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$5 Million in MakerDAO Loans Have Been Liquidated, But Help Is on the Way

There’s always a risk in taking out a loan, even more so when you make that loan on a blockchain.

That fact is perhaps no better understood than by those building the programmatic lending platform MakerDAO, which, having created the first widely used U.S.-dollar stablecoin on ethereum, the DAI token, is responsible for one of the most groundbreaking decentralized finance applications to date.

“The success of Maker and DAI is not only a testament to the innovation happening within the ethereum community, but also to the flexibility and utility of the ethereum platform itself,” said Brian Mosoff, CEO of Ether Capital, who announced an investment of $1 million in MakerDAO tokens two weeks ago.

Indeed, it’s widely agreed DAI is becoming a needed source of financial predictability and liquidity in the ethereum economy.

“It’s much simpler to hold a stablecoin. It makes the budgeting totally predictable,” explains Lane Rettig, independent core developer and volunteer project manager of ethereum.

But unlike most other dollar-backed stablecoins of its kind, the value of DAI doesn’t actually come from the creators of MakerDAO, but rather users that leverage a feature called a “Collateralized Debt Position” (CDP).

Users that want to generate new DAI take out a loan by using their own ether as collateral. What’s more, for the entire duration this amount of DAI is in circulation, it’s up to the users – not MakerDAO – to ensure they have sufficient reserves to back its value until the DAI is returned and an accrued fee (currently 7.5 percent) is paid. Only then is the ether held in a CDP released back to a user.

It goes without saying that this comes with a considerable amount of risk to the user borrowing DAI, given that sudden drops in ether price may devalue collateral held within a CDP.

Should the value of any contract fall below the minimum collateralization ratio of 1.5 ETH to DAI, the MakerDAO system will forcibly liquidate a user’s CDP and sell all staked ether automatically at a 3 percent discount to cover outstanding DAI debt – all this on top of a 13 percent liquidation penalty.

To date, software engineer for ethereum research and development startup Decenter Nenad Palinkasevic tells CoinDesk roughly 37,000 ETH – over $5 million –  has been lost due to this liquidation penalty fee. In addition, Palinkasevic highlights that out of the 16,249 CDPs that have been created by users in total, roughly 14 percent or 2,278 CDP smart contracts have ended up forcibly liquidated to date.

An unfavorable outcome for users, there are a number of third-party applications currently being tested to take the risk out of CDP risk management. One of these applications live on ethereum test network Kovan and markets itself as the “complete, one-stop solution for CDP management” on Reddit.

Enter CDP Saver

Engineered by Decenter, CDP Saver is a web application envisioned to prevent CDPs from liquidation – automatically.

At present, users must keep a careful eye on the value of their ETH collateral being stored within a CDP. If the user thinks that their CDP will fall below the minimum collateralization ratio, they can either lock up more collateral to boost up the ratio or simply close the CDP and pay back the full amount of their loan in DAI.

CDP Saver dashboard. Image courtesy of Decenter.

But there’s also a third way to save CDPs from liquidation, as explained by Palinkasevic. Rather than wiping the entirety of their debt, users can partially “unwind” their CDP through the CDP Saver.

The first step to unwinding a CDP is drawing an available surplus of ETH collateral and swapping it on a cryptocurrency exchange for DAI. Then, the newly converted DAI is used to repay a portion of owed CDP debt and thereby increase the collateralization ratio.

This whole process of unwinding, Palinkasevic explains, can be done in a single transaction. On the CDP Saver, this feature is called “Repay.” Palinkasevic tells CoinDesk:

“The Repay function works great because of two facts. CDPs are always overcollateralized and paying back debt increases your [collateralization] ratio more than locking up ether would.”

The CDP Saver also alternatively features a function called “Boost” to perform the exact reverse of repaying CDP debt. Using Boost, users would be able to initiate conversions of DAI into ETH and decrease their relative collateralization ratio.

At present, currency conversion on CDP Saver is carried out through a decentralized cryptocurrency exchange platform called Kyber Network. And while Palinkasevic insists a first version release of the application on ethereum mainnet is coming “soon,” he also admits that the first release of the platform will only allow users to Repay and Boost their CDPs manually.

“In the second iteration of CDP Saver, we will releasee the automatic CDP saving feature,” said Palinkasevic. In this iteration, Palinkasevic notes:

“A user will authorize a [smart] contract to be able to do the Repay. The contract is predefined and audited to only be able to do a Repay if conditions are met. Then, bots will monitor the CDPs and their ratios and will trigger the transaction for Repay.”

Once a repay is triggered, users will be required to pay a small fee for leveraging the CDP Saver tool. Details about the exact fee amount is yet to be determined, according to Palinkasevic.

An emerging toolkit

To date, over 80 million DAI tokens have been liquidated, with one infamous CDP smart contract – CDP 3228 – being liquidated back in November 2018 for nearly 7 million DAI. At the time, this accounted for approximately 10 percent of the total DAI supply, according to MakerDAO community lead David Utrobin on Reddit.

Even so, new CDP contracts are being opened every day. Thus far, in 2019, over 6,000 new CDPs have been opened. To a growing user base of DAI holders, CDP management tools like the CDP Saver are just one of a myriad of third-party applications being built and released.

As highlighted by MakerDAO core community lead David Utrobin on a weekly community call, a new application called Keydonix has recently launched. It enables “one-button” closes of CDPs such that users who “are close to being liquidated” are able to pay back DAI debt more quickly.

Another application called InstaDApp is aimed at building a decentralized bank on top of the MakerDAO lending protocol. Co-founder of the platform Samyak Jain tells CoinDesk:

“Our main goal is to reduce complexity for the user on a smart contract and user interface, user experience level … For InstaDApp, we have our own smart contracts where we have reduced the complexity of the MakerDAO protocol for the user.”

InstaDApp currently hosts a webpage called MakerScan where users can track CDPs, receive automated alerts about their activity, bolster collateral to CDPs by donating ETH, among other functions. Jain adds that InstaDApp is also working to develop more complex alerting mechanisms similar to the ones being tested by CDP Saver.

“We are currently working on more complex alerts. So in the future, we’ll also provide whenever the [collateralization] ratio is above this then give the alert to deposit more ETH or pay some more DAI,” highlighted Jain.

A third application called the CDP Liquidator was initially created as a hackathon project. Similar in aim to Keydonix, one of the developers behind the CDP Liquidator David Terry explained the CDP Liquidator tool has “never been launched on mainnet” and still requires “significant work in polishing and auditing.”

But noting the fast development of other projects in the space,  Terry tells CoinDesk:

“I am very happy to see others building this kind of tooling and hope to see even more similar services merging.”

Ethereum workers via Shutterstock

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‘Facebook Coin’ Could Generate Billions in Revenue: Barclays Analyst

Facebook’s reported stablecoin project could be a significant moneymaker for the social media giant, according to Barclays analyst Ross Sandler.

In a note to investors first reported by CNBC and later obtained by CoinDesk, Sandler says Facebook’s cryptocurrency efforts could yield anywhere from $3 billion to $19 billion in additional revenue by 2021. To put that estimate in context, the Menlo Park, California, company brought in $40.6 billion in total revenue in 2017, with $39.9 billion from advertising.

However, the analysis hinges on whether “Facebook Coin proves successful in reinvigorating FB’s micro-payment strategy for digital content distribution,” Sandler wrote.

Sandler also sees two primary challenges for Facebook achieving its crypto goals: “demonstrating a value prop for users above what is available today in payments” and overcoming consumers’ “trust issues after 2018’s problems.”

In an apparent bid to account for said trust issues, CEO Mark Zuckerberg issued a lengthy post last week calling for Facebook to become more privacy-oriented in the years ahead. While “cryptocurrency” isn’t mentioned, payments and encryption are frequently invoked.

Face from the past

Sandler of Barclays noted that much remains unclear about Facebook’s crypto project. However, there is a precedent for virtual currency on the social media site: Facebook Credits.

“Facebook coin may simply be [looking] to process micro-transactions and re-invigorate the original business model that was in place in 2010-2012 under Facebook Credits,” Sandler wrote. “However, the scope of the project could be much larger, especially considering David Marcus (former CEO of PayPal) is heading up the project.”

Indeed, Facebook has been on a hiring spree on the cryptocurrency front in recent months, with a hiring push and at least one startup acqui-hire.

Underscoring the breadth of the recruitment program, Facebook’s careers website now lists 20 job openings related to the technology.

Facebook image via Shutterstock

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JP Morgan’s Stablecoin: A Feat of Engineering or Marketing?

Ben Jessel is head of enterprise blockchain at Kadena, a next-generation blockchain company offering both public and private blockchain solutions. 

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The world of blockchain and banking was set alight last month by the announcement that JP Morgan has created its own stablecoin. It was a rare move that has simultaneously excited the banking and enterprise blockchain community as well those in the cryptocurrency world. But is this excitement justified?

The story, as with most blockchain developments, isn’t so clear-cut. It has certainly been the case lately that when JP Morgan innovates (especially around blockchain) the market listens with interest.

In the last few weeks, blockchain innovation managers’ phones across Wall Street investment banks have been ringing with executives inquiring about JP Morgan’s stablecoin and how they should be responding.

Banking is where blockchain began, and over several years has started to gain adoption, albeit at a far slower pace than industry observers were expecting. Many institutions have committed to being “fast followers,” leaving a handful of institutions to be the first to embrace the cutting-edge technology – and its expensive mistakes. When a purported technological breakthrough occurs – as JP Morgan’s announcement suggests, those on the sidelines start to question whether now is the time to jump in and be first in the fast-follower line.

Upon first examination, the JPM coin development is exciting; it signals a major Wall Street organization – one whose CEO had expressed open skepticism to cryptocurrencies – beginning to blur the lines between institutional banking and the brave new world of cryptocurrency.

However, the reality is more complicated.

What JP Morgan has achieved is more a feat of marketing than one of technological innovation. To see why, we need to understand the primary objective and the benefit of a stablecoin.

What, how and why?

JP Morgan’s stablecoin seeks to solve two problems in financial markets today: the expensive and inefficient process of settlement and the volatility involved in holding money in cryptocurrency.

Settlement is the process of paying crediting and debiting bank accounts between financial institutions in exchange for the transferring of a security, such a stock, bond or derivative. With over $1.6 quadrillion being settled by the DTCC a year, settlement is a major aspect of financial markets.

And settlement for banks today is an expensive business for many reasons.

For one, payments are rarely made in real-time, which means that in many cases funds that should be paid are not actually made available until the end of the day. In some cases, money isn’t available until days later. When billions of dollars are tied up and cannot be put to good use, it ends up being an expensive and wasteful liquidity trap. For instance, syndicated commercial loans can take an average of seven days to settle.

This settlement challenge becomes compounded when considering global banks with complex operations.

A large multinational bank may simultaneously be in credit to a counterparty one in country, and in debt for the same amount to the same counterparty in another. Because banking operations are so broad and complex, these banks often are not able to “net out” their position – they will hold collateral to pay for a debt or exposure. So, not only are banks holding on to debts and not receiving credits for a day and sometimes multiple days, they also may be holding onto collateral for debts that they do not realize they do not actually have.

Furthermore, maintaining pockets of liquidity across different countries in anticipation of the need for settlement (or “float”) can be costly too as often this money sits idly by in reserve.

Banks adopting the casino model

Blockchain offers the opportunity to reduce settlement time and costs, and enable institutions to be able to settle instantaneously as opposed to at the end of each day (or longer in the case of equities) by settling in digital cash rather than crediting and debiting each other’s accounts at the end of the day.

This digital cash is often referred to as a “settlement coin.” A good analogy is to consider the use of gambling chips at a casino in Las Vegas.

On the strip, the major casinos have an agreement to honor the chips of all other’s chips – enabling someone to exchange $100 into chips at the Bellagio, use them to play roulette at the Venetian, and then cash out at the MGM Grand. In the case of financial institutions, the chip is a digital cash in the form of a “settlement coin.”

Instead of paying at the end of the day by crediting and debiting an actual account, a balance is held in these digital tokens, with each trade that occurs simultaneously leading to the trading of these chips. At any point, each bank can “cash in” these settlement tokens on a one for one basis for actual cash.

The benefits include reducing settlement complexity, speeding up settlement time and providing the ability to better manage “intra-day” liquidity, which means they can put their assets to work in a more efficient way and make them more money.

One such initiative is the Utility Settlement Coin, which is a UBS backed innovation that projects annual industry savings of $65 and $80 million.

The scourge of digital money

One of the challenges facing digital money concerns volatility: the rate that digital money can be exchanged for can fluctuate significantly due to aspects like demand and “market events.”

Bitcoin has been significantly volatile, having run up from $2,000 to over $19,000 before crashing down to $3,000 all within the space of the year. This makes holding money in digital cash a risky proposition and not something that banks would have the appetite to do.

This has resulted in the innovation of the stablecoin, which is a mechanism whereby digital cash can be “pegged” to the value of an asset, which is always redeemable at a fixed price. For example, a US dollar pegged stablecoin will always be redeemable for one USD.

However, stablecoins also have issues. A stablecoin can only be pegged if there are sufficient assets and reserves behind it.

In the same way that George Soros famously broke the bank of England, with enough financial firepower, it is possible to break the peg of a stablecoin. Also, stablecoins have been in tarnished with scandal, most recently with a project called Tether which may not have had the financial reserves that it claimed to have.

Putting the pieces together

JP Morgan’s stablecoin neatly connects the dots between the aspects of settlement and volatility management by providing digital cash that can be used and enabling the ability to redeem the coin at a stable rate.

While this may sound like a significant achievement, all JP Morgan’s stablecoin actually provides is the ability for a counterparty to be paid by JP Morgan in exchange to being provided a digital certificate.

It is actually the anathema to the idea of creating an ecosystem whereby all participants can utilize a universally accepted and redeemable digital cash. Instead, it is a mechanism where JP Morgan will redeem a token, that it issues on its platform only. This is akin to only being able to buy, gamble and cash in your gambling chips at the Venetian casino.

And far from being a technology innovation, this is something that at its most fundamental is old technology masquerading as a new innovation. At its most fundamental, JP Morgan is promising to credit the account of a user when presented with a digital certificate that has a redemption value of a dollar.

The ability to digitally invoke the payment mechanisms of a bank has existed for some time – it is called an API, where an API (or Application Programmable Interface) is merely a way of digitally interacting with an online service such as a payment processing interface of a bank.

But that doesn’t mean JP Morgan’s innovation should be dismissed. Any innovation in the blockchain for financial services – a world of anachronistic business processes and notoriously old technology, where a fax machine still is considered a vital part of how business is done today – should be cautiously applauded.

So, keep up the good work JP Morgan. The industry is rooting for you.

JP Morgan image via Shutterstock

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MakerDAO Opens Token Holder Vote on Fee Hike for Ethereum Stablecoin

The open-source developer group behind the dollar-pegged, ethereum-backed stablecoin DAI is considering whether higher fees could help stave off mounting liquidity issues.

During the weekly developer call on Feb. 28, some token holders, including MakerDAO founder Rune Christensen, voiced concerns about whether the peg, the mechanism by which the cryptocurrency holds a stable value, can continue under the present design constraints.

Christensen said last Thursday that the DAI’s dollar-peg is “almost at a breaking point” as a lack of organic demand threatens to start a “dangerous feedback loop” driven by “a speculative drop in the price.” He then called for a community poll to guide stakeholder votes about increasing fees and raising the stablecoin system’s debt ceiling.

Launched Monday, people who hold MKR governance tokens are now able to vote on whether to raise the “Dai Stability Fee” from 1.5 percent to 3.5 percent. According to CoinMarketCap, the stablecoin has fluctuated between $0.98 and $1.02 across global markets so far in 2019. On Coinbase Pro and Bitfinex in particular, the range has consistently hovered around $0.98 since January.

“We were giving out a good deal but unfortunately, we’ve got to lock that back a little bit until we find the right level of stability fees,” MakerDAO risk management lead Cyrus Younessi said Tuesday during a public call.

Back in February, MKR holders voted to increase the fee twice by 0.5 percent. However, an official Reddit post published Monday warns that “the impact of this combined 1 percent increase was negligible” and further states:

“Accordingly, the Internal Risk Team suggests that the incremental step size for this and future proposals be increased by 2 percent until the trend in the peg has been corrected.”

The impact of these fee increases could have far-reaching effects on several applications already leveraging the popular stablecoin for in-house operations.

For example, Gitcoin bounties are frequently denominated and paid out in DAI coins, and entire payment channel platforms – such as the Connext Network that will soon see a mainnet launch on ethereum – leverage DAI as their primary transaction medium.

DAI CDPs

At present, there are currently over 2 million ether tokens locked in MakerDAO smart contracts, accounting for roughly 2 percent of the total ether supply.

Still, most DAI adoption at the moment is taking the form of a “collateralized debt position,” meaning the user locks three times the amount of ether in a smart contract that they want to withdraw in the dollar-pegged DAI. Then, DAI holders generally liquidate the DAI on external exchanges to pay fiat bills.

The growing popularity of such loans could be a contributing factor to the destabilization of the broader network. In short, it appears organic demand for DAI itself isn’t growing as quickly as demand for loans that have essentially become a fiat off-ramp.

Based on MakerDAO’s data, the gap between DAI holders who sold out their positions and those that return to purchase DAI later that same month (presumably to pay off loans), is widening in 2019.

DAI supply. (Graphic via MakerDAO)

To be fair, MakerDAO contributors and employees are working to increase demand for the stablecoin beyond the ethereum ecosystem.

Nadia Alvarez, MakerDAO’s business development associate for Latin America, told CoinDesk that crypto-financial service companies now use DAI for backend value transfers. For example, the bitcoin exchange BuenBit and the fiat currency exchange BuenGiro both use DAI for value transfers behind the scenes.

Meanwhile, according to MakerDAO’s own statistics, the majority of new DAI holders spend the stablecoin loot within the first hour of acquiring it, presumably to liquidate the asset.

Plus, the ether collateral in any DAI CDP is automatically liquidated if the ETH price drops below 150 percent, compared to the original 300 percent collateralized. Users are not guaranteed they will get all of their collateral back. Therein lies the contradiction of DAI CDPs.

DAI user habits. (Graphic via MakerDAO)

Transparency questions

So far, it’s unclear who is in charge of feeding the price-tracking data into the smart contract.

There are several players in this ecosystem, including the DAI-centric project MakerDAO and the nonprofit MKR Foundation, with a secondary MKR token that grants holders the ability to vote on DAI governance issues.

A MakerDAO spokesperson said the year-old CDP smart contract was written by “Maker developers,” including the project’s “head of Oracles,” Mariano Conti, and has also been used by companies such as Compound Finance and Gnosis.

Without specifying any person or company by name, “for security reasons,” the spokesperson explained that a “decentralized network of Maker employees, community members and people from other projects” queries roughly 14 sources, aggregates their price data and calculates the overall median price of ether.

The spokesperson added that people who hold MKR tokens are the only ones with the power to vote to add or remove data sources. This becomes a crucial focal point as DAI holders grapple with conflicting opinions on whether to increase the DAI treasury’s debt ceiling.

Talk of “liquidating the [ether] collateral” if the broader market drops is a real prospect discussed during public governance meetings, although during the Feb. 28 call Christensen emphasized this consideration is only hypothetical at the moment and the team aims to prevent that type of worst-case scenario.

And, according to a study by the venture capital firm Placeholder, less than 10 percent of MKR token holders participated in the previous vote to raise stability fees to 2 percent.

Stakeholders

In order for this stablecoin to survive, it will require a diverse ecosystem of stakeholders. For now, DAI governance is managed by investors who hold the foundation’s MKR tokens, of which 6 percent is owned by Andreessen Horowitz’s a16z fund.

According to Etherscan, the top three MKR holders own a combined 55 percent of the tokens, with the top holder alone controlling 27 percent. A spokesperson for crypto hedge fund Polychain Capital confirmed it owns a “significant portion” of MKR tokens.

Likewise, 1confirmation co-founder Nick Tomanio confirmed his hedge fund is also a significant holder of MKR tokens, adding:

“MakerDAO is slowly turning [bitcoin] maximalists into cryptocurrency realists and is undeniably one of the most exciting projects in the ecosystem right now in terms of both ambition and real-world usage.”

As for the rest of the top 10 holders, their names are not publicly listed. Spokespeople for both ethereum co-founder Joseph Lubin, who owns the ConsenSys conglomerate that incubates MetaMask and GitCoin, and the Ethereum Foundation declined to comment on whether they own significant portions of MKR. Regardless of whether ConsenSys owns MKR, it is undoubtedly a key player pushing for broader retail adoption.

Austin Griffith, director of research at Gitcoin, developed the xDai burner wallet to help users join the system without generating private keys. According to Griffith, simplifying access to that first transaction and denominating value in dollars could make crypto more approachable for people who aren’t already familiar with tokens.

“We’re finally ready to make some of these tradeoffs,” Griffith said, “not having to think about .0001 ETH when you can just say you have one DAI and DAI is pegged to a dollar.”

Transparency and liability

The Maker Foundation, run by MKR token holders, funds the MakerDAO project, which is responsible for maintaining the price-monitoring system that’s referred to as an Oracle.

According to MakerDAO COO Steven Becker, by 2020, DAI users will be able to take dollar-pegged loans leveraging diverse tokens, such as those formerly used by ethereum projects in token sales and invested in heavily by companies like Polychain Capital.

In the meantime, Stephen Palley, a partner at the Washington, D.C.-based law firm Anderson Kill, told CoinDesk the lack of transparency around the DAI ecosystem and its Oracle could leave room for liability.

“They are paradoxically creating something that is supposed to transparent, but basing it on something that they apparently won’t explain,” Palley said. “What assurance is there that liquidations are based on rational, objective, reasonable analysis? I suspect – though I don’t know – that there is an Oz behind the word Oracle. I’d be curious to know who sits behind that curtain.”

The plan for the revamped Oracle system has DAI users like Richard Burton, CEO of crypto wallet company Balance, feeling bullish. Burton took out a CDP to pay salaries at his startup. Likewise, former SpankChain employee Chelsea Palmer, who was laid off when ether prices tanked, tweeted that she plans to put her remaining ether into DAI CDPs to pay her fiat bills.

Regarding the growing use of CDP loans, Burton told CoinDesk:

“The reason Maker has gotten people so excited, including myself, is it’s finally started to deliver to people something meaningful and tangible.”

Christine Kim contributed reporting.

MakerDAO image via ETHDenver YouTube

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Will Fiat-Backed Stablecoins Pass Legal Muster With the SEC and CFTC?

Benjamin Sauter and Jake Chervinsky of Kobre & Kim LLP are litigators and government enforcement defense attorneys who specialize in disputes and investigations related to digital assets. This article is not intended to provide legal advice.

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As we enter the second year of this so-called “crypto winter,” the stablecoin market is hotter than ever.

In recent months, stablecoins – digital assets pegged to the value of fiat currencies like the U.S. dollar – have exploded in size and variety thanks to high-profile offerings from companies like Circle, Paxos and Gemini. Even traditional banks are joining the action, with JP Morgan recently announcing its own stablecoin-like product called JPM Coin.

Thus far, stablecoins have largely avoided public scrutiny and criticism from agencies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), which have focused their attention on the many issues arising out of the 2017 initial coin offering bubble instead. Yet, as stablecoins see greater capital inflows and industry adoption, the SEC and CFTC will likely take a harder look at their compliance status.

Unfortunately for stablecoin proponents, agencies like the SEC and CFTC are often quick to assert their jurisdiction over new financial innovations, even if their intervention may not serve the best interests of an emerging industry.

Stablecoins 101

Stablecoins promise many of the same benefits as other cryptocurrencies – like cheap transactions and rapid settlement – without the price volatility typically found in the crypto markets. Through that combination, stablecoins could satisfy the demand for high-quality fiat currencies in parts of the world with limited access to the global financial system, like Iran or Venezuela.

Stablecoins also could be useful for crypto exchanges that want to offer fiat-based trading pairs while reducing their engagement with legacy financial institutions.

To maintain their one-to-one peg with fiat currencies, most stablecoins use either a fiat-collateralized, crypto-collateralized, or algorithmic model. Fiat-collateralized stablecoins are backed by actual fiat currencies held in reserve by the stablecoins’ issuers, whereas crypto-collateralized stablecoins are backed by digital assets locked in smart contracts.

Algorithmic stablecoins, by contrast, aren’t backed by collateral at all. Instead, they use various mechanisms to expand or contract their circulating supply as necessary to maintain a stable value.

It was this type of stablecoin that apparently caught the SEC’s attention last year.

A basis for concern

In April 2018, an algorithmic stablecoin project called Basis made headlines when it raised $133 million from several prominent funds and venture firms. But, only eight months later, Basis shut down unexpectedly and returned its remaining capital to investors. The reason for the shuttering, according to Basis CEO Nader Al-Naji: “We met with the SEC to clarify a lot of our thinking [and] got the impression that we would not be able to avoid securities classification.”

It’s not hard to see why the SEC might view Basis through the lens of a securities offering.

The Basis protocol was designed to maintain stability by auctioning “bond” and “share” tokens to investors who would profit as long as Basis held its peg. Tokens like these could qualify as “investment contracts” under U.S. law, and thus may fall within the definition of a security. Apparently, the Basis team decided that the regulatory requirements imposed by that classification were too onerous to overcome.

Despite Basis’ startling end, there hasn’t been much discussion in the crypto industry about how U.S. securities and commodities laws might apply to stablecoins.

In fact, most industry players seem to take for granted that fiat-collateralized stablecoins are safe from regulatory scrutiny. That assumption may prove dangerous.

Stablecoin regulation under federal law

Most dollar-backed stablecoins are created in roughly the same way: purchasers deposit dollars with a stablecoin issuer, and in exchange, the issuer mints and returns an equivalent amount of the stablecoin. The process also works in reverse: stablecoin-holders can send a stablecoin back to its issuer in exchange for an equivalent amount of dollars.

Given how these stablecoins are redeemed, the SEC might characterize them as “demand notes,” which are traditionally defined as two-party negotiable instruments obligating a debtor to pay the noteholder at any time upon request.

According to the Supreme Court’s 1990 decision in Reves v. Ernst & Young, demand notes are presumed to be securities under Exchange Act Section 3(a)(10) unless an exception or exclusion applies.

For its part, the CFTC might take the position that stablecoins are “swaps” under Commodity Exchange Act Section 1(a)(47)(A). That provision defines swap to include an “option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, or other financial or economic interests or property of any kind.”

Under that definition, the CFTC might characterize stablecoins as options for the purchase of, or based on the value of, fiat currencies.

Of course, individuals and companies dealing with stablecoins will have good arguments as to why the “demand note” and “swap” classifications shouldn’t apply. For example, issuers could invoke the Reves court’s “family resemblance” test for demand notes, or challenge the CFTC’s jurisdiction over retail foreign currency options, depending on the circumstances. The regulators, however, may take a different view.

What could this mean for stablecoins?

If stablecoins are classified as regulated securities or swaps, there could be serious consequences for a large segment of the crypto industry. For example, stablecoin issuers might have to register their offerings and comply with all the ensuing regulatory requirements. Similarly, a company or fund that conducts or facilitates stablecoin transactions might have to register as a broker-dealer.

Plus, the SEC and CFTC aren’t the only regulators that may take an interest in stablecoins.

Only time will tell how other state and federal entities, such as the New York Department of Financial Services (NYDFS) or the Financial Crimes Enforcement Network (FinCEN), will approach the regulation of stablecoins, particularly if they’re used to evade trade sanctions or other transaction reporting obligations.

For now, it’s clear that anyone who issues or uses stablecoins should give considerable thought to their potential risk under U.S. securities and commodities laws.

U.S. Capitol building image via Shutterstock