Washington’s battle to reign in crypto has a new beginning: stablecoins.
The Securities and Exchange Commission is investigating whether stablecoins, cryptocurrencies that maintain a price of $1, are among the products issued in violation of investor protection laws. SEC enforcement lawyers have told Paxos Trust Co. that regulators plan to take enforcement action regarding his stables, BUSD, although that decision is not final.
The SEC lawsuit regarding BUSD, the third-largest stablecoin by market value, would be a significant blow to an industry that has suffered a series of shocks in recent weeks. Following the failure of crypto exchange FTX, the SEC has ended the ability of some crypto middlemen to offer lending services that allow crypto investors to earn interest by lending their tokens.
It may not be easy for the SEC to win a lawsuit about stablecoins, according to securities lawyers, because stablecoin users do not expect profits from owning the tokens. That motivation is one of the crucial aspects of the 1946 Supreme Court test, known as Howey, which regulators use to determine which cryptocurrencies are securities.
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“In your classic stable … the house keeps the profit,” said Timothy Spangler, a partner at Dechert LLP who has advised clients on the structure and formation of products tied to digital assets. However, he said, “Regulators are well within their jurisdiction to look under the hood.”
Stablecoins are a type of cryptocurrency that makes it easier to trade other digital assets. Each unit is supposed to hold a value of $1. Traders can use stablecoins as a store of value, or use them to pay for other digital assets. The SEC could be tasked with overseeing payment products, which it does not regulate.
Stablecoin issuers say they are backed 1-for-1 with cash or cash equivalents such as US dollars and Treasury securities. Tether Holdings Ltd., the largest stablecoin issuer, discloses most but not all of its portfolio holdings. It has invested in riskier assets such as corporate debt and made money by lending strings to customers, a practice it is ending.
Tether briefly lost its $1 peg in May 2022, when it traded as low as 95 cents, reflecting factors including investor concerns at the time about the value of its assets and whether they could be easily sold to meet demand redeemed in a market panic.
Another potential complication for any SEC cases: The Commodity Futures Trading Commission and the New York State Department of Financial Services have labeled both the tether and the BUSD as “virtual currencies”. That doesn’t mean the SEC can’t allege they’re securities, lawyers say, but it muddies the waters and illustrates the difficulty of deciding which laws apply.
Coinbase Global Inc. was revealed. that the SEC is also investigating its stablecoin product. Coinbase Coinbase to maintain a partnership on the operation of USDC, the second-largest stablecoin, with Circle Internet Financial Ltd. Circle also disclosed that it is facing an SEC investigation. A Circle spokesman declined to comment on the focus or status of the probe.
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The SEC could also allege that BUSD is a security by applying another Supreme Court test that governs notes, or securities that promise the return of money, often with interest.
The SEC has indicated that the Supreme Court case, known as Reves, in other recent enforcement actions that found crypto lending programs operated by BlockFi Lending LLC and Nexo Capital Inc., should be registered as securities. In those cases, the SEC said BlockFi and Nexo users were motivated by the ability to earn interest by lending their crypto.
“We clearly believe that our stables are not securities under Howey or Reves, and we look forward to continuing to work privately with federal regulators, including the SEC, to make this case,” said a Paxos spokesperson.
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Reves is a flexible test that can be applied to a variety of situations. The Reves test considers the motivations of the parties but also asks whether a different regulatory regime applies to the asset, thereby eliminating the need for SEC oversight. The issuance of BUSD was authorized by New York’s financial regulators, and Paxos Trust is overseen by the state agency.
“We think a court is going to look at that and say this is not the kind of situation where there’s a vacuum to be filled,” Coinbase Chief Legal Officer Paul Grewal said.
Stablecoins don’t look too much like money market funds, a comparison made by SEC Chairman Gary Gensler, Mr. Grewal and others said. Money funds promise to hold the value of $1-a-share but, unlike stablecoins, they pay interest.
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The SEC’s mutual fund rules have not always made these products as safe as investors had hoped. US authorities were forced to back money funds in 2008 and 2020, when investors panicked about several, creating the potential for losses for slower-moving users.
“The regulation of money funds is not really designed to support something that is supposed to be a payments instrument,” said Jonah Crane, a partner at Klaros Group, a financial services advisory firm.
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Other parts of the Biden administration have said that banking products look more like stables. The Treasury Department and US financial regulators said in a report in November 2021 that Congress should require stablecoin issuers to be banks. Congress has not advanced such legislation.
In the absence of congressional action, the Federal Reserve could oversee the stable coins. But a multi-agency panel of regulators would first have to designate stablecoin’s activities as a potential threat to the financial system. That didn’t happen, either.