Lawmakers and regulators around the world have been racing to craft rules and regulations for stablecoins, and the recent collapse of the Terra UST algorithmic stablecoin has served as a tailwind to push the agenda forward. At a supranational level, the Financial Stability Board (FSB) was compelled to release a statement that cautioned: “The recent turmoil in crypto-asset markets highlights the importance of progressing ongoing work of the FSB and the international standard-setting bodies to address the potential financial stability risks posed by crypto-assets, including so-called stablecoins.”

Some countries are farther along than others. Japan’s parliament has already passed a law that enshrines the definition of stablecoins as well as provides standards for investor protection. Meanwhile, the Council of the European Union has also reached an agreement on the markets in crypto-assets (MiCA) proposal that introduces stringent requirements for stablecoin issuance, including a possible cap if payment volumes exceed a certain threshold.

All eyes are now on the United States, which now has draft stablecoin legislation in both the Senate and the House of Representatives. This article will focus on the regulatory developments in the United States and make the case that USD stablecoin issuers do not currently fully meet preliminary regulatory standards. Stablecoin issuers need to continue to improve practices in order to meet escalating scrutiny and standards. 

A US state regulator takes charge

In the United States, the state of New York — which earlier had forced Tether, the stablecoin giant, into providing more disclosures about its reserves — has already introduced guidance on stablecoin issuance. The guidance from the New York Department of Financial Services (NYDFS) will directly apply to stablecoins issued by Gemini and Paxos, which are both Trust companies regulated by the NYDFS, while Circle and Tether operate under different structures and are not under the purview of the NYDFS. The guidance focuses on three main pillars: (1) backing and redeemability, (2) reserve requirements and (3) independent audits.

Backing and Redeemability: The stablecoin must be fully backed by a Reserve of assets, meaning that the market value of the Reserve is at least equal to the nominal value of all outstanding units of the stablecoin as of the end of each business day. The issuer of the stablecoin (the “Issuer”) must adopt clear, conspicuous redemption policies, approved in advance by DFS in writing, that confer on any lawful holder of the stablecoin a right to redeem units of the stablecoin from the Issuer in a timely fashion at par for the U.S. dollar. 
Reserve Requirements: The assets in the Reserve must be segregated from the proprietary assets of the issuing entity and must be held in custody with U.S. state or federally chartered depository institutions and/or asset custodians. 
The Reserve must consist of the following assets: U.S. Treasury Bills acquired by the Issuer three months or less from their respective maturities, Reverse repurchase agreements fully collateralized by U.S. Treasury bills, U.S. Treasury notes, and/or U.S. Treasury bonds on an overnight basis, subject to DFS-approved requirements concerning overcollateralization, and Deposit accounts at U.S. state or federally chartered depository institutions, subject to DFS-approved restrictions. 
Independent Audits: The Reserve must be subject to an examination of management’s assertions at least once per month by an independent Certified Public Accountant (“CPA”) licensed in the United States and applying the attestation standards of the American Institute of Certified Public Accountants (“AICPA”) 
Source: New York DFS

US lawmakers setting their sights

On the U.S. national stage, a bipartisan bill by Senators Cynthia Lummis (R-Wyoming) and Kirsten Gillibrand (D-New York) lays the groundwork for depository institutions to issue “payment stablecoins,” formally defined as “redeemable, on demand, on a one-to-one basis for instruments denominated in United States dollars.” 

If made into law, payment stablecoins will need to be fully reserved and 100% backed by high-quality liquid assets, while issuers will be required to disclose assets monthly (within 10 business days) and subject to examination and verification by appropriate banking regulators.

Depository institution issuers would face a tailored supervisory approach that calls for a simplified regulatory capital framework and a custom plan to resume or wind down operations under stress. Importantly, the bill does not preclude the issuance of stablecoins by non-depository institutions.

More recently, Bloomberg reported that a draft stablecoin bill making its way through the U.S. House of Representatives is also aimed at preventing another Terra UST disaster. A working draft of the bill, which could be introduced and voted on before the U.S. midterm election in November, would ban “endogenously collateralized stablecoins” whose reserve value is solely dependent on the creator or issuer of the stablecoin.

Mind the gap

Reading between the lines of the current state and federal efforts to regulate stablecoins in the U.S., there is ample guidance to formulate a preliminary U.S. regulatory standard. We offer here a gap analysis to shed light on how close each stablecoin issuer is to meeting what seems to be the forming of a U.S. standard, that an issuer must be fully reserved — or 100% backed by assets with attestations, conducted by third-party firms, of assets versus liabilities. 

With the exception of Tether, all major stablecoins currently on the market are backed solely by U.S. Treasury securities or cash deposits at regulated depository institutions. Tether’s asset allocation to commercial paper is well-known, and the company has vowed to cut its exposure down to zero, according to a company blog post. On a related note, Tether might be better served by reporting monthly as the other issuers do. More frequent and timely reporting would have also provided clarity around commercial paper that the public was searching for without the need for an explanatory blog post. 

Additionally, Paxos and Circle have gone as far as listing individual CUSIP identifiers of treasury securities holdings. However, this carries little weight as these management-reported figures are unaudited and not subject to third-party review.

A finer nuance is the distinction between attestations and comprehensive auditing. The periodic reporting relies on third-party firms to conduct attestations that management’s assertions are “fairly stated.” Circle appears to be the only stablecoin issuer that currently conducts an annual audit, which they describe as “an assurance engagement that verifies the accuracy of financial statements” that “verifies the accuracy, completeness and composition of the reserve and tests the internal controls over financial reporting that ensure financial statement accuracy.” Tether’s CTO has also revealed plans for a future audit in an interview with Euromoney.

Regarding redeemability, the empirical evidence suggests that issuers have been able to meet redemption in a timely manner, even during times of stress. That includes Tether, which saw outflows of 13% of total assets within a 10-day period due to the downfall of Terra and the overall slump in the stock and crypto markets.

IssuerTokenReserve mix1Reporting FrequencyReportingLag2Attestation FirmComprehensive Audit
CircleUSDC76% US Treasuries
24% Cash Deposits
Monthly28 daysGrant ThorntonAnnual
GeminiGUSDUnreported3Monthly14 daysBPM LLPUnknown
PaxosUSDP73% US Treasuries4
27% Cash Deposits
Monthly28 daysWithumUnknown
PaxosBUSD96% US Treasuries
4% Cash Deposits
Monthly28 daysWithumUnknown
TetherUSDT44% US Treasuries8% Cash Deposits
13% Comm.Paper & CD
Quarterly41 DaysMHA CaymanPlanned
1Based on 6/30/2022 reporting
2Based on most recent reporting
3Could not be found on Gemini’s public website
4From Paxos unaudited reserve holding report

Higher bar to clear

Following the epic meltdown of Terra UST, an algorithmic stablecoin, policymakers around the world are on high alert. Beyond individual countries, international standard-setting bodies such as the Financial Stability Board have taken note of the potential systemic risks arising from stablecoins. 

Policymakers and regulators are also advancing the cause through the application of existing guidance and bringing stablecoins into existing regulatory perimeters. One such example is the Bank of International Settlement’s application of Principles for Financial Market Infrastructures (PFMI) to “stablecoin arrangements” that are determined to be systemically important. BIS describes PFMI as “the international standards for financial market infrastructures, i.e. payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories.” The principles-based guidance set forth by the PFMI would set standards for governance and risk management applicable to stablecoin arrangements.

Our final conclusion is that none of the current major USD stablecoin issuers fully meet regulatory expectations despite demonstrating both an ability and willingness to improve practices. However, it is clear that the escalated regulatory scrutiny is leading to rapidly rising standards, and stablecoin issuers need to remain vigilant in order to not run afoul of the regulations sure to come — or fall behind.