Binance and its stablecoins

Yesterday, the SEC issued a Wells notice to the stablecoin issuer Paxos, warning it that the SEC intended to take legal action against it for issuing an unregistered security. The security in question is the fully-reserved stablecoin BUSD (Binance USD), which Paxos issues expressly for use on the Binance crypto exchange. The Wells notice doesn't apply to Paxos's other fully-reserved stablecoin, USDP, which it issues for use on its own platform. 

A few hours later, the New York Department of Financial Services (NY DFS) ordered Paxos to stop minting BUSD. In a consumer alert published on its website, the NY DFS said there were "several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD." It didn't specify what these issues were, but it went on to clarify that Paxos's BUSD and Binance's coin of the same name are not the same thing, and that it only regulates Paxos's coin, not Binance's:

It is important to note that the Department authorized Paxos to issue BUSD on the Ethereum blockchain. The Department has not authorized Binance-Peg BUSD on any blockchain, and Binance-Peg BUSD is not issued by Paxos. There is currently no restriction on the listing or exchange in New York of existing Paxos-issued BUSD by DFS-licensed entities.

Now, maybe I am reading too much into this, but to me the NY DFS sounds distinctly irritated that Binance has seen fit to issue an offshore unregulated coin with the same name as an onshore regulated one, and deploy it on multiple blockchains, none of which is the one on which the NY DFS has authorized Paxos to issue its coin. And it has a point. 

The fact that there are two coins with the same name is bound to confuse customers. I have no doubt that this was intentional. Binance and Paxos (yes, both of them) want customers to use Binance-pegged BUSD through Binance's platform, not Paxos-issued BUSD through some other platform regulated by NYDFS. This would be fine if Binance-pegged BUSD, like Paxos BUSD, were fully reserved and regulated by the NYDFS, as Binance's website implies. But it is not. 

As Binance explains in a blogpost, Binance-pegged BUSD is a "wrapped" version of Paxos BUSD, or what in tradfi parlance we might call a "derivative" or a "securitization". Whereas Paxos BUSD only operates on the Ethereum blockchain, currently these "wrapped" versions run on six blockchains (click for larger image):

By exchanging Paxos BUSD for Binance-pegged BUSD, holders can use their BUSD tokens on multiple blockchains, rather than being restricted to the Ethereum blockchain. It's a bit like putting a coin into a slot machine and getting out a token which you can use on other slot machines that don't take the coin you put into the first machine. We could say it increases the liquidity of the BUSD token - though only in Binance's arcade. 

Another way of looking at it is to regard Paxos BUSD as equivalent to dollars issued by the Federal Reserve (bank reserves and physical currency), and Binance-pegged BUSD as equivalent to dollars issued by commercial banks. Dollars issued by commercial banks are much more liquid than Fed dollars, but since they aren't issued by a U.S. government agency, they need a Federal guarantee to maintain their value. So they are hard-pegged to Fed dollars at par, and the Fed guarantees the peg subject to the commercial banks stumping up sufficient acceptable collateral.* Similarly, Binance-pegged BUSD is more liquid than Paxos BUSD, but it's not regulated by the NY DFS and isn't fully backed by US dollars and USD-denominated safe assets. So Paxos guarantees Binance-pegged BUSD's par peg to Paxos BUSD, subject to Binance providing collateral. 

Paxos is far from a passive participant in this scheme. It is every bit as invested in maintaining an equal relationship between the two coins as Binance. Binance creates demand for its stablecoin, and it earns income from the assets that back the stablecoin. 

The deal between the two companies says that Binance-pegged BUSD is always backed 1:1 by Paxos BUSD:

How can users be sure that the value of Binance-Peg BUSD tokens is equally protected? That’s simple: each Binance-Peg BUSD token that Binance mints correspond to a BUSD token held in reserve by its issuer – Paxos. BUSD (ERC-20) and Binance-Peg BUSD holders can swap their tokens between the blockchains freely. In sum, each Binance-Peg BUSD token represents the value of a native BUSD custodied outside of Binance, meaning that its value is secured by the same robust protection mechanisms that make BUSD one of the most reliable stablecoins on the market.

But between September 2020 and July 2021, it wasn't. At times, the gap between Binance-pegged BUSD in circulation and Paxos BUSD reserves was over $1bn. Binance insisted that these were merely "timing differences" and that customers were never at risk of not being able to withdraw their funds. But as anyone familiar with Herstatt risk knows, timing differences can become permanent differences. Despite Binance's assurances to the contrary, customer funds were at risk. 

So the NY DFS's action might have been precipitated by the revelation that Binance-pegged BUSD had not always been fully backed by Paxos BUSD. But if so, why didn't it act a month ago? Why has its action come hot on the heels of the SEC's Wells notice? 

The obvious explanation is that the SEC's notice alleges that Paxos BUSD is an unregistered security. Unlike Binance-pegged BUSD, Paxos BUSD is regulated by the NY DFS. Once the SEC had deemed it illegal, the NY DFS had no choice but to close it down. It couldn't be seen to be regulating an illegal security. 

However, the NY DFS was already investigating Paxos BUSD because of its questionable relationship with Binance. So maybe it would have closed it down anyway. Perhaps it just brought its planned action forward. Or perhaps the two agencies coordinated their enforcement actions. It would be nice to think they did. The US's regulatory smorgasbord can have some very unfortunate effects, and not just in tradfi. And the optics are frankly terrible. There's been much criticism from the crypto community of the SEC's patchwork approach to regulation, but really the same criticism can be levelled at all the US's regulators. A coordinated approach is sorely needed. 

The withdrawal of Paxos BUSD will hit Binance hard. Binance currently autoconverts USD deposits to Binance-pegged BUSD, which as we have discussed, is supposedly backed 1:1 by Paxos USD. Clearly, if the supply of Paxos BUSD will fall over time, so too must the supply of Binance-pegged BUSD, unless Binance moves to an explicitly (rather than accidentally) fractionally-reserved model. Binance will have to choose between persisent liquidity problems because of reserve shortages, or a partially (and eventually wholly) unbacked stablecoin worth considerably less in USD terms than it is today. The collapse in the price of BNB today reflects sharply increased uncertainty about the future of Binance:

If Binance were a public company, its share price would be tanking.

Binance will no doubt look for alternative stablecoins to back its home USD stablecoin. Perhaps the most obvious candidate is USDT, though USDC would also be a candidate. However, we don't yet know why the SEC is targeting BUSD. Why have they picked on the stablecoin that is most closely linked to Binance? If the SEC's purpose in pursuing this legal action is to shut Binance off from sources of USD, then any stablecoin that replaced Paxos BUSD in Binance's ecosystem would surely be next in line for a SEC Wells notice.

But there's another mystery. Why is the SEC alleging that Paxos BUSD is an unregistered security? Binance-pegged BUSD is almost certainly a security, since it is a derivative or securitization of another stablecoin. But it's much less clear why Paxos BUSD should be classed as a security. The Howey test that the SEC uses to determine whether a cryptocurrency is a security has four criteria, all of which must be met for the cryptocurrency to be deemed a security:

• it must involve an investment of money
• it must be investment in a common enterprise (ie other people are investing too)
• investors must have a reasonable expectation of profits
• the profits must come from the efforts of others

Paxos BUSD meets three of the four criteria: it involves an investment of money, it is a common enterprise, and any profits (e.g. returns on the backing assets) would come from the efforts of others. But it is hard-pegged to the US dollar at par. All investors can reasonably expect is to get their money back when they redeem the coins. So where does the "reasonable expectation of profits" come from?

There are a few possibilities. Firstly, the fact that BUSD is a listed asset in Binance's Earn program. Customers can lend their BUSD to Binance at a stated rate of interest, and Binance pools their coins and lends them out. Similar Earn programs at other exchanges have already been deemed illegal securities: Coinbase pulled the launch of its Earn program when the SEC issued a Wells notice. 

Secondly, the relationship between Paxos and Binance. Paxos earns a return on the assets that back Paxos BUSD, and remits part of this to Binance. Since Binance is Paxos's customer, it could perhaps be argued that Binance has a reasonable expectation of profiting from its investment in Paxos BUSD. 

Thirdly, it's possible that the SEC regards Paxos BUSD as a note which has characteristics of a security. If this is the case, then the Reves test, not the Howey test, is the right one to use. Notes are included in the general list of securities types in the Exchange Acts, but over the years, case law has carved out a number of exceptions, mainly products offered by licensed banks. So the Reves test works differently from the Howey test. Where the Howey test defines four criteria that a product must meet to be classed as a security, the Reves test says that unless you can come up with a good reason why a note should not be classed as a security, it is a security. Clearly, this could catch a much wider range of crypto products than a strictly-applied Howey test. There has already been quite a bit of discussion about whether DeFi products would fail the Reves test.

Fourthly, it's possible that because of the nature of the assets backing Paxos BUSD, the SEC regards it as a money market mutual fund (MMMF) or some other kind of investment fund. Many people have argued that securities-backed stablecoins such as Tether are MMMFs, and it would appear the SEC looks favourably on this approach. In this speech, Gary Gensler, current Chair of the SEC, cites former Chair, Jay Clayton, defining stablecoins backed by commercial paper as MMMFs:

“A stablecoin that promises $1 back to you, in exchange for the coin, and is backed by cash is one item. Such a coin that is backed by commercial paper, whether it’s 30, 60 or 90 days, sure looks like a money market mutual fund to me. So the second element really looks like a security. We have decided that a pooled vehicle of commercial paper that you use for daily liquidity is a money market mutual fund and should be regulated as such.”

The first two of the above possibilities concern the relationship between Binance and Paxos. This would be consistent with the line taken by the NY DFS and might explain why the agencies appear to have coordinated their action. Both of these possibilities could have unfortunate consequences for Paxos and/or Binance, but unless one or both of these companies crashes and burns in the way that FTX did, there should be little impact on the wider crypto ecosystem.

But the third and fourth possibilities have far wider implications.

If the SEC successfully argues in court that Paxos BUSD is a money market mutual fund or some other kind of investment fund because of the nature of the backing assets, then the logical next step would be to class all securities-backed stablecoins as MMMFs or other investment funds, consistent with Jay Clayton's definition. 

And if the SEC convinces a court that Paxos BUSD is a note with security-like characteristics, then not only other stablecoins, but things like DeFi staking** could potentially be classed as securities. This would have profound and long-lasting ramifications for the entire crypto ecosystem.

The crypto ecosystem relies on stablecoins as a cheap and plentiful form of dollar liquidity. If all stablecoins were classed as securities, dollar liquidity for onshore crypto exchanges and platforms would dry up as stablecoin issuers either went offshore or out of business. It is very hard to see what would replace it, at least in the short term: U.S. dollars (and other fiat currencies) are not liquid on crypto exchanges, because to move them around requires banks, and non-USD stablecoins have gained little traction thus far. So trading crypto onshore would become much more expensive and considerably riskier. The dollar liquidity drought could also severely impact DeFi, because that relies on stablecoins (or derivatives of stablecoins) as collateral. So the SEC's action could bring down the onshore crypto ecosystem. 

Conversely, the offshore industry might get bigger, as enforcement actions by the SEC and others drove crypto platforms and exchanges offshore. Indeed I suspect this is the point. The SEC wants to prevent US citizens interacting with crypto. What the rest of the world does is not its concern.

However, regulators in other countries are likely to follow suit. Those that are reliant on the U.S dollar for trade won't want to find themselves playing host to an industry to which the U.S. has turned a cold shoulder - indeed, it would be dangerous for them to do so. And although Asian and Middle Eastern powerhouses might not be so concerned about the long reach of U.S. regulators, they have their own reasons to impose strict regulation of crypto platforms and exchanges. So liquidity and safe collateral on crypto exchanges and platforms is going to become ever scarcer, not only in the U.S. but globally. The crypto winter is about to get much, much colder. 

There's a possibility that this could bring about an existential crisis in the crypto world similar to the dollar Armageddon about which Bitcoiners like to fantasise. The crypto world has allowed itself to become dependent on crypto equivalents of the US dollar and US Treasuries. Just as the world economy would collapse if the supply of these suddenly dried up, so the crypto economy could collapse if the supply of the crypto equivalents evaporated like the morning mist.

But the links to the real economy are sufficiently strong now to make a sudden collapse of the entire crypto ecosystem a serious threat to real-world financial stability. The SEC won't want to trigger another 2008 or 1929. So although the SEC could simply close down all stablecoins overnight, I don't think it will do so. Rather, I think it will slowly strangle the crypto ecosystem by banning new mints and forcing stablecoin issuers to redeem their coins, just as the Fed is slowly strangling the offshore dollar finance industry by withdrawing reserves from the tradfi system. Quantitative tightening is coming to a stablecoin near you, any time now. 

Whatever the SEC does, it won't mean the end of stablecoins. The worst case is that they will just become another regulated instrument issued by licensed and regulated financial institutions. In a decade's time, you'll have forgotten that the unregulated variety ever existed. That's how the financial system rolls. 

Related reading:

There's no such thing as a safe stablecoin

Stablecoin issuer Circle warned New York regulator about rival Binance's token - Bloomberg

Image: Laocoon and his Sons being Devoured by Serpents, statue. Via Wikimedia Commons. I'm sure the symbolism won't be lost on readers of this post. 

* Collateral gives banks access to Fed liquidity, thus making it possible for banks to honour customer redemption requests. FDIC insurance protects depositors in the event that the bank becomes insolvent, but doesn't guarantee liquidity for redemption requests. So it's the Fed that guarantees the par peg, not FDIC. I hope this distinction is clear. 

** A DeFi stake is similar to a certificate of deposit (CD). A 1982 Supreme Court judgment (Marine Bank vs Weaver, 455 U.S. 551) established that CDs issued by licensed banks aren't securities, because the banks are Federally regulated and the products are Federally insured. But the court said that in other contexts, similar products might be classed as securities.