Stablecoin Supervision is Approaching （Part）: Current Situation and Risks

【TL; DR】
1. In the last half of the 2021, with in-depth discussion on the issue of stablecoins by governments of various countries, the direction of stablecoin supervision has gradually become clear.
2. Stablecoins can be divided into three types: Off-Chain-Backed Stablecoin, On-Chain-Backed Stablecoin and Algorithmic Stablecoin.
3. Stablecoins are considered one of the technical foundations behind DeFi and play a role in accelerating the development of blockchain technology.
4. The lack of supervision and some problems in the design of the stablecoins make the systemic financial risks imminent with the growth and scale of stablecoins.


In the whole cryptocurrency industry, the stablecoins and its derivative risks have always been the focus of supervising departments. In the last half of the 2021, with the in-depth discussion on the issue of stablecoins by governments of various countries, especially the U.S. government, the direction of stablecoin supervision has gradually become clear.

In November 2021, the US President's Working Group on Financial Markets (PWG) issued a stablecoin report, which proposed that stablecoins may lead to bank runs and bring risks to the payment system.

In December, the U.S. Senate continued to follow up the issue of stablecoins, with a hearing on “Stablecoins: How Do They Work, How Are They Used, and What Are Their Risks?” The hearing was held by the Senate Committee on Banking Housing and Urban Affairs.

Over the past year, the DeFi sector has witnessed amazing growth, with more than 280 types of stablecoins and a total supply of more than 10 times. With the increasing impact of cryptocurrency and DeFi on the real economy, it can be expected that the stablecoin supervision system will be effected in 2022 or 2023.


What are Stablecoins?
The concept of stablecoins was born in 2012.

Encrypted assets such as Bitcoin are often issued through node mining, so as to achieve complete or partial decentralization. However, due to its large volatility, it is often considered a speculative asset. In this case, if you want to find a common value target for many assets in the cryptocurrency market, you need a more stable token of value, which is how stablecoins came into being.

Stablecoins give various digital assets direct and comparable digital value, making the exchange between various assets in DeFi more convenient. At present, in principle, stablecoins can be divided into off-chain-backed stablecoin, on-chain-backed stablecoin and algorithmic stablecoin.

off-chain-backed stablecoin and on-chain-backed stablecoin both maintain the same value by anchoring one asset. Among them, the off-chain-backed stablecoin is generally issued and managed by a centralized organization.

At present, USDC and USDT, two largest stablecoin categories, are both off-chain-backed stablecoins. On-chain-backed stablecoins, another stablecoin category, is used to issue digital currency with fixed fiat price by staking digital assets on smart contracts.

The algorithmic stablecoins are special. This kind of stablecoins has no value support, but adjusts the relationship between supply and demand through algorithms to maintain its own price stability. This process is somewhat similar to the central bank in the real world. The typical representative of this mode is AMPL. Algorithmic stablecoins generally control the supply of stablecoins through open market operation, while Rebasing and issuing secondary tokens.

Stablecoins are considered one of the technical foundations behind DeFi and play a role in accelerating the development of blockchain technology. When stablecoins have stable value, the cryptocurrency with unstable price will obtain the anchor point of mutual exchange. Therefore, the stablecoins have certain value scale functions. For traders, in the falling market, they can also convert risky digital assets into stablecoins, so as to achieve hedging without leaving the whole cryptocurrency ecology.

Stablecoins also expand the boundary of legal currency and are a bridge between blockchain and the real world. As a means of payment, stablecoins have less price change than other digital assets and are closer to the real currency. In addition, since the stablecoins are based on various blockchains, no matter where they are located in the world, anyone can accept or send the stablecoins by simply connecting to the blockchain network. The stablecoins also have a variety of possibilities in cross-border payment, Inclusive finance and so on.


Risk still Exists: Stablecoins Bring "Instability"?
Although the stablecoins have such a huge impact and play such a huge role, there has been a gap in the supervision of the stablecoins for a long time. Coupled with some problems in the design of the stablecoins themselves, the systemic financial risk gradually becomes imminent with the increase of the scale of the stablecoins.

Firstly, due to the shortcomings including long-term unrestricted issuance of stablecoins and non-disclosure and non-transparency of relevant information of the issuers, stablecoins are pointed out as being an "unsecured money printer". Take Tether Limited (USDT), the largest provider of stablecoins, as an example. USDT accounts for approximately 70% of the market value of global stablecoins. Although the company mentioned in the white paper that USDT has 100% dollar reserves behind it, the authenticity of this statement has been repeatedly questioned because Tether's operation is not transparent enough.

In April 2019, USDT issued more than US $800 million within one month. Tether Limited and its exchange Bitfinex were charged by the New York Attorney General's Office (NYAG). Tether Limited later admitted that only 74% of the total USDT issuance was supported by cash and equivalents, which put iFiniex, Tether Limited's parent company, under scrutiny for financial fraud.

In October 2021, Tether Limited was fined $41 million by the Commodity Futures Trading Commission (CFTC) because CFTC believed that the company concealed the truth of its reserves and failed to achieve the 1:1 reserve target most of the time. According to CFTC data, from September 2016 to November 2018, the legal reserve in Tether Limited's account was only enough to support 27% of the total amount of tokens issued by the company.

Secondly, as virtual currencies, stablecoins are anchored to a certain legal currency, but it is free from the traditional financial system, which makes the major stablecoin issuers become "Internet shadow banks" that are difficult to be supervised.

Taking USDT as an example, after Tether Limited updated its disclosure statement, its tokens are no longer supported by 100% US dollars, but include US dollars and a series of cash equivalents. A report last October showed that USDT's current reserves consist of 12% cash, 29% treasury bonds, 58% commercial bonds, fixed deposits and 2% bills.

For different stablecoin providers, the cash equivalents purchased may have large or small risks and liquidity problems. In the event of an economic crisis, the rapid liquidation of stablecoins will become a problem.

More seriously, with the expansion of the issuance scale of stablecoins, this risk may also spill over to the whole cryptocurrency field and even the whole financial system, affect the transmission of monetary policy and introduce systemic risks.

Thirdly, the stablecoins may be applied to future cross-border capital flows, which will have an impact on the global monetary and clearing system. Compared with the Libra project which had the vision of a "global common currency" designed by Facebook, Libra was officially stopped by the supervision department for this reason. At present, from a global perspective, since most of the stablecoins in the market are based on the US dollar, the stablecoins may be conducive to the consolidation of the international advantages of the US dollar, but it will have an impact on the monetary sovereignty of other countries, especially vulnerable countries.


Conclusion
These issues highlight the challenges caused by the lack of stablecoin supervision. How to ensure the transparency of stablecoin issuers, how to conduct public audits, how issuers use funds, and how issuers avoid price manipulation are all problems that need to be solved. We call for appropriate regulation to promote the compliance of stablecoins and cryptocurrency as a whole.
In the next article, we will continue to discuss the recent stablecoin supervision scheme of the U.S. government. Please keep an eye on the following updates on the Gate.io platform.


Author: Gate.io Observer: Edward.H
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