Welcome to Finance and Fury. In this episode, we will be looking at what I believe is emerging to be the next major risk to crypto markets.

I was doing some further research on the fallout of FTX and contagion risk – in the episode we covered FTX, I mentioned that regulation was likely to be accelerated by this – which I believe could be the next major risk to the crypto market – This isn’t in the form of regulation on exchanges themselves, or regulation on crypto at large, but on stable coins  

  1. We will go through the potential fallout of this in detail – as the FTX collapse could be used as an excuse for global government ban on stable coins
  2. Note that this is speculation at this stage – as the regulation at this time is simply at a country level or individual state levels in the US – but I want to look at the wider ramification of if this sort of isolated regulation spread throughout the world, being driven by entities like the G20 – which I believe is in the works behind the scenes – mostly to destroy the competitor to the Central Bank Digital Currencies that we will start to see emerging in western economies over the next decade – already happening in China – which is paving the way and is case and point on the control a government can have over the economy at large – New York Fed has started a 12 week digital dollar pilot between banks

 

To start with – The FTX collapse will further solidify the excuse used by Governments to pass new regulations on crypto assets – but previous collapses also paved the way for an excuse for regulation in the form of consumer protection – i.e. that this asset class is too dangerous and hence the government needs to protect people from it

 

  1. Looking at a brief history – TerraUSD and Luna – both of these coins collapsed – however these were not quite stable coins – Stable coins like USDC and USDT are meant to be backed by real assets – being a 1 for 1 for the UDS
    1. Terra (UST) was an entirely different beast – it was an algorithmic stablecoin backed by nothing more than the magic of computer code. This made it easy prey for savvy short-sellers and created a collapse
    2. After the dust settled in June of 2022 from the collapse of Terra, the entire stablecoin industry found itself under the microscope – but remember, some coins like Tether are meant to be asset backed, whilst Terra was not – either way, this increased the scrutiny from state and federal lawmakers and regulators – further reducing the confidence and increasing the uncertainty for the crypto market
  2. But Tether is a true stablecoin, right? as USDT is pegged one-to-one against the U.S. dollar. That means it could theoretically remain stable even during periods of volatility in crypto markets – hence the name stablecoin
    1. These coins go beyond a function of store of wealth – they are a medium of exchange within the crypto markets – as they became one of the most important aspects of the crypto ecosystem
    2. A stablecoin such as tether serves as a necessary on and offramp that has been used by traders to move quickly in and out of positions and provide a stable unit of account for settling crypto payments – most only hold a stable coin for a matter of minutes in the process of switching between different NFTs or other crypto assets – but these coins serve as the oil to the cog in a big machine
  3. So whilst these stable coins are not a long term buy and hold crypto like what people might be doing with BTC or ETH, it is what helps to facilitate many trades within this community
    1. To get an idea of how critical these stablecoins are to the crypto space, consider that more than half of all trading activity on exchanges is conducted using stable coins – and over 90% of the assets borrowed to trade on an exchange are USDC or USDT
    2. the reality is major stablecoins are currently all backed by assets held in traditional, easily-regulated financial institutions – this gives governments a backdoor to regulate and ban a major part of the crypto economy
      1. the White House announcedthat the Treasury Department will complete an illicit finance risk assessment on the crypto sector by February 2023 – a major part of this review is to support the effectiveness of economic sanctions imposed by the U.S. around the world – For instance on Russia, which has seen a recent boom in stablecoin use to get around the sanctions placed on them
    3. There are plenty of signs that the powers that be want to start regulating and controlling crypto assets
      1. This comes from the horse’s mouth – looking at the recent comments from the Chair for Supervision of the board of Governors of the Fed – Michael Barr – he said “As banks explore different options to tap into the potential of the technology, it is important to identify and assess the novel risks inherent in those models and whether those risks are surmountable. For instance, with some models that are being explored, the bank may not be able to track who is holding its tokenized liability or whether its token is being used in risky or illegal activities. While there is work underway on technical solutions for managing these risks, it remains an open question whether banks can engage in such arrangements in a manner consistent with safe and sound banking and in compliance with relevant law.”
    4. What would be the effect of regulation on the crypto market
    5. Like with any industry – stronger regulations on stablecoins would be massive – part of many exchanges and trading applications is that users can trade, borrow, lend, and conduct other financial activities without handing over personal information – these benefits disappear in a situation where stablecoin users must identify themselves under AML or KYC regulations
      1. They may also have to implement the Travel Tule – which is a guideline from the Financial Action Task Force (FATF) this is an anti-money laundering, intergovernmental organization – dictating that virtual asset service providers need to help stop terrorist financing, payments to sanctioned entities, enable law enforcement to subpoena transaction records, assist with reporting suspicious financial activity, and prevent money laundering via crypto assets more generally – this would be a major blow to the demand for stable coins
    6. The large point is that the reality of these stable coins is that they are still IOU tokens where a traditional bank still holds the real value of the money that backs them
      1. Remember that stable coins have a wide use as a medium of exchange – it can easily be transferred between exchanges or people, instead of transferring money through banks. It is easy to buy and sell and can be used as a way to hold money on exchanges when traders feel the market is volatile
    7. In terms of the potential effects of stricter stablecoin regulation – this is some of the groundwork that is needed for larger financial institutions to enter the crypto market – banks and financial institutions already operate under a highly regulated market – so it would open up the market to larger entities controlling this space – simply turning stable coins into another form of PayPal
    8. While crypto markets obviously won’t disappear in a world with stricter regulation, such as KYC and AML enforcement on stablecoins – it could decrease the demand and size of this space significantly
    9. The stablecoin market is valued at more than $150 billion – Tether, being the world’s largest stablecoin has over $68 billion in assets – around 45% of the market
    10. In terms of daily trading volume, tether dominates. It accounted for over 76% of the $39 billion traded on average each day in crypto markets
    11. Due to this constant demand – Tether holds a strong, conservative, and liquid portfolio – So Stable coins enable the crypto market to function
    12. One major issue is that most derivative products in crypto are priced against USDT – the reduced transaction capacity and reduced use of Tether could have a flow on effect with counter party risks on open derivative positions

This brings up an inherent risk of crypto – can these stable coins be trusted – just like FTX as an exchange – as the collapse of FTX caught many people off guard as the founder kept saying nothing to see here

  1. While Tether USDT’s growth and market share looks impressive- this stablecoin is now in the crosshairs – It has been under pressure to be more transparent about the reserves backing USDT – as there are allegations of price manipulation, regulatory legal fights
    1. Additional disclosure would help investors better understand potential risks and determine how auditors are interacting with the company – this is because there are some in the community that believe USDT might not be backed by the reserves it claims to have – as there is no real auditing process to this
    2. Tether has also been investigated by the U.S. Commodity Futures Trading Commission on account of the reserves backing its USDT stablecoin. It paid more than $41 million in fines for inaccurately reporting that USDT was 100% backed by the U.S. dollar.
      1. the stablecoin was 100% backed by a combination of the dollar and other non-fiat assets
    3. So – Tether is owned by a Hong Kong-based company called iFinex, which in turn owns Bitfinex exchange – they have refuted these allegations as they work with a Cayman-based accounting firm called MHA and provided a screenshot of their balance sheet on a given date – According to this screenshot, similar to the FTX screenshots that were provided, Tether USDT reserve is made up of $28.86 billion in U.S. Treasury bills, $8.40 billion in commercial paper, $6.81 billion in money market funds, and $5.42 billion in cash – and the remainder is held in other assets such as corporate bonds – but these figures are completely trust based – i.e. do you trust the screenshot that they posted, like SBF when they say they are operating in the way that they say they are?
    4. Back in 2019, iFinex was sued by New York Attorney General on allegations of mixing up to $1 billion in corporate and customer deposits, later lost or stolen. It settled in an $18.5 million deal involving a ban on trading – which is why exchanges like Binance do not operate for customers in NY
  2. Looking back at the collapse of the Terra blockchain in May, USDT did temporarily lose its parity to the dollar, dropping to $0.95, as investors exited the stablecoin in panic – as the demand sale was over $7 billion was redeemed within 48 hours – so the stability of stable coins does come down to normal market factors – so this is a risk that the price didn’t maintain parity in a redemption period

But I believe that the main reason that stable coins are under major regulatory scrutiny, is due to their equivalent competition to Central Bank Digital Currencies

  1. As stable coins will challenge the new status quo, Tether is likely to land itself in the crosshairs of regulators to kill the competition of those companies not controlled by the financial system
  2. Stablecoin regulation will provide the framework for larger financial institutions to enter the crypto market – it will open up the gateways for more products to be introduced to the markets by the traditional financial entities we are used to – so more regulation is what they are pushing for
  3. If USDT is banned, it will instantly cause it to lose its dollar peg which will cause major volatility in the crypto market that could easily send other cryptoassets like Bitcoin even further

In summary – why do regulators want to kill stable coins?

  1. It is competition – many countries around the world, (including the US), are in the process of rolling out their central bank digital currencies, and independent crypto stable coins are their competition.
  2. Avenues for regulation –
    1. AML regulation – decrease exchanges
    2. Underlying assets that back these coins are created by central banks and controlled by fiat
    3. Ban from purchase as backing
  3. The fact that stable coins will get fully regulated is just speculation at this point – but I think it’s inevitable at some point
  4. Therefore – if this does come true – stable coins like Tether will lose their parity to the dollar and other stable coins

This can flow on to other crypto assets – as the off and on ramp mechanisms to purchase and sell these assets will now be removed from the basic function of crypto markets

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