An article to interpret the impact of the US Stablecoin Act on the development of stablecoins

As of September 2022, stablecoins account for about 15% of the entire cryptocurrency market capitalization, or about $150 billion. It is heavily used by crypto market players and has shown excellent product-market fit. During the 2017 bull cycle, stablecoins were virtually non-existent. Because use cases are often exchange-specific, stablecoins aren't everyone's top concern. In the middle and early part of 2020, the DeFi summer came, and everything changed. Until then, there isn't any significant reason to use a stablecoin if you're trading on a centralized exchange. Transactions are settled off-chain, and you can easily cash out into USD if you want to stay on the sidelines. Even in the derivatives market, traders are 1x shorting BTC on BitMEX while holding spot BTC to remain neutral.

With the advent of DeFi in 2020, on-chain market infrastructure is growing exponentially. Protocols like Uniswap and Compound provided the environment necessary for stablecoins to find product-market fit, kicking off a boom in stablecoin supply.

Source: The Block

Before long, industry players realized the importance of owning their own stablecoins and began a series of trials of innovative stablecoin models. Most notable is Terra’s UST stablecoin, which has a brilliant idea of creating an algorithmic stablecoin without any actual collateral. UST is pegged to the protocol’s native token, LUNA, and uses a minting and burning mechanism to maintain a 1:1 peg to the U.S. dollar. At first, it seemed like a genius idea to combine the blockchain’s native token with smart contract functionality and a native stablecoin.

Source: CoinGecko

Surprisingly, UST suddenly collapsed, evaporating $18 billion in value overnight. Simply put, this decoupling event was caused by the endogenous design of the UST. Endogenous basically means that a stablecoin is backed or partially backed by any token from the same issuer. Luca Prosperi, a researcher active in the MakerDAO community, has previously written about this concept. In fact, the term endogenous is a key wording in the U.S. House of Representatives’ draft stablecoin bill, which we’ll unpack in this article. The future of this multi-trillion dollar industry may have been changed forever.

A quick rundown of the main points of this article:

• The U.S. stablecoin bill, if passed, would result in stricter regulatory requirements, including registration and a ban on endogenously collateralized stablecoins.
• The important part is the registry aspect, which can create a second-order effect for protocol-owned stablecoins.
• A strong stablecoin industry will exacerbate the "dollar milkshake theory" (the theory that all fiat currencies are flawed and ultimately doomed because they are rooted in debt and not backed by any absolute store of value .by contrast, the U.S. dollar is inherently less flawed than other currencies due to its status as the world's primary reserve currency).
• It is unrealistic to expect no regulation of any kind or to expect light regulation of stablecoins.
• There will be a rise in non-USD-pegged stablecoins that aim to stabilize value without being pegged to any fiat currency.

Stablecoin Act

The goal of the Stablecoin Act is to introduce a framework around stablecoin issuance. It covers "how" and "who" issues.

The "how" part specifies what types of stablecoins can be issued. Blame it on Do Kwon. The new bill will impose a two-year ban on stablecoins that are not collateralized by cash or highly liquid assets, while issuing "endogenously collateralized" stablecoins will be punished as a crime. For existing stablecoins with the above model, issuers will have a 2-year grace period to change their collateral model.

There are more details to come as the bill moves forward. A conversation on Twitter pointed out an interesting discrepancy in wording. "Relies solely" means that Terra's UST may not be affected by the act, as it is partially backed by BTC in its final stages of life.

Source: Twitter

The “who” section specifies the requirements that stablecoin issuers must comply with, and who regulates those issuers.

Non-bank issuers of fiat-backed stablecoins would also be regulated by state banking regulators and the Federal Reserve.
Banks or credit unions could issue their own stablecoins, which would be regulated by the Office of the Comptroller of the Currency and the FDIC.
Issuing stablecoins without approval from these regulators could be punished with up to five years in prison and a $1 million fine.
——The Block

If the bill passes, the requirement to obtain approval could pose further problems. It could directly destroy the composability of DeFi. For example:

• If USDC has been approved by the relevant regulators, does Compound need to obtain the same approval to issue cUSDC (a yield-generating asset) for its lending platform?
• If I run a bridge protocol, do I need to get approval for the bridge version of USDC?
• If a wrapped version of a stablecoin is required to connect to real-world assets, how would that be achieved?

The bill is likely to create more uncertainty than provide a clear framework for industry players.

existing stablecoins

How Will the Stablecoin Act Affect Top Decentralized Stablecoins?

• DAI

DAI is not backed by MKR, but in the event that the Maker protocol suffers losses, MKR can be used as a tool of last resort to cover losses to the protocol.

This happens rarely, but it has happened before.

The bill should have no impact on MKR.

• FRAX

FRAX is partially backed by FXS, the governance token of FRAX.

The mortgage rate of FXS will be updated according to the utilization rate of FRAX.

The bill would subject FRAX to scrutiny because it is partially collateralized endogenously by tokens from the same issuer.

• LUSD

LUSD is not backed by LQTY, which is the governance token of LUSD.

LUSD is primarily backed by ETH.

The bill should have no impact on LUSD.

• USDD

USDD is partly supported by TRX, which is endogenous to the USDD ecosystem.

USDD is backed more than 30% by TRX.

The bill would put USDD under scrutiny because it is partially collateralized endogenously by tokens from the same issuer.

• USDN

USDN is supported by WAVES, which is endogenous to the USDN ecosystem.

The bill would bring USDN under scrutiny because it is partially collateralized endogenously by tokens from the same issuer.

• MIM

MIM is not supported by SPELL, which is MIM's governance token.

MIM is backed by other assets, mainly FTT.

The bill should have no impact on MIM.

I think we will see the rise of non-USD-pegged stablecoins that aim to stabilize value without being pegged to any fiat currency. However, these types of stablecoins are unlikely to reach mainstream adoption. Don't get me wrong, I'm not giving up on these concepts (e.g. RAI), but there's still a lot of work to be done to extend it and make it friendly to non-crypto-native consumers.

pragmatic

In line with the spirit of this post, I think it is unrealistic to expect stablecoins to be unregulated or lightly regulated. We still live in a society governed by governments, where stablecoins are directly linked to fiat currencies, which are tools of governance and stability for governments around the world. This is why even a country like South Korea, which has had phenomenal economic growth over the past few decades, still has some form of capital controls in place.

Even with the US allowing the stablecoin industry to flourish and exacerbating the dollar milkshake theory, jurisdictions outside the US will not stand still and allow their currencies to weaken. I'm a believer in the dollar milkshake theory, but it's naive to expect other fiat currencies to go down without a fight.

We will see more and more regulation in the stablecoin space. Industry participants need to start from two aspects. Seek truth and be pragmatic, make the best use of the situation, and actively advocate more friendly supervision through various measures. No matter what happens, the stablecoin industry will still be worth trillions, it is not a question of when but how.