WASHINGTON – It’s been a brutal few weeks for the crypto market.
Half a trillion dollars was wiped from the sector’s market cap as terraUSD, one of the most popular USD-pegged stablecoins, imploded virtually overnight.
Meanwhile, digital coins like Ether continue to pound the price charts as the sell-off continues to plague the industry.
Some investors have dubbed last month’s events a Bear Stearns moment for crypto, likening the contagion effect of a failed stablecoin project to the fall of a major Wall Street bank that ultimately predicted the 2008 mortgage debt and financial crisis.
“It really uncovered some deeper weaknesses in the system,” said Michael Hsu, Acting Comptroller at the US Treasury Department.
“They’ve clearly seen contagion, not just from Terra to the broader crypto ecosystem, but to other stablecoins as well, and I think that’s something that hasn’t been embraced. And I think that’s something that people really need to pay attention to.”
But so far, government officials don’t seem worried about a crypto crash that will shut down the entire economy.
Several senators and regulators told CNBC on the sidelines of the DC blockchain summit this week that spillovers are contained, crypto investors shouldn’t freak out, US regulation is key to cryptocurrency success, and most importantly, crypto asset class does not. I do not go anywhere.
“There must be rules to this game that make it more predictable and transparent where there is the consumer protection needed,” said Sen. Cory Booker, D-NJ.
“What we don’t want is to stifle new industry and innovation so that we miss opportunities. Or what I’m seeing right now, a lot of those opportunities just go offshore and we’re missing out on the economic growth and job creation that goes with it. So this is a really important area if we get the regulation right that can actually help the industry and protect consumers,” continued Booker.
A contained event
In early May, a popular stablecoin known as terraUSD, or UST, plummeted in value in what some have dubbed 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 tied to the price of a real-world asset like the US dollar. UST is a specific breed known as an “algorithmic” stablecoin. Unlike USDC (another popular dollar-pegged stablecoin), which holds fiat assets in reserve to back its tokens, UST relied on computer code to self-stabilize its value.
UST stabilized prices at nearly $1 by linking it to a sister token called Luna via computer code running on the blockchain — essentially, investors could “destroy” one coin to stabilize the price of the others . Both coins were issued by an organization called Terraform Labs, and developers used the underlying system to build other applications like NFTs and decentralized finance apps.
When Luna price became unstable, investors rushed out of both tokens, causing prices to plummet.
While UST’s failure was contagious, it didn’t come as much of a surprise to some crypto insiders.
Coin Metrics’ Nic Carter tells CNBC that no algorithmic stablecoin has ever been successful, noting that the fundamental problem with UST was that it was largely underpinned by trust in the issuer.
Sen. Cynthia Lummis, R-Wyo., who is among the most forward-thinking lawmakers on Capitol Hill when it comes to crypto, agrees with Carter.
“There are a few types of stablecoins. The one that failed is an algorithmic stablecoin, very different from an asset-backed stablecoin,” Lummis told CNBC. She said she hopes consumers can see that not all stablecoins are created equal and that choosing an asset-backed stablecoin is essential.
This assessment was confirmed by the Executive Director of the International Monetary Fund at the annual meeting of the World Economic Forum in Davos.
“I would like to ask you not to withdraw from the meaning of this world,” said IMF chief Kristalina Georgieva. “It offers us all faster service, much lower costs and more inclusion, but only if we separate apples from oranges and bananas.”
Georgieva also stressed that stablecoins that are not backed by assets to support them are a pyramid scheme and stressed that the responsibility rests with regulators to put in place safeguards for investors.
“I think it’s likely that regulation will happen more quickly because of what’s happened over the last few weeks,” said Hester Peirce of the Securities and Exchange Commission, who also noted that stablecoin legislation was already on the agenda before the UST fall was standing.
“We need to ensure that … people’s ability to experiment with different models is preserved in a way that is within regulatory guard rails,” the SEC commissioner continued.
Legislation against shadow banking
For Commissioner Caroline Pham of the Commodity Futures Trading Commission, the collapse of the UST shows how much action regulators need to take to protect themselves against a possible return of shadow banking – i.e. a type of banking system in which financial activities are facilitated or underused by unregulated intermediaries unregulated circumstances.
Pham says many existing safeguards may suffice.
“It’s always quicker to put in place a regulatory framework when it already exists,” Pham said. “They’re just talking about expanding the regulatory framework to include newer, novel products.”
Months before the UST algorithmic stablecoin project failed, the President’s Working Group on Financial Markets released a report outlining a regulatory framework for stablecoins. In it, the group divides the stablecoin landscape into two main camps: stablecoin trading and stablecoin payment.
Today, stablecoins are typically used to facilitate trading of other digital assets. The report aims to establish best practices for regulating stablecoins so that they become more widely used as a means of payment.
“For those who are banking regulators like me, we’re sort of a historian of money-like instruments,” said Hsu, whose Office of the Comptroller of the Currency co-authored the report.
“This is a really well known story and the way to deal with it is prudential regulation. So I think some of the options, the proposals for a more bank-like regulatory approach, are a good place to start.”
The key question for regulators and lawmakers to ask is whether stablecoins, including the algorithmic stablecoins subset, are actually derivatives, Pham says.
If people would start thinking of some of these truly novel crypto tokens as lottery tickets. If you go and buy a lottery ticket, you might make it big and get rich quick, but you might not.
Caroline Pham
CFTC Commissioner
In general, a derivative is a financial instrument that allows people to trade the price fluctuations of an underlying asset. The underlying asset can be almost anything, including commodities like gold or, according to the SEC’s current understanding, a cryptocurrency like bitcoin.
The SEC regulates securities, but for anything that isn’t a security, the CFTC likely has a regulatory touchpoint, Pham says.
“We have regulation of commodity-based derivatives, but we also have certain areas … where we regulate spot markets directly,” Pham said.
“The last time we … exploded something like this in the financial crisis — risky, opaque, complex financial products — Congress found a solution for it, and it was with Dodd-Frank,” Pham continued, referring to 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 trading practices of FDIC-insured entities.
“If some of these trading stablecoins are actually derivatives, you’re basically talking about a custom basket exchange, and then it’s the trader who has to manage the risk involved,” Pham explained.
Congress is in charge
Ultimately, says SEC Commissioner Peirce, Congress has the say on how to move forward with crypto regulation. While Wall Street’s top regulator is already acting with the authority at its disposal, Congress must divide enforcement responsibilities.
Lummis has partnered with Sen. Kirsten Gillibrand, DN.Y., to flesh out this division of regulatory work in a bill.
“We’re betting it on the current regulatory framework for assets, including the CFTC and the SEC,” Lummis told CNBC. “We ensure that capital gains are taxed and not ordinary income. We looked at some accounting practices and some definitions, we looked at consumer protection and privacy.”
The bill also addresses stablecoin regulation. Lummis says the bill takes into account the existence of this particular subset of digital assets and requires them to be either FDIC-insured or more than 100% backed by hard assets.
Booker says there’s a group in the Senate with “good people on both sides of the aisle” who are coming together and banding together to get it right.
“I want the rules to be right,” Booker continued. “I don’t think the SEC is the place to regulate much of this industry. Ethereum and Bitcoin, which make up the majority of cryptocurrencies, are clearly more commodity-like.”
But until Capitol Hill enacts a bill, Pham says crypto investors need to exercise a lot more caution.
“If people started thinking of some of these really novel crypto tokens as lottery tickets, if you go and buy a lottery ticket, you could make it big and get rich quick, but maybe not,” Pham said.
“I think what I’m concerned about is that without proper customer protections and proper disclosures, people are buying some of these crypto tokens because they think they’re guaranteed to get rich,” she said.
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