By Sanjay Ragavan, Head of Structured Securities & co-lead Blockchain Initiatives at Roofstock
The Lummis-Gillibrand Responsible Financial Innovation Act (RFIA) announced on June 7, 2022, by Senators Cynthia Lummis (R-WY) and Kristin Gillibrand (D-NY) would become the first comprehensive legislation to cover regulation, taxation and consumer protection of cryptocurrency, digital assets and blockchain technology. Key aspects of the legislation include clarification of what types of digital assets are treated as commodities vs. securities and the specific requirements for collateralization and for reporting transparency of fiat backed stable coins.
In this article, we will discuss the impact of this legislation on fiat backed stablecoins and those that are either collateralized with other assets, or not collateralized. We will also discuss the impact to current and future stakeholders in the web3/crypto space at large.
Proposed Stablecoin regulation in the Responsible Financial Innovation Act (RFIA)
Let’s start by examining what the RFIA legislation entails. First, the RFIA classifies payment stablecoins (fiat backed stablecoins) differently than other forms of “virtual currencies”. Payment stablecoins are defined as digital assets that are:
- Redeemable, on demand, on a one-to-one basis for instruments denominated in United States dollars or a legal tender under the laws of a foreign country
- Issued by a business entity
- Accompanied by a statement from the issuer that the asset is redeemable from the issuer, or another identified person
- Backed by one or more financial assets (excluding other digital assets) and intended to be used as a medium of exchange.
Legislators are more concerned about price stability, transparency, and consumer protection than decentralization or capital efficiency. They are not trying to stymie innovation by restricting issuers to only banks or trusts, though it is likely that banks and credit unions will enter this space to continue staying relevant in an increasingly digitized world of payment rails.
Senators Lummis and Gillibrand also acknowledge the existence of other “virtual currencies” that are trying to maintain a soft peg to a fiat currency, whether through overcollateralization, under collateralization or not collateralization at all. Because of the soft peg, these virtual currencies, even if they are intended to act like stablecoins, will not receive the “payment stablecoin” designation.
Title VI (Responsible Payments Innovation) covers payment stablecoins in detail. Section 601 requires all issuers of payment stablecoins to:
- Maintain high-quality liquid assets valued at 100% of the face value of all outstanding payment stablecoins;
- Provide public disclosures on the assets backing the stablecoin and their value; and
- Have the ability to redeem all outstanding payment stablecoin at par in legal tender.
- Also establishes a detailed, optional process for depository institutions (banks/credit unions) to issue a payment stablecoin.
Sec. 606 (Implementation Rules Relating to Payment Stablecoins) also ensures that existing stablecoin issuers and new entrants into the market have an adequate opportunity to compete with existing banks and credit unions for the issuance of payment stablecoins.
The NY Department of Financial Services (DFS) recently released its industry guidance on US Dollar denominated stablecoins (these would be payment stablecoins in the RFIA legislation). Their key focus areas are:
- Redeemability: 1:1 exchange, net of any ordinary well-disclosed fees; maximum T+2 settlement after receiving the settlement order (unless determined as extraordinary circumstance by the DFS)
- Ensuring reserves are backing the stablecoins: must be fully backed and the market value of the Reserve must be at least equal to the nominal value of all outstanding units of the stablecoin as of the end of each business day; can only comprise of short-term T-Bills, reverse repo agreements collateralized by US Treasuries, money market funds, and deposit accounts at federal or state charter depository institutions
- Attestations concerning the reserves: Examined, at least monthly AICPA audit by an independent CPA.
If the RFIA legislation is passed into law, we may likely see further evolution of centralized payment stablecoins with highly liquid US Dollar based collateral held in accounts at banks and other depository institutions. It is also likely that large issuers operating in this space will eventually start offering integrated corporate transaction and treasury management services to coincide with the mass adoption of such stablecoins.
While Circle is largely known for USDC, it plans to expand further outward into other assets. In a conference call between Concord Acquisition Corp and Circle, Jeremy Fox-Geen, CFO of Circle, describes their Transaction and Treasury Services (TTS) product as “a direct analog to the corporate and transaction banking businesses that sits at the heart of every major financial institution offering banking services to business customers.” In their latest investor presentation, Circle projects that its revenue from USDC (interest income on reserves) for 2022 is estimated at $111MM growing to $196MM in 2023, while revenues from TTS are estimated to be $257MM in 2022, growing to $622MM in 2023.
Currently, Circle is integrated with crypto forward banks like Silvergate Bank and Signature Bank to facilitate faster settlement between fiat and USDC. Looking ahead, Circle is also hoping to receive its own bank charter license in the near future, a move that will allow it to further integrate banking services with its TTS product line.
As USDC continues to gain further adoption, stablecoins like Tether (USDT) that are mostly backed by fiat, but also have smaller allocations to a larger basket of collateral (corporate bonds, funds, precious metals, secured loans, and other assets like digital tokens), will likely be treated as virtual currency and not a payment stablecoin under the RFIA.
As discussed earlier, decentralized crypto backed stablecoins like DAI have capital efficiency issues. Maker core protocol engineer @Hexonaut recently presented a proposal on the Maker Forum titled “Aggressive Growth Strategy.” He argues that with the bull market cooling off, they are seeing an increasing demand for DAI which requires the onboarding of more non-interest bearing USDC to maintain its peg. With this, he goes on to make the argument that Maker will need to start integrating real world assets (RWA) and other innovative loan products to continue scaling DAI. Under the RFIA framework, DAI would also be considered virtual currency and not a payment stablecoin.
Several algorithmic stablecoins have lost their peg and failed over the years. Prime examples include Basis Cash (BAC), Empty Set Dollar and Iron Finance. While Terra’s failure is fresh on our minds, it was not the first, nor will it be the last. However, given the recent failure of Terra, purely algorithmic stablecoins will likely not be successful at the same scale that it reached at its height. All in all, it truly remains to be seen what happens to fractional algorithmic stablecoins.
Impact on the web3 ecosystem
- Corporate clients: Whereas web3 native projects may charge for products and services in various cryptocurrencies, corporate clients entering the web3 ecosystem will likely favor a stablecoin that better satisfies transparency, reserve and redeemability requirements – in other words, a payment stablecoin. Issuers like Circle are poised to take full advantage of this phenomenon, as their financial projections suggest.
- If Maker DAO decides to provide low cost of capital against overcollateralized RWA assets, it is likely we will see continued growth in the market capitalization of DAI. Rather than deal with numerous counterparties, if Maker were to go this route, it is likely that they will become lending pool capital providers with protocols like Maple or TrueFi.
- There is a strong case to be made that retail clients (including developers and creators) will continue using a combination of payment stablecoins and virtual currencies based on specific use cases.
How should asset backed Stablecoins operate in the current legislative and regulatory climate?
The RFIA has specifically defined fully fiat backed stablecoins as payment stablecoins while leaving everything else bucketed under virtual currencies. As the legislation goes to committee, we may end up with further clarification on payment stablecoins and virtual currencies. In general, the industry may benefit from further classifications of stablecoins down the road as the RFIA comes into full force.
To try and differentiate from stablecoins we coined the term (no pun intended) “Assetcoin.” As opposed to f payment stablecoins, an assetcoin could be defined as:
- Redeemable, as available, for an asset denominated for redemption by the Assetcoin
- Issued by a business entity
- Market value of the reserve at least equal to the nominal value of all outstanding units of the assetcoin and fully backed by one or more assets (including financial assets, real world assets or digital assets)
- Attestations made concerning the reserves at the end of each business day (or monthly, depending on the type of underlying assets) by the issuer and examined monthly by an independent CPA.
Under this definition, here are some examples of assetcoins:
- Crypto backed assetcoins: These assetcoins would be backed by one or more crypto assets, and would be required to maintain their reserve at or above the nominal value of all outstanding units of the assetcoin. Given the volatility of crypto assets, crypto backed asset coins will likely need to be overcollateralized. Maker’s DAI would be a good example of a coin that fits into this particular asset class.
- Debt backed assetcoins: These assetcoins would be backed by one or more fixed income assets (that could include short and long-term treasuries, corporate bonds, municipal bonds, other fixed income or income-oriented instruments).
- Hybrid financial assetcoins: These assetcoins would be backed by a combination of cash, cash equivalents, fixed income, and equity instruments. Tether’s USDT is the most well-known example in this category.
- Commodity backed assetcoins: These assetcoins would be backed by commodities such as precious metals. PAX Gold (PAXG) is an example of commodity backed assetcoin. Each PAXG token is backed by one fine troy ounce (t oz) of a 400 oz of gold stored in Brink’s vaults.
- Real estate backed stablecoins: These stablecoins would be backed by real estate assets and are currently under development.
In general, when the reserve assets of an assetcoin are not highly liquid, these assetcoins will also need to hold some portion of their reserves in highly liquid cash or equivalent assets (to permit redemptions).
How assetcoins should look to manage redemptions, surplus and deficits
Unless an assetcoin is verifiably backed by a physical(off-chain) asset and redeemable in the same asset (like PAXG), depending on the underlying assets, an assetcoin would be likely to experience periods of surplus as well as significant deficits in reserves. Additionally, the assetcoin would also need to have some highly liquid assets to support any redemptions.
Figure 1: Surplus and Deficit management for assetcoins
For illustrative purposes, let us assume that the Cash Reserve % of the assetcoin is 20% and the assetcoin is redeemable for US Dollars.
- The Cash portion of the asset reserves could be invested in interest generating cash and short-term cash equivalents like T-Bills, US Treasuries, reverse repo, etc.
- If the Cash Balance ever exceeds the Cash Reserve %, then the interest income could flow to the Surplus Reserve.
- If the Cash Balance is lesser than the Cash Reserve % (e.g., from redemptions), the interest income would flow back to top up the Cash Reserves.
- Income generated from the Asset Reserve would go to fund the Surplus Reserve as long as Asset Reserve had no impairments and the Cash Reserve was adequately capitalized. Otherwise, Asset Income would go toward curing impairment to the Asset Reserve or to replenish overall Cash Reserves.
- In the case of the Asset Income and Interest Income being insufficient to cover asset impairments or cash deficiency, Surplus Assets could be liquidated to cover Asset or Cash Reserves.
The model proposed here will prevent projects masquerading to be a stablecoin or a retail-oriented project from making highly speculative investments, potentially resulting in large scale liquidations and insolvencies. Adopting a model such as the one described here will allow for responsible innovation in creating new kinds of digital assets backed by a variety of crypto assets, commodities, financial and real-world assets.
Sanjay Ragavan is the Head of Structured Securities & co-lead Blockchain Initiatives of Roofstock where he leads the real estate investing platform’s blockchain initiative. After being accepted into Cypher Accelerator, the first-of-its-kind Wharton-backed program for blockchain startups, Sanjay continues to build connections between real estate investing and blockchain. With over 20 years of finance and product experience, Sanjay has an extensive background consulting, developing, and founding several financial companies. Prior to Sanjay’s current role at Roofstock, he was the Co-creator and GM of Roofstock One, an innovative, transparent rental investment platform that allows accredited investors to get targeted exposure to the economics of curated SFR properties. Before joining Roofstock, Sanjay served as a Product Manager at Renew Financial and Director of Carolina Financial Group LLC. He also co-founded LCAP Advisors which provides Wall Street caliber portfolio analysis and risk assessment solutions to small banks and credit unions for their on-balance sheet loans. Sanjay has a Masters in Business Administration from The Wharton School.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.