Stablecoin regulatory strategies

Critics of stablecoins often describe them as unregulated. But that's not accurate.

Over the last few months I've been familiarizing myself with the various financial regulatory strategies stablecoin issuers have been adopting. I thought I'd share my findings in a blog post. Perhaps journalists, investors, and others will find this information useful. (For those not interested in stablecoins, I apologize. This will mostly be gobbledygook to you.) I'll most definitely make a few mistakes in this post, so readers: do not hesitate to provide feedback in the comments section.

I tweeted out the short version of this post last month:

Amongst US$ stablecoins, I've seen four regulatory strategies:

1) The NYDFS trust company model [Paxos, Gemini, BUSD]
2) Piggyback off of a (Nevada) state-chartered trust [TrueUSD, HUSD]
3) Get dozens of money transmitter licenses [USDC]
4) Stay offshore [Tether]

— John Paul Koning (@jp_koning) July 14, 2021

As you can see I've isolated four regulatory strategies that the major U.S. dollar stablecoin issuers have adopted. In this post I'll provide some details on each strategy.

My guess is that when people criticize stablecoins for being unregulated, they have the fourth strategy in mind: stay offshore. But they are ignoring or unaware of the other three.

A few caveats before starting. I'm only going to deal with U.S. dollar stablecoins in this post. Which means I'm ruling out euro-based stablecoins that operate within the EU's e-money regulatory framework. But there aren't really any big non-U.S. dollar stablecoins, so focusing on U.S. stablecoins covers most of the market.

Second, I won't be talking about Dai, Terra USD, Frax or any of the more exotic decentralized stablecoins. I'm sticking to centralized stablecoins: Tether, USD Coin, Gemini Dollar, HUSD, Binance USD, Paxos Standard, and TrueUSD. By centralized, I mean that the stablecoin's backing assets are compromised of traditional assets like Treasury bills, commercial paper, or deposit accounts held at a bank. Redemption or creation of new stablecoin tokens occurs via underlying bank infrastructure.

Lastly, this post doesn't address so-called "FinCEN regulation." Stablecoins will sometimes market themselves as being regulated by the Financial Crimes Enforcement Network, a department of the US Treasury that oversees America's anti-money laundering regulations. In the tweet below, a Tether executive makes this claim:

Reminder: #Tether is registered and regulated under FinCEN as all the centralised competitors. Strict KYC/AML is applied to all Tether direct users, as the other main issuers are doing. Less regulated is just FUD. Ask yourself who benefits from spreading such misinformation? 🤡 https://t.co/0izlgpJ75r

— Paolo Ardoino (@paoloardoino) December 30, 2020

However, this is mis-marketing. When stablecoins interface with FinCEN, they are best described as being registered with FinCEN, not regulated by FinCEN.

Further more, FinCEN registration doesn't qualify as operating under a financial regulatory framework. A financial regulatory framework sets out the rules an issuer has to follow in order to ensure that the product is safe for consumers. It is at this level that fraudsters are caught and poorly designed stablecoins pre-empted. A financial regulatory framework may also address issues like overall stability of the financial system. For its part, FinCEN has nothing to do with financial regulation. It is a money laundering watch dog.

So let's start.  

1. The New York DFS model

The first stablecoin regulatory model is the New York Department of Financial Services (NYDFS) model. The NYDFS regulates money transmitters, trust companies, and banks that do business in the state of New York.

The NYDFS has created an explicit framework for regulating stablecoin issuers. Two issuers currently conform to this model, Paxos Trust and Gemini Trust. Paxos issues its own Paxos Standard stablecoin. It also manages Binance USD (BUSD) on behalf of Binance, a large offshore cryptocurrency exchange. For its part, Gemini Trust issues the Gemini Dollar stablecoin.

Under the NYDFS model, a would-be stablecoin issuer first secures a limited-purpose trust company charter from the NYDFS. This means that it must comply with the NYDFS rules concerning trusts and submit to ongoing oversight.

Once chartered as a trust, the institution can then seek additional NYDFS approval to issue a "price-stable cryptocurrency – commonly known as 'stablecoin'– pegged to the U. S. dollar." The NYDFS says that its approvals for individual stablecoins are based on "stringent requirements for these products," and follow a "comprehensive and rigourous review." Post approval, the stablecoins are subject to continuing "examination and inspection" by DFS examiners.

2. The Nevada Trust model  

The second regulatory framework I have encountered is the Nevada trust model. There are two stablecoins that have chosen to use Nevada as their regulatory jurisdiction: HUSD and TrueUSD.

Let's deal with each stablecoin separately, because they use slightly different versions of the Nevada trust model.

Huobi Technology Holdings, the company that owns both the HUSD stablecoin and the Huobi cryptocurrency exchange, also owns a trust company, Huobi Trust Company. This trust company has been chartered by the Nevada Department of Business and Industry, or DBI. The Nevada DBI is Nevada's counterpart to New York's DFS.

The second stablecoin operating under the Nevada model is TrueUSD. TrueUSD has adopted a rent-a-charter, or multi-layered regulatory model. The TrueUSD stablecoin itself is owned by Techteryx, a Chinese company. But this isn't the layer at which the financial regulatory framework is applied; that occurs several steps removed.

Tecteryx has hired another company, TrustToken, to manage the stablecoin. TrustToken has in turn hired a third company, Prime Trust, a Nevada DBI chartered trust to manage the stablecoin's finances. Prime Trust acts as the regulated container for TrueUSD.

Prime Trust and Huobi Trust are regularly examined by the Nevada DBI to make sure that they are in compliance with Nevada's rules and regulations surrounding trusts.

What makes the Nevada model different from the New York model is that the NYDFS has explicitly acknowledged that New York trust companies can engage in stablecoin-related business. The NYDFS has a process in place to approve the stablecoins themselves, and provides continual inspections of these stablecoins.

The Nevada DBI has not explicitly acknowledged that trusts may (or may not) engage with stablecoin issuers. Unlike the NYDFS, the DBI has not explicitly familiarized itself with stablecoins, and has not set up additional procedures in place to regulate trusts that are engaged in stablecoin business.

For consumers and investors, it may be preferable to own stablecoins that have received explicit regulatory approval.

You'll notice that both the New York and Nevada models are based on trust companies. A trust company is what is known as a fiduciary. That is, it has a legal obligation to place customers' interests above the company's own interests.

The fiduciary nature of the relationship between stablecoin customer and stablecoin issuer is important. When Gemini Trust, Paxos Trust, Prime Trust, or Huobi Trust take in customer funds, their duty as fiduciaries prevents them (in theory) from investing this money in risky high-yielding investments. Were they to do so, they would be breaking their fiduciary duty to end users, the stablecoin owners, and could lose their charter.

The trust structure also protects customer funds in the case that the parent company, which owns the stablecoin, goes bankrupt. That is, if Binance or Tecteryx were to go bankrupt, BUSD or TrueUSD stablecoin owners needn't worry about fighting with other creditors for a piece of the company's resources. Their funds are protected at the trust company level.

3. The dozens of money transmitter licenses model

The only stablecoin that has adopted the dozens of money transmitter licenses regulatory model is the world's second largest stablecoin, USD Coin, issued by Circle. This is the same model that is used by well-known non-bank payments companies such as Square, PayPal, Skrill, Payoneer, Transferwise, Western Union, and Moneygram.

To operate under this model, an issuer gets a money transmitter license from each and every state that requires firms that engage in the business of money transmittal to be licensed. Montana is one of the states that lets money transmitters operate without a license. A few states such as Wyoming have exceptions for firms involved in crypto.

For its part, Circle has obtained 44 money transmittal licenses.

State licensing boards impose audit requirements on money transmitters and conduct examinations. Each state sets its own unique requirements, too. These include what sorts of investments money transmitters are permitted to make, capital requirements, and the size of the surety bond they are required to post. Some states are lenient, others are strict. (Dan Awrey has a good paper on the state-by-state requirements.) 

Some are very strict, like Texas, and some aren't, like Montana. https://t.co/Aa5PNsqVSn pic.twitter.com/OAX3Jco9QJ

— John Paul Koning (@jp_koning) May 20, 2021

But in general, my understanding is that the requirements placed by states on money transmitters are not as demanding as those that they impose on trust companies and banks. So pound for pound, a dollar issued under the NYDFS or Nevada trust model will have more oversight than a dollar issued under the dozens of money transmitter licenses model.

That's not the only advantage of the trust model relative to the dozens of money transmitter licenses model.

Circle is not regulated as a trust company, and thus it doesn't have a fiduciary obligation to its customers. That is, the funds Circle receives to back its stablecoins can be invested in such a way that may be good for Circle's investors and not necessarily good for Circle's customers. By contrast, issuers operating under either the New York or Nevada trust models are fiduciaries and must prioritize the customer's financial interests. Presumably that means that trusts can't put stablecoin customers' money in unsegregated accounts or risky instruments – but Circle can.

In addition, if Circle were to go bankrupt it's not apparent whether USD Coin holders would have better rights to Circle's remaining resources than other unsecured creditors. At least with the trust company model, stablecoin customers are insulated from the bankruptcy of the parent.

So from a customer's perspective, you are probably better off owning a stablecoin operating under either the NYDFS or Nevada model, rather than the dozens of money transmitter licenses model. Not only do the NYDFS or Nevada model have more oversight (because trusts generally face more oversight than money transmitters), but they are legally obligated as fiduciaries to keep the interests of their customers first and foremost. And the trust model probably provides better protection in the event of bankruptcy.

There is another difference between the NYDFS model and the dozens of money transmitter licenses model. Money transmitter licenses are generic. That is, they are a regulatory umbrella for a variety of very different businesses models, including remittance companies like Western Union, wallets like PayPal or Skrill, and finally stablecoins like USD Coin.

Compare this to the NYDFS model, which explicitly recognizes stablecoins and has created a specific process for authorizing and examining these products. (Nevada has not. The Nevada model is also a generic one). If I owned a bunch of stablecoins, I'd probably prefer if the regulator of these products had acknowledged them.

One last difference worth noting is that USD Coin must get 44 money transmitter licenses to operate across the U.S., but stablecoins operating under the Nevada and New York trust models seem to only need that one charter. Why is that?

A state chartered trust is typically exempt from having to get a money transmitters license in its home state. Depending on the circumstances, they may also be able to do business in other states without having to be independently chartered or licensed as a trust and/or money transmitter in those states. This seems to depend on whether the trust's home state has negotiated a reciprocity agreement with other states. Alas, I don't have a list of these agreements.

In any case, because trust company charters have a degree of portability, a single trust company charter seems capable of doing the work of 44 money transmitter licenses.

4. Stay offshore

The largest of the stablecoins, Tether, has adopted the last regulatory strategy: stay offshore. That is, Tether operates from the Cayman British Virgin Islands where it issues a U.S. dollar stablecoin. Tether's Cayman's-based Bahamas-based bank, Deltec, manages Tether's banking needs. And thus Tether avoids the necessity of setting up a New York or Nevada trust, or acquiring 44 money transmitter licenses.

The drawback of this structure is that that Tether can't operate in the U.S. Tether's terms of service prohibits "U.S. persons" from using the product.

Conclusion

In sum, those are the four regulatory strategies I've seen stablecoins pursue. Whereas stablecoins are often criticized for being unregulated, I think my post suggests the opposite. Yes, Tether can be criticized as such. But the New York and Nevada trust company models stand out for providing a significant amount of safety to stablecoin consumers, the NYDFS's approach particularly so because it has explicitly named and recognized stablecoins as products.

If you have comments or criticisms, do share them in the comments section of this post.

Postscript:

You'll notice that the first three strategies all operate at the state level. That is, the financial regulatory framework under which the major stablecoins are currently operating is governed by state licensing boards, and not at the national level by Federal banking regulators.

Might stablecoins eventually jump from a state-by-state framework to the national one?

One of the major financial banking regulators, the Office of the Comptroller of the Currency (OCC), has suggested that Federal financial institutions can support stablecoin transactions, but only if they involve "hosted wallets." A hosted wallet is a digital account hosted by a third-party financial institution. An unhosted one is controlled by the consumer.

But all of the big stablecoins I've mentioned in my blog post allow oodles of unhosted activity, so I suspect that Federal banks regulated by the OCC can't do business with them. Paxos, for instance, has recently secured a national trust bank charter from the OCC. But it appears that Paxos won't be using this national charter as the regulatory home for either the Paxos Standard and Binance USD stablecoins. Its NYDFS-chartered trust company will continue to be the regulatory anchor for its two stablecoin products.