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Last week, lawmakers in Washington tried to ignore their years of cheerleading for crypto, and put on their sober and serious faces at a Senate Agriculture Committee hearing notionally about the FTX collapse. Amusingly, the conclusion of the hearing was exactly the same as before the FTX debacle: Regulation of digital assets should be put in the hands of the Commodity Futures Trading Commission, whose chair Rostin Behnam was formerly a staffer for the committee’s chair, Sen. Debbie Stabenow (D-MI).
FTX and its avatar Sam Bankman-Fried lobbied for and consulted on that bill, the Digital Commodities Consumer Protection Act, making it a little too hot to handle, no matter what the Ag Committee’s boosters say. Stabenow strained to argue that their bill would have actually prevented FTX’s fraudulent activities, even though every new idea she brought up—that crypto exchanges shouldn’t be able to gamble with customer funds, accept unregistered securities as collateral for loans, and self-deal for the benefit of executives—is already illegal, and well within the purview of criminal law enforcement.
Similarly, Behnam insisted that financial regulations should apply to crypto. They do. In fact, FTX’s derivatives clearing outlet was already registered with the CFTC and subject to oversight, not that it mattered much.
This all makes the insistence that more regulation is needed ring quite hollow. It seems like the only role for new crypto rules would be to exempt crypto firms from existing rules, or worse, to hook crypto into the broader financial system, making bailouts possible. Some Democrats have appropriately labeled crypto, and I’m quoting now, as “bullshit.” So is this call for regulation.
However, if anything is going to happen in the next Congress, it will be a long-standing effort to create a regulatory framework for stablecoins, the dollar-like objects that are often used to purchase digital assets. There’s just one big problem: All the major stablecoin firms are under federal investigation. If it would have been foolhardy to grant regulations that would have protected fraud-tainted FTX, it seems just as untenable to take up legislation to regulate fraud-tainted stablecoin firms.
The bipartisan bill comes out of the House Financial Services Committee, where Rep. Patrick McHenry (R-NC) will take the gavel next year. It appears that this legislation would allow banks to issue stablecoins, with 100 percent reserve requirements. The current non-bank issuers would fall under Federal Reserve supervision. This bill was on a fast track until this summer, when the White House got involved and sought to have customer assets fully ring-fenced.
McHenry’s Republicans will almost certainly go their own way rather than bow to the Treasury Department’s wishes. McHenry said a year ago that stablecoin regulation could be the “soft entry point” to broader regulation of the system, and in October he said the bill was a top priority.
The danger of this legislation, much like the CFTC supervision legislation, would be that it brings stablecoins into the traditional banking system. Non-banks would have access to Federal Reserve benefits, despite no requirements on liquidity and capital. Banks would have an instrument to offer that doesn’t have federal insurance or strict regulations. In addition, these deposit-like instruments could be enforced under current law, or simply frozen out of the financial system entirely.
The danger of this legislation would be that it brings stablecoins into the traditional banking system.
The latter option becomes more plausible once you understand the current market participants. TerraUSD, a so-called “algorithmic” stablecoin that had no assets behind it, collapsed this spring, joining several others whose value broke well under the $1 peg. The so-called “dynamic” adjustments that were supposed to stabilize the coins didn’t work. The bipartisan House legislation would ban algorithmic stablecoins, but only for two years.
The two major stablecoins—Tether and USD Coin, which is issued by Circle—are not algorithmic. At various points, they have assured that they have physical assets backing the coins. But Tether briefly dropped below the peg back in May, revealing a key point about the coins: their vulnerability to speculation on unregulated exchanges. Since stablecoins are supposed to trade in a tight band at $1, short-sellers can bring the price down without risking much on the upside. Tether disclosed back in 2021 that its coins were backed in part by commercial debt—meaning a crisis of confidence might force a fire sale and bankruptcy.
Meanwhile, both Tether and Circle are under some level of investigation. In October, Circle revealed publicly that it is cooperating with a Securities and Exchange Commission probe involving “certain of our holdings, customer programs, and operations.” It has not been disclosed what the investigation covers. Circle CEO Jeremy Allaire urged lawmakers last month to pass comprehensive stablecoin regulation.
Tether has been under criminal investigation for at least a year for what has been described as “bank fraud,” with prosecutors in New York recently taking over the case, according to Bloomberg. The question appears to be whether Tether secured bank accounts falsely, pushing crypto through the financial system. Specific executives could be targets of the investigation. Last year, the SEC rejected a Freedom of Information Act request about Tether by using a law enforcement exemption, again suggesting an investigation.
Tether has claimed that the Justice Department “does not appear to be actively investigating.” But last week, news broke that Tether has not been retaining 100 percent asset reserves, instead lending billions of dollars’ worth of coins to customers. Lending what are supposed to be completely liquid assets represents a dire risk for the largest stablecoin, leaving it even more vulnerable to runs.
USD Coin is technically a joint project of Circle and Coinbase. Of course, Coinbase has been in and out of SEC investigations, including charges against a former Coinbase manager for insider trading and another probe into whether it allowed unregistered securities to be traded by customers.
And that’s not all. FTX and its hedge fund partner Alameda Research owned a tiny bank in a small town in Washington state, whose chair also chairs a bank in the Bahamas called Deltec, whose leading client is … Tether. FTX was actually a large trading partner in Tether, through Alameda. It just isn’t known how many ties there are between FTX and Tether.
Stablecoins, by the way, are the safest of the safe cryptocurrencies, the ones that are basically cash, intended to give stability to customers who trade other digital assets. The fact that there’s this much federal scrutiny into stablecoins’ biggest players suggests a few things. One, they may not be as safe as supporters claim. Two, there’s already plenty of federal involvement in stablecoins, without any new regulation that might ultimately chill those investigations.
Third, those investigations involve fraud, which is illegal whether it involves mortgages, structured derivatives, or crypto. I remain unconvinced that some regulatory framework needs to be invented to deal with fraud. You’ll hear a lot next year about stablecoins being “unregulated,” but that’s an argument against their continued existence, not an argument to protect and sustain them.
The early returns on stablecoins, with law enforcement all over the place, does not inspire any confidence that this is some precious innovation that must be allowed to thrive. We have dollar-like instruments; they’re called dollars. And we have laws against shady financial schemes; they’re called criminal statutes.
