with Satoshi’s vision, and representing a move away from the ‘sound money’ described in the bitcoin whitepaper.

None have been more criticised than the first popular stablecoin—Tether—which has faced allegations of lack of transparency. In terms of regulation, Tether, along with its rival TrueUSD, is registered with FinCEN as a Money Services Business (MSB), which requires it to comply with AML regulations but doesn’t mandate audits of the vaults to check the asset is backed.

In the explosion of stablecoins that have followed Tether and TrueUSD, several have pursued a stronger relationship with the authorities to help inspire investor confidence that the assets are in fact backed.

The Gemini dollar, which the Winklevoss brothers claim is “the world’s first regulated stablecoin” has, along with PAXOS and Circle, been approved by the New York State Department of Financial Services (NYDFS) as a New York trust company—giving it a statutory duty to hold participant deposits on trust and as fiduciary, and legally enforcing the 1:1 ratio of assets to issued stablecoins.

As a New York trust company, these stablecoins are governed under banking law similar to e-money providers in the European Union, which must keep all customer funds in a segregated account, or insure the value of those funds.

To stay regulated under the NYDFS, Gemini and Paxos must ensure that the stablecoin remains fully exchangeable for USD, and that all transactions comply with AML regulations including the Bank Secrecy Act and Office of Foreign Assets Control (OFAC) controls to prevent criminal activity, terrorist financing, and market manipulation.

This requires transaction monitoring, and gives regulators the power to seize, freeze, or forfeit stablecoins if found to be used for illegal activity, or even alleged to be used in this manner by another law enforcement agency. This has again put collateralised stablecoins at odds with crypto purists, who contend that by putting trust in the centralised entities of auditors and regulatory agencies, the coins have departed from the original idea of an immutable, decentralised currency that relies only on the trust and transparency of the open blockchain.

Algorithmic Stablecoins

The main alternative to asset-backed stablecoins are algorithmic stablecoins, which use algorithms to maintain a steady value by automatically adjusting the supply of the coin in response to demand. As they are completely code-based, these stablecoins are arguably more in line with Satoshi’s vision of decentralisation but have also come up against some challenging regulatory hurdles.

Algorithmic stablecoin pioneer BASIS—with euro-pegged coin EURS—shut down earlier this year and returned all remaining funds to investors after speaking with the SEC:

“We met with the SEC to clarify a lot of our thinking [and] got the impression that we would not be able to avoid securities classification,” said founder Nader Al-Naji.

With securities classification, the project would need regulated broker-dealer status, and would only be open to accredited investors for the first year—a burden which could make a big difference in the fast-moving world of cryptocurrency.

Whether or not other algorithmic stablecoins can escape the fate of BASIS remains to be seen. The mechanism that BASIS used to maintain stability vaguely resembled the real world bonds and shares of legacy finance—employing a three token model with “Base Shares”, “Base Bonds” and one stablecoin, which may have made the coin particularly susceptible to securities categorisation. But, other algorithmic stablecoin schemes, such as Kowala, have also found themselves in a “regulatory limbo” that’s forestalling development.

While the SEC has yet to take a definitive stance, stablecoin projects must tread carefully, and public speeches made by the agency have suggested that both algorithmic and digital-asset backed stablecoins could be considered securities, depending on whether or not a central party is controlling price fluctuations:

“It’s these kinds of projects, where there is one central party controlling the price fluctuation over time that might be getting into the land of securities,” said SEC Senior Advisor for Digital Assets Valerie Szczepanik earlier this year. “Not to sound cliche, but we’d much rather people come to us and ask for [permission], or come talk to us before they do something, rather than doing something and then coming in and asking for forgiveness.”

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