UK Treasury Creates New Proposal to Limit Effects of Stablecoin Collapses

Following the fallout of the crash of the algorithmic stablecoin Terra this month, the U.K. Treasury tables a new insolvency regime designed to protect consumers’ assets.

The now infamous crash of the stablecoin Terra earlier this month following a series of seemingly uncoordinated deposits and withdrawals wreaking havoc with the algorithmic stablecoin has been met with a new U.K. proposal to limit the fallout of future stablecoin crashes.

In the new proposal, the U.K. Treasury assigns maintaining business continuity and limiting the effects of a stablecoin crash to the central bank, the Bank of England. This proposal comes after announcements last month to regulate reserve-backed stablecoins in the wake of the Queen’s speech.

Unlike Bitcoin, which is not pegged to anything, stablecoins are tied to the value of a fiat currency, relying on liquid reserves, including cash and short-term government debt, to maintain their peg to fiat. Or, in the case of Terra, a software algorithm without guardrails. They are often an on-ramp into the crypto ecosystem, allowing people to buy other cryptocurrencies without leaving the digital asset ecosystem. Famous stablecoins include USDT, issued by Tether, and USDC, issued by Circle. The market capitalization of stablecoins is almost $160B, according to Coingecko.

Recently, Terra lost its peg with the U.S. dollar due to a series of large withdrawals and deposits that pushed the algorithm to create more and more of a sister token, Luna, sending its price spiraling. The broader crypto market was shaken to its core as other digital assets plummeted amidst massive bitcoin sell-offs by the Luna Foundation Guard, an organization holding bitcoin designed to prop up the Terra stablecoin.

The close correlation between stablecoins and traditional assets has stoked global concern from regulators, prompting a narrower focus on regulating this niche within the broader digital asset market. “Events in crypto-asset markets have further highlighted the need for appropriate regulation to help mitigate consumer market integrity and financial stability,“ Her Majesty’s Treasury told the Financial Times on May 31, 2022.

Essential to follow oversight holdings

The government department believes that it is essential for stablecoins to follow oversight mechanisms to mitigate potential risks. Following the 2008 financial crisis, the Treasury called on leading banks to develop “living wills,” or instructions on possible action that can be taken when an institution is distressed.

Lenders need to keep minimum holdings of reserves to shore up their balances and prevent a “bank-run” situation where banks hold insufficient cash to meet all their withdrawal requirements, causing the bank to default.

The U.K. government is also considering creating new laws on stablecoin collapses that pose risks to payment services, following announcements that it would adapt existing laws governing electronic money to stablecoins. At the same time, the Treasury proposes modifications to insolvency rules for payments networks should an important stablecoin fail.

Stablecoin holders must be reimbursed in the event of a collapse

Current laws governing payment networks are designed to ensure business continuity should the network fail. However, since people hold stablecoins, laws must also deal with recouping customer funds and returning private keys when the network fails. Keys are long strings of numbers that essentially function as passwords for transacting in crypto. When customers open an account with a custodial crypto exchange, they entrust the keys for their wallets to the institution in exchange for a more traditional password.

Last month, Chancellor of the Exchequer Rishi Sunak commissioned the Royal Mint to create an NFT as part of a broader push to make the U.K. a “global hub” for crypto.

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