How EU regulation of stablecoins can lead to financial innovation

Written by Swarm co-founders, Timo Lehes and Philipp Pieper

Stablecoins are essentially tokenized forms of fiat currency. They act as an entry point for people to move on chain and, at times, have been safe haven assets for those who want to escape the volatility of crypto-native tokens like bitcoin and ether. Stablecoins are gaining importance as blockchain-based products are becoming a part of consumers’ daily lives because they are digital cash and generate additional benefits in comparison to traditional financial products. There are a variety of different stablecoins available and algorithmic coins use a series of complex algorithms, crypto-asset reserves and tokenomics to maintain the peg of a stablecoin to its underlying fiat currency. But algorithmic stablecoins have faced challenges in tough market conditions. The largest collapse of an algorithmic stablecoin was the Terra/Luna blow-up in Spring 2022 when an estimated $60 billion got wiped from the digital assets market. Now, asset-backed tokens have emerged as a preferred option for stablecoin issuers in the past couple of years. The stablecoin market today sits at over $125 billion and the most popular coins are Tether’s USDT and Circle’s USDC, which have a combined market share of 90%. High-profile de-pegs, even in asset-backed tokens, have resulted in greater industry demand for transparency over the assets held in reserve that support a stablecoin’s price. Since the last bull run, there has also been a flight to quality for reserve assets, diversifying away from volatile crypto assets and commercial paper and towards highly liquid tokenized traditional financial products. The growth of tokenized, short-term US Treasury Bills has exploded to over $600 million this year, earning many stablecoin issuers a yield of 4.5%. In fact, in Q2, Tether, which has issued $84 billion worth of USDT, reported operational profits of more than $1 billion.

Developments in German regulation mean that retail investors have avenues in which to invest directly in the same yield-bearing assets that stablecoin issuers are using to back their tokens and subsequently make profit on. We expect the business models of stablecoin issuers to change, where some of this yield is passed on to stablecoin token holders who are helping these companies generate so much profit. As a direct integration of Web3 infrastructure with a traditional financial asset class, it makes sense that these tokens are first addressed by regulators because they are the most easily understood within the realm of traditional financial market regulation. MiCa is the first attempt by European legislators to regulate Euro-denominated stablecoins and Singapore is hot on its heels. MiCa comes into force for stablecoins in June 2024, requiring stablecoin issuers to be licensed in one of the EU27 countries. Those distributing euro coins will also have to have e-money licenses to do so, which could invariably inhibit the EU-stablecoin market as regulatory barriers for issuance are higher than in the US and Asia. Legal experts have also raised concerns that stablecoin daily limits stipulated in MiCa could also cause issues for the market. The transaction limit shows that the regulations, in both word and application, need to be flexible to the market which it serves.

But, there are always going to be kinks in the outlay of the initial framework that need adjusting - it’s up to legislators and regulators to pay attention to the industry and its needs in that sense. More broadly though, we’re likely to see a MiCa II emerge in due course, similar to MiFID and MiFID II. The difference here is the pace of regulatory change seems to be improving. It took years for the second MiFID to come through, but we anticipate much quicker updates of a theoretical MiCa II in this instance.

The market is growing at pace and regulators will need to stay ahead to continue to offer the most encouraging environment possible. When you’re in a global regulatory race for space, this becomes inevitable. For all its foibles, the EU has often led in regulatory matters with many other jurisdictions following where it leads. Having a regulated stablecoin market will incubate a healthy DeFi system. Whilst some see a regulated stablecoin market as a route to integrating DeFi with traditional banking, we could actually end up seeing more financial applications bypass the banking system altogether. We are already seeing innovation-first companies taking tokenized forms of cash and financial products to give consumers direct access to yield-bearing assets that cut out the middleman. Not only can they earn on these assets, but they can also trade them, lend against them and spend them. In this new world, traditional financial institutions will need to re-think financial product design that puts consumers at the heart.