Lets begin this article by first outlining the technology underpinning stablecoins and digital ledger technology (DLT). The DLT's underlying money and payment systems have evolved at an incredibly rapid pace. Both the emergence of DLT and rapid advances in "fintech" are moving money and payments away from "legacy" financial systems into new unchartered horizons. It is fundamentally this shifted trajectory away from legacy finance that encapsulates and embodies the need for private stablecoins.
With this in mind, UST is an algorithmic stablecoin, which differs from other stablecoins because it has no traditional reserves. Rather, UST maintains its value based on an algorithm that is coded to strike a balance between the stablecoin and a partner coin. In UST's case, that partner coin is it's sister cryptocurrency - Luna.
Other stablecoins are usually cryptocurrencies with values tied to fiat currencies or other assets like gold, debt and, certain financial instruments. Stablecoins, and specifically, what are known as “global stablecoins” pose a range of challenges from a regulatory and financial compliance standpoint.
When regulating stablecoins, "regulatory responses to global stablecoins should take into account the potential of other stablecoin uses, such as embedding a robust monetary instrument into digital environments, especially in the context of decentralized systems. One possible option from a regulatory standpoint is to embed supervisory requirements and minimum standards into stablecoin systems themselves, allowing for “embedded supervision”. Yet it is an open question whether central bank digital currencies (CBDCs) and other initiatives could in fact provide more effective solutions to fulfil the functions that stablecoins are meant to address." (Stablecoins: risks, potential and regulation (bis.org))
With the recent instability and unpegging of UST in recent days, discussions around the implementation of a CBDC as a way to protect retail investors may be at the forefront of regulatory considerations. While CBDCs would use blockchain technology, it is important to note that they are not the same as conventional decentralized cryptocurrencies and are arguably diametrically opposed to the philosophy behind the technology. There are open questions as to whether CBDCs and other initiatives by regulators would adequately fulfill these functions more effectively than privately developed stablecoins. Although there is an argument that CBDCs would enjoy the backing of the central bank of the respective jurisdiction, in Australia's case - the Reserve Bank of Australia, and would not be subject to the same conflicts of interest around the asset backing and stabilization mechanism.
There is also an argument that its value could be pegged by design to the currency they reference, for example the Australian dollar ($AUD), thus eliminating fluctuations in value. The question is how a CBDC could be designed to offer robust interoperability with novel decentralised financial solutions and in the most dystopian view, whether CBDC's could be used to control a country's citizens, issues around privacy, and other unintended consequences (the pros and cons of CBDCs are not the focus of this paper).
In the case of private stablecoins, while it is designed to hold its value by being pegged to some asset or currency, rather paradoxically, it is this very expectation that stablecoins will maintain a constant value that could make them dangerous during periods of stress. This fear has only been exacerbated during the recent Luna and UST fiasco. UST's price on 11 May 2022 (AEST) reached an all time low of approximately $0.30 (USD). If at some point holders of stablecoins worry that they will not be able to convert their stablecoins into dollars, they might try to cash out quickly — perhaps a few owners at first, then many more. This is possibly (in addition to other factors) what caused the UST unpegging. To satisfy demand, issuers would have to sell the assets backing their coins. That could result in a fire sale of traditionally safe securities that would harm critical parts of the financial system.
As is often said about the present crypto regulation approach in Australia (and globally), we are trying to fit a square peg into a round hole, or in some cases, hammer the square peg into the round hole. If this situation occurred in Australia, a question arises as to whether Luna and UST would be classified as a security for the purposes of appropriately invoking relevant legislation.
So what does this mean for blockchain and cryptocurrency regulation in the US and Australia?
It is too early to predict what regulatory approach will be taken to mitigate artificially manipulated crypto markets, and whether CBDCs are the answer to this. Indeed, part of this difficulty is distinguishing between merely trading legally on the one hand, and utilizing existing legal loopholes to manipulate markets on the other. Both are, and can be, somewhat "legal" in the strictest sense of the word, and while occasionally some bad actors are brought before the law, most sail into the sunset unscathed. In 2007 and 2008, runs on “shadow banks” (Shadow banks are companies that perform bank like activities and functions without being subject to bank oversight, in Australia banks, and financial services providers are primarily regulated by APRA, RBA, AUSTRAC, ASIC and the Corporations Act) helped fuel a crisis that effectively swallowed the United States banking system and much of the world leading to the global financial crisis. While the consequences of this were severe, few people were properly prosecuted.
Going back to Luna, UST and stablecoin regulation, what can be said, is that regulation must be balanced, technology agnostic, fit for purpose, and protect members of the public that are most likely to be effected in manipulated markets, namely, the retail investors. Moreover, it should endeavor to regulate and treat blockchain protocols differently. For example, the cryptocurrency ADA on the Cardano protocol, a peer reviewed public blockchain platform that is open-sourced, decentralized, with consensus achieved using proof of stake, is diametrically distinct from perhaps a cryptocurrency like Doge and Binance coin. Where possible, regulation should be applied in a way that reflects the differences between cryptocurrencies so that it specifically targets "coins" that are scams- or a "Ponzi", from those that have real utility.
As touched on earlier, regulation must also be drafted so that it is possible to appropriately distinguish between those cryptocurrencies that may be a security, from those that are merely governance and utility coins or tokens on a protocol. This has been somewhat of a fools errand, and the ongoing SEC v Ripple case in the US illustrates just how arbitrary this test is when applied to cryptocurrencies at present.
Further complexity is the fact that the status of stablecoins in the US regulatory framework is the subject of a great deal of debate. To this end, even if UST's design was built to elude the application of US federal securities laws, the subsequent transactions that have taken place, and it's unpegging, could drive it back into the purview of the SEC. If UST loses its stability, it may well also lose its ability to defend a claim on the basis that it no longer meets the test to be based on an expectation of a third party acting to create profit for investors. In other words, changing facts and circumstances surrounding an asset can change whether the SEC approaches it as a security. This would likely influence the regulatory approach in Australia though It is difficult to say how this might have been dealt with in Australia's jurisdiction given the differences in the legislation and regulatory approach to date.
There are some further unique features in the UST case that strengthen a potential claim that it is prima facie a security because of its Anchor protocol. The issue being the associated Anchor protocol’s promise of 20% returns on staked UST, as well as the Luna Foundation Guard’s to preserve the peg. Ultimately, UST was pegged to the US dollar, though a substance over form argument is possible here.
To conclude, and reiterate some earlier sentiments in this article, the UST and Luna fiasco must not be used as a red herring to roll out a number of draconian laws, none of which appropriately deal with fundamental issues, and instead, bring forth a cascading effect on blockchain regulation that stifles innovation and the industry whilst simultaneously entrenching, in the worst case scenario, a dystopian set of laws unfit for purpose.
© 2022 Inoke Faletau - The Minted Brief, All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
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