$60 billion Terra washout not crypto’s Bear Stearns moment: regulators

WASHINGTON — It’s been a bru­tal few weeks for the cryp­to market.

Half a tril­lion dol­lars was wiped off the sec­tor’s mar­ket cap as ter­raUSD, one of the most pop­u­lar U.S. dol­lar-pegged sta­ble­coins, implod­ed vir­tu­al­ly overnight.

Mean­while, dig­i­tal coins such as ether con­tin­ue to take a beat­ing on the price charts, as the sell-off keeps ham­mer­ing the industry.

Some investors have called the events of the last month a Bear Stearns moment for cryp­to, com­par­ing the con­ta­gion effect of a failed sta­ble­coin project to the fall of a major Wall Street bank that ulti­mate­ly fore­told the 2008 mort­gage debt and finan­cial crisis.

“It real­ly revealed some deep­er vul­ner­a­bil­i­ties in the sys­tem,” said Michael Hsu, act­ing Comp­trol­ler of the Cur­ren­cy for the U.S. Trea­sury Department.

“Clear­ly, you saw con­ta­gion, not just from ter­ra to the broad­er cryp­to ecosys­tem, but to teth­er, to oth­er sta­ble­coins, and I think that’s some­thing that was­n’t assumed. And I think that’s some­thing peo­ple have to real­ly pay atten­tion to.”

But so far, gov­ern­ment offi­cials don’t seem to be wor­ried about a cryp­to crash tak­ing down the broad­er economy.

Sev­er­al sen­a­tors and reg­u­la­tors told CNBC on the side­lines of the DC Blockchain Sum­mit this week that the spillover effects are con­tained, cryp­to investors should­n’t freak out, U.S. reg­u­la­tion is the key to suc­cess for cryp­tocur­ren­cies, and cru­cial­ly, the cryp­to asset class isn’t going anywhere.

“There need to be rules to this game that make it more pre­dictable, trans­par­ent, where there are the need­ed con­sumer pro­tec­tions,” said Sen. Cory Book­er, D‑NJ.

“What we don’t want to do is choke a new indus­try and inno­va­tion out so that we lose out on oppor­tu­ni­ties. Or what I’m see­ing right now, a lot of these oppor­tu­ni­ties just move off­shore, and we’re miss­ing the eco­nom­ic growth and job cre­ation that’s a part of it. So this is a real­ly impor­tant space if we get the reg­u­la­tion right, that can actu­al­ly be help­ful to the indus­try and pro­tect­ing con­sumers,” con­tin­ued Booker.

In ear­ly May, a pop­u­lar sta­ble­coin known as ter­raUSD, or UST, plum­met­ed in val­ue, in what some have described as a “bank run,” as investors rushed to pull out their mon­ey. At their height, luna and UST had a com­bined mar­ket val­ue of almost $60 bil­lion. Now, they’re essen­tial­ly worth­less.

Sta­ble­coins are a type of cryp­tocur­ren­cy whose val­ue is teth­ered to the price of a real-world asset, such as the U.S. dol­lar. UST is a spe­cif­ic breed, known as an “algo­rith­mic” sta­ble­coin. Unlike USDC (anoth­er pop­u­lar dol­lar-pegged sta­ble­coin), which has fiat assets in reserve as a way to back their tokens, UST depend­ed on com­put­er code to self-sta­bi­lize its value.

UST sta­bi­lized prices at close to $1 by link­ing it to a sis­ter token called luna through com­put­er code run­ning on the blockchain — essen­tial­ly, investors could “destroy” one coin to help sta­bi­lize the price of the oth­er. Both coins were issued by an orga­ni­za­tion called Ter­raform Labs, and devel­op­ers used the under­ly­ing sys­tem to cre­ate oth­er appli­ca­tions such as NFTs and decen­tral­ized finance apps.

When the price of luna became unsta­ble, investors rushed out of both tokens, send­ing prices crashing.

UST’s fail­ure, though infec­tious, was­n’t much of a sur­prise to some cryp­to insiders.

Coin Met­rics’ Nic Carter tells CNBC that no algo­rith­mic sta­ble­coin has ever suc­ceed­ed, not­ing that the fun­da­men­tal prob­lem with UST was that it was large­ly backed by faith in the issuer.

Sen. Cyn­thia Lum­mis, R‑Wyo., who is among the most pro­gres­sive law­mak­ers on Capi­tol Hill when it comes to cryp­to, agrees with Carter.

“There are a cou­ple types of sta­ble­coins. The one that failed is an algo­rith­mic sta­ble­coin, very dif­fer­ent from an asset-backed sta­ble­coin,” Lum­mis told CNBC. She said she hoped con­sumers could see that not all sta­ble­coins are made equal and that choos­ing an asset-backed sta­ble­coin is essential.

That sen­ti­ment was echoed by the man­ag­ing direc­tor of the Inter­na­tion­al Mon­e­tary Fund at the World Eco­nom­ic Forum’s annu­al meet­ing in Davos.

“I would beg you not to pull out of the impor­tance of this world,” said IMF chief Kristali­na Georgie­va. “It offers us all faster ser­vice, much low­er costs, and more inclu­sion, but only if we sep­a­rate apples from oranges and bananas.”

Georgie­va also stressed that sta­ble­coins not backed by assets to sup­port them are a pyra­mid scheme and empha­sized that the respon­si­bil­i­ty falls to reg­u­la­tors to put up pro­tec­tive guardrails for investors. 

“I think it is like­ly that we’re going to have reg­u­la­tion hap­pen faster because of the events of recent weeks,” said Secu­ri­ties and Exchange Com­mis­sion’s Hes­ter Peirce, who also not­ed that sta­ble­coin leg­is­la­tion was already on the dock­et before the fall of UST.

“We have to make sure to…preserve the abil­i­ty of peo­ple to exper­i­ment with dif­fer­ent mod­els, and do so in a way that fits with­in reg­u­la­to­ry guardrails,” con­tin­ued the SEC Commissioner.

For Com­mis­sion­er Car­o­line Pham of the Com­mod­i­ty Futures Trad­ing Com­mis­sion, the UST melt­down high­lights just how much action reg­u­la­tors need to take to pro­tect against a pos­si­ble return of shad­ow bank­ing — that is, a type of bank­ing sys­tem in which finan­cial activ­i­ties are facil­i­tat­ed by unreg­u­lat­ed inter­me­di­aries or under unreg­u­lat­ed circumstances.

Pham says a lot of exist­ing safe­guards could do the trick.

“It’s always faster to stand up a reg­u­la­to­ry frame­work when it’s already exist­ing,” said Pham. “You’re just talk­ing about extend­ing the reg­u­la­to­ry perime­ter around new­er, nov­el products.”

Months before the UST algo­rith­mic sta­ble­coin project failed, the Pres­i­den­t’s Work­ing Group on Finan­cial Mar­kets pub­lished a report out­lin­ing a reg­u­la­to­ry frame­work for sta­ble­coins. In it, the group divides the sta­ble­coin land­scape into two main camps: trad­ing sta­ble­coins and pay­ment stablecoins.

Today, sta­ble­coins are typ­i­cal­ly used to facil­i­tate trad­ing of oth­er dig­i­tal assets. The report looks to set down best prac­tices to reg­u­late sta­ble­coins to be more wide­ly used as a means of payment.

“For those who are like me, bank reg­u­la­tors, we’re kind-of his­to­ri­ans of mon­ey-like instru­ments,” said Hsu, whose Office of the Comp­trol­ler of the Cur­ren­cy co-authored the report.

“This is a real­ly famil­iar sto­ry, and the way to deal with it is pru­den­tial reg­u­la­tion. This is why I think some of the options, the pro­pos­als for more of a bank kind of reg­u­la­to­ry-type approach is a good start­ing point.”

The key ques­tion that reg­u­la­tors and law­mak­ers need to address is whether sta­ble­coins, includ­ing the sub­set of algo­rith­mic sta­ble­coins, are in fact deriv­a­tives, says Pham.

Gen­er­al­ly speak­ing, a deriv­a­tive is a finan­cial instru­ment that allows peo­ple to trade on the price fluc­tu­a­tions of an under­ly­ing asset. The under­ly­ing asset can be almost any­thing, includ­ing com­modi­ties such as gold or — accord­ing to the way the SEC is cur­rent­ly think­ing — a cryp­tocur­ren­cy such as bitcoin.

The SEC reg­u­lates secu­ri­ties, but for every­thing that is not a secu­ri­ty, the CFTC prob­a­bly has some reg­u­la­to­ry touch­point over it, says Pham.

“We have the reg­u­la­tion over deriv­a­tives based on com­modi­ties, but we also have cer­tain areas … where we direct­ly reg­u­late spot mar­kets,” said Pham.

“The last time we had … some­thing blow up like this in the finan­cial cri­sis — risky, opaque, com­plex finan­cial prod­ucts — Con­gress came up with a solu­tion for that, and that was with Dodd-Frank,” con­tin­ued Pham, refer­ring to the Wall Street Reform and Con­sumer Pro­tec­tion Act, passed in 2010 in response to the Great Reces­sion. The act includ­ed stricter reg­u­la­tion of deriv­a­tives, plus new restric­tions relat­ed to the trad­ing prac­tices of FDIC-insured institutions. 

“If some of these trad­ing sta­ble­coins are, in fact, deriv­a­tives, basi­cal­ly, you’re talk­ing about a cus­tom bas­ket swap, and then it’s the deal­er who has to man­age the risk asso­ci­at­ed with that,” explained Pham.

Ulti­mate­ly, SEC Com­mis­sion­er Peirce says, Con­gress calls the shots on how to move for­ward on cryp­to reg­u­la­tion. While Wall Street’s top reg­u­la­tor is already act­ing using the author­i­ty that it has, Con­gress needs to divvy up enforce­ment responsibilities.

Lum­mis has paired up with Sen. Kirsten Gilli­brand, D‑N.Y., to spell out this divi­sion of reg­u­la­to­ry labor in a pro­posed bill.

“We’re set­ting it on top of the cur­rent reg­u­la­to­ry frame­work for assets, includ­ing the CFTC and the SEC,” Lum­mis told CNBC. “We’re mak­ing sure that the tax­a­tion is cap­i­tal gains and not ordi­nary income. We’ve dealt with some account­ing pro­ce­dures, some def­i­n­i­tions, we’re look­ing at con­sumer pro­tec­tion and privacy.”

The bill also delves into sta­ble­coin reg­u­la­tion. Lum­mis says that the bill con­tem­plates the exis­tence of this spe­cif­ic sub­set of dig­i­tal assets and requires that they either be FDIC-insured or more than 100% backed by hard assets.

Book­er says there is a group in the Sen­ate with “good folks on both sides of the aisle” com­ing togeth­er and part­ner­ing to get it right.

“I want there to be the right reg­u­la­tion,” con­tin­ued Book­er. “I don’t think the SEC is the place to reg­u­late a lot of this indus­try. Clear­ly, ethereum and bit­coin, which are the major­i­ty of the cryp­tocur­ren­cies, are more commodity-like.”

But until Capi­tol Hill push­es a bill into law, Pham says that cryp­to investors need to exer­cise a whole lot more caution.

“If peo­ple start­ed to think about some of these real­ly nov­el cryp­to tokens as frankly, lot­tery tick­ets, when you go and you buy a lot­tery tick­et, you might strike it big, and get rich quick, but you might not,” said Pham.

“I think what I’m wor­ried about is that with­out appro­pri­ate cus­tomer pro­tec­tions in place, and the right dis­clo­sures, that peo­ple are buy­ing some of these cryp­to tokens think­ing that they’re guar­an­teed to strike it rich,” she said.