Amid Rising Stablecoin Risks, Regulators Battle to Avoid Spillover Into Tradfi

Regulation of stablecoins has rapidly become the top priority of financial regulatory bodies worldwide. From TerraUSD’s depegging from the U.S. dollar to the run risk on centralized exchanges after the FTX meltdown, last year’s incidents have all added to the urgency for proper regulatory frameworks as risks associated with stablecoins surfaced. 

Stablecoins’ dominance showed signs of dangers

Even before mid-2022, the dramatic growth of stablecoins’ market capitalization had already attracted significant attention, pressuring lawmakers to respond quickly.

Based on data from The Block, stablecoins’ total market value has achieved exponential growth since 2020, with its market capitalization reaching over 18% of the crypto market by the end of 2021. Only after Terra’s crash did that trend begin to reverse.

In October 2020, the Financial Stability Board (FSB) had published a report on stablecoins, noting the risks of a bank run due to factors such as illiquidity and called for a global regulatory framework. 

Not-so-stable stablecoins pose risk to consumers and financial systems

These once-hypothetical concerns became reality after Terra’s crash. And soon after the meltdown of FTX, the Bank of Canada published a research note pushing for stricter regulations. It noted that the impressive stablecoin market capitalization (USD 161 billion as at December 2022) indicates significant risks to the stability of the financial system globally. This echoes the commentary from the FSB from back in 2020.

The collapse of Terra in May 2022 exemplified the contagion risks that come with stablecoins, said the bank. “Some firms were forced to suspend trading and the withdrawal of client funds after other firms filed for bankruptcy. Fortunately, ties to the traditional financial system have been very limited, but could grow in the future,” said the Bank of Canada. 

Another common concern with stablecoins is run risk. Following the FTX debacle, coupled with news of flaws in Binance’s management of stablecoin reserves, many consumers began pulling money from Binance as well as other CEXs due to a lack of confidence, as evidenced by the outflow of stablecoins from major CEXs.

In a recent CNBC interview, esteemed economist Eswar Prasad warned that a run on stablecoins could spill into bond markets, as issuers of these types of cryptocurrencies may have to sell U.S. Treasuries to honor redemptions. 

“The key aspect of stablecoins that keeps their value stable is the fact that they are backed up by reserves of fiat currencies, and typically these reserves are in the form of liquid government securities,” Prasad said.

“The concern of regulators is if there were to be a loss of confidence in stablecoins — maybe because some exchanges come down, or for other reasons — then you could have a wave of redemptions,” he added.

Firewall between TradFi and crypto may diminish 

While the crypto contagion crisis has not yet spilled over to traditional financial markets, related concerns remain as traditional financial institutions continue to incorporate crypto into their business models and adopt stablecoins.

Contrary to the common notion that DeFi platforms compete with traditional banks, one of the largest French banks, Societe Generale, recently used its MakerDAO vault to withdraw $7 million worth of stablecoin DAI. When the bank’s subsidiary, Forge, first raised this loan in 2021, its CEO Jean-Marc Stenger said, “I truly see banks and the financial industry as a whole, as probably the best and the largest clients, potentially, of those decentralized protocols.”

Regulation is the way forward, but not without challenges

Regulators are speeding up the process of putting regulations in place.

Researchers at the FSB suggested that stablecoin issuers should be treated like banks on the basis of “same activity, same risk, same regulation.” 

Take for instance the United States Congress’s bipartisan stablecoin legislation. Although it failed to pass the first session last year, it is expected to be a focus point of congressional members in the next session, in particular rules around reserve reporting and liquidity requirements, a spokesperson of Bitwise Asset Management told Blockworks.

However, regulatory systems on the national level are too fragmented when it comes to crypto, including stablecoins, to ensure appropriate oversight, as the International Monetary Fund and the FSB have pointed out in the past. 

“Global regulation for stablecoins should be comprehensive, consistent, risk-based, flexible, and focus on their structural features and use,” the IMF summarized in a research paper.

Would a global regulatory framework really work?

Even though a global regulatory framework would be ideal to many parties, effective implementation is by no means guaranteed. Take for example the paralysis within the U.S.’s domestic regulatory landscape. Multiple regulators such as the SFC, CFTC simultaneously possess authority over the regulation process. Consensus on such regulations on an international level seems proportionately more difficult to achieve.

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