It’s time to stop coddling crypto


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

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 announced fixed exchange rate has been difficult for stablecoin issuers. TerraUSD’s failure this month was followed by Tether “breaking the ball”.

The crypto industry says only the lightest regulation will allow its blockchain technology and the “on-chain” products built on it to thrive, echoing a familiar refrain from the tech industry.

There are three types of stablecoins: algorithmic, crypto, and fiat. TerraUSD is now the most famous example of an algorithmic stablecoin whose values ​​are supposed to be stabilized by altering the relative supply of the stablecoin and a peer cryptocurrency. Non-algorithmic stablecoins back their liabilities with cryptocurrency or fiat currency. Due to the volatility of cryptocurrency values, crypto stablecoins are usually heavily over-collateralized. Since both algorithmic and crypto stablecoins are obviously exposed to a cryptocurrency price crash, neither is a strong candidate for a run-proof stablecoin design.

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

The first is a currency board. (The United States does not use one, but 14 other countries and territories do.) A currency board issues and redeems a state’s domestic currency for foreign currency at a fixed exchange rate. To ensure that currency board liabilities maintain their fixed exchange rate, currency boards are typically required to hold high-quality foreign reserve assets equivalent to between 100 and 110 percent of their liabilities.

Second, a chartered bank can create deposit liabilities by making loans. Deposits can be exchanged at any time for dollars. The fixed exchange rate between deposit money and dollars is backed by safety nets including prudent lending, risk management, bank capital, deposit insurance for FDIC members, and security reviews. the competence of management.

Third, a qualified investment manager can operate a money market mutual fund. These funds are only permitted to fix their net asset value in relation to the dollar when they hold a portfolio of liquid government securities; otherwise, the net asset value must float.

These proven models suggest that defending a fixed exchange rate requires a skilled and qualified issuer who guarantees liabilities one-to-one with safe assets. These seem to be the minimum requirements for a well-regulated stablecoin.

Senator Toomey’s Stablecoin Transparency of Reserves and Uniform Safe Transactions Act specifically exempts issuers of stablecoins from securities and investment management laws. Rather than requiring stablecoin issuers to qualify as chartered banks or investment managers, the TRUST Act allows the Office of the Comptroller of the Currency to decide what qualifications are necessary.

While the bill requires full coverage of stablecoin liabilities with high-quality government assets, it is easy to verify. Quarterly reserve coverage testing is limited to attestations which, unlike audits, do not corroborate the data presented or seek to identify deficiencies in systems or controls.

Stablecoins inherently carry another serious risk. They are designed to move irrevocably between buyers and sellers in minutes. But transactions on reserve assets that back stablecoins require a day or more to settle. Transactions sometimes fail due to computer problems, communication failures or other reasons.

Imagine a sequence of stable trades across many tokens. The equivalent of $100 million circulates “on-chain”, accompanied by an “off-chain” collateral flow. Collateral flow lags behind token-based transactions. If you are a stablecoin issuer in the middle of this streak, would you transmit tokens and incur a $100 million liability before knowing if collateral has arrived? Suppose an upstream stablecoin issuer is unwilling or unable to send collateral. This is essentially what happened on June 26, 1974, when Bankhaus Herstatt, a private German bank, went bankrupt between receiving Deutsche Marks and disbursing dollars to its foreign currency counterparties. The Herstatt counterparties never received these dollars.

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

Senator Toomey’s proposal cannot build the trust needed to prevent further runs on stablecoins. It would be easier to admit that stablecoins are not stable, that cryptocurrencies are not stores of value, and that a parallel crypto-forensic financial system is not essential to advancing finance.

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

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