The Stablecoin Two-Step

Three years ago I wrote about the one truly new thing stablecoins were good for: giving USD payment facilities to people living in jurisdictions that did not permit such things. And, as highlighted at that time, this activity can become political quickly. Giving USD access to dissidents in a given country may well align with the politics of the party granting the access or building the service. But there is a good chance the local authorities on the receiving end do not share those politics. This whole thing, to quote that old column “raises new ethical and moral questions.”Now there is a pattern emerging in the wild of pairs of stablecoins. One of these pairs provides the USD access thing that is novel. But the second is not novel at all. The second in these pairs just provides yield like a money-market account, traditional bond or interest bearing bank account. The first product is both arguably offering something new and arguably not any sort of investment product on which governments should impose investment-like regulations. But the second? Let's look at this.Stablecoin BackgroundKey in that old analysis was that stablecoins didn’t pay yield. Stablecoins were payment instruments that let pseudonymous users keep balances in USD and make payments. But they were very much not investment products. These no-interest stablecoins acted like cash with additional payments functionality. Cash preserves value just as well as a non-interest-bearing stablecoin. But cash is a pain to store. And it's not useful for payments if you are, say, a dissident living in a country that wants to actively deny you access to USD.Even for residents in major money centers that do not face political or legal challenges, cash is still a pain. Stablecoins, for this purpose, may well be an engineering improvement for users. International payments can be challenging (for a range of reasons) and products that make them easier will find use. At least somewhat independent of how, um, legally careful or compliant the products are.Now, there are myriad payment products out there already that compete with stablecoins. Credit cards. PayPal. All kinds of local bank transfer or phone-number-to-phone-number systems around the world. And generally none of these products is an investment either. PayPal makes you money because it allows customers to pay your business. But it’s not a product you would use to invest surplus cash.Why? Well, for starters PayPal and pre-paid credit card balances don’t pay interest. You don’t load on up mobile phone credits as an investment strategy. Nobody sends a surplus funds to a government-linked instant payment app as part of a portfolio management process. Maybe you’d pre-pay a few months of expenses before a rate-hike or something. But nobody stores millions of dollars this way.A baseline qualification to be an investment product is some expectation of return. That can be return from price appreciation. Or return from yield paid from some process. Or something else. It doesn't really matter where the return comes from. The important element here is that people make investments to get returns. And you can make some sort of intellectually honest and consistent argument that stablecoins which don't pay yield and are used for payments should remain outside of the standard regulatory structures for investments. But stablecoins that pay yield are different.Emerging Regulations & ProductsSomething like this distinction is codified in the EU's Markets in Crypto-Assets (MiCA) regulations. MiCA provides for stablecoin issuer licenses and prohibits licensed issuers from paying yield to tokenholders. Similar provisions exist in many of the bills being considered in the US and by other governments around the world. What all of these regulatory regimes have in common is that they exempt payment stablecoins from the rules around investment schemes in exchange for preventing them from paying yield. They're exempted from certain investment-vehicle-related requirements in exchange for insuring they never look like investments. Fair enough.But, as is often the way in web3, schemes to evade these rules abound. Enter the "dual stablecoin" pattern. This is when an issuer sets up a non-interest-bearing stablecoin. The reserves backing this stablecoin are still going to earn yield because the reserves are just currency and commercial amounts of currency are easy to invest in money market funds and similar. But in this model the issuer keeps the yield. At least in part this is so because they cannot pay it out without legal problems. That's been Tether's model forever. But in the dual model the same organization sets up a second stablecoin, backed by the first, which pays yield. The yield forgone by the holders of the first token.Precisely how the yield is funneled from the first token to the second varies by scheme. But the high-level mechanics are the same. For example the Usual USD team has two products. USD0 does not pay yield and is legally issued by a French company called Up Only Co. Then USD0++ pays yield and is created by staking USD0. USD0++ is issued by a different French entity called Association de Développement de la DAO Usual. The two separate entities mentioned in one Terms of Services. This is not really a secret scheme. The team's not hiding anything.Something similar exists with Falcon Finance's USDf, Anzen's USDZ, Ethena's USDe and others. One token is yieldless. And then you can stake that token to get a second token which pays yield derived from the reserves backing the first token. These structures clearly serve no economic purpose. And the second token is clearly an investment product.Then when you go and look at these products you routinely find that the vast majority of the use of the yieldless token is creating the yield token. What's interesting here is that while the yield-bearing token is clearly an investment contract it is not clear why or how anyone thinks these schemes achieve anything like legal cover. They're too transparent.If there is an enforcement effort these facades are not going to help. And if there is no enforcement effort then, well, structure doesn't matter at all. In fact the main result of these schemes is probably to sully the reputation of these teams in the eyes of the legal community. "They can't seriously think that is worth doing?" comes up fairly often when I describe these to lawyers that don't work on web3 products.Then at the other end of the spectrum are products that explicitly pay yield and go through some regulatory motions to clear that up. BlackRock has BUIDL, Ondo has USDY, Spiko has USTBL. Spiko even has EUTBL doing this in Euros. Those look like a more serious attempt to fit within the legal system. And relative adoption of the two camps is an excellent way to measure how hard the industry is trying, overall, to sensibly follow the rules as written. That is a key theme to watch as more rules get written around the world. And when the next, inevitable, crisis arrives projects that chose to hide behind fig leaves like the dual stablecoin scheme are likely to face bigger legal problems than those that made a genuine effort to follow the rules.So?This pattern involves one product that is pretty obviously an investment of some sort. But most of the rules around stablecoins do not permit the payment of interest that makes these tokens into investments. So we end up in the strange situation where someone can create a payment stablecoin, get it regulated as a payment product, and then build a second unregulated investment product that ends up holding all the money and paying traditional yield. And, at least so far, no action has been taken against any of these schemes.You may now be thinking "good on them, what is the problem here?" The problem is bank runs. And, to a lesser extent, a basic lack of fairness in investor protection. Let's take the second, smaller, issue first. Everything that is functionally the same as a money-market fund should be regulated in pretty much the same way. That's just general principles-based regulation. Or technology-neutral regulation if you prefer.And the first problem? That's the big one. The whole argument for reducing the regulatory burden on payment products vs investment products is that payment products do not impose the same sorts of risks on the financial system. But interest-bearing tokens held by pseudonymous blockchain addresses? If those are held for investment purposes it is perfectly reasonable to expect bank runs. Why would tokenholders be any different than other holders of short-term interest-bearing instruments?All of this of course ignores the pretty obvious fact that interest-bearing stablecoins like this, by virtue of their being investment products, run afoul of the existing investment regulations in much of the world. Maybe they are not securities as a lot of short-term debt instruments are exempted from securities rules. But they are some kind of investment that fits within traditional regulations in the EU, US, UK and around the world. By "doubling down" on the dual stablecoin pattern this branch of web3 is setting itself for a future reckoning.Stay ahead of the curve. Join the Blockhead community on Telegram @blockheadco