May you live in interesting times.

Note: the substance of this note was written with expectation of, but not full detail of, the SEC’s February 15th meeting on safeguarding advisory client assets, and specific language by SEC chair Gary Gensler within that process targeting institutional custody of crypto.

Are stablecoins securities? On the face of it, the question seems absurd; no major stablecoin is yield-generating on an asset level, and nobody buys stablecoins with an expectation of profit from that act alone. It is absurd that we have to even consider the question. Unfortunately, due to the SEC, and in particular due to the SEC issuing a notice to Paxos last week ordering it to stop issuance of Binance’s BUSD stablecoin on that basis, we do in fact have to.

There have generally been two viewpoints when it comes to stablecoin regulation and the US regulatory approach to it. One is that stablecoins ultimately represent a threat to government authority as a money controller and hence, while other jurisdictions may accept the situation out of expediency, there can be no permanent peace between US regulators and USD stablecoins. The other, more pragmatic, view has been to look at what stablecoins represent in real terms. Even at an over $100bn combined market cap, stables are a drop in the ocean of overall money supply, and in practical terms, they are a tool for and demonstration of US soft power, especially given that their main real-world uses are primarily in trade in the global south and international remittances.

The pragmatic approach has always seemed to ring truer; partially, of course, because it represents an easier path forward for the industry in general, and few in crypto are anything but optimists at heart, but also because it generally has been borne out by the flow of events. The relatively soft penalties given to Tether, the rise of USDC and Circle as the de facto currency of on-chain activities (remember that even DAI is now essentially an USDC proxy), and many other things have pointed towards a relaxed approach overall.

The problem is that, as many a Chinese OTC desk will be able to tell you, a pragmatic governmental approach can turn on you in a matter of months or even days. We don’t even need to think about this in terms of FTX and Terra and the collapsed CeDeFi platforms; we can instead just think of it in terms of the macro environment that we now find ourselves in.

There has been a tendency in crypto to hold onto the Howey test – which conveniently pegs the worst of the worst of the 2015-7 ICO boom as securities, but leaves Bitcoin, (under most interpretations) Ethereum, and crucially stablecoins, untouched – as a Rumplestiltskinian object of focus. We know the true name of ‘no expectation of profit’, therefore we render the regulator powerless!

This is fine as a rallying cry, even fine as an operating principle, but it has never been totally bulletproof. US securities law, as in truth with most stress-tested systems, has almost infinite scope for regulators to call an audible and assign something that dreaded ‘security’ label. To give one example: the Reves test (via Reves v. Ernst & Young, 494 U.S. 56 (1990)) covers notes (i.e. a commitment to pay a specific sum) instead of investment contracts, and starts from the position that all notes are securities. Reves actually postdates and supersedes Howey. A fuller explanation of Reves in relation to stablecoins can be found in a Congressional Research Service paper from last year, linked here.

In any case, though, the particulars of whether or not a stablecoin as an asset can or should be considered a security seems almost secondary here to the aforementioned environment shift. There is an argument to be made that stablecoin issuers were tolerated in a low-rates environment precisely because their operations carried risk and because they couldn’t exist on the straightest and narrowest path with money markets where they were; this of course rather exposes the lie that stablecoin regulation is about consumer regulation, but still.

In a high-interest environment, where there is more incentive for governments and regulators to bring and keep cash flowing within systems that they can monitor, and where the financial plumbing involved in profiting as an issuer is much more accessible, it probably should not come as a huge shock that US regulators in particular are now changing tack, and coming after the ‘shadow banks’ of stablecoins by any means possible.

How far this reverberates, and where it ultimately ends, is at this point unclear, but in our view, the key thing to monitor will be the fate of Circle and USDC specifically. The winding down of BUSD is less important than it may seem to the industry as a whole, because as we quickly saw, uses and volumes quickly flowed back primarily to Tether, and with little friction at that; the value proposition of BUSD and USDT alike has always been less as ‘programmable money’ in real terms and more about the simple economic value that they represent.

USDC has always been different in two regards; first, with respects to its focus on doing things ‘the right way’ (first recipient of the BitLicense, headquartered in Boston, always kept everything explicitly onshore), and second, with respects to it very quickly becoming the de jure stable of DeFi over USDT, to the point of the ‘OG’ decentralised stablecoin DAI shifting its reserves last year in such a way that it became little more than an USDC proxy.

Incidentally, the motive behind that aforementioned shift was, in fact, to take advantage of Circle’s yield program; the company was quite aggressive in 2021 and early 2022 in pushing a 4.5% rate offering to corporate entities. This may seem like a lifetime ago, and it is worth noting that this a) predates even the first domino in the CeDeFi collapses, and b) that 4% dwarved the general 1% risk-free rate, even if it couldn’t hold a candle to Celsius and co.’s 20% rates.

It should be emphasised here that, in spite of some reports on Tuesday night, Circle have denied having received a Wells notice (essentially a warning of charges over possible security status). Nonetheless, it remains something to keep an eye on, because while Circle may be more transparent and hence presumably cleaner operationally than a Binance or Tether, its fundamental business model – provide stablecoin, earn yield from treasury – is the same as its competitors, and the big threat here is that Gensler essentially puts such firms in the same bucket as lenders and the like with respects to being ‘shadow banks’.

If USDC were to be targeted, the next steps are unclear. As has happened many times before, we would expect the crypto industry to adapt. Binance CEO Changpeng Zhao’s talk of non-USD stablecoins should probably not be taken all that seriously; said stables are always going to be a part of the crypto landscape, but there is no real alternative in terms of a different unit of account in general, and a variety of base pairs is fanciful when most major exchanges (including Binance) tend to struggle to even maintain liquidity on pairs like BTC/EUR and BTC/GBP, let alone non-G10 currencies.

The short-term move, then, would be towards Tether; however, this would likely not be the smoothest of transitions, given that so much infrastructure has been deliberately build on an explicitly USDC-connected basis over the last few years. The Y2K metaphor feels apt here – the kneejerk reaction is to assume disaster, said reaction is probably not accurate and any genuine disorder within the industry would be short-lived and isolated, but a lot of resources would end up being spent on the transition and it would slow absolutely everything down for a while as a result.

While warning against crises, this nonetheless does still paint a bleak short-term picture for the industry as a whole, and breath does need to be held in places with respects to seeing how far Gensler’s blitz will extend over the next few weeks.