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Llama Risk Response to FCA Discussion Paper: DP23/4

From LlamaRisk

To Whom It May Concern,

We are grateful for the opportunity to provide feedback on the FCA's discussion paper on stablecoins regulation. The response herewith is informed by our extensive risk assessment of USDM, a regulated Real-World Asset (RWA) token backed by short-term U.S. Treasuries, and asset overview of USDY, a tokenized note anchored by U.S. Treasuries and bank deposits. Additionally, our insights are aligned with the recent S&P Stability Assessments of centralized stablecoins, reflecting our commitment to maintaining the highest standards of safety and compliance in this evolving market.

Q4: Do you agree with our proposed approach to regulating stablecoin backing assets? In particular, do you agree with limiting acceptable backing assets to government treasury debt instruments (with maturities of one year or less) and short-term cash deposits? If not, why not? Do you envision significant costs from the proposal? If so, please explain.

We opine that focusing stablecoin backing assets at government treasury debt instruments (with maturities of one year or less) and short-term cash deposits offers specific benefits as observed in the USDM and USDY reports, and in the S&P Global Ratings assessments.

1. USDM

The collateral composition of USDM employs a diverse and secure portfolio with a dollar-weighted average duration capped at 60 days. This includes treasury bills, short-term treasury notes nearing maturity, Money Market Funds focused on short-term US treasuries, Treasury ETFs, and Reverse Repurchase Agreements backed by US Treasuries.

Additionally, collateral management includes a strategic over-collateralization through a collateral buffer. This buffer being composed of cash and stablecoins like USDC, is designed to mitigate interest rate risks, primarily during asset transit phases, while the stablecoin issuer strives to minimize cash holdings in line with the company's objectives. Over-collateralization serves as a financial safeguard, ensuring USDM's stability even in the face of declining Treasury values due to rising interest rates. The equity buffer, set at 50 basis points, is designed to sustain the USDM Reserve through extreme scenarios, such as simultaneous interest rate hikes and widening bid/ask spreads, effectively protecting against potential bank run situations.

The reserves are managed by E.Q. Capital, a Bermuda-licensed Investment Manager, ensuring separation from the issuer’s operational funds. Adhering to a strict investment mandate, E.Q. Capital invests with a focus on liquidity and minimizing interest rate risk, maintaining a portfolio with short-dated, high-liquidity instruments. This careful management strategy, alongside Bermuda's regulatory compliance, safeguards token holders' rights and contributes to USDM's stability and reliability.

2. USDY

USDY's asset strategy, which includes short-term cash deposits and treasury bills, offers liquidity and safety. These assets are less volatile and more reliable during market fluctuations, supporting the stablecoin's value stability.

35% of funds are strategically allocated to short-term U.S. Treasury bills with a 3-month maturity, regarded as cash equivalents for their liquidity and safety. A significant portion, 65%, is maintained in demand-deposit accounts at highly-rated banks, chosen for their robust risk practices. These accounts offer immediate accessibility, akin to cash, ensuring liquidity. Additionally, USDY maintains a 3% first-loss position in cash, serving as over-collateralization to further enhance the stability and reliability of the token.

3. S&P Rated Stablecoins

The S&P Global Ratings Assessments provide detailed insights into the backing assets of various stablecoins:

  • USDC: Managed by Circle, USDC's reserves are predominantly in short-dated securities and bank deposits, held mainly at the SEC-registered Circle Reserve Fund managed by BlackRock.
  • USDT: Tether's reserves include a mix of short-term U.S. Treasury bills, cash equivalents, and a portion in higher-risk assets. A significant share of USDT's reserves is in short-term U.S. treasury bills.
  • GUSD: Issued by Gemini Trust Company, GUSD's reserves consist of cash deposits at various banking institutions, U.S. Treasury bills with maturities of three months or less, and money market funds.
  • USDP: Paxos Trust Co. maintains USDP's reserves in cash deposits at various banking institutions, U.S. Treasury bills, and reverse repurchase agreements backed by Treasury bills or money market funds.

Each stablecoin's reserve composition reflects its strategy to maintain stability and liquidity, crucial for preserving the peg to the dollar.

Q8: We have outlined two models that we are aware of for how the backing assets of a regulated stablecoin are safeguarded. Please could you explain your thoughts on the following:

i. Should regulated stablecoin issuers be required to appoint an independent custodian to safeguard backing assets?

ii. What are the benefits and risks of this model?

iii. Are there alternative ways outside of the two models that could create the same, or increased, levels of consumer protection?

Above all, we should highlight the importance of transparency and trust in third-party custodianship. An independent custodian's involvement can enhance the credibility of the stablecoin, ensuring that assets are held securely and are not mismanaged by the issuer.

In the following section, we present arguments supporting the requirement for appointing an independent custodian to safeguard backing assets, emphasizing the enhanced security and regulatory compliance this approach offers.

1. USDM

USDM, issued by Bermuda-based Mountain Protocol Limited, operates under a Class M license from the Bermuda Monetary Authority, in accordance with the Digital Asset Business Act (DABA). This regulatory framework assures that digital asset business activities are well-managed and compliant. The solvency of USDM is reinforced by the establishment of bankruptcy-remote collateral accounts. These reserves, segregated and held at regulated financial institutions, offer protection to USDM holders, ensuring their exclusion from proceedings like receivership or insolvency. Additionally, Mountain Protocol employs an industry leader, i.e. Fireblocks, for managing digital assets, ensuring that USDM held by them is under qualified custody, reflecting adherence to stringent custodial practices.

2. USDY

The USDY's collateral infrastructure is meticulously structured for optimal security and compliance. U.S. Treasuries are held in cash-custody accounts at Morgan Stanley and StoneX, with a clear stipulation against rehypothecation and accrual of standard T-bill yields. Bank deposits are securely held in Demand Deposit Accounts at highly-rated financial institutions like Morgan Stanley and First Citizens Bank, each earning respective yields. Particularly, the selection of Morgan Stanley, a Global Systemically Important Bank (G-SIB), underscores the issuer’s commitment to robustness and stability, given their enhanced capital requirements and stringent regulatory oversight. This strategic choice mitigates risks associated with lower-rated banking institutions, exemplified by the challenges observed in the March 2023 Silicon Valley Bank incident.

3. S&P Rated Stablecoins

The observed USDT case exemplifies the need for transparency. S&P underscores that "... asset assessment of 4 (constrained) reflects a lack of information on entities that are custodians, counterparties, or bank account providers of USDT's reserves." Without clear knowledge of who manages the reserves, it's challenging for users and regulators to fully trust the stablecoin. An independent custodian's involvement would ensure that there's a transparent and auditable trail for how the reserves are managed, enhancing the overall credibility of the stablecoin.

In this regard, the assessment of FDUSD raises concerns about "the identity and creditworthiness of some financial institutions where these reserves are deposited". An independent custodian, known for its stability and reputation, could significantly reduce such risks, providing a more secure and reliable backing for the stablecoin.

On the other hand, GUSD and USDP, both supervised by the NYDFS, serve as a prime example of the benefits of regulatory oversight. The NYDFS framework provides a comprehensive model for asset custody in the stablecoin industry.

  • Segregation of Assets: reserve assets must be distinctly segregated from the proprietary assets of the issuing entity. Segregation is crucial for ensuring that the assets backing the stablecoin are not commingled with the issuer's operational funds.
  • Custody with Approved Depository Institutions: reserve assets must be held in custody with U.S. state or federally chartered depository institutions, which have deposits insured by the Federal Deposit Insurance Corporation (FDIC). As FDIC insurance provides a safety net for the assets against bank failures up to the insured limits, thus an extra layer of security is achieved.
  • Pre-Approved Asset Custodians: Additionally, reserve assets can be held with asset custodians, but only if they are pre-approved in writing by the NYDFS. The approval process ensures that the custodians meet certain regulatory standards and are capable of providing a secure and stable environment for the reserve assets.
  • Beneficial Ownership and Account Titling: The guidance also mandates that the reserve assets be held for the benefit of the stablecoin holders, with appropriate titling of accounts. The assets are not just physically segregated but are also legally recognized as being held for the benefit of the stablecoin users.

In conclusion, the bankruptcy-remote setup of stablecoin issuers is paramount to ensure the consistent ability of users to redeem their tokens at any time and at par value. Entrusting collateral custody to renowned, qualified custodians is vital, yet it's equally important for the issuer to regularly attest to and publicly disclose the state of reserves. This practice is fundamental to maintaining transparency in stablecoin distribution, bolstering user confidence and ensuring the integrity of the stablecoin ecosystem.

References to LlamaRisk’s reports:

  1. https://cryptorisks.substack.com/p/asset-risk-assessment-mountain-protocol
  2. https://cryptorisks.substack.com/p/asset-overview-us-dollar-token-usdy
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