Terra

SEC Guidance to Hold Client Cryptoassets on Balance Sheet Meets Resistance and Dampens Bank Plans; Staking Raises Prospect of Ether Being Classified as a Security

Thomas Murray Digital Newsletter

Securities and Exchange Commission Headquarters (SEC)

Reverberations from the SEC’s back-door attempt to move cryptoassets onto banks’ balance sheets – as we reported in May – continue as banks push back while their plans to offer digital asset services in the US falter. And the Ethereum Merge – a major and long-planned upgrade to the most widely used blockchain – passed uneventfully a week ago, shifting its operating model from Proof of Work to Proof of Stake and drastically reducing its energy consumption by an estimated 99.9%. While the change is welcome for environmental reasons, we examine whether the blockchain’s native ether token could be walking into a regulatory trap in which it could be reclassified from a commodity to a security.

Major Digital Asset Developments

SEC Accounting Guidance Issue Rumbles On
According to an article by Reuters, the US Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin 121 (SEC), published in March earlier this year, is having a material dampening effect on banks looking to engage with digital assets. While ostensibly more of an expectation for organisations wishing to remain on good terms with the regulator than a rule, the accounting guidance requires public companies including banks to hold clients’ crypto assets as liabilities on their balance sheets, rather than off them as is customary for custodians of traditional client assets. This is problematic for banks which are subject to strict regulatory capital ratio rules.
Many of the largest banks in the US have announced intentions to support digital assets in one way or another, with some services already live, albeit primarily with select or private wealth clients. Nonetheless, the article makes clear that banks’ efforts in this space are undermined by the financial burden the capital requirements place on them, and some have had to ‘cease moving forward with [their] plans’. Both State Street and Bank of New York Mellon are reported to have been disrupted.
Nadine Shakar, head of State Street Digital, previously suggested at a recent Fund Forum panel discussion that this was no great imposition, and hinting that it could be an opportunity for large institutions like State Street to gain market share, saying ‘unless you have larger custodians moving into the space and be the big kids at the table, it’s [digital assets] unlikely to see institutional a doption’. It is now reported that she sees the SEC’s expectations as an issue for the bank, one that does not necessarily prevent them from custodying digital assets but that reduces its economic viability: ‘We do have an issue with the premise of doing that, because these are not our assets. This should not be on our balance sheet.’ (Reuters) U.S. Bancorp has paused onboarding new crypto custody clients, and anecdotally several European banks are pulling back from US advances until the issue is addressed.
Until there is clearer guidance, or changes to the capital impact faced by supporting crypto assets for banks – which seems unlikely in the short term – there may be a decline in ecosystem development, which is perhaps already being reflected in the value of the cryptocurrency market.

The Ethereum Merge and Securities Implications
The Ethereum blockchain successfully merged with the Beacon Chain on 15 September (CoinDesk), transforming it from a proof-of-work (PoW) to a proof-of-stake (PoS) protocol. The transition, which was many years in the making, has been welcomed as Ethereum is expected to consume 99.9% or so less energy as a result of the change (see previous newsletter). This, according to Bank of America (FXStreet), is an opportunity for greater institutional adoption of the blockchain’s native ether token, as those that were prohibited from investing in PoW systems due to ESG considerations may now acquire the cryptocurrency.
Ethereum and the thousands of tokens it supports have now removed themselves from potential moves by jurisdictions such as the EU and the US to ban or de-incentivise PoW: the EU has flip-flopped on including a ban in its pending Markets in Crypto-assets (MiCA) regulation, adding (The Block) then ultimately removing (CoinDesk) such clauses; the State of New York has implemented a moratorium on PoW mining using carbon-based energy sources (CoinDesk); and earlier this month one of the first responses to President Biden’s Executive Order on cryptoassets – from the White House Office of Science and Technology – asked the Environmental Protection Agency and the Department of Energy to consider a ban if the US cannot meet its climate goals through other means (Blockchain News).
However, by transitioning to PoS, with its reliance on the process of staking to secure and validate the network and its transactions, ether may have walked directly into the SEC’s securities oversight purview. In return for delegating ether to network validators (if they do not have enough tokens to qualify them to run staking nodes themselves), token-holders are rewarded in more ether tokens, which according to Chairperson Gensler of the SEC (Decrypt) and other regulatory agencies could constitute an investment contract under the US Howey test: ‘a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party’ (US Supreme Court).
While the SEC has not presented any formal analysis of the issue, it is assumed it does not consider ether to be a security, although the fundamentals are much harder to assess now and there is considerable scope for questions of consistency of approach to arise. Earlier this month, Gensler announced qualified support for Congress to hand more power to the Commodity Futures Trading Commission (CFTC) to regulate non-securities digital assets such as cryptocurrencies (Crypto Slate) so long as the move would not reduce the SEC’s power to regulate securities. He and the SEC have been the subject of notable dissatisfaction from the digital asset community and even the Commissioner of the CFTC due to the SEC’s failure to proactively shape a robust digital asset framework, receiving criticism for frequent cases of ‘regulation by enforcement’. Handing greater responsibility to the CFTC for such assets is seen by the community as a welcome development.
Bolstering the argument that ether and similar tokens should remain classed as commodities, Coin Center, a non-profit research and blockchain advocate, points out that the SEC looks at the economic realities underlying a project, rather than the terms and technologies used to create it, and given that the participation in the consensus mechanism is explicitly designed to be open to anyone, and not reliant solely on the efforts of others (Coin Center), staking, or mining for that matter, should not meet the criteria.

Other News and Links

	White House Releases Inaugural Framework for Crypto Regulation (Crypto Slate) Following President Biden’s Executive Order in March this year (described previously in our newsletter here), The White House has released a framework which offers a number of recommendations including how to approach the regulation of crypto assets, ways in which to mitigate fraud perpetrated using digital assets, and how to improve standards across the financial industry more broadly. The framework pays particular attention to fraud and fighting illicit finance, and suggests the President may call upon Congress to amend the Bank Secrecy Act so that digital asset exchanges and non-fungible token (NFT) platforms would explicitly fall subject to it.
	US Banks Must Maintain Cautious Approach to Crypto, Says Acting OCC Head (Crypto Slate) Michael Hsu, Acting Head of the Office of the Comptroller of the Currency (OCC), believes that US banks should remain caution when considering digital assets. The OCC was the first to green-light the provision of crypto custody services by national banks and federal savings associations when it issued its Interpretive Letter #1170 in July 2020, which in all likelihood contributed to the crypto bull market. That said, in his speech at the TCH + BPI Annual Conference Hsu made clear that he is much more cautious than the previous head of the OCC, and sees ‘red flags in crypto’s rapid growth’. As such, the agency has reportedly tightened its criteria for acceptance, indicating that these institutions can only engage in certain crypto activities so long as they can demonstrate the activities can be performed in a ‘safe, sound and fair manner.’
	Crypto Oversight Should Resemble Traditional Bank Rules, Fed Official Says (CoinDesk) In his first speech since taking office, Fed Vice Chair for Supervision, Michael Barr, articulated the need for greater regulatory oversight, particularly in how banks engage in crypto activities. He reiterated the need to regulate based on the “same activity, same risk” approach cited by multiple regulators and commentators over the preceding months.
	UK Introduces Law to Seize, Freeze and Recover Crypto (CoinDesk) The Economic Crime and Corporate Transparency bill supplements the Economic Crime (Transparency and Enforcement) Act used to impose sanctions against Russia and freeze UK-held assets – both traditional and digital – and is ostensibly designed to prevent sanctioned Russians from using crypto to evade those measures, as well as aid in combatting criminal activities.
	Crypto Exchanges in UK Required to Report Sanction Breaches (Finextra) The UK has updated its guidance towards sanctions reporting, which now brings crypto exchanges into scope for reporting violations and freezing assets. The guidelines were implemented by the Treasury’s Office of Financial Sanctions Implementation (OFSI) to combat potential breaches conducted with the use of cryptocurrencies.
	New French Bill Could Give Authorities Powers to Seize Crypto Assets (CoinDesk) In line with other countries around the world, such as the UK’s Economic Crime Bill, the French state is attempting to make it easier to freeze and seize the digital assets of suspected criminals. The proposal is due to be discussed next week by France’s Constitutional Law Committee.
	Korea to Launch Security Token Guidelines, Pilots This Year (Ledger Insights)
	SEC, CFTC Propose Amendments for Large Hedge Fund Crypto Reporting (Crypto Slate) First announced earlier this month, the Securities and Exchange Commission (SEC) and the Commodities and Futures Trading Commission (CFTC) look set to introduce rules that will require hedge funds to report investments more accurately in digital assets. In particular, the Proposed Rule (Federal Register) will seek to distinguish between assets that have similar characteristics such as digital assets and cash and cash equivalents, and establish a new sub-asset class which will help regulators to more easily monitor systemic risks and economic stability.
	Russia to Consider Possible Legalization of Cryptos for Cross-border Payments (AMBCrypto) Due to the impact of financial sanctions on Russia, its Ministry of Finance is considering using cryptocurrencies as a means to support cross-border payments. This comes after Putin signed an order effectively banning the use of crypto-based assets for domestic payments in July earlier this year. Views are said to be softening in light of the ongoing financial situation, with Prime Minister Mikhail Mishustin suggesting the country needs to look to digital assets as a ‘safe alternative’ to support cross-border commerce. The Central Bank has tried to limit the use of crypto assets in the country as it looks to develop its own digital ruble, and once rolled out, may try to impose another ban on cryptocurrencies.
	Australian Senator Releases Draft Bill to Push for Crypto Regulation (Crypto Slate) Australian Senator Andrew Bragg has released a draft Digital Assets (Market Regulation) Bill 2022 (Andrew Bragg). It seeks to apply pressure to the Australian regulatory system in order to push forward with the regulation and oversight of the digital asset market and its constituent components. At a high level, the bill proposes to provide a framework for digital asset exchanges, digital asset custody, issuance of stablecoins, and the protection of consumers while promoting investment in Australia. Interestingly, another objective of the bill is to provide for the reporting of information from banks that facilitate the use or availability of China’s digital yuan in Australia. Consultation on the bill is being received until October 31, 2022.
	Colorado Enables Crypto Payment for Taxes (Crypto Slate)
	House Stablecoin Bill Would Put Two-Year Ban on Terra-Like Coins (Bloomberg)
	Nigeria Plans to Create a Virtual Free Zone with Binance Crypto Exchange (CoinDesk) Nigeria’s Export Processing Zones Authority (NEPZA) is looking to create a digital city to support the growing digital asset economy. It is reportedly looking to partner with Binance, the largest cryptocurrency exchange by volume, which signed an agreement to assist Dubai with the establishment of a similar industry hub for digital assets in December 2021.
	Binance Secures Licence in Dubai to Offer More Crypto Services (CoinDesk)
	Coinbase Is Helping Sue the US Treasury Over Tornado Cash Sanctions (Bloomberg UK) Coinbase is challenging the authority of the US Treasury Department after it publicly declared its intention to pay the legal costs of a lawsuit brought by six individuals who are contesting the legality of the Treasury’s sanction of Tornado Cash. The plaintiffs argue that the move by the US Treasury’s Office of Foreign Assets Control (OFAC) to sanction wallets associated with the application, as well as the smart contract code itself, was unprecedented, as neutral technologies and tools are reportedly out of the scope of sanctions law. Brian Armstrong, CEO of Coinbase, stated that the Treasury issued a blanket-wide sanction rather than targeting the wallets of those known to have committed an offence, further suggesting that it was used by many law-abiding citizens looking for increased privacy, who now have funds trapped on the platform. Crypto Investment firm Paradigm strongly agrees with the action brought by the lawsuit, as it too stated in a legal argument (Paradigm) that blockchain infrastructures and the providers that support them should not be subject to US Treasury sanctions, as monitoring or censoring Specially Designated Nationals and Blocked Persons (SDN List) would jeopardise the neutrality of base blockchain layers and compromise their integrity and core functionality.
	Coinbase Gains Regulatory Approval in the Netherlands (Coinbase)
	Deutsche Börse to Issue Digital Securities on DLT-ready D7 Platform (Ledger Insights)
	Societe Generale Securities Services Extends Its Offer to Funds Investing in Digital Assets (Societe Generale) SGSS now offers asset managers to act as a fund custodian, valuator and liability manager, and has onboarded its first client, Arquant Capital.
	Hong Kong’s HashKey Receives Approval to Manage 100% Crypto Portfolio (CoinDesk) HashKey, a Hong Kong based asset manager, has received a Type 9 (Asset Management) Licence (Offshorelicense) from the Securities and Futures Commission (SFC) of Hong Kong, permitting it – alongside a growing number of virtual asset managers – to manage portfolios that are 100% invested in digital assets.
	Nasdaq Launches Crypto Custody Service (Nasdaq) Nasdaq is moving into the digital asset business, citing growing institutional demand from its financial institution clients. It is set to launch a digital asset custody offering which, following regulatory approval, will incorporate liquidity and execution services, effectively creating a full-service solution that may take a lead from Switzerland’s SDX.
	Royal Family of Dubai Company Seed Group Partners with Coincorner to Facilitate Bitcoin Transactions in the UAE (Bitcoin Magazine)
	Brazil Exceeds 1M Registered Crypto Users in July for First Time as Number Grows 68% in a Month (CoinDesk)
	Abra Launching First US Regulated Crypto Bank (Blockworks) Abra, a crypto exchange and lending platform, has successfully acquired a licence to become the first US regulated crypto bank. With the licence comes an ability to offer clients regulated interest-bearing crypto accounts, an activity that some providers have had to discontinue. For example, BlockFi was sued successfully by the SEC for USD 100 million (The Verge) as its offering was considered an unregistered security and the firm was not registered as an investment company. Abra is due to launch in the US in Q1/2 2023.
	Tokenization of Illiquid Assets to Reach $16T by 2030: Report (Cointelegraph) A report by Boston Consulting Group (BCG) and ADDX, a digital asset exchange, estimates that illiquid assets such as pre-IPO stock, real estate, art, and private debt will become a USD 16.1 trillion tokenised market by 2030.
	Singapore’s Financial Authority Grants License to SBI’s Digital Asset Arm (Cointelegraph) The Monetary Authority of Singapore (MAS) has granted Japan-based SBI Holdings a Capital Markets Services licence for its digital subsidiary SBI Digital Markets. In-principal approval was granted in May this year, however the full licence will now permit the firm to offer digital asset custody, capital markets products, and financial advisory services in Singapore as a regulated business.
	Singapore’s Largest Bank DBS to Offer Crypto Services to 300,000 Investors (Crypto Slate)
	Fidelity to Launch Bitcoin Retail Trading in November (Crypto Slate)
	ErisX Introduces Settlement Service for OTC Crypto Transactions (Finextra) ErisX, a leading digital asset exchange, has launched a new settlement service for OTC transactions that is designed to eliminate counterparty risk by routing orders through a US-licensed crypto spot exchange, thus reducing the risk and operational burden associated with OTC transactions.
	Broadridge Integrates with Coinbase (Finextra) Broadridge, a leading provider of shareholder services, has partnered with Coinbase’s Prime offering, enabling enhanced liquidity and the ability for Broadridge’s clients to route orders to Coinbase Prime via its NYFIX order-routing network.
	Crypto Custody Specialist Anchorage Digital Offers Japanese Yen Stablecoin (CoinDesk)
	Gunvor, Total Execute First Physical Oil Trade Confirmation using VAKT Blockchain (Ledger Insights) VAKT, a post-trade blockchain startup backed by oil majors including BP, Saudi Aramco, Shell, Total and Chevron, has launched an electronic trade confirmation solution which is designed to replace manual processing of oil contracts, which according to VAKT’s own analysis is responsible for a 15% error rate.
	Major Fund Administrator Apex Offers Blockchain-based Valuation Data for Private Assets (Ledger Insights)
	SWIFT Runs Blockchain Pilot for Corporate Actions Data (Finextra) The banking infrastructure provider is trialling a new blockchain system for corporate actions with the aid of Symbiont, a private technology platform, as well as seven securities market participants. Corporate actions are seen as one of a number of key areas in which post-trade can be better served by blockchain technology, with SWIFT estimating as much as 30% of the costs associated with processing corporate actions are related to manual processing.
	CME Group Launches Ether Options (Finextra)

CBDC Corner

HKMA’s Policy Stance on e-HKD (Hong Kong Monetary Authority)
HKMA has concluded several consultations under its ‘Fintech 2025’ strategy and will take steps to prepare for a possible future retail CBDC based on broad support by working on technical and legal foundations while exploring application, implementation, and design issues.

IMF Says Crypto and Central Banks Could Set the Stage for Rich and Diverse Monetary Ecosystem – Here’s How (DailyHodl)

Crypto’s Adaptability, Openness Key to Ideal Monetary System, Say BIS Execs (Cointelegraph)

India’s Central Bank Plans CBDC Launch in 2022 with Help from Fintechs, Public Banks (Crypto Slate)

Digital Dollar Project Launches Sandbox Programme (Finextra)

Brazil, India Join CDBC Race: Will Start Pilot Projects in 2022 (The Tokenist)

Norwegian Central Bank Taps Ethereum for CBDC Work (Finextra)

ECB Taps CaixaBank and Amazon for Digital Euro Prototypes (Finextra)

China to Extend CBDC Trial to Most Populous Province, Guangdong, Three Others: Report (CoinDesk)

Iran to Start Testing a Digital Rial This Week (CoinDesk)

Thomas Murray Digital

Andrew Wright | Hugo Jack

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State of the Digital Asset Market: ‘Crypto Winter’ and Silver Linings

Hugo Jack

For investors in digital assets, and cryptocurrencies in particular, the last couple of months have been something of a nightmare. Ongoing macro and geopolitical pressures have continued to hit the digital asset ecosystem as investors – both retail and professional – have continued to exit the market as uncertainty around the regulatory and fiscal environment remains. While 2021 was officially the year in which institutional investors entered crypto in significant numbers, it is fair to say that the digital asset sector is still reminiscent of the early days of the Internet, evidenced by ecosystem failures, the misallocation of capital, and poor investor protection.

That said, while a much-needed shakeout (mostly of irresponsible leverage trading) is taking place, a digital asset future is still very much on the cards. Just as the tech bubble in 2001 paved the way for the Internet success stories of today, now global banks, financial institutions and FinTechs are continuing to invest and build new operational models and DLT-based infrastructure. The scope for this new environment is not just cryptocurrencies, which constitute a meaningful but relatively small asset class, but all financial instruments including equities, bonds, funds and alternative assets that will in time all likely run on blockchain rails. That said, as cryptocurrencies currently comprise the largest part of today’s real use cases for digital assets, it is worth taking a look at what is happening today: where things are going wrong, but also the continuing positives driving the industry forward.

Digital assets continue to dive amid macro uncertainty and ecosystem failures

In the past couple of weeks the cryptocurrency sell-off has continued as bitcoin crashed to its lowest level in two years. The period from May to June has seen one of the largest month-on-month declines with over USD 416 billion wiped from the total market capitalisation, which now sits at USD 933.0 billion. Considered a key line of support, bitcoin crossed its 200-week moving average (200W MA) last week, which has reportedly only occurred three times in its 13-year history. Historically, this has usually correlated with a market bottom. That said, central bank tightening is likely applying greater pressure to markets globally, which in crypto is compounded by miners of bitcoin needing to sell their BTC rewards to cover their operational costs which currently stand at approximately USD 20,000 per bitcoin. Consequently, there may still be some way to go before any sign of a true turnaround can be found.

The crypto markets are still reeling from the collapse of the Terra/Luna ecosystem in May, which impacted tens of thousands of investors globally including a well-known Dubai-based crypto focused hedge fund, Three Arrows Capital (3AC). It was quickly reported that 3AC was facing insolvency after incurring at least $400 million in liquidations. It failed to meet margin calls and is now considering multiple options including an asset sale, or a bail out by another firm. Celsius, a crypto lending platform which at one point claimed more than USD 20 billion in assets under administration, has come under pressure by investors in an old-fashioned “bank run”, with depositors scrambling to pull assets from the platform. On Monday 13 June Celsius released a community memo announcing its decision to pause all withdrawals, swaps and transfers between accounts, an option which it reserved under its terms of use. According to reports, Celsius is similarly in the process of considering insolvency proceedings and has appointed a legal firm that specialises in business restructuring, as well as hiring Citigroup as an independent advisor to brainstorm possible financing options. Nexo, another lending platform, put forward an unsolicited offer to acquire “any remaining qualifying assets”, although following a swift initial rejection it is unlikely the offer will be accepted.

It is unclear where the market goes from here. A significant amount of speculative capital has been put into the crypto ecosystem over the last couple of years during a period of exceptionally loose monetary policy and government stimulus; however, a flight to safety is now well underway across all asset classes. In addition, well established and high profile firms have put their reputations on the line and acquired significant amounts of bitcoin; the poster child for this tactic is MicroStrategy (Nasdaq: MSTR) which has 130,000 bitcoin, acquired at a cost of circa USD 3.97 billion, on its balance sheet, bought with cash from sequential debt offerings totalling nearly USD 2.4 billion. As a significant holder of bitcoin, all eyes are on the institution which at current prices is facing an unrealised loss of over USD 1 billion. In May it was reported that if bitcoin fell to USD 21,000 then a margin call would be triggered on a USD 205 million loan it took with Silvergate Bank in March to purchase additional bitcoin. That number was reached last week and has in the following thereafter gone as low as USD 17,744 as of Saturday 17 June. There is an inevitable concern that further liquidations would panic the market even further, however, MicroStrategy CEO Michael Saylor confirmed last week that a margin call had not been made, and that the company has reserves to protect against bitcoin dropping much lower.

Re-evaluation of business needs triggers firing and hiring

The bear market and general downturn is causing concern across the industry, as companies grapple with the implications of a looming recession and even stagflation. Financial considerations are being made a priority amidst declining revenues. Consequently, some digital asset institutions have announced reductions in head count. Coinbase (Nasdaq: COIN), one of the leading digital asset custodians and exchanges, announced cuts to staff of 18%, or approximately 1,100 staff, and furthermore rescinded 300 new hire offers. Gemini, an equally established exchange, expects to lay off 10% of its employees, while BlockFi and Crypto.com, more retail focused entities, will reduce headcount by 20% and 5% respectively, citing a “dramatic shift in macroeconomic conditions worldwide” which are impacting growth. However, at odds with the trend is Citibank, which this week announced its intention to hire 4,000 tech workers in a $10 billion effort to enhance online customer experience. It is joined by Binance and Kraken, two of the largest and most well-known cryptocurrency exchanges, which have similarly advertised their on-going efforts to recruit for 2,000 and 500 new positions respectively.

Longer-term sentiment remains positive as adoption increases

Despite the obvious pain that is being felt by the market during the latest crypto winter, sentiment around the future of the ecosystem and about cryptoassets remains positive. This week, Bank of America carried out a survey in which 91% of US adults said they plan to buy more cryptoassets over the course of the next six months, with 30% of respondents confirming their intention to hold their assets for at least the next six months despite the uncertainty. Echoing this sentiment, PwC’s Global Crypto Hedge Fund Report showed that allocations by crypto-focused and traditional hedge funds have increased over the past year, with 38% of traditional hedge funds currently investing in digital assets, up 21% from a year ago. Furthermore, 27% of the traditional funds that had not yet invested in digital assets reported that if the main barriers to adoption were removed they would accelerate their investments in them. Capgemini, a leading technology consulting firm, also released its 2022 World Wealth Report last week. Of the 2,973 global High Net Worth Individuals (HNWI) polled, 71% of them have allocated capital to cryptocurrencies and other digital assets. Furthermore, in assessing the demographic of respondents, 91% of under 40s have invested in digital assets, with Capgemini observing that cryptocurrencies remain their favourite digital asset investments for now. Even J.P. Morgan – whose chairman and CEO Jamie Dimon has been famously anti-bitcoin – has declared cryptocurrencies its new favourite alternative asset in preference to real estate, and has set a ‘fair value’ for bitcoin of USD 38,000, nearly twice its current price. And a joint PayPal and Deloitte survey of 2,000 senior U.S. retail executives found that nearly 85% of them expect digital currency payments to be ‘ubiquitous’ within the next five years.

Continued growth in institutional products and services

In other news, Goldman Sachs (GS) has launched a derivatives product linked to ether (ETH). The non-deliverable forward will enable investors to speculate on the price of ether without having to hold it directly. It comes at a time when investor confidence is low in the short term, however the firm reinforced its belief that digital assets are still desirable, stating that “institutional demand continues to grow significantly in this space”, with this offering helping the firm to evolve its nascent cash-settled cryptocurrency capabilities. And despite the reputation of stablecoins taking a knock of late, demand for them remains high as Circle Internet Financial – creator of the popular USDC dollar-pegged token – launches a new regulated euro-pegged stablecoin, EUROC, fully backed by euros held in custody by US qualified custodians.

Digital infrastructure for the repo market is also having a good month. BNP Paribas recently joined J.P. Morgan’s Onyx Digital Assets system, a tokenisation platform whose Intraday Repo application has processed over USD 300 billion of US treasury-based transactions in the year since it launched and is now looking to tokenise money market funds and other traditional securities as collateral. Meanwhile, Finteum’s DLT-based intraday FX swap and repo trading platform – due to go live next year – has been successfully tested by 14 banks, including Citi, NatWest and Barclays.

In Japan, the country’s two largest banks are making further moves in the digital asset space. Nomura – already one of the backers of custodian Komainu – will launch a new wholly-owned subsidiary to offer a range of digital asset services to institutional clients, with an unnamed executive quoted as saying, ‘If we don’t do this, then it’s going to be more difficult down the line to be competitive’. Meanwhile, Tokyo cryptocurrency exchange Bitbank has partnered with Sumitomo Mitsui Trust to create a new institutional digital asset custodian to be named Japan Digital Asset Trust. And the country has just become the first to pass legislation to limit yen stablecoin issuance to licensed institutions and guarantee their redemption back into fiat currency at par, a move that come into effect next year as a consortium of 74 Japanese banks and corporations moves to launch a private sector yen stablecoin.

Growing pains belie a maturing sector

The current market shake-up is inflicting short-term pain on investors, and the drying up of the previous flood of cheap capital that led to poor investment choices is now consigning thousands of weaker tokens and their associated projects to the scrap-heap. Investors are being reminded of the need to focus on utility and fundamentals over speculation. The last crypto market crash occurred in early 2018 when cryptocurrencies were the preserve of retail investors and the bravest of hedge funds, and institutional-grade services and infrastructure were not yet established. Four years later, the build-out of the foundations of the future financial system has got off to a strong start and continues apace. At the same time, regulation is beginning to catch up with the exuberant growth of this sector. We are witnessing the latest shift in a free market that should lead us to a more robust digital asset economy. Perhaps this moment will be seen in retrospect as an inflection point in the march towards a future financial system that encapsulates the best aspects of both stability and innovation.

TerraUSD Fallout – Debating the Future of Stablecoins and CBDCs

Thomas Murray Digital team

Following the recent failure of the TerraUSD algorithmic stablecoin, the fallout affecting the cryptocurrency markets and the policy questions that the incident raises have continued to dominate discussions. At issue are what – if any – role privately-operated stablecoins may have in the future of wholesale and cross-border settlements, the parameters and priority of stablecoin regulation, and the degree to which Central Bank Digital Currencies (CBDCs) – previously viewed by some major economies as more relevant to retail applications – could assume wholesale roles.

Finance ministers from the G7 group of nations meeting in Germany this month with representatives from the International Monetary Fund, World Bank Group, Organisation for Economic Cooperation and Development, and the Financial Stability Board discussed the potential role that CBDCs could play in realising greater efficiencies, in the context of the G20 Roadmap for enhancing cross-border payments. They highlighted the potential international uses of CBDCs and the need to minimise negative effects on the international monetary system by introducing consistent and comprehensive regulation of digital asset issuers and service providers. They noted in particular the need to achieve widespread compliance with the Financial Action Task Force’s ‘travel rule’ and the need for greater reporting requirements of the assets backing stablecoins.

Policymakers at the Bank of England have previously been open about their view that any so-called ‘Britcoin’ would not be a priority for wholesale settlement, given the introduction in 2021 of omnibus accounts permitting regulated entities to commingle tokenised money in order to settle among themselves. The Bank’s governors also cited the ability of the private sector to manage such settlements, which have fewer complexities and policy implications than retail CBDC usage, without government involvement. However, the UK Treasury has this week published a consultation paper titled Managing the failure of systemic digital settlement asset (including stablecoin) firms that proposes that the Bank of England be designated as the regulator of stablecoins, giving it the power to appoint administrators should so-called Digital Settlement Assets encounter difficulties. Similarly, the Financial Conduct Authority would bring stablecoin activity under its existing electronic money and payments regulatory regime.

In South Korea, the government has reacted to Terra’s collapse – believed to have affected 280,000 Koreans – by proposing a new digital assets committee to oversee the imposition on the industry of investor protections equivalent to those for securities, uniting a currently fragmented regulatory environment under one roof.

The US and Japan commenced preparations for the regulation of stablecoin issuers last year. In November, the President’s Working Group on Financial Markets coordinated a report on stablecoins that proposed that issuers should be treated like banks. And in December, Japan’s Financial Services Agency proposed legislation to limit the number of stablecoin issuers by restricting their issuance to banks and wire transfer companies, positing that this would increase trust in them and help to avoid runs that could crash their value and potentially destabilise the wider financial markets.

While TerraUSD – a bold and unusual ‘algorithmic’ (rather than fully asset-backed) stablecoin – may not have enjoyed widespread institutional use, its collapse has put a sharp focus on its more traditionally structured erstwhile competitors.

The long-running controversy over Tether (USDT), the first and largest stablecoin, continues as the company behind it has still not produced an audited set of financial disclosures, despite past promises, to offer assurance that it has adequate asset backing for the USD-pegged tokens it has issued. Its CTO, Paolo Ardoini, has hinted at a reluctance to publish full details of the constitution of Tether’s reserves, or of its counterparties, calling the information its ‘secret sauce’. Senator Elizabeth Warren has called this lack of transparency a ‘gigantic red flag’. Tether’s accountant, MHA Cayman, introduced new language in its latest attestation report dated 18 May, covering Tether’s Consolidated Reserves Report as at 31 March, stating that there is significant uncertainty regarding the value of large parts of the reserves – for example, during a run on its tokens – and Tether’s exposure to risk resulting from potential issues with its unnamed custodians and counterparties:

“The valuation of the assets of the Group have been based upon normal trading conditions and do not reflect an unexpected large-scale sale of assets, or the case of any key custodians or counterparties defaulting or experiencing substantial illiquidity, which may result in materially different or delayed realisable values. No provision for expected credit losses was identified by management at the financial reporting date.”

MHA Cayman also states that Tether’s management makes no provision for the potential costs of two legal cases that it is currently defending nor for credit losses.

At the end of March, approximately 47% of the reserves were in less liquid and riskier forms such as digital tokens, commercial paper, corporate bonds, and money market funds. Just under 5% of its reserves were held as cash.

By contrast, Tether’s younger rival Circle – issuer of the USD Coin (USDC) stablecoin – is making hay from Tether’s misfortunes. Its CFO Jeremy Allaire published a blog post provocatively titled How to Be Stable asserting that USDC’s reserves are held entirely in cash and US Treasuries with maturities of 3 months or less, and that those assets are custodied by Bank of New York Mellon, US Bank and BlackRock. It has also recently stepped up publication of the full breakdown of its reserves from a monthly cadence to weekly, with monthly attestation reports from accountants Grant Thornton continuing.

USDT chart May 2022 — Tether’s USDT market capitalisation, May 2022 (CoinMarketCap)

USDC chart May 2022 — Circle’s USDC market capitalisation, May 2022 (CoinMarketCap)

As of writing, the market capitalisation of Tether’s USDT has fallen by approximately USD 11 billion since 7 May (when TerraUSD first showed signs of instability) while that of Circle’s USDC has risen by about USD 5.5 billion over the same period.

Algorithmic Stablecoin Failure Crashes Cryptocurrency Markets

LUNA USD price chart

Ben Ashley

The past week saw another crash in the value of cryptocurrencies; bitcoin fell to USD 24,000, its lowest value since December 2020. Although bitcoin’s price has been slowly falling since the end of the last year – reflecting the current macroeconomic climate of increasing inflation and interest rates facilitating a risk-off environment – this latest capitulation was a result of the TerraUSD (UST) stablecoin catastrophically losing parity with its dollar peg and the fallout thereafter.

UST, an algorithmic stablecoin, works in conjunction with the Terra blockchain to maintain a 1:1 peg with the US dollar via a set of on-chain mint and burn mechanics. In theory, these mechanics ensure that one dollar of UST can always be swapped for one dollar of LUNA, the Terra blockchain’s native token, by allowing traders to take advantage of arbitrage opportunities. However, on 8 May this mechanism began to fail, and the value of UST fell below USD 0.8 the following day. Although the price managed to recover to USD 0.94, 11 May saw the sticking plaster ripped off and the price falling below USD 0.3 as trader sentiment around the stablecoin dropped. At the time of writing UST is now trading below USD 0.1, over 90% down on its supposed peg.

This de-pegging resulted in a significant knock-on effect for the price of the LUNA token used to help maintain the peg. The token opened May with a price of USD 80, down from its early April all-time-high of USD 120. However, at the time of writing the token’s price is a measly USD 0.0002, meaning the price has fallen over 99% in little over a week. Before the rout, LUNA was a top ten crypto asset with a market capitalisation in excess of USD 30 billion, while UST was the third largest stablecoin with a market capitalisation of USD 18 billion. The combined market capitalisation of the two tokens is now around USD 2 billion, meaning investors have lost over USD 45 billion.

The after-effects have rippled throughout the crypto market. The price of bitcoin fell over 20% in the three days following UST’s de-pegging, triggered by sell-offs of 80,000 bitcoin from the reserves of the firm behind LUNA and TerraUSD and a loss in sentiment, while the total market capitalisation of all cryptocurrencies fell over 30%. This – together with bitcoin’s value more recently falling in step with technology equities rather than ploughing its own furrow – suggests that the ‘bitcoin as an inflation hedge’ narrative is now well and truly dead. This is the first time since its creation that the cryptocurrency market is experiencing rising inflation and interest rates, and it is currently performing as badly as equity markets.

Tether (USDT) – the largest stablecoin with a market capitalisation of over USD 70 billion – also lost its dollar peg for a time. USDT differs from UST as it is supposedly backed 100% by a combination of cash, commercial paper, fiduciary deposits, reserve repo notes and treasury bills. Tether fell to USD 0.95 as fear and uncertainty spread throughout the market. Although the price recovered, it did not stop investors from redeeming USD 7 billion worth of the token.

The collapse of TerraUSD and the brief de-pegging of Tether have seen an outpouring of calls for the introduction of stablecoin regulations, including from the US Secretary of the Treasury Janet Yellen. With the rapidly increasing size of the stablecoin market, it is now obvious that regulation is needed to protect investors and address the risks posed to financial stability. The stablecoin debacle could lead to central banks rethinking the use cases for CBDCs and imposing themselves on the wholesale settlement markets after all, rather than prioritising exclusively retail-oriented applications. Indeed, as the European Central Bank’s Fabio Pannetta states: “Recent developments in the market for crypto assets illustrate that it is an illusion to believe that private instruments can act as money when they cannot be converted at par into public money at all times.”