S&P: the future of stablecoins relies on clear regulation

According to the report by S&P Global, the main challenge for authorities would be to find the golden mean between nurturing digital innovation and safeguarding financial stability.

A stablecoin is a cryptocurrency whose value is pegged to a certain fiat currency, and in 95% of cases, it would be the US dollar. In fact, stablecoins can be tied to any other assets, be it Mexican peso or cans of AriZona Iced Tea. The main purpose of such cryptos is to serve as a bridge between DeFi and TradFi and act as a store of value for investors during periods of high volatility.

The idea of stablecoins sounds pretty simple and innocent in theory. However, when the third-largest stablecoin UST and its sister coin Luna collapsed at the beginning of May, wiping $60b off the crypto market cap and costing life savings for many investors in developing countries, it became obvious that the era of the “Wild West” stablecoin space was gone. Lawmakers across the world started closely eyeing stablecoin regulation.

China, for instance, decided not to waste time on trifles and introduced a blanket ban on all cryptocurrencies, including stablecoins, so they won’t interfere with the launch of the central bank-backed e-CNY. In the US, the main concern is to develop the regulatory framework for stablecoins without sacrificing consumer protection and undermining the status of the USD as the global reserve currency.

The UK lawmakers currently seek to update existing legislation on electronic money and payments to cover stablecoins properly and also intend to update insolvency law for the “systemically important” stablecoin issuers. Japan already allowed banks and other registered financial services providers to issue asset-backed Yen-linked stablecoins from next year. And the EU started tightening its grip on stablecoins even before the Terra fallout to prevent Facebook’s Diem clones from replacing the euro.

The report outlines three main approaches to stablecoin regulation. The first one is to grant stablecoin issuers a general bank license. This way, issuers will become banks under a fractional reserve system, and stablecoins will be deemed tokenized deposits. As a result, holders will be protected by deposit insurance. At the same time, unexpected bank runs may affect the entire economy if the new stablecoin issuer is financially interconnected, probably requiring central bank intervention.

Another approach is a narrow bank license for stablecoin issuers with a 100% reserve system. In this case, stablecoin issuing banks could expand their product and service offerings outside of their actual expertise, providing loans and asset management.

And the last possible way to regulate stablecoins is two-tiered intermediation. Under such a framework, stablecoin issuers won’t get a bank license, remaining clients of the commercial banks where their reserves are deposited. This approach means less risk of undermining financial stability, but holders probably won’t benefit from the deposit insurance, plus such a client can pose a liquidity risk to the partnering bank.

Currently, the main challenges to the stablecoin model are the need for independent third-party auditing and the insufficient quality of reserves. S&P claims that the most reliable stablecoins are the ones backed 1:1 by short duration, high creditworthy government securities, thus giving USDC an upper hand over USDT.

At the same time, stablecoin issuers can cause a lack of liquidity in the broad market by locking a large volume of high-quality assets. Under such circumstances, other market participants won’t be able to use them in their transactions or comply with regulatory requirements. And crypto-backed stablecoins are vulnerable during the extreme market swings similar to the one we are going through now. For that reason, S&P projects that stablecoins might not be suited for wide-scale adoption.

Stablecoins have the potential to make cross-border payments and remittances more cost-effective and available to a larger number of underbanked people, especially in developing economies. The domestic retail payments would also benefit from stablecoin adoption due to decreased fees for merchants, as there are fewer intermediaries than in TradFi. But this is possible only if there is a trust in stablecoin issuers. Such trust can be achieved due to the combination of clear regulation, investor protection, and 100% reserves transparency.