Senators and regulators explain why the $60 billion collapse of a major cryptocurrency is not the industry's Bear Stearns moment

The crypto market has had a rough few weeks.

The market cap of the industry was wiped out by half a trillion dollars when terraUSD, one of the most popular dollar-pegged stablecoins, crashed almost overnight.

Meanwhile, as the sell-off continues to rock the sector, digital currencies like ether continue to take a blow on the price charts.

Some investors have compared the contagion impact of a failed stablecoin project to the loss of a large Wall Street bank, which eventually prophesied the 2008 mortgage debt and financial crisis.

"It showed some deeper weaknesses in the system," Michael Hsu, acting Comptroller of the Currency for the United States Treasury Department, stated.

"Clearly, you saw infection, not just from terra to the larger crypto community, but also from terra to tether and other stablecoins, and I think that wasn't expected." And I believe that is something to which people should pay close attention."

Government officials, on the other hand, are unconcerned about a crypto meltdown bringing down the entire economy.

On the fringes of the DC Blockchain Summit this week, many senators and regulators told CNBC that the spillover effects are controlled, crypto investors shouldn't panic, U.S. regulation is the key to cryptocurrencies' success, and, most importantly, the crypto asset class isn't going anywhere.

"This game needs regulations to make it more predictable, transparent, and provide the necessary consumer safeguards," said Sen. Cory Booker, D-New Jersey.

"What we don't want to do is suffocate a new sector or invention, robbing ourselves of opportunity." Or, as I'm seeing right now, a lot of these possibilities are just moving abroad, and we're missing out on the associated economic development and job creation. So, if we get the regulation right, this is a really crucial sector that can really assist the industry and safeguard consumers," Booker concluded.

An occurrence that is contained

Early this month, the value of a popular stablecoin known as terraUSD, or UST, fell in what some have dubbed a "bank run," as investors hurried to withdraw their funds. Luna and UST had a combined market worth of about $60 billion at their peak. They're now almost useless.

Stablecoins are a sort of cryptocurrency that is linked to the price of a real-world asset, such as the US dollar. UST is a type of stablecoin called a "algorithmic" stablecoin. Unlike USDC (another prominent dollar-pegged stablecoin), which relies on computer code to maintain its value, UST relied on computer code to maintain its value.

UST kept its price near $1 by tying it to a sister token called luna via blockchain computer code — effectively, investors could "destroy" one currency to help keep the price of the other stable. Developers leveraged the underlying infrastructure to construct other applications such as NFTs and decentralized finance apps, and both currencies were produced by Terraform Labs.

Investors raced out of both tokens as the price of luna became shaky, sending values tumbling.

The demise of UST, while contagious, came as no surprise to some crypto specialists.

According to Nic Carter of Coin Metrics, no algorithmic stablecoin has ever succeeded, and the basic problem with UST was that it was mostly supported by confidence in the issuer.

Sen. Cynthia Lummis, R-Wyoming, agrees with Carter. She is one of the more progressive politicians on Capitol Hill when it comes to cryptocurrency.

"Stablecoins come in a variety of shapes and sizes. Lummis told CNBC that the one that collapsed was an algorithmic stablecoin, which is distinct from an asset-backed stablecoin. She expressed her hope that customers would recognize that not all stablecoins are created equal and that selecting an asset-backed stablecoin is critical.

At the World Economic Forum's annual gathering in Davos, the managing director of the International Monetary Fund reiterated that opinion.

"I implore you not to lose sight of the value of our planet," IMF Managing Director Kristalina Georgieva stated. "If we differentiate apples from oranges and bananas, it provides us all speedier service, far reduced prices, and greater inclusiveness."

Georgieva also stated that stablecoins that are not backed by assets are a pyramid scheme, and that it is on to authorities to put in place safety guardrails for investors.

"I think we're going to see regulation move faster because of the events of recent weeks," said Hester Peirce of the Securities and Exchange Commission, who also pointed out that stablecoin legislation was already on the table before UST's demise.

"We have to make sure to...preserve people's flexibility to experiment with diverse models while staying inside regulatory guardrails," the SEC Commissioner stated.

Anti-shadow banking legislation

The UST meltdown, according to Commodity Futures Trading Commission Commissioner Caroline Pham, demonstrates how much action regulators must take to prevent the return of shadow banking — a type of banking system in which financial activities are facilitated by unregulated intermediaries or under unregulated conditions.

Many existing measures, according to Pham, might suffice.

"It's always easier to set up a regulatory framework when one already exists," Pham explained. "You're just proposing that the regulatory perimeter surrounding newer, unique items be extended."

The President's Working Group on Financial Markets produced a paper establishing a regulatory framework for stablecoins months before the UST algorithmic stablecoin project collapsed. The organization separates the stablecoin landscape into two camps: trading and payment stablecoins.

Stablecoins are now being utilized to make trading of other digital assets easier. The goal of the paper is to lay out best practices for regulating stablecoins so that they may become more commonly accepted as a form of payment.

"Those of us who are bank regulators, we're kind of historians of money-like instruments," said Hsu, who co-authored the paper with the Office of the Comptroller of the Currency.

"This is an all-too-familiar narrative, and prudential regulation is the only way to deal with it." This is why I believe some of the possibilities, particularly the ideas for a more bank-like regulatory approach, are a solid starting point."

According to Pham, the most important question for regulators and politicians to answer is whether stablecoins, particularly the subset of algorithmic stablecoins, are derivatives.

A derivative is a financial product that enables investors to trade on the price changes of an underlying asset in general. The underlying asset may be nearly anything, including commodities like gold or cryptocurrencies like bitcoin, according to the SEC's current understanding.

The SEC controls securities, but the CFTC is likely to have some regulatory oversight over anything that isn't a security, according to Pham.

"We have commodity derivatives regulation, but we also have specific sectors... where we actively control spot markets," Pham explained.

"The last time something like this blew up in the financial crisis — risky, opaque, complex financial products — Congress came up with a solution for that, and that was Dodd-Frank," Pham continued, referring to the Wall Street Reform and Consumer Protection Act, which was passed in 2010 in response to the Great Recession. The measure includes tighter derivatives regulation as well as additional curbs on FDIC-insured banks' trading activities.

"If some of these trading stablecoins are derivatives, you're really talking about a bespoke basket swap, and the dealer is in charge of managing the risk associated with that," Pham stated.

Congress is the one who makes the decisions

In the end, according to SEC Commissioner Peirce, Congress decides how to proceed with crypto regulation. While Wall Street's top regulator is already working in accordance with its powers, Congress must divide enforcement duties.

Lummis has teamed up with Sen. Kirsten Gillibrand, D-N.Y., to draft a measure that lays out this regulatory divide.

Lummis told CNBC, "We're putting it on top of the present regulatory framework for assets, including the CFTC and the SEC." "We're making certain that capital gains, not ordinary income, are taxed." We've covered accounting methods and terminology, and now we're looking at consumer protection and privacy."

The law also addresses the regulation of stablecoins. According to Lummis, the measure anticipates the emergence of this subset of digital assets and mandates that they be either FDIC-insured or backed by more than 100 percent physical assets.

Booker claims that in the Senate, there is a group of "decent guys on both sides of the aisle" working together to get it right.

"I'd want to see the correct regulation," Booker concluded. "I don't believe the SEC is the appropriate venue for regulating much of this sector." Clearly, the bulk of cryptocurrencies, such as ethereum and bitcoin, are more commodity-like."

However, until a bill is passed by Congress, Pham advises crypto investors to exercise extreme caution.

"If people began thinking of some of these truly creative crypto tokens as lottery tickets, you may strike it rich and get rich rapidly, but you might not," Pham added.

"I guess what I'm concerned about is that without sufficient customer safeguards and disclosures in place, individuals are buying some of these crypto tokens in the hopes of striking it big," she added.

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