Time to Stop Coddling Crypto

Even among crypto believers, confidence in stablecoins has been shaken and calls for regulation have grown louder. Sen. Pat Toomey (R., Pa.) has proposed legislation, but the real question is why the government continues to sidestep existing laws and protections to coddle a stagnant, wasteful technology in search of a compelling legal use case.

A stablecoin is the crypto world’s preferred medium of exchange: a token pegged to a fiat currency like the US dollar. However, maintaining the advertised fixed exchange rate has been difficult for stablecoin issuers. This month’s failure of TerraUSD was followed by Tether, which “broke the buck.”

The crypto industry claims that only the lightest of regulations will allow its blockchain technology and the “on-chain” products built on it to thrive, echoing a well-known tech industry refrain.

There are three types of stablecoins: algorithmic, crypto-backed, and fiat-backed. TerraUSD is today the most prominent example of an algorithmic stablecoin that seeks to stabilize values ​​by changing the relative supply of the stablecoin and a counterpart cryptocurrency. Non-algorithmic stablecoins collateralize their liabilities with cryptocurrency or fiat currency. Due to the volatility of cryptocurrency values, crypto-backed stablecoins are typically heavily over-collateralised. Given that algorithmic and crypto-backed stablecoins are obviously facing a collapse in cryptocurrency prices, neither are serious candidates for a run-safe stablecoin design.

Investor confidence in fiat-backed stablecoins largely depends on the issuer’s “off-chain” operations. These are the issuer’s transactions in assets such as bank deposits and Treasury bills that support its stablecoin’s value. There are three models that stablecoin issuers could follow to make their products less unstable.

The first is a currency board. (The US doesn’t use one, but 14 other countries and territories do.) A currency board issues a state’s domestic currency at a fixed exchange rate and redeems it for foreign currency. To ensure that currency boards’ liabilities remain at their fixed exchange rate, currency boards are typically required to hold 100% to 110% of their liabilities in high-quality foreign reserves.

Second, a chartered bank can create deposit liabilities by extending credit. Deposits can be redeemed for dollars at any time. The fixed exchange rate between deposit money and the dollar is supported by safeguards including prudent lending, risk management, bank capital, deposit protection for FDIC members and reviews of management competency.

Third, a Qualified Investment Manager may operate a money market fund. Such funds may fix their net asset value against the dollar only if the fund holds a portfolio of liquid government securities; otherwise the Net Asset Value must fluctuate.

These proven models suggest that defending a fixed exchange rate requires a competent, qualified issuer that backs liabilities on a one-to-one basis with safe assets. These appear to be the minimum requirements for a well-regulated stablecoin.

Sen. Toomey’s Stablecoin Transparency of Reserves and Uniform Safe Transactions Act specifically exempts stablecoin issuers from securities and investment management laws. Instead of requiring stablecoin issuers to qualify as licensed banks or investment managers, the TRUST Act lets the Office of the Comptroller of the Currency decide what qualifications are required.

While the bill requires full coverage of stablecoin liabilities with high-quality government assets, verification is straightforward. Quarterly tests of reserve coverage are limited to attestations which, unlike audits, do not seek to substantiate the data presented or to identify gaps in systems or controls.

By their very nature, stablecoins carry another serious risk. They are designed to irrevocably move between buyers and sellers within minutes. But reserve assets backing stablecoins take a day or more to settle. Deals are sometimes not completed due to computer malfunctions, communications failures or other reasons.

Imagine a sequence of stablecoin transactions across many tokens. The equivalent of $100 million is flowing on-chain, accompanied by an off-chain flow of collateral. Collateral flow lags behind token-based transactions. If you are a stablecoin issuer in the middle of this sequence, would you transfer tokens and incur $100 million in liability before knowing if the collateral has arrived? Suppose an upstream stablecoin issuer is unwilling or unable to post collateral. This essentially happened on June 26, 1974, when Bankhaus Herstatt, a German private bank, fell short between receiving Deutschmarks and paying out dollars to its foreign exchange counterparties. Herstatt’s counterparties never received these dollars.

The “Herstatt Risk” can be eliminated by synchronizing on- and off-chain transactions. But then the stablecoin loses its speed advantage. One might as well trade regulated bank deposits or money market fund balances, eliminating the “stablecoin” fiction entirely.

Senator Toomey’s proposal fails to build the confidence needed to prevent further runs on stablecoins. It would be easier to admit that stablecoins are not stable, cryptocurrencies are not stores of value, and a parallel, cryptolegal financial system is not strictly necessary to drive finance forward.

Mr. Hanke is Professor of Applied Economics at Johns Hopkins University. Mr. Sekerke is a Fellow at the Johns Hopkins Institute for Applied Economics, Global Health and the Study of Business Enterprise.

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https://www.wsj.com/articles/time-to-stop-coddling-crypto-cryptocurrency-stablecoin-financial-regulation-senator-toomey-money-11653494847 Time to Stop Coddling Crypto

Alley Einstein

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