Stablecoins and Regulatory Developments Post Terra
In the sobering aftermath of the collapse of the Terra ecosystem – amid deep market crashes and massive liquidations around the crypto space – financial regulators around the world were stirred into reaction, working to clarify their stance on stablecoin and build regulatory frameworks around the new piece of financial technology.
Once considered one of the most promising stablecoin ecosystems with the sole objective to deliver the largest algorithmic stablecoin, Terra’s ambitious mission attracted a plethora of investors who readily jumped on the Terra bandwagon predicting that their investments would pay off heavily at the finish line.
As it often turns out, nothing is too big to fail, and the Terra Death Spiral sought to teach valuable lessons from the Fourth Industrial Revolution to those in the legal profession.
In this article, Learn Crypto takes a look at the legal definitions that are currently associated with stablecoins. The article takes a snapshot of how Japanese financial regulators reacted or responded to Terra’s demise and its perceived ripple effect on crypto markets in the following months. It then discusses how the global legislative landscape might look like for stablecoins in the coming years.
In this snapshot of regulatory developments on stablecoins:
- The legal nature of stablecoins
- The Japanese legal solution to the crypto crisis
- Whether such regulations could have helped in avoiding the Terra collapse.
The Legal Nature of Stablecoins: Definition, main types, and legal perspective
A dam against crypto volatility
There are plenty of tropes about cryptocurrency but perhaps one that all sides can agree on is that crypto is volatile. Depending on your appetite for tolerance and relative to the type of crypto, crypto is either very volatile or at the very least, prone to volatility. Even the most mature digital currency of them all, Bitcoin, experiences deep and distinct periods where the price can swing in either or both directions in unpredictable ways.
Double-digit percentage changes in price are common enough occurrences, even if Bitcoin's intraday swings tend to be somewhat milder compared to newer assets like, say, Solana or Cardano. Its most recent peak of some $68,000 in November 2021 happened barely 18 months after trading below $4,000.
While this specific feature explains why speculation continues to be cryptocurrency’s biggest use case, it makes a difficult argument for crypto’s original concepts as alternative methods for routine transactions and store of value.
For cryptocurrency to succeed as a medium of exchange, proponents sought to bring some semblance of stability in value to it, willing to settle for a compromise in the form of a digital currency that might lose some of Bitcoin’s unique aspects like decentralisation in return for minimised volatility to make it practical for daily and ordinary use.
Called stablecoins, the underlying technology of public ledgers remained intact – with a few omissions and unique defining characteristics.
The following section takes a look at what makes a stablecoin.
Defining stablecoins
To lay it down lightly, a stablecoin in the cryptocurrency aspect is a token that has its value pegged to the price of a national currency.
To get a more in-depth look into stablecoins, read this Learn Crypto article: What is a Stablecoin?
The main idea behind stablecoins is to have a digital token backed by the security benefits of blockchain and the stable value of a national currency. In this way, it would be able to combat the volatility associated with crypto, while utilising the benefits of crypto technology, effectively bridging the gap between cryptocurrencies and fiat currencies.
The most common type of stablecoins are cryptocurrencies that have their price pegged to a particular asset or a basket of assets; most often the US dollar. Pegging their value to traditional assets such as fiat currencies or even precious metals like gold makes them a less volatile option than typical cryptocurrencies.
Recognised assets with a crypto twist
Perhaps the obvious question to ask now would be if we already have traditional assets, namely fiat currencies or precious metals, and most people already place their trust in them, then why the need to complicate things and create cryptocurrencies that act just like traditional assets?
Or in other words, why is the use of stablecoins more efficient than the use of traditional banking?
The answer is simple. Just like their cryptocurrency predecessors, stablecoins promise more rapid transactions and lower costs as an alternative to traditional banking services. Additionally, they allow traders to keep their funds in the crypto ecosystem by storing them in a stable crypto asset during periods of trades or volatile times. This is far more cost-effective than converting between crypto and traditional finance systems.
In essence, stablecoins seek to be the best of both worlds, straddling the border between cryptocurrency and traditional banking.
The different types of stablecoins
Today, stablecoin development has led to multiple types of currencies in this asset class, defined by the type of asset backing them, or even the type of programming they use. Stablecoins are generally grouped into four types: fiat-collateralized stablecoins, commodity-backed stablecoins, crypto-backed stablecoins, and finally, algorithmic stablecoins.
1. Fiat-collateralized stablecoins
Fiat-collateralized stablecoins are stablecoins backed by fiat currencies such as the US dollar (USD), euro (EUR), or pound sterling (GBP). They are the most popular variant of stablecoins and the simplest sort as well, with a 1:1 ratio backing. That means that one stablecoin ever issued also has an equal unit of backed currency, acting as collateral. Hence, for every fiat-backed cryptocurrency, there is a real cash reserve. This is one of the simplest and most popular categories of stablecoins for beginners to jump onto the crypto bandwagon.
2. Commodity-backed stablecoins
Secondly, we have commodity-backed stablecoins. These kinds of stablecoins are backed up by traditional and valuable commodities such as gold, platinum, and real estate. Commodity-backed stablecoins are another really popular variant with a 1:1 unit ratio as well. For instance, a gold-backed-stablecoin might be pegged to one gram of gold. The use of commodity-backed stablecoins, in theory, makes it possible for anyone in the world to invest in precious commodities, creating novel opportunities for high-value commodity investments for ordinary people.
3. Crypto-backed stablecoins
Next, we look at crypto-backed stablecoin, which might sound confusing at first, if the whole point of stablecoins were to avoid the volatility of crypto!
However, proponents of a true crypto-economy might argue that 1 Bitcoin will always be 1 Bitcoin, and would prefer to exchange value with a token backed by Bitcoin itself.
In general, crypto-backed stablecoins often store a reserve for each minting of its tokens. They may, ironically, be less stable compared to conventional variants, but can encompass some significant traits of decentralization, transparency, and security.
4. Algorithmic stablecoins
Finally, we’re down to algorithmic stablecoins. Unlike all the other types of variants, algorithmic stablecoins don’t tend to be backed by any sort of asset or commodity, as they need to be flexible in expanding or contracting supply. Terra, which this article talked about in the introduction, was an example of such a stablecoin. Grounded on algorithms, Terra had to expand and contract its supply, minting and burning tokens as its value shifted in the market, to try and achieve equilibrium with a peg. In Terra’s case, this peg was the US dollar.
Hence, if the price of the stablecoin increases, the algorithm will do the work to adjust itself to issue more coins and vice versa. While being the riskiest variant, it also provides the highest level of decentralisation and independence.
A legal perspective on stablecoins
At the beginning of June 2022, Japan became the first major economy to act during the ongoing crypto crisis by passing a specific law on stablecoins, requiring their operators to provide clarity and provide a safety net for investors. This new legal framework will only come into effect next year in June – though that is perhaps a quick turnover in the legal sphere, giving enough time between passing the law and its coming into effect for people to get to familiarise themselves with the law and to build up an efficient framework to support the new law coming into force.
The most important aspect of this new law is that stablecoins are going to be considered digital money that can be issued only by trusted third parties such as licensed banks, trust companies, and registered money transfer agents.
To continue the discussion on the legal nature of stablecoins, we can accept that it was mainly a lack of crypto-related regulations that contributed to the severity of the problem that emerged when Terra fell apart.
While Terra claims to have had some safety nets in place, none had been proven. There had been no audits of their defence mechanisms, nor was there any independent testing of the system to see if it could be manipulated.
Additionally, the way Terra attempted to attract investment would never have been greenlighted in a regular market – inviting people to invest and lock up funds for up to 12% APY gains would have been a glaring red flag in a regulated environment.
Recognising the legal gap, Japan was the first to step in, not unlike how the nation reacted to the infamous Mt Gox exchange hack in 2013.
The Japanese legal solution to the crypto crisis
The revised Funds Settlement Law, passed by the Japanese Parliament, includes novel provisions on stablecoins.
In 2016, Japan already recognised Bitcoin and other types of cryptocurrency as a method of payment via an amendment in its Payment Services Act and Fund Settlement Law. Legally recognizing stablecoins as digital money now makes Japan the first major economy to establish a legal framework for a range of crypto assets that went beyond traditional crypto like Bitcoin.
The crypto-friendly climate of the Japanese market, along with growing adoption by retail and institutional investors served as a decent setting to enact such legislation. Over the next few months, the Japanese Financial Services Agency (FSA) plans to release a plethora of rules and regulations for stablecoins creators, which is widely believed to mean that only authorized businesses and banks would be able to create and issue stablecoins.
To be fair, like many other market regulators and watchdogs, Japan’s FSA had already been drawing the framework even before the market’s recent downfall, so it was fairly easy to derive a framework that is similar to draft European and American solutions. Only, in passing the law, Japan has become a pioneer in stablecoin regulation while being in line with international developments.
The revised Funds Settlement Law
Let’s go through the revised provisions of the Funds Settlement Law.
Revising the law regulating payment services in general, stablecoins have been regulated as digital funds that can be issued only by licensed banks, authorized and trust businesses, and registered money transfer agents.
The legal novelties rest on three main pillars: the regulation of stablecoins, rules for monitoring in relation to potential risks of money laundering, and crackdowns on money laundering tools. Such revisions have been introduced to finally create a fund settlement system regarding the ongoing and rapid digitalization of financial services.
It is interesting to note that the longstanding objective of the crypto community to remove the ‘middleman’ appears to have been shelved since all these legislative novelties, whether talking about the Japanese revised law or the European and American proposals, include bringing the intermediaries back on the main financial stage.
To sum it up, the Japanese revised law says that stablecoins are going to be handled by authorized issuers and intermediaries that are responsible for their circulation.
Taking into account that licenses are going to be issued to highly credible businesses, these revised provisions seem not to be start-up friendly. For instance, Mitsubishi UFJ Trust and Banking Corp have declared that, as soon as the new law comes into force, they will issue their own stablecoin under the name Progmat Coin.
Another interesting thing is that the law doesn’t address existing asset-grounded stablecoins from overseas or algorithmic stablecoins (like Terra, which prompted the revision). Looking only into the future, the law says that the stablecoins will be pegged to the Japanese national currency or another legal tender.
Is this enough regulation?
Before Japan took its major step, there had been some sporadic stablecoin-related regulation developments in Europe by the provisions of the Electronic Money Directive 2 (EMD2 Directive). This directive was then expected to encompass only the fiat-backed sort of stablecoin (with a promise for future expansion) with the Markets in Crypto-assets regulation (MiCA) proposal that protected investors from fraud.
Still in the legislative process, the MiCA proposal includes a broader and more specific definition referring to stablecoins as asset-referenced tokens.
The significance of regulating stablecoins also emerged in the United States way before the Terra collapse. A policy paper delivered to the US Congress back in 2021 regarding the ongoing issue of stablecoin regulation was written on the notion that a $130 billion stablecoin market could become crucial as it grows and intertwines with the traditional market. The policy paper reported potential future risks of not regulating stablecoins such as investor protection and market integrity, along with misconduct and fraud in the trade of digital assets. It recommended that Congress pass legislation that would allow banks to issue stablecoins to put custodial wallet providers under the oversight of federal agencies. The American plan on stablecoins was to treat them like bank products.
Yet as Terra showed, none of these regulations, whether in development or existing, brought practical solutions or even predicted the event. In respect of Terra specifically, keep in mind that Terra was built as an algorithmic-based stablecoin that used Luna to absorb volatility and maintain the value. It had a myriad of interlinked systems and multiple tokens, some decentralised and others opaque.
As we discover, neither the Japanese, nor the European and American proposals have managed to broaden legal definitions to properly regulate the problem of algorithmic-based stablecoins. The innovative algorithmic stablecoin’s stability is as theoretical today as it ever was when it first emerged several years ago. In practice, there has been no successful algorithmic stablecoin and plenty of failed ones. Terra simply created the biggest splash and affected the most people.
The fact remains that regulations should have been set in place earlier and that the market has failed to protect consumers.
Whether Terra’s collapse has ushered in urgency to redress the regulatory landscape or whether it has only served to provide more ammo to governments to introduce more control into the crypto market under the pretense of consumer and investment protection, only time will tell.