Everything you need to know about the stablecoin wars

For operators of fiat-backed stablecoins, the transparency wars are underway.

Paxos escalated the conflict last month when its general counsel Dan Burstein published a blog post in which he argued that competitors Tether and Circle — unlike Paxos — are unregulated.

“These tokens are backed by illiquid and risky debt obligations — a critical weakness that no prudential regulator would allow to exist as this creates undue risk for their customers,” Burstein wrote.

Coinbase, which along with Circle supports the Centre Consortium that governs USDC, hit back at the beginning of August with a rebuttal of Paxos’ claims that also took pains to highlight USDC’s far larger market cap.

This skirmish between Paxos and Coinbase comes as legal issues surrounding stablecoins in general and Tether, in particular, are bringing about a sea change in the stablecoin market.

Policymakers are paying close attention. A closed-door meeting of the leading financial regulators of the U.S. at the end of July centered on the issue of stablecoin transparency. According to comments from Acting Comptroller of the Currency Michael Hsu to Bloomberg, these conversations focused in particular on Tether and Diem (the Facebook-bootstrapped project formerly known as Libra).

Also at the end of July, it came to light that the Department of Justice is reportedly investigating Tether’s executive team.

Members of Congress have been zeroing in on stablecoins, too. Newly introduced legislation would require all fiat-backed stablecoins to get Treasury approval, allowing none to be grandfathered in.

Faced with this unprecedented scrutiny, operators of fiat-backed stablecoins are throwing their resources into a competition to demonstrate transparency. Their traditional fight has been for a greater market cap, but now stablecoin operators are scrapping to appease the very regulators who are now taking a closer look.

The contestants

By market cap, the largest stablecoin operators are Tether (USDT), Centre (a union of Circle and Coinbase) (USDC), Paxos (PAX and BUSD, as well as custody of HUSD), TrueUSD (TUSD) and Gemini (GUSD). All are pegged to equal the value of the U.S. dollar.

While Tether remains by far the biggest game in town, USDC’s market cap has soared from around $4 billion to $28 billion since the beginning of 2021. BUSD has seen similar gains. Tether, meanwhile, has flatlined since beginning its reserve reports to the NYAG, as a function of which they also need to provide more non-public information on their holdings to the NYAG

PAX is hanging below $1 billion, right in the same range as TrueUSD. GUSD, which sticks to dollars in bank accounts, has been frenetically jumping around $250 million.

Diem, formerly known as Libra, has yet to launch — and recent developments raise questions about its overall future  — but it has played a critical role in drawing public attention on stablecoins, enough so that it merits mention.

The contest

As to Paxos's claim that it is distinct in that it is "regulated," the firm has long touted its status as the first digital asset company to get a limited purpose trust charter from the NYDFS.

“It is a very old stable form of banking registration and it is very difficult to obtain and very difficult to maintain,” Deputy General Counsel Emily Meyers said in a recent interview with The Block.

Meyers went on to say:

“It also means that the New York Department of Financial Services supervises all of our business activity. And what is unique about Paxos' stablecoins is that in addition to Paxos as the issuer being regulated by NYDFS the tokens themselves are regulated by DFS.”

Since NYDFS is supervising the stablecoin “on an ongoing basis,” Burstein wrote in the July blog post, Paxos says it can only hold reserves in “the safest forms, such as FDIC-insured bank accounts and in short-term maturity US Treasury instruments.”

The post generously includes GUSD as another equally regulated stablecoin. Gemini itself has long advertised a similar claim to fame as “the first exchange to apply for and be designated as a New York Trust Company.” Both Paxos and Gemini received those charters in 2015; Paxos in May and Gemini in October.

Beyond the degree to which a given stablecoin is “regulated,” a central question has historically been how they report out their reserves. Providers have settled on two main ways of doing so: reserve breakdowns and attestations.

Reserve breakdowns are, in principle, a dissection of the assets that firms hold. Based on the original promises of most stablecoin operators, these should have been unnecessary, as those reserve assets would have been 100% dollars in a bank. The actual investments in play have, however, varied over time, and have included assets like Treasury bills, corporate debt and, allegedly, crypto investments in addition to actual currency holdings or cash.

It is an open discussion as to what constitutes appropriate backing if not a dollar in a bank account. The operators themselves stand to gain from riskier investments, which could allow greater returns. On the other hand, what stablecoin users seek out is reliable value built on fast-moving tech.

Tether’s first-ever breakdown of its reserves came in May, part of the terms of a high-profile settlement with the New York Attorney General. At the time the firm’s general counsel, Stuart Hoegner, wrote that Tether was “setting a new standard of transparency.”

According to the breakdown, less than 3% of Tether’s total backing was in actual cash, with an even smaller percentage in U.S. Treasury bills, which are widely seen as equivalently reliable while slightly interest-bearing. Almost half of USDT’s total backing is in the vague category of “commercial paper” — a short-term form of unsecured corporate debt — which the firm classified as a cash-equivalent.

“We voluntarily provided the Attorney General’s office with substantial information about the composition of Tether’s reserves, and, after reviewing all of that information, the Attorney General’s office made no negative findings whatsoever regarding the issuance and backing of tethers,” Hoegner told The Block. “That is, the Attorney General made no findings that tethers were not fully backed.”

That apparently depends on how one defines “fully backed.” The announcement of the settlement featured the following quote from New York Attorney General Letitia James: “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”

Then, in July, Tether’s closest competitor, Circle, revealed the composition of the reserves for USDC.

Circle’s breakdown showed a more conservative allocation than USDT, but still only 61% of total assets were defined as cash or cash equivalents. That’s a significant change from 100%, and it correlates to a huge upshoot in USDC in circulation.

Paxos, meanwhile, holds all of its reserves in Treasury bills, classifying those with maturities of less than three months as “cash equivalents,” which make up 96% of the total.

Another transparency measure stablecoin issuers have started rolling out is an “attestation.”

Reserve breakdowns and attestations are often separate, though not in the case of TrueUSD. The idea of an attestation is that a separate entity signs off on claims that you have all of the reserves you claim to have, though the reliability of that accounting firm may also be a source of debate.

TrueUSD, for its part, maintains 24/7 real-time reporting based on escrow accounts that hold 100% cash and cash equivalents, though its continuously accessible attestations don’t break down its “cash equivalents” beyond saying they "include short-term, highly liquid investments of sufficient credit quality that are readily convertible to known amounts of cash."

Gemini, meanwhile, maintains that all of its tokens are backed 1-to-1 with dollars in U.S. bank accounts, so in the company's view there is no need for a reserve breakdown. Still, they have been issuing monthly attestations of their balances since launch in Sept. 2018, attested to by accounting firm BPM.

Circle’s first attestation for USDC was that October, through the services of Grant Thornton.

Tether’s first attestation came after the NYAG settlement but was not one of the conditions of that settlement. The process involved accounting firm Moore Cayman verifying that the firm’s total assets were worth more than the dollar amount of USDT in circulation. Controversially, there was no information at the time about where exactly those assets were held or what they were. The firm involved is, meanwhile, based in the Cayman Islands and features a site with a dead phone line. A representative declined to comment on the firm’s work on the attestation except to confirm that it took place.

The standard attestations process is still developing in part as a result of this competition between operators. Firms are trying to outdo each other in terms of frequency and specificity. It seems likely that as time passes, the barrier between attestations and reserve breakdowns will dissolve.

John Paul Koning, who runs the blog Moneyness, tweeted that “if you wanted to create the perfect attestation standard, it would adopt Gemini Dollar's practice of listing all of its investments, Tether's disclosure of the size of its capital, and TrueUSD's real-time 24/7 reporting.”

“The whole idea of having attestation reports is a manifestation of competition for more transparency,” Koning told The Block. “Why do they do it? In a way they have to.”

Circle VP of finance Patrick Corker told The Block regarding recent conversations with regulators that “the feedback that we got is there will be a war in the future where daily attestations are probably going to be required.”

At the same time, he noted that the process was taking Circle a considerable amount of time.

The history

Keep in mind that the idea behind a reserve breakdown is directly opposed to the original claims of dollar-to-dollar backing. The reason that some issuers aren’t simply holding dollars in a bank account is that they have a chance to make a whole lot more money — and therefore ramp up supply — with riskier investments.

Indeed, Tether pioneered these kinds of business practices.

Having launched in 2014 and started trading in 2015, Tether possesses something of a first-mover advantage. Today, scale alone has made it a critical infrastructure for crypto markets. At the same time, that scale has also attracted enormous attention and criticism.

Tether’s supply is double that of USDC, the next closest competitor. By daily volume, that becomes a factor of 10 difference. USDT alone regularly outpaces Bitcoin and Ether combined in daily trading, leaving all other stablecoins in the dust.

Tether launched in an era when there were lower expectations for know-your-customer (KYC) checks on wallet access, and no real conception of how to “peg” a digital token to reserves in a bank account. These ideas of reserve breakdowns and attestation reports came about later, as means by which younger competitors sought to distinguish themselves from Tether.

Starting April 10, 2016, Tether’s website claimed 1-to-1 backing with “traditional currency”:

At the beginning 2018, it came to light that the CFTC was investigating Tether and sister crypto exchange Bitfinex (both companies share a parent company). Tether’s general lack of transparency had already become a divisive issue among cryptocurrency advocates, but the investigation made it even more polarizing. Critics like the pseudonymous Bitfinex’d alleged that Tether has largely fabricated its own reserves.

“I got into crypto because I was a believer in don’t trust, verify. Apparently that goes out the window when it comes to Tether. The crypto community seems to be trust, don’t verify, in reality,” Bitfinex’d wrote to The Block.

USDC, PAX, TUSD, and GUSD all launched that year, perhaps sensing a competitive opening. Then, that fateful NYAG suit kicked off in April 2019. Incidentally, sometime between Feb. 19 and March 4 2019, Tether’s reserve statement became:

In June of 2019, Facebook announced Libra. Initially envisioned as a global stablecoin backed by a floating basket of currencies reminiscent of the International Monetary Fund’s special drawing rights, the proposed stablecoin got dogpiled by lawmakers and regulators from around the world. The social media giant distanced itself, the Libra Association lost some of its backers, the project's designers abandoned its basket in favor of a 1-to-1 dollar backing, and it ultimately rebranded as Diem.

The latest news is that Diem is working with Silvergate on a dollar-pegged stablecoin. More importantly, the firm relocated from Switzerland to the U.S., promising to register with FinCEN as a money services business — which, as of July 30, it has not done. Diem is, to all appearances, dead. Even the wallet provider Novi — previously, Calibra — that originally launched to provide services to Diem, is now looking for alternative stablecoins with which to work.

Tether, while still functional, is at the very least going through major changes that are muting its long-term rapid growth. Some observers predict that it will run into further legal pitfalls as a result of the settlement’s terms, even if the new Department of Justice inquiries go nowhere.

The younger brace of stablecoins has managed to avoid the aggressive legal response that smothered Diem and is routing Tether. But they remain controversial among policymakers as a whole.

The principle

In fact, fiat-backed stablecoins are problematic to both the crypto industry and regulators because they bridge traditional banking and the decentralized world in such a way as to threaten each with the strengths of the other. The most successful stablecoin operators have ended up with a level of control over those bridges that terrifies both central banks and the crypto community.

Government opposition is in some way more understandable. A monopoly on the local monetary system has become a fairly central pillar of governmental authority. Stablecoins delegate some of that authority onto potentially untrustworthy third parties.

The crypto community’s reaction to stablecoins is more complicated. Consider: Tether’s success on crypto markets implies that despite the traditional rhetoric of true cryptocurrencies (like Bitcoin), people really want the stability of fiat currency — specifically the U.S. dollar. This is despite seemingly endless talk and memes among crypto fans critical of fiat currencies and central banks.

An issuer of a backed stablecoin is just another entity that users must trust — and that's on top of trusting the Federal Reserve. The industry that began with Satoshi Nakamoto’s promise of “a peer-to-peer electronic cash system” has become dependent on third parties shilling dollars that just move really fast.

“You get to stablecoins because you’ve given up on the crypto dream,” said Rohan Gray, an associate law professor at Willamette University and frequent critic of the crypto industry. “Once you get to that point, governments go ‘why are we giving up the whole new world and digital money to private actors again?’”

The future

Recently, private stablecoins have taken on new relevance as central bank digital currencies (CBDC) have emerged as a viable upgrade. CBDCs, especially a digital dollar, would in theory eliminate the need for holders to trust in stablecoin issuers — a prospect that obviously frightens these firms.

At the same time, it remains very much an open question whether the U.S. will actually issue a digital dollar at all. In mid-July, Federal Reserve Chairman Powell professed to be “legitimately undecided.” Meanwhile, Senator Pat Toomey implied that private stablecoin operators are a better choice than the Fed to operate a digital dollar.

“Public-private partnership” is a common refrain from digital dollar advocates. For the actual software that runs a digital dollar, these firms hope that the Fed will likewise contract private firms to manage any new digital money.

Diem, for example, has put off any private stablecoins repeatedly. As it returned to the U.S. from Switzerland, it seems also to be pivoting from operating an independent stablecoin to providing services to CBDC issuance in the U.S.

While Tether is almost certainly out of the running, many other stablecoin issuers are eyeing a future CBDC as the newest means of making money. Heightened transparency of asset reserves will likely limit future earnings from stablecoins, as fiat holdings and money market funds are, by their nature, low-risk but also low-yield.

“If interest rates now were what they were a few years ago, they’d be earning a lot of money,” said Koning. “Of course that’s why they’re trying to move into things like commercial paper.”

New demonstrations of transparency are an indication not only that the market has changed for stablecoin users -- ultimately, these companies may well be auditioning for roles in the distribution of a digital dollar.

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