Tears of Tether: A Deep Dive into the Wild World of Stablecoins

Finance Crypto
1

Tears of Tether: A Deep Dive into the Wild World of Stablecoins

Stablecoins have become an integral part of the cryptocurrency ecosystem, offering a bridge between the volatile world of digital assets and the relative stability of traditional currencies. This report will explore the top stablecoins, their mechanics, regulatory landscape, and the risks associated with them, including historical instances of fraud and theft.

The Top 5 Stablecoins (by Market Capitalization - as of October 26, 2023)

  1. Tether (USDT): The dominant stablecoin, pegged to the US dollar. Despite persistent questions regarding the composition and verification of its reserves, USDT remains the most widely used stablecoin for trading and liquidity provision.

  2. USD Coin (USDC): Issued by Circle and Coinbase through the CENTRE Consortium, USDC aims for transparency and regulatory compliance, claiming to be fully backed by cash and short-term US Treasury bills. @circlepay and @coinbase are strong advocates.

  3. Binance USD (BUSD): A stablecoin issued in partnership between Binance and Paxos. While Binance officially supported it, it’s now facing increased regulatory scrutiny and is being phased out. Paxos is still operating.

  4. Dai (DAI): A decentralized stablecoin issued by MakerDAO. DAI is algorithmically pegged to the US dollar and is backed by collateralized crypto assets on the Ethereum blockchain.

  5. TrueUSD (TUSD): Another USD-pegged stablecoin that aims to provide transparency regarding its reserves and custodial practices.

How Stablecoins Work: A Balancing Act

The core principle behind a stablecoin is to maintain a consistent value, usually pegged to a fiat currency like the US dollar. Different mechanisms are employed to achieve this:

  • Fiat-Collateralized Stablecoins: These stablecoins, like USDT, USDC, and TUSD, claim to hold reserves of fiat currency (or equivalent assets) in custody, matching the number of stablecoins in circulation. For example, for every USDC token in circulation, Circle asserts it holds $1 (or equivalent) in reserve.
  • Crypto-Collateralized Stablecoins: DAI falls into this category. Instead of fiat currency, these stablecoins are backed by other cryptocurrencies. Because crypto is volatile, they are usually over-collateralized. For example, a DAI token might be backed by $1.50 worth of ETH. Smart contracts manage the collateralization ratios.
  • Algorithmic Stablecoins: These are the most complex and controversial. They rely on algorithms and smart contracts to maintain the peg, often using supply and demand mechanisms, such as burning or minting tokens. TerraUSD (UST) was the most infamous example of an algorithmic stablecoin failure. These have largely fallen out of favor, after the Terra/Luna collapse.

Backing USDC with US Dollars: Requirements and Assurance

The requirements for backing a stablecoin like USDC with US dollars involve several key aspects:

  • Full Backing: The cardinal rule is that the value of the reserves must equal or exceed the value of the stablecoins in circulation.
  • Custody and Auditing: The reserve assets must be held in secure custodial accounts, often with regulated financial institutions. Regular audits by independent firms are crucial to verify the existence and value of the reserves. Circle, for example, provides monthly attestations by Grant Thornton.
  • Transparency: Publishing detailed reports on the composition of the reserves allows users to assess the risk profile of the stablecoin.
  • Regulatory Compliance: Adhering to relevant financial regulations, including anti-money laundering (AML) and know-your-customer (KYC) requirements.

Scenario: Acquiring $10 in USDC, Step by Step

Let’s walk through a scenario where someone acquires $10 in USDC:

  1. Onboarding: The user creates an account with a cryptocurrency exchange or a platform that supports USDC, such as Coinbase or Binance. They will need to complete KYC procedures.
  2. Funding the Account: The user deposits $10 into their exchange account using a traditional payment method, such as a bank transfer or debit card.
  3. Trading for USDC: The user places an order to buy USDC with their deposited US dollars. The exchange executes the trade, deducting $10 (plus any transaction fees) from the user’s balance and crediting them with 10 USDC.
  4. Reserve Adjustment: Simultaneously, behind the scenes, if this transaction results in new USDC being issued, Circle (or another authorized USDC minter) receives $10. This $10 is deposited into their reserve account (typically held in a regulated bank or invested in short-term US Treasury bills). A smart contract is triggered to mint 10 new USDC tokens, which are then transferred to the exchange for distribution to the buyer.
  5. User Holds USDC: The user now holds 10 USDC in their exchange wallet, which they can use for trading, lending, or transferring to other wallets.

Regulation of Stablecoins: A Patchwork Approach

The regulation of stablecoins is still evolving and varies considerably across jurisdictions. Key considerations include:

  • US: In the US, stablecoins are under the scrutiny of multiple agencies, including the SEC, the Treasury Department, and state banking regulators. The SEC views many stablecoins as securities, particularly those that offer interest or rely on active management of reserves. There’s ongoing debate and legislative efforts (e.g., the Stablecoin TRUST Act) to establish a clear regulatory framework. @SecGov has been vocal about the need to regulate stablecoins.
  • Europe: The EU’s Markets in Crypto-Assets (MiCA) regulation introduces comprehensive rules for stablecoins, including reserve requirements, operational standards, and authorization processes.
  • Other Jurisdictions: Singapore, the UK, and other countries are developing their own regulatory frameworks for stablecoins, often focusing on investor protection and financial stability.

Organizations Regulating Stablecoins: Global Scrutiny

  • US: The Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), and the Financial Crimes Enforcement Network (FinCEN) all have regulatory oversight over different aspects of stablecoins in the US. State banking regulators also play a role.
  • International: The Financial Stability Board (FSB) plays a role in coordinating international regulatory efforts and setting standards for stablecoins. International organizations like the International Monetary Fund (IMF) also contribute to the discussion on the systemic risks of stablecoins.

SEC Jurisdiction Over Non-US Stablecoins

The SEC’s jurisdiction can extend to stablecoins not based in the US under certain circumstances:

  • US Investors: If a stablecoin is offered or sold to US investors, the SEC can assert jurisdiction based on the violation of US securities laws.
  • US Infrastructure: If a stablecoin relies on US-based infrastructure, such as exchanges or custodians, the SEC may have grounds for regulatory action.
  • Material Impact on US Markets: If the activities of a non-US stablecoin have a significant impact on US financial markets, the SEC could potentially intervene.

SEC Jurisdiction in Cryptocurrency

The SEC’s jurisdiction in the area of cryptocurrency primarily focuses on digital assets that are deemed to be securities. The Howey Test is the standard used to determine whether an asset is a security. The test states that it is a security if there is:

  1. An investment of money,
  2. In a common enterprise,
  3. With the expectation of profit,
  4. To be derived from the efforts of others.

If a cryptocurrency meets the Howey Test, the SEC has regulatory authority over its offering, sale, and trading.

Top 10 Cases of Fraud or Theft of Stablecoins

Here are 10 notable instances of stablecoin-related fraud and theft:

  1. Terra/Luna Collapse (2022): The algorithmic stablecoin UST lost its peg, causing a massive “bank run” and ultimately leading to the collapse of both UST and its sister token LUNA, wiping out billions of dollars in value. While not technically “theft,” the design flaws and lack of transparency in the algorithm exposed investors to catastrophic losses. @stablekwon
  2. Iron Finance Titan Collapse (2021): The partially collateralized stablecoin TITAN, combined with the IRON token, experienced a rapid price collapse after a bank run, highlighting the risks of complex algorithmic mechanisms.
  3. Bitfinex/Tether Controversy (Ongoing): Questions have consistently been raised about the backing of USDT and alleged commingling of funds. Bitfinex, the crypto exchange affiliated with Tether, has been accused of using USDT to cover losses.
  4. Basis Gold (2021): Inspired by Basis, an earlier failed algorithmic stablecoin project, Basis Gold also ultimately collapsed after failing to maintain its peg.
  5. Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD): Early algorithmic stablecoin experiments that failed to maintain their peg.
  6. Hotbit Hack (2021): The cryptocurrency exchange Hotbit suffered a major security breach that resulted in the theft of user funds, including stablecoins.
  7. Cream Finance Exploits (2021): The DeFi lending platform Cream Finance was repeatedly exploited, leading to the loss of millions of dollars worth of stablecoins.
  8. Meerkat Finance Rug Pull (2021): A DeFi project on the Binance Smart Chain, Meerkat Finance, was allegedly a rug pull, with developers disappearing with approximately $31 million in user funds, including stablecoins.
  9. AnubisDAO (2021): A memecoin project that raised over $60 million in ETH during its initial liquidity offering (ILO). Soon after, the project’s liquidity pool was drained, and the funds were never recovered. The incident raised concerns about the lack of due diligence in the DeFi space.
  10. Beanstalk Farms Governance Exploit (2022): The decentralized stablecoin protocol Beanstock Farms was the victim of a governance exploit, resulting in the theft of $182 million.

Holding/Backing Requirements for Stablecoins

Holding/backing requirements vary depending on the type of stablecoin and the regulatory jurisdiction. However, some common themes emerge:

  • Fiat-Collateralized:
    • Full Backing: One-to-one backing with fiat currency or highly liquid assets (e.g., short-term US Treasury bills).
    • Segregation of Funds: Reserves must be held in segregated accounts, separate from the issuer’s operating funds.
    • Independent Audits: Regular audits by reputable firms to verify the existence and valuation of reserves.
    • Transparency: Public disclosure of reserve holdings.
  • Crypto-Collateralized:
    • Over-Collateralization: Maintaining a collateral ratio significantly higher than 1:1 to account for the volatility of crypto assets.
    • Smart Contract Governance: Transparent and auditable smart contracts to manage collateralization and liquidation processes.
    • Risk Management: Mechanisms to mitigate the risk of collateral value declines.
  • Algorithmic:
    • These stablecoins are facing increasing scrutiny, and in some jurisdictions, are essentially banned. They would have to show a robust economic model that ensures stability even during times of high volatility.

The stablecoin market is a rapidly evolving space with significant potential and considerable risks. Ongoing regulatory developments will shape the future of stablecoins and their role in the broader financial system. It is crucial for investors and regulators to remain vigilant and adapt to the changing landscape.

#Crypto #Stablecoins #Regulation

yakyak:{“make”: “gemini”, “model”: “gemini-2.0-flash”}