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Considered by many to be a tame part of the crypto space, regulation around stablecoins is slowly progressing.

Ever since the idea and concept of stablecoins became part of mainstream financial conversations, these seemingly boring types of cryptos have proven to be just as difficult to regulate as more volatile assets such as bitcoin or non-fungible tokens. In both the House of Representatives and the US Senate, several bills have been proposed aimed at establishing regulations and guidelines for stablecoins; none has gone beyond committee discussion, let alone the passing of a law.

Headlines and market sentiment, as always, play a role in the difficulties regulators and policymakers have faced. TetherUSDT, while still the largest and most widely used stablecoin in the world, has only recently taken decisive steps to improve the quality and speed of financial reporting. Paxos, a major issuer of stablecoins, including issuing BUSDBUSD, faces possible lawsuits from the SEC, as well as enforcement action from the New York State banking regulator. Even the Circle-issued USDCUSDC, considered by many in the space to be the most transparent stablecoin issuer, has come under scrutiny after a short-lived unpeg following the collapse of Silicon Valley Bank, where Circle had more than $3 billion on deposit.

As stablecoins continue to grow in importance and major financial institutions like JP Morgan issue versions of these instruments, albeit under different names like depository tokens, one has to wonder what follows? Why do financial instruments that are seemingly so simple in nature, often drawing comparison with money market funds (a well-regulated and transparent space) prove so difficult to achieve any kind of consensus?

We’ll take a look.

Surprising complexity. The appeal of stablecoins for many investors and entrepreneurs is that these cryptoassets are connected to an external asset, which in most cases is the US dollar. Despite claims that dedollarization is well underway, the fact remains that the dollar is the world’s reserve currency and far exceeds any other currency for international transactions.

Several questions come to the fore when trying to evaluate stablecoins, and in particular stablecoin issuance as a viable business model. How much does it cost the issuer to maintain the announced attachment? Similar to a currency pegged to another currency, maintaining this peg incurs costs for the organization. Also, how easy is it for users/investors who bought the stablecoin to exit that position? Many investment vehicles have blackout periods or other withdrawal limits, but for a crypto-asset looking to complement (and possibly supplant) existing currencies, this process should still be smooth.

Reserve report. If a problem quickly emerged during the crypto crash that was punctuated by the failure of FTX, it was that reporting and disclosure rules regarding crypto-assets were sorely lacking. No authoritative crypto-specific auditing standards have been issued to date in the United States, with very limited financial accounting guidance to be issued in 2023. Faced with this gap, with standard setters trying to catching up and the private sector moving forward, the idea of ​​proof of reserves has quickly gained market acceptance. The idea behind this reporting framework was to present a report, prepared by an independent third party, of the assets held at the issuer of a stablecoin or crypto exchange. A simple idea, but one that seemed to hold great promise for the space.

Following the bankruptcy of FTX, and revelations that this alleged fraud could be completed even with audits performed, questions quickly began to arise about the validity of proof of reserves. Specific issues that were raised that ultimately undermined the usefulness of proof of reserves include that 1) these reports presented only an overview of the assets in question, 2) there is limited comparability between the various reports issued by different preparers, and 3) claims of balance sheet fronting (moving funds between accounts and portfolios) have been made against some companies that have adopted proof of reserves.

In short, the rapid rise of evidence of reserves as a substitute for auditing is matched only by how quickly the concept has fallen out of favor with regulators, practitioners and investors.

Systemic issues. One of the biggest political questions related to stablecoins is how these instruments will connect to the existing financial system, and this question has led to vigorous debate and opinion on both sides of the issue. With regulation still lacking, individual regulators such as the SEC have cracked down on certain organizations in the space, such as Paxos, while entities like Tether have continued to operate even with a history of legal issues and settlements.

Since so many stablecoins are backed and/or backed by the US dollar, these instruments are already connected to the traditional banking system. A common refrain from some policymakers is that the implementation and use of stablecoins presents a systemic risk problem for the banking system; that misses the point. A fully reserved, crypto-first banking option has already been developed, submitted for review, and would avoid the potential for bank runs that occurred in 2023.

For example, regulators and investors should take a fresh look at the business model and proposal put forward by Custodia to see 1) how close the US is to realizing this, and 2) how stablecoins and fully reserved deposits could play an important role. in risk reduction for financial institutions.

Stablecoins are a simple idea with tough regulatory issues, and that’s all the more reason to work on it proactively.

Follow me on Twitter or LinkedIn. Check out some of my other work here.

I am a professor at City University of New York Lehman College. I sit on the advisory board of the Wall Street Blockchain Alliance, where I chair the accounting working group. I’m also the chair of the NJCPA Emerging Technologies Interest Group (#NJCPATech). I serve on the advisory board of Gilded, a TechStars 19 company and a participant in the AICPA-CPA.com startup accelerator. I was a visiting scholar at the American Institute for Economic Research in 2019.

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