Cap Hill Crypto

Week of May 13, 2022

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Top Points

  • Stablecoins were under the spotlight at Senate and House committee hearings on the Financial Stability Oversight Council's ("FSOC") 2021 Report following the TerraUSD crash.

  • House Agriculture Committee hosted a hearing on the FTX US proposal before the CFTC to offer crypto derivative products on margin directly to customers, rather than use traditional intermediaries for clearing.

  • The SEC extended the public comment period for a proposed rule that would potentially expand the definition of "exchange" to encompass a broad swath of the de-fi ecosystem.

Stablecoins raised in FSOC hearings before House and Senate following TerraUSD crash.

Setting the stage:

  • In March, President Biden issued an Executive Order on Digital Assets, which, in part, tasks FSOC with writing a report on digital assets and providing recommendations to address potential financial risks, including those stemming from stablecoins. This report is due no later than October 5, 2022.

  • This Monday, TerraUSD ("UST") -- an algorithmic stablecoin that attempts to maintain a peg with the U.S. dollar through arbitrage trading -- was, well, no longer stable, and began trading below $1.

  • As the market lost faith in UST's ability to re-establish the peg, a downward spiral in UST continued.

Against this backdrop, the Senate convened its FSOC hearing at 10am on Tuesday.

Senate Hearing

  • Ranking Member Toomey (R-PA) first raised stablecoins, asking Sec. Yellen to confirm the urgency for Congress to enact comprehensive stablecoin legislation, and whether we could "shoot for a goal of getting legislation done this year."

  • Sec. Yellen agreed, stating such timeline "would be highly appropriate."

  • Sec. Yellen was the first to raise UST specifically, citing it as an example of the risks posed by stablecoins and the need for comprehensive regulation to protect consumers against future "bank run" type incidents.

  • Both Sec. Yellen and Sen. Toomey agreed that distinctions can be drawn between algorithmic stablecoins and those backed by actual assets (e.g. cash or cash equivalents) on a 1-to-1 basis.

Fast forward to Thursday morning...

By 10am Thursday, UST had fallen below a nickel and USDT, an asset-backed stablecoin, "broke the buck," briefly dipping as low as 96 cents. At this point, virtually the entire crypto market had suffered significant losses. Not surprisingly, then, the House hearing had a greater focus on stablecoins and crypto generally.

House Financial Services Hearing

Key Takeaways:

  • There is bipartisan agreement that a comprehensive bill addressing stablecoin regulation is needed.

    • Sec. Yellen and members from both sides often expressed hope for reaching a comprehensive framework for regulating stablecoins.

  • Policymakers seemed to agree that regulations should distinguish between stablecoins backed by secure assets and those backed by algorithms.

    • As Rep. McHenry (R-NC) stated: “Not all stablecoins and not all digital assets are the same. Nor should they be regulated the same.”

    • As in the Senate FSOC hearing, Sec. Yellen agreed that lines can be drawn between stablecoins that are backed 1-to-1 by cash or cash equivalents and those that aren't.

  • There may be a push to limit stablecoin issuers to banks (insured depository institutions), but this is unlikely to succeed.

    • The President's Working Group report on stablecoins, released in November 2021, recommended that Congress require stablecoin issuers to be "insured depository institutions" to protect against risks stemming from "bank run" type incidents.

    • Lawmakers from both sides pushed back against this position, noting that there are fundamental differences between banks and stablecoin issuers.

      • For example, Rep. Ritchie Torres (D-NY) aptly asked: "If a stablecoin issuer has no fractionalization of reserves, and has no lending, it would seem to me that the stablecoin issuer is operating differently from a bank and should be regulated differently from a bank. Is that a fair assessment?"

      • Rep. McHenry (R-NC) also asked: "In your mind, how does [limiting] stablecoin issuances to only banks promote innovation?"

        • According to Sec. Yellen, the benefits would be added regulatory clarity. Moreover, she asserted that banking regulations have historically protected against the risk of bank runs, which are similar to the risks posed by stablecoins.

  • Sec. Yellen confirmed that UST and USDT's recent de-pegging from the dollar is not a threat to systemic financial stability given the cryptos' relatively small market size. The Secretary declined to provide a dollar figure for a market size threshold that could potentially trigger systemic wide concerns.

  • Rep. Stephen Lynch (D-MA) brought up the potential for a U.S. Central Bank Digital Currency ("CBDC").

    • Specifically, Rep. Stephen Lynch (D-MA) suggested, and Sec. Yellen agreed, that one benefit of a CBDC would be to limit "the proliferation of private stablecoins" and the risks they might pose.

So what's next?

  • Prior to the UST drama this week, the general consensus in Washington, D.C. was that if any crypto package passed this year, it would most likely be a bill addressing stablecoins.

  • UST's de-peg, and the associated crypto market dip, placed stablecoins center stage in the crypto regulation debate.

  • On the one hand, this may lead to calls for increased consumer protection -- driving the Administration and members of Congress previously skeptical of crypto towards more extreme positions (e.g. limiting stablecoins issuers to banks and/or the federal reserve via a CBDC).

  • On the other hand, members may unite around a bipartisan proposal to address the issue while it is at the forefront of the crypto policy debate.

  • If nothing else, the UST debacle has accelerated members' research into understanding stablecoins. For example, compared to just last week, there are likely more members in Congress who can now distinguish between asset backed stablecoins and algorithmic based stablecoins.

Current Stablecoin Proposals

You can find a chart comparing draft stablecoin legislative proposals here.

As you'll see, despite variances in the details, there is broad agreement that any bill should provide clear disclosure and capital reserve requirements for stablecoin issuers. None of the proposals suggest limiting stablecoin issuance exclusively to insured depository institutions.

House Agriculture Committee hosted a hearing on an FTX proposal before the CFTC to offer margined crypto derivative products directly to consumers, rather than use the traditional intermediaries to clear trades.

  • Witnesses included:

    • Terrence A. Duffy, CEO, CME Group

    • Sam Bankman-Fried, CEO, FTX US Derivatives

    • Walt Lukken, CEO, Futures Industry Association

    • Christopher Edmonds, Chief Development Officer, Intercontinental Exchange ("ICE")

    • Christopher Perkins, President, CoinFund Management LLC

Key Takeaway:

Overall, lawmakers presented a balanced tone, noting the importance of protecting the public from financial risk, especially given crypto's volatility, while also supporting innovation. Both sides tipped their hat to the CFTC for carefully considering the proposal and weighing the input from Congress, stakeholders, and the public.

Arguments for the Proposal:

Sam Bankman-Fried defended the FTX proposal, arguing approval would afford retail customers greater choice and lower costs by increasing competition in an industry where volume is currently dominated by just two exchanges. Moreover, he asserted, the proposed structure would mitigate risks by requiring traders to pre-fund their collateral and adjust collateral requirements in real time, 24/7/365. Further, SBF argued, the proposal would bring economic growth to the U.S, as most crypto derivative trading is currently done offshore.

Arguments Against:

CME and ICE warned against the untested nature of the proposal, with the CME Group Chairman and CEO describing the risks associated with it as "catastrophic." Granting the proposal, they argued, would add volatility and uncertainty to an industry already ripe with risk. In particular, they warned against an auto-liquidation provision in the proposal that could potentially result in sudden and massive customer losses for retail customers.

Opponents of the proposal repeatedly raised concerns that FTX would ultimately expand their model beyond crypto, further spreading risk and disrupting the industry, though FTX denied having any intention of doing so.

The public comment period for the proposal ended on May 11.

​On May 25, the CFTC will host a roundtable from 9:30AM to 4:00PM to discuss the proposal further. The roundtable will include industry representatives, futures commission merchants, academics, traders, public interest groups, and others.

SEC extended the public comment period for a proposed rule that would expand the definition of "exchange."

  • The SEC's proposed expansion of the definition of "exchange" drew fire from the crypto industry and certain members of Congress because, they argued, the proposed rule failed to adequately define the scope of the new definition and arguably exceeded the SEC's statutory authority under the Securities Exchange Act of 1934.

  • The public comment period will be reopened for 30 days following publication of the release in the Federal Register.

  • Here is the SEC press release.

Look Ahead

On Wednesday, May 18, SEC Chairman Gary Gensler will testify before the House Appropriations Committee.

Worth the Read

So what happened with UST exactly? Here is the best play-by-play I could find.

Trivia

Back by popular demand...

Q: Who is the only Chairman of the SEC to also serve as a Supreme Court Justice?

Thank you for reading, and please enjoy your weekend.

Sincerely,

GSL