WASHINGTON — The past few weeks have been brutal for the crypto market.
Half a trillion dollars was wiped out of the sector’s market cap when terraUSD, one of the most popular US dollar-pegged stablecoins, imploded virtually overnight.
Meanwhile, digital currencies like ether continue to take a beating on the price charts as sales continue to hammer the industry.
Some investors are calling the events of the past month The Bear Stearns moment for crypto, comparing the contagion effect of a failed stablecoin project to the fall of a major Wall Street bank that ultimately predicted mortgage debt and the 2008 financial crisis.
“It’s really exposed deeper vulnerabilities in the system,” said Michael Hsu, acting currency controller for the US Treasury Department.
“You’ve clearly seen the contagion not just from terra to the broader crypto ecosystem, but also to other stablecoins, and I think that’s something that wasn’t assumed. And I think that’s something people should really pay attention to.”
But so far, government officials seem unconcerned about a crypto crash destroying the broader economy.
Several senators and regulators told CNBC on the sidelines of the DC Blockchain summit this week that ripple effects are limited, crypto investors should not panic, US regulation is key to cryptocurrencies’ success and, most importantly, that the crypto asset class is not going anywhere.
“There should be rules for this game that make it more predictable and transparent, where there’s the necessary consumer protection,” said Senator Cory Booker, D-NJ.
“What we don’t want to do is nip new industry and innovation in the bud to miss out on opportunities. Or what I’m seeing now, a lot of those opportunities are just moving overseas, and we’re missing out on the economic growth and job creation that’s part of that. So this is a really important space if we have the right regulation, it can really help the industry and protect consumers,” Booker continued.
A contained event
In early May, a popular stablecoin known as terraUSD, or UST, plummeted in value in what some described as a “bank run” as investors rushed to withdraw their funds. At their peak, Luna and UST had a combined market value of nearly $60 billion. Now they are essentially worthless.
Stablecoins are a type of cryptocurrency whose value is linked to the price of a real asset, such as the US dollar. UST is a specific breed, known as an “algorithmic” stablecoin. Unlike USDC (another popular dollar-pegged stablecoin), which has fiat assets in reserve as a way to back up its tokens, UST relied on computer code to stabilize its value on its own.
UST stabilized prices near $1 by linking it to a sister token called luna via computer code running on the blockchain — essentially, investors could “destroy” one coin to help stabilize the price of the other. Both coins were issued by an organization called Terraform Labs, and the developers used the underlying system to create other applications, such as NFTs and decentralized financial applications.
When the price of luna became volatile, investors rushed to both tokens, causing prices to plummet.
UST’s failure, while contagious, came as no surprise to some crypto insiders.
Coin Metrics’ Nic Carter told CNBC that no algorithmic stablecoin has ever been successful, noting that the fundamental problem with UST was that it was largely backed by trust in the issuer.
sen. Cynthia Lummis, R-Wyo., who is one of Capitol Hill’s most forward-thinking crypto lawmakers, agrees with Carter.
“There are different types of stablecoins. The one that failed is an algorithmic stablecoin, very different from an asset-backed stablecoin,” Lummis told CNBC. She said she hoped consumers could see that not all stablecoins are created equal and that choosing an asset-backed stablecoin is key.
This sentiment was echoed by the director of the International Monetary Fund at the World Economic Forum’s annual meeting in Davos.
“I beg you not to withdraw from the interest of this world,” said IMF director Kristalina Georgieva. “It gives us all faster service, much lower costs and more integration, but only if we separate the apples from the oranges and bananas.”
Georgieva also pointed out that stablecoins that are not backed by assets to back them up are a pyramid scheme and stressed that the responsibility lies with regulators to create protective safeguards for investors.
“I think it’s likely that we’re going to speed up regulation because of the events of the past few weeks,” said Hester Peirce of the Securities and Exchange Commission, who also noted that stablecoin legislation is already on the agenda. of the US.
“We need to make sure that we… preserve people’s ability to experiment with different models, and do it in a way that fits the legal guardrails,” the SEC commissioner continued.
Legislation against shadow banking
For Commodity Futures Trading Commission Commissioner Caroline Pham, the collapse of the UST highlights how regulators should take steps to protect themselves from a potential return of shadow banking, i.e. a type of banking system in which financial activities are facilitated by unregulated intermediaries. or in unregulated conditions.
Pham says many existing guarantees can do the trick.
“It’s always faster to set up a regulatory framework if it already exists,” Pham said. “You’re just talking about expanding the regulatory perimeter around new innovative products.”
Months before the failure of the UST algorithmic stablecoin project, the President’s Financial Markets Task Force released a report outlining a regulatory framework for stablecoins. In it, the group divides the stablecoin landscape into two main camps: trading stablecoins and payment stablecoins.
Today, stablecoins are typically used to facilitate trading other digital assets. The report seeks to define best practices for regulating stablecoins so that they are more widely used as a means of payment.
“For those like me, banking regulators, we’re sort of historians of monetary instruments,” said Hsu, whose Office of the Comptroller of the Currency co-authored the report.
“It’s a very familiar story, and the way to deal with it is prudential regulation. So I think some of the options, the proposals for a more banking regulatory approach are a good start.”
The key question for regulators and lawmakers to answer is whether stablecoins, including the subset of algorithmic stablecoins, are in fact derivatives, Pham says.
In general, a derivative is a financial instrument that allows people to trade on the price movements of an underlying asset. The underlying asset can be almost anything, including commodities like gold or – depending on how the SEC currently thinks – a cryptocurrency like bitcoin.
The SEC regulates securities, but for anything that isn’t security, the CFTC probably has a regulatory touchpoint, Pham says.
“We have commodity-based derivatives regulation, but we also have certain areas… where we regulate spot markets directly,” Pham said.
“The last time we … had something like this in the financial crisis – risky, opaque, complex financial products – Congress found a solution to that, and that was with Dodd-Frank,” Pham continued, referring to the Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the Great Recession. The law included stricter regulation of derivatives, as well as new restrictions on the business practices of FDIC-insured institutions.
“If some of these stable trading currencies are in fact derivatives, you’re really talking about a custom basket exchange, and it’s the dealer who has to manage the associated risk,” explains Pham.
Congress takes the lead
Ultimately, SEC commissioner Peirce says, Congress will decide how crypto regulation moves forward. While Wall Street’s top regulator is already acting with the authority it has, Congress must allocate enforcement responsibilities.
Lummis is working with Senator Kirsten Gillibrand, DN.Y., to enshrine this legal division of labor in a bill.
“We place it above the current asset regulatory framework, including the CFTC and the SEC,” Lummis told CNBC. “We make sure that tax is levied on capital gains and not on ordinary income. We’ve covered some accounting procedures, some definitions, we’re looking at consumer protection and privacy.”
The bill also addresses the regulation of stablecoins. Lummis says the bill takes into account the existence of this particular subset of digital assets and requires them to be FDIC-insured or more than 100% backed by durable assets.
Booker says there’s a group in the Senate with “good people from both sides of the aisle” who come together and work together to get it right.
“I want there to be the right rules,” Booker continued. “I don’t think the SEC is the place to regulate much of this industry. Obviously, ethereum and bitcoin, which make up the majority of cryptocurrencies, are more like commodities.
But until Capitol Hill passes a bill, Pham says crypto investors should be much more careful.
“If people started thinking of some of these really new crypto tokens as, frankly, lottery tickets, if you’re going to buy a lottery ticket, you could make it big and get rich quick, but you can’t,” said Pham.
“I think what worries me is that without the right customer protections and the right disclosures, people are buying some of these crypto tokens under the assumption that they are guaranteed to get rich,” she said.