The Truth Behind Stablecoins

Stablecoins have been getting a lot of negative buzz recently. Between the Tether Controversy, congressional hearings regarding stablecoins, and Senator Elizabeth Warren’s recent censure of stablecoins, you may be wondering what exactly is going on in this corner of DeFi, and what this controversy means for the future of the ecosystem.

A stablecoin is cryptocurrency backed by real-world assets. FIAT-Collateralized Stablecoins, like USDT or PAXG, are tied to the US dollar and to gold, respectively. By tying the cryptocurrency to FIAT assets, these tokens allow for the ease-of-use and universal access of crypto without the volatility of non-backed cryptocurrencies. Crypto-Collateralized Stablecoins, like $TIME, are backed by other cryptocurrencies, often in the form of a basket reserve. Maker DOA’s token, DAI, for example, is tied to both the US dollar and a basket of reserve cryptocurrencies locked in a smart contract. Non-Collateralized Stablecoins, like Carbon, are not backed by anything. Instead, they rely on the Seigniorage Shares system to keep the price regulated. The Seigniorage Shares system is an algorithmic approach to price regulation that keeps prices stable by relying on smart contracts to change the supply volume depending on the price of the token.

Stablecoins have recently been under regulatory scrutiny. Many regulators want to classify them as securities, subject to harsher guidelines and penalties. In a recent episode of Cryptonized, Bill Barhydt (CEO of Abra) explained the difference between stablecoins and securities as such: “So a stable coin can be a security, and it can also not be a security, it depends upon how you implement the stable coin… Traditionally, banks are allowed to take deposits and invest them, and the FDIC in the United States will come in and [audit] what they’re investing in. The question becomes: what is Tether allowed to do and not be deemed a security? That's an open question I think has not really been clarified by the regulators yet.” 

Regulators use the Howey Test to determine whether or not an asset is classified as a security. The Howey Test, determined in the landmark case of SEC vs. W.J. Howey Co, defines securities as: (i) =an investment of money, (ii) in a common enterprise, (iii) with an expectation of profit, (iv) solely from the effort of others. The SEC has cracked down on crypto several times, including the 2018 ICO regulation. They issued millions of dollars in fines after finding ICOs to be securities, which bankrupted many projects. 

In October of 2021, the stablecoin Tether, or USDT, paid $41 million dollars in fines to the Community Futures Trading Commission after being found guilty of making misleading statements about their reserves. Tether claimed that 100% of their tokens were backed up by the US dollar. An investigation by the NY attorney general showed that not only did they not have 100% of funds in reserve, they also had reserves in non-fiat assets and nonsecured deliverables. 

This is one of the potential problems with stablecoins. Lots of people are utilizing stablecoins; even going so far as to accept them as payment for work delivered, due to ease of access. The fractional reserve banking system has bled into crypto, and stablecoins could potentially cause a financial crisis if their reserves are not at 100%. 

People aren’t complaining. They seem to understand the risk and accept it as a fair trade-off to participate in the DeFi ecosystem. The world of crypto has always required a high-risk threshold, and most are more comfortable with the risks associated with DeFi over the risks associated with the US’ volatile, hyper-inflated FIAT.

Senator Elizabeth Warren recently tweeted: “Stablecoins pose risks to consumers & to our economy. They’re propping up one of the shadiest parts of the crypto world, DeFi, where consumers are least protected from getting scammed. Our regulators need to get serious about clamping down before it is too late.” It feels like new regulation is coming, even though stablecoins should fall within existing parameters. 

Barhydt also said, “When we think about stable coins, we're generally talking about money in a bank account that should, in theory, be auditable and verifiable but…represented by software or a smart contract; in this case, a token. Basically, a token that represents a portion of that money in a bank account. There's a one-to-one relationship between the size of the token float and the amount of money in the bank. In the US, we have prepaid access rules that actually stem from the prepaid card space that are overseeing how most of this works today. Meaning, if you issue a prepaid card, you have to have a float in a bank account that mirrors the value locked up in those prepaid cards. Think of those tokens legally speaking as another form of accessing that float the same way a prepaid card does.”

Why are stablecoins, arguably the most secure component of DeFi, under fire? The answers probably all circle back to money. DeFi is a serious threat to our legacy financial institutions. More and more people are choosing to be bankless. Even the layman is losing faith in FIAT. The Fed’s excessive money-printing and economic turmoil of the past two years have real-world implications - and one of them is that the masses are walking away from financial institutions because they’re loath to give up their money and power.