The Breakdown - How Should Washington Regulate Stablecoins?

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, May 15th, and that means it's time for Long Reads Sunday. Now, as you might imagine, this week has been a pretty juicy one on Twitter. Because of that, I thought it would be good to just round out this stable coin week with a few threads that I thought were really useful or particularly educational in the wake of all of this. I promise we will start talking about other things again soon. But for this week, we are talking stablecoins still.

Starting point is 00:00:52 Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the breakers discord. You can find a link in the show notes or go to bit. dot Lee slash breakdown pod. Also a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. All right. So our first thread comes from Spencer Noon, the co-founder of Varian Fund, and it's really just an educational 101-style fund. And I'm reading this because I believe that some number of you may not fully have had the time to get into what stable coins are, how they work, and how to frame UST and Luna in that context. Spencer says, first, what are stablecoins? A stable A crypto asset whose price is pegged to the reference price of a reserve asset.

Starting point is 00:01:37 The most popular reserve asset for stablecoins is one US dollar. Stablecoins have a combined market cap of more than 170 billion. I'll look at the market prices of the top 10 stable coins on Coin Gecko, and we can see that not all of them are functioning properly. Why is that the case? To understand why, we need to understand how stable coins work. The best framework I've seen was published by a team of Defi researchers in 2020. I'm going to break down the major concepts here so you don't have to read it.

Starting point is 00:02:01 There are two major classes of stable coins. Custodial, entrusted by off-chain collateral assets like fiat dollars that sit in a bank, requires trust in a third party. Non-custodial, aka decentralized, fully on chain and backed by smart contracts and economics, no trusted parties. In custodial stablecoins, custodians hold a combination of assets, currencies, bonds, commodities, etc., off-chain, allowing issuers, possibly the same entity to offer digital tokens of a reserve asset. The top two custodial stable coins today are USDT and USDC. There are three types of custodial stable coins. Number one, reserve fund, 100% reserve ratio.

Starting point is 00:02:38 Each stable coin is backed by a unit of the reserve asset held by the custodian. Number two, fractional reserve fund. The stable coin is backed by a mix of both reserve assets and other capital assets. And finally, number three, central bank digital currency, a digital form of central bank money that is widely available to the general public. CBDCs are in their nascency, as today only nine countries and territories have launched them, many of them small. Custodial stablecoins have three major risks.

Starting point is 00:03:04 Counterparty risk, fraud, theft, government seizure, etc. Censorship risk, operations blocked by regulators, etc. Economic risk, off-chain assets go down in value. Each can result in the stable coin value going to zero. Next, non-custodial stablecoins aim to operate without the societal institutions that custodial stable coins rely on. They achieve this by creating an economic structure on. on blockchains enforced via smart contracts.

Starting point is 00:03:28 TLDR, economic structure plus rational actors equals price stability. There are three types of non-custodial or decentralized stable coins. Number one, exogenous collateral. The stablecoin is backed by assets that have uses outside the stablecoin system. The most prominent stable coin in this category is dye, which is backed by a number of crypto assets like ETH. Number two, endogenous collateral. An asset created with the purpose of being collateral for the stable coin.

Starting point is 00:03:53 Examples include synthetics, whose token SNX collateralizes its S-U-S-D stable coin. Number three, implicit collateral, aka algorithmic. Stablecoins without explicit collateral that instead use market mechanisms to adjust supply to stabilize price. U.S.T. is the most prominent Algo-stable. Non-custodial stable coins have five major risks. Collateral, value less than issuance. Data feed, the system can't price itself. Governance, parameter failure. Base layer, chain fails. Smart contract, hack leads to insolvency. Each can result in the stablecoin value going to zero. Algo-stable coins like UST are especially susceptible to collateral risk because they are not explicitly backed by collateral.

Starting point is 00:04:33 When there is a crisis in confidence such as the overall crypto markets going down, it can lead to a bank run or death spiral. This is when an Algo-stables fractional liquid reserve is depleted by redemptions, causing its system to default and remaining liquid assets needing to be sold at a discount. This in turn depletes the system's overall equity resulting in a spiral that is hard to overcome. algorithmic stable coins are a brand new type of asset, and while most attempts to date have failed, not all of them have. It remains to be seen whether they are viable long term at scale, however many people in the crypto industry are optimistic.

Starting point is 00:05:03 I thought this was a super useful, just 101-style thread. It's more sophisticated and more clearly put than many explanations of the different categories of stable coins than I've seen. The only thing I wanted to add isn't actually something that I wanted to add, but since Spencer left on this note that many are optimistic that algorithmic stable coins, coins will actually work, I think for the sake of completeness, it's worth pointing out that it feels like many fewer people might feel that way this week. The best quote that I saw that sums up this point of view comes from Nick Carter. He said, I saw someone today compare it to the history

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Starting point is 00:07:39 He writes, There's no sugar-coding it. This is among the most painful weeks in crypto history, and one will reckon with for a long time to come. Some thoughts for policymakers as they consider the path forward for stablecoin regulation. First, a quick summary of what happened. Terra-USD, or UST, was a stable coin on the Terra blockchain. It aimed to hold a peg to the US dollar, a stable value of $1 per U.S.T. Unlike most stable coins, UST was purely algorithmic,

Starting point is 00:08:04 meaning it didn't use any collateral to hold its peg. Instead of collateral, it used an algorithmic mechanism designed to stabilize UST's price at $1 by incentivizing market forces of supply and demand. It sought to let users redeem one U.S.T for $1 of Terra's native token, Luna, no matter the price of U.S.T on the secondary market. Similarly, it sought to let users redeem $1. of Luna for one UST, regardless of UST's market price. For example, if UST traded at 98 cents, arbitrages could redeem it for $1 of Luna, earning two cents and pushing up UST's price by reducing its supply. Same in reverse if UST traded above $1. This mechanism failed. UST lost its peg, triggering a death spiral that caused both UST and Luna to lose all their

Starting point is 00:08:42 value. Luna went from $80 two weeks ago to $0 today. I'll skip the details of exactly how and why it failed. UST's collapse wrought havoc in the crypto markets, resulting in billions of dollars in lost value. The question everyone's asking in DC now is what should policy makers do? To answer, we first have to step back and consider the stablecoin space as a whole in where UST fits in. Stablecoins are a vital innovation with massive promise for advancing U.S. interests at home and abroad. To strengthen global dollar dominance, promoting stablecoins should be a top national priority, not to mention the benefits for inclusion, efficiency, competitiveness, and more. In general, there are two types of stablecoins, custodial and decentralized. Custodial stable coins are issued by a central administrator

Starting point is 00:09:22 and backed by collateral held in a bank or other institution. These are usually fully collateralized $1 in assets for every $1 of stable coin. Custodial stable coins represent the vast majority of total stable coin volume and are very stable and reliable, provided the issuer is trustworthy and transparent. The industry standard is circle and it's widely adopted and regulated stablecoin USDC. There are other solid ones too. But not all custodial stable coins are created equal. They're only as good is their issuer, and not all issuers are so trustworthy and transparent. One of the main goals of blockchain technology is to disintermediate untrustworthy third parties. Entered decentralized stablecoins. Decentralized stable coins consist of autonomous self-executing protocols running on public

Starting point is 00:10:01 blockchains that seek to produce a dollar-peg token without relying on a trusted third party. The best known example is the Ethereum-based Maker Dow protocol and its Dai stablecoin. Stable coins like Dai are collateralized by other assets like ETH, but instead of being held by a custodial issuer, assets are held in a non-custodial smart-concorn. contract on the blockchain. Since those assets are volatile, over collateralization is required to maintain stability. The result is a decentralized and stable asset at the cost of capital efficiency, more than $1 in assets for every $1 in stable coin. This finally brings us to U.S.T. It tried to be everything at once. Decentralized, stable, and perfectly efficient,

Starting point is 00:10:35 using no collateral at all. U.S.T was in a category of its own, relying solely on its algorithmic mechanism, a risky model that many predicted might fail. That's far different from the many collateralized stablecoins, custodial and decentralized, which all performed well during this week's high volatility. Which brings us back to the question, what should policymakers do? First and foremost, they should fully understand these assets before making any decisions. Last November, the president's working group's Stablecorn report was a great start, but didn't address decentralized or algorithmic assets. Two months ago, President Biden issued an executive order identifying crypto's opportunities and risks, assigning responsibility for analyzing them and calling for written

Starting point is 00:11:11 reports. That work is ongoing and will be critical to inform next steps in Congress and across the administration. I fully agree with Treasury Secretary Janet Yellen's testimony in Congress about this yesterday. She said, we need a regulatory framework to guard against the risks, but that stable coins aren't at, quote, the scale right now where there are financial stability concern. She supported the EO process, saying that reports that Treasury and FSOC are writing in response to the EO, quote, will address the risks that these assets pose. And she reiterated the PWG report's recommendation that Congress, quote, produce a comprehensive. framework, importantly through a bipartisan effort. So what should policy makers do about

Starting point is 00:11:46 stablecoins? Follow the process called for by the EO, develop a bipartisan consensus in Congress, adopt new regulations that are fit for purpose. This is how we maximize the benefits and minimize the risks of responsible innovation. Stablecoins present too big an opportunity for us to risk getting them wrong as a matter of policy. We are locked in a global competition to be the home of Web 3. The data suggests we're behind. It's time for deep strategic thought and deliberate action. Back to NLW here, just to do a quick wrap-up. First of all, thanks both to Spencer and to Jake for these great threads. I think the real question when it comes to policymakers is who's going to be willing to put in the time, put aside their priors to actually see these differences and

Starting point is 00:12:28 distinctions that they're trying to draw. The hopeful thing is that there are some pretty common-sense agreements around how to regulate custodial stable coins. Put it this way. I don't know anyone in this industry who wouldn't like more rather than less information. about where the reserve assets of the big custodial stable coins are held, in what instruments, how much, all of that stuff. Transparency has been increasing as a matter of course, but full attestations of reserve backing seem obvious as a part of any stable coin legislation. Where it gets much thornier is with this whole different category. Call me an optimist, but I actually do think Congress and other elected officials, when they dig into this, are going to find that these

Starting point is 00:13:05 distinctions aren't that hard to draw, even if figuring out the right rules for different categories might be a little bit more difficult. I think that that's only the case because there has been so much work done over the last year especially in terms of educating the policymakers in Washington about this whole space. But as Jeremy Aller put it on Friday's show, ready or not, here it comes. This has moved from urgent to urgent-urgent-urgent. For now, I want to say thanks again to my sponsors, nexus.com, near and FTCX, and thanks to you guys for listening. be safe and take care of each other. Peace.

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The Breakdown - How Should Washington Regulate Stablecoins?

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