I am a music fan. Of all sorts, from classic, to pop, to etc. In the sixteenths, I visited the National Jazz and Blues Festival in Plumpton South England. And there I saw Deep Purple for the first time. It was great.

Recently I read that, notwithstanding the music industry is an incredibly big business, many artists still have a pover life. This while the main streaming platforms such as Spotify and other intermediaries are grasping more than 80% of the revenues.

There is however a technology that could bring fundamental changes: blockchain. Blockchain may solve many of the existing problems and challenges in the music industry.

The Music Industry: present state

But before going into more detail in what blockchain could bring, let us first look at the problems in the music industry this technology could help to resolve.

Over the past few decades, the music industry has undergone constant change and

has seen many disruptions over the years. For decades record labels like Universal Music Group, Warner Music Group, and Sony BMG have dominated and controlled the whole music industry, managing the music rights and reaping much of the profits.

Since early 2000 music streaming platforms have emerged as new market leaders thereby triggered by the arrival of the internet. These streaming platforms such as Spotify and YouTube have helped to change the story to some extend and transformed the way music is experienced by making it more widely accessible to users.

Shortcomings within the music industry

Though these platforms brought in more disruptions, while changing the stakeholder landscape, the old structures that formed the music value chain have hardly changed.

That also means that a number of big shortcomings still exist, including rising operational costs and high administrative fees, minimal artist pay-outs due to lots of middlemen, overall lack of transparency especially when it comes to metadata and copyrights, and as a result inefficient and lengthy royalty payment processes as well lack of global collaboration due to an absence of trust.

Many middlemen
The current music industry is overloaded with a large number of middlemen like record labels, radio companies and streaming services. That also means that a very significant proportion of royalties are not received by artists, either because of high and costly administrative fees while it is hard to determine how much one typical artist is supposed to receive.

Centralised services
Another shortcoming is that most centralized music streaming services act like search engines. These are often inaccurate, unsafe, and vulnerable to malicious agents. And, as with any centralized search engine, there is an algorithmic bias that might favour and give more exposure to some artists or tracks and neglect others.

No global database for copyrights and neighboring rights
And there is the low transparency, especially when it comes to metadata and copyrights. Although the volume of data has increased manifold, there is still no global database for copyright and neighboring rights. To manage this chaotic amount of different rights, a complex structure has been developed, whereby the music industry was turned into a complicated array of publishing and recording agreements and other licenses. Finding who is the owner of a determined right in order to obtain a license could be difficult or even impossible. Artists often don’t know how their royalty payments are calculated

Minimal artists pay-outs
And as a result of all these shortcomings, while the music business is still very much booming and makes billions of dollars, most of the artists themselves are receiving minimal pay-outs. In 2020, musicians only gained 12% of $50 billion generated in the music streaming industry, according to a Citigroup report. On top of that it can take years for the money to reach the artist’s bank account. 

Blockchain as a solution

Since blockchain technology is based on the ideas of fully database decentralisation and enhanced security, it holds huge potential for the music industry to overcome a lot of these challenges faced by music fans and artists.

Blockchain and the use of smart contracts could revolutionize and fundamentally change the music industry by removing third party middlemen from music sales and centralized music streaming platforms  and put the power and control back into the creators’ hands from an economic and creative perspective.

By bypassing this long list of intermediaries blockchain could ease the process of copyright, allow artists to verify the copyright of their songs, thereby streamlining royal payments. They could thereby solve the problem of adequate compensation for artists and right holders, ensure more efficient and equitable royalty distribution and revenue sharing, and secure music rights and intellectual property management.

Improve copyrights/intellectual property management
Blockchain holds huge potential for the music industry, particularly for music copyrights and intellectual property management. This technology can help securely manage music rights by introducing transparency in music ownership rights and royalties, via the launch of music rights marketplaces and royalty management platforms.

For artists blockchain could bring direct management of copyright and intellectual property by having a comprehensive peer-to-peer database in which detailed music copyright and intellectual property information is stored. This by using smart contracts containing up-to-date information anybody can view and verify, thereby ensuring that the right people get compensated for the content’s use.

Deeper data insight: transparency and traceability
This massive database would present benefits and opportunities for both collection societies, distributors, and labels, in terms of better marketing and curation, along with verification of the data itself thanks to its immutability, inalterability and transparency.

As music is recorded on the ledger with a unique ID and time stamp, this would address the longstanding issues of consumers downloading, copying and altering digital content. By saving their work directly to a blockchain, it creates an immutable ledger which makes it impossible for someone to steal or copy lyrics or melodies—artists can essentially own their own “masters.” That would also make it more difficult to attack a blockchain database or tamper with the data, because the members of the blockchain network will immediately spot a change to one part of the database.

Full audience ownership
Blockchain platforms also allows full audience ownership. The blockchain makes up for a secure way to prove ownership over a specific piece of music, as well as confirm every person who is involved in its copyright. Blockchain and smart contracts can automate this process by allowing artists to create an immutable record listing all their contributors, producers, and others who participated in the creative process of music files. Every time music files are transferred on the blockchain; this data stays intact. Additionally, it can grant all streaming and fan activity data directly to the hands of the artists. As a result blockchain provides deeper data insights into music lovers’ favourite artists, music videos etc

Instant micro-payments
Blockchain and the use of smart contracts could also solve the issue of adequate compensation for artists and rights holders with instant micro-payments. Blockchain smart contracts could thereby be used to optimise automatic payments, with no middlemen delaying or taking a portion of this payment. They could set the terms under which the music can be downloaded and used, as well as the percentage of royalties to be destined to each copyright holder. Through smart contracts musicians could be paid for fractions of a cent after each sale or stream, allowing the process of royalty payments to take place in seconds instead of multiple months. This paves the way for a new approach to providing on-demand music services, whereby users choose their favourite record and reward and royalties and profits go directly to the artists themselves.

Fostering closer artist-fan relationships
Blockchain technology also enables artists to access some other important sources of revenue for independent musicians: engaged groups or fans. Blockchain music distribution platforms would be able to connect artists directly with listeners, building a direct seller-consumer relationship. Everyone would have equal chances to be found based on relevancy to the search query instead of being pushed by an algorithm.
Composers and artists will no longer be obliged to go through intermediaries such as purchasing platforms and financial brokers, enabling them to take a much large share of the earnings when their music is played while reducing the cost for listeners to access music.  

Blockchain based music platforms

The interest in blockchain technology by the music industry is rapidly growing.

There are now a fast growing number of initiatives by artists and start-ups developing and launching music platforms based on blockchain technology, aimed at changing the face of the music industry and put power in the hands of artists and fans.

Apart from platforms focused on music streaming, streamlining royalty payments and allow direct artist-fan interaction, blockchain is increasingly being used to construct music licensing platforms, platforms to manage ownership rights and payments, while there are a growing number of platforms that operate as music rights marketplace, and as a peer-to-peer blockchain music database creating a music library for film and television.

In this blog I will only describe these platforms to give an idea how they work, what their goal is and just mention a number of interesting platforms that are nowadays operational. A number of these platforms can be found in other blogs such as “15 companies utilizing blockchain in music to reshape a changing industry” from Sam Daley, June 29, 2022.

Music streaming platforms

Blockchain-based streaming platforms allow for the transparent and secure peer-to-peer transfer of music and music related purchases. They connect artists and fans directly without the interference of intermediaries, thereby greatly solving the payments issue getting up to 90% of the streaming revenues. These platforms that are aimed to facilitate the creation, consumption and distribution of music in a shared economy, may bring a high level of trust, automation and transparency to the process. Through new streaming platforms using blockchain technology and non-fungible tokens, or digital assets, it is the artist themselve, and not the record labels, who stand to benefit. They ensure that artists receive compensation for their music straight from their fans, while most of the revenues goes to the artist. There are a number of these platforms that incentives music discovery even further by allowing users to receive a share of royalties. Main streaming platforms include the names like  Audius, BitSong, Music Foundation, NewCoin Founder and Opus.

Music licensing platforms
And there are decentralized music licensing platform for music rights holders and creators that allow them to perform their licensing transactions directly, or provides on-chain licensing for blockchain native content such as intellectual property for audio, visual and images. These platforms thereby utilizes smart contracts and crypto to facilitate more efficient licensing transactions and payments. These music licensing Platforms include names like Dequency and  Digimarc.

Music copyrights marketplace/platforms

There are also several platforms, like eMusic, Mediachain, Musiclife, Open Music Initiative, as well as others, that address the copyrights problem and use blockchain technology to monitor music right holders and act as a royalty management platform that rewards both artists and fans. These platforms are exploring the use of blockchain to help identify the rightful music rights holders and originators so they can receive fair royalty payments.

There are music rights marketplaces that allow music fans to directly fund their favourite artists, songwriters and producers. In exchange, fans can receive royalties generated from their favourite recordings. The platform accomplishes this by collecting royalties from performing rights organizations, record labels and publishers on behalf of fans and then tracks them using proprietary blockchain technology. Other platforms feature instant royalty pay-outs, a rights management and tracking database, fan-to-artist crowdfunding and back-catalogue monetization for copyright holders.

Music database
And there are the various platforms like Viberate, Mediachain, Blokur, Verifi Media and Mycelia that act as peer-to-peer, blockchain music database for sharing information across different applications and organizations. Some of these music databases act  as a source for global publishing data for management and monetization of music, thereby combining different sources of rights data in one database. And there are  peer-to-peer, blockchain databases for sharing information across different applications and organizations. Others run an entire database on blockchain to ensure that artists are paid fairly and acknowledged quickly, containing full information about a song, including ID’s, acknowledgements, business partners and payment mechanisms, so all contributors are treated fairly.

Direct artist-fan connection platforms
Artists are looking to blockchain technology to connect more directly with fans and to bolster their earnings. These direct artist-fan connection platforms can also offer economic rewards to music listeners, increasing the entire experience more interactive and rewarding. Artists could thereby promote their own music and offer special rewards for buyers like extra downloads or rights. Consumers can directly pay for streaming music using blockchain platforms. They would then have the same access to their music, with a more direct connection to the artist who would be paid instantly via the same currency. Examples are Choon that is helping to provide new avenues for more revenue and incentivizing fans through rewards for listeners curating personalized playlists, while Drrops allow artists to communicate directly with their fans and offer them exclusive content and perks while Viberate rewards fans with native VIB tokens.

Non fungible tokens (NTFs)

A growing number of artists in the music world now also have entered the world of NFTs in a massive way. NFTs or non-fungible tokens are seen as the perfect way to create proofs of authenticity for digital content. They promise improved access to global markets for so-called indie artists and other creators to showcase and sell their art including music streams.

NFTs are stored on a blockchain network, are unique and indivisible and can be used to indicate ownership of one-of-a-kind goods. They are protected by the blockchain, which means no one can change the ownership record or create a new NFT. This helps artists to prove that they have created their artworks. In turn, this helps them to get fair compensation for their work.

An NFT can either be one of a kind, like a music song, or one copy of many, but the blockchain keeps track of who has ownership of the file. These attributes make NFTs ideal for tokenizing music. Music NFTs can technically contain anything digital, like logos, album covers, live performances, concert photo prints, videos of life streams  etc.

NFTs allow you to buy and sell ownership of unique digital items and keep track of who owns them using the blockchain, aside from a musician making an initial NFT sale and profiting from it, as they can keep a percentage of all future NFT sales.

Current and future challenges 

But not all risks are gone when using blockchain. Notwithstanding the arrival of official crypto regulations such as MICA in the EU, there are still no guidelines, legislation, or established case law for using blockchain in the music industry.

There are still a number of challenges, regulatory and structural, that need to be addressed. One of the most pressing issues for the music industry, notwithstanding blockchain, is the lack of a global, comprehensive database of rights. And there is the issue of disintermediation, as is common with many, if not all, tech-driven disruptions. Another issue is: how will the traditional players in the music world react.

One standard across all music databases
With multiple stakeholders, including artists, music publishers and labels, music streams, collecting societies, and event organisers, achieving consensus on data standards is inherently challenging. If blockchain is to be adopted at industry level, it is all the more crucial to have correct and complete rights data at the onset, since once recorded on the blockchain it will be inherently unalterable. Today’s music industry consists of a large number of databases with little to no interoperability, meaning that if you mention a songwriter in one database, it is not going to synchronize in another. Stakeholders in the music industry don’t share their data nor use a standard music file format.

Data protection

And there is the issue of data protection. Just as other industries, the music industry is also required to comply with the EU General Data Protection Regulation (GDPR). When using blockchain to record personal data, these rules become especially complex since the technology is designed to prohibit retroactive changes to the ledger. This is directly in violation at the GDPR guideline allowing individuals the right to ask for their data to be deleted. Other areas like intellectual property laws will also need to be revisited in the light of new ways of working. This would solve many issues such as conflicting or incomplete records and allow content creators to have all elements of their musical work completed on a universal system.

Hacks
Notwithstanding it was said that blockchain for the music industry would prevent hacks and other misuses, Audius, the blockchain music streaming platform, lost  millions in a recent hack. Hackers that breached the platform were able to steal approximately $18 million AUDIO (Audius crypto token) that is estimated to be worth around $6 million. This is definitely a wakeup call for these platforms to continuously update their security measures.

Transition period
With blockchain adoption, the role of traditional labels, streaming platforms and copyright collection societies could be diminished with the increase in smart contracts and micropayments. But it is still uncertain what will happen during the transition period. How will traditional players react: in a cooperative way or would they “back against the wall”. Steering the industry past the chaotic phase will be critical for it to achieve its full potential.

Forward looking

Though blockchain in music is still in its early years, the technology undoubtedly has the potential of disrupting the music industry for good. Given the firm rise in blockchain-based music platforms it will fundamentally change the manner in which the music business is being conducted. It will lead to the development of a more balanced and fair music ecosystem, one focused on artist and consumers.

The music market will certainly undergo structural change as blockchain adoption spreads. It will shift the power from present intermediaries thereby saving the music industry billions in lost revenues, delayed payments and legal costs and help artists regain ownership and revenue. It will also create ways to reward artists directly, this by revolutionising the rights and royalties process, ensuring artists, writers, publishers and everyone in the music. Ultimately, the financial benefits to artists will likely boost overall creativity.

But in order for this to happen, the industry needs to come together to determine a standard practice and trust in each other and the technology. Thanks for reading!

The recent crypto market crash shows how highly risky and speculative crypto currencies are. It confirmed the urgent need for enhanced regulatory and law enforcement frameworks in the EU. So far, digital assets, such as cryptocurrencies, have been largely out of the scope of EU legislation, while divergent laws exist in the member states.

But what may we further expect? Is this the start of further regulatory co-operation worldwide or will it trigger growing regulatory competition between the various countries, especially the US and UK, that are presently dominating the crypto market.

The deals

The deal reached on 30 June consists of two elements: the Markets in Crypto Assets or MICA regulation and a Bill on the Transparency of crypto asset transfers. Both laws are put in place to set clear common rules for a harmonized market in the EU.

The aim of the regulation is to put an ’end to the crypto wild life’ by creating a comprehensive regulatory framework for the crypto-asset market in a balanced way that supports innovation and harnesses the potential of crypto-assets while preserving financial stability and protecting investors.

Such a regulation should provide legal clarity for the crypto business including crypto asset issuers, guaranteed equal rights for asset service providers, as well as ensuring high standards for consumers and investors.

While MICA will put new requirements on exchanges and issuers of stable coins, and provide legal certainty for crypto-asset issuers, guarantee equal rights for service providers and ensure high standards for consumers and investors, the Transparency Bill will force crypto asset service providers(CASPs) to gather information about the transfers they operate to prevent money laundering in crypto.

New provisions

The proposed EU regulation is especially targeting so-called crypto asset services providers(CASPs) and aims to provide a consistent approach across all 27 member states and covers issues like authorisation and supervision, transparency, disclosure and authorisation and supervision of transactions by crypto asset service providers (CASPs) as well as consumer and investor protection, stablecoins and environmental considerations.

License

MiCA will change the registration and authorization process for crypto asset services providers in Europe. Under the provisional agreement they will need an authorization in order to operate in the EU. National authorities will thereby be required to issue authorisations within a timeframe of three months. Regarding the largest CASPs, national authorities will transmit relevant information regularly to the European Securities and Markets Authority (ESMA).

These CASPs will have to be licensed by national authorities and must be based in the EU and have their office within the European Union by a legal person, with a predetermined capital base and adhere to consumer protection safeguards, and be listed on a register held by the European Securities and Markets Authority.

This license will give issuers of crypto assets and providers of related services a “passport” to issue and sell digital tokens in the EU \nd serve clients across the EU from a single base.

Public register

To avoid any overlaps with updated legislation on anti-money laundering (AML), which will now also cover crypto-assets, MiCA does not duplicate the anti-money laundering provisions as set out in the newly updated transfer of funds rules agreed on 29 June.

The new framework will put ESMA in charge of a public register where all non-compliant crypto providers who offer services without authorization will be listed. This to reduce anonymity to tackle money laundering and evasion of sanctions.

EU cryptocurrency exchanges will be obliged to identify users and track suspicious transactions. Entities issuing crypto assets will have to disclose basic information such as a description of the issuer, the project and the use of the funds. This “identity card” will be backed up by details of the rights, obligations and risks associated with these digital assets. National authorities will be notified of all of this information.

Crypto-asset service providers, whose parent company is located in countries listed on the EU list of third countries considered at high risk for anti-money laundering activities, as well as on the EU list of non-cooperative jurisdictions for tax purposes, will be required to implement enhanced checks in line with the EU AML framework. Tougher requirements may also be applied to shareholders and to the management of the CASPs, notably with regard to their localisation.

White Paper: transparency

CASPs will also be obliged to be more transparent about their financial position as well as the tokens they offer. The regulation makes it a legal obligation for crypto projects to issue a White Paper on all tokens, with all the characteristics and risks  and submit it to the regulatory authorities, although the submission will be merely declaratory and the regulatory authorities do not enjoy the power to authorise or reject crypto projects, other than stablecoins.

The list of information that crypto projects are required to share with the public is relatively slim and does not include many aspects that are already customarily included in white papers. Most importantly, the regulation does not require white papers to explain the project’s ‘tokenomics’.

Consumer and investor protection

This regulatory framework also aims to provide an appropriate level of consumer and investor protection against some of the risks associated with  the investment in crypto assets. Consumer protection standards adopted in the regulation will legally protect consumer funds against cyber-attacks, theft or misuse which are within the responsibility of the cryptocurrency exchanges.

Crypto companies will be held more accountable for investor protection and for investor losses. They must act ‘fair, honest, professional in the best interest of their clients and provide such clients or potential clients with fair and not misleading information’.

Once implemented, the law will require crypto asset service providers (CASPs) to adhere to certain requirements aimed at protecting investors as well as warn clients about the potential risk associated with investing in a volatile crypto market, and publish their pricing policy on their website.

Although these regulations will not provide protection against all of the risks associated with cryptocurrencies, individuals’ own knowledge and analyses will therefore continue to be a key method of consumer protection.

Un-hosted wallets

Unhosted wallets, also known as cold storage or self-custody that enable the user to maintain a cryptocurrency balance outside of an exchange, are mostly excluded from regulation. Transfers between exchanges and so-called “un-hosted wallets” owned by individuals will need only to be reported when transfers are made to a person’s own wallet, and when the value tops the 1,000-euro threshold. This move is designed to reduce anonymity, and thus money laundering, through crypto transactions.

Stablecoins

Stablecoins, which the regulation calls ‘asset-referenced’ tokens’, are also subject to strict regulatory standards of transparency, operation, and governance.

When the regulation comes into force, existing stablecoins will have to seek authorisation from the regulatory authorities to be traded within the EU. Issuers of these so-called asset referred stablecoins will need to have a registered office in the EU to ensure the proper supervision and monitoring of offers to the public of asset-referenced tokens. Most importantly, the regulation prohibits the issuance of interest to e-money tokens. The authorisation requirement applies also to stablecoins already in circulation.

Reserves will have to be “legally and operationally segregated and insulated” and must also be “fully protected in case of insolvency.” Stablecoins that become too large/big also face being capped at 200 million euros in transactions a day under the new regulation.

Holders of stablecoins will be offered a claim at any time and free of charge by the issuer, with all stablecoins be supervised by the European Banking Authority (EBA), with a presence of the issuer in the EU being a precondition for any issuance.

Environment

MiCA will also address environmental concerns surrounding crypto. Crypto asset providers will be required todeclare information on their environmental and climate footprint and disclose their energy consumption to regulators as well as the environmental impact of digital assets they choose to list, using the EU regulatory standards as a basis.

The ESMA is now developing draft regulatory technical standards on the content, methodologies and presentation of information related to principal adverse environmental and climate-related impact.

Oversight of the crypto industry

The new EU regulation of the crypto market will primarily be enforced by national regulatory authorities designated by the member states. They will employ national procedural rules and impose remedies foreseen in national law, including criminal remedies where applicable, when they enforce the regulation.

While EU member states will be the main enforcers of the rules, the regulation also gives the European Banking Authority and the European Securities and Markets Authority significant supervisory and investigative powers.

ESM will be responsible for oversight of the industry, while a new legal framework will seek to regulate public offers of crypto assets to protect market integrity. ESMA will thereby be given powers to step in to ban or restrict crypto platforms if they are seen to not properly protect investors, or threaten market integrity or financial stability.

In the meantime the European Council reached an agreement to form an anti-money laundering body that will have the authority to supervise certain CASPs. And will  probably get the name of AMLA.

Reactions from the cryptomarkets

How ate crypto firms reaction? Overall, crypto industry players are reacting positively to the EU’s MiCA efforts, and largely welcomed this outcome that heralds the end of several months of negotiations.

As such a harmonized, comprehensive framework could give market participants regulatory the desired clarity to make sure their activities are compliant with AML regulations and crypto end-users key projections and market-wide assurances. The rules would underpin the development of a robust and well-functioning market, within which they could safely operate their businesses further driving crypto innovation and adoption in the EU region.

Some called the rules “a significant milestone”, while others said the comprehensive new framework was “exciting”, providing regulatory certainty to the market, and raising industry standards.

Crypto expansion in Europe

These regulatory developments haven’t stopped firms within the digital asset space from planning their expansion in the EU. Several industry insiders see the move as a positive step and believe Europe could lead the way on crypto regulation saying the EU framework represented a “significant milestone’.

A growing number crypto firms operating or planning to expand into Europe have already taken steps ahead of schedule to ensure compliance. Such as cryptocurrency exchange STEX, that  has partnered with KYC and AML platform Ondato in March 2022 to ensure the exchange’s continued customer growth within a compliance environment of imminent new EU regulation of crypto-assets. But also Coinbase, that already holds authorisation  from Germany and Ireland, as well as  other crypto platforms are seeking licenses in several Eurpean countries.

How to progress?

We are not there yet! The provisional agreement will now move to be approved by the Economic and Monetary Affairs Committee, and should be rubber-stamped by the European Parliament before being translated into legislative text and gazetted in the EU’s Official Journal. The European capitals will then have 18 months to implement them in the national legislation. This process could thus take until 2024 for states to implement MICA and the EU crypto regulation effectively be working.

Some loose ends 

There are still a number of regulatory open issues that should be taken into account in a future revision of the EU crypto regulation such as NFTs, the environment, supervision .etc. An additional problem is that legislation is always lagging behind practice, this especially goes for crypto where technological developments are very rapid. In the meantime EU policymakers are already planning MICA2 to tie up any legal loose ends.

NFTs

Members of the European Parliament have proposed that NFT trading platforms should be made subject to the EU anti-money laundering (AML) laws and should be brought in the scope of MiCA, with authorization and supervision of crypto firms at member state level. They have been tasked with determining whether NFTs require a separate regulatory framework to address the emerging risks of such new market.

Environmental impact

Another issue that should be solved is the question how to address the environmental impact of crypto assets. The final version of the new directive mandates co-legislators to take into account the environmental impact of crypto assets in a future review. The European Commission would assess the energy footprint of crypto assets. Within two years, the European Commission will have to provide a report on the environmental impact of crypto-assets and the introduction of mandatory minimum sustainability standards for consensus mechanisms, including the proof-of-work.

Some concerns

But there are still a number of concerns that should be taken into account before the new regulation becomes law and is fully implemented..

Regulatory overlap

The ECB has warned EU member states about the necessity of harmonizing the different crypto regulations across EU member states until MICA becomes law and is fully implemented. The ECB is concerned about the different crypto regulations across member states and the possible regulatory overlap between respective central banks in the EU and crypto companies during that period.

The ECB is set to warn countries in the eurozone of the dangers of national regulators getting ahead of MiCA and proposing new rules that may affect the future harmonization of rules. The ECB is concerned that countries start providing crypto-related licenses to traditional banks when there is not yet a pan-European framework in place.

The central bank wants to discuss the need to harmonize the provision of these licenses across countries before MiCA is fully implemented. Regulators from 19 EU member states will reportedly attend a supervisory board meeting in July to discuss MiCA and its possible implementation.

Regulatory competition or cooperation

The much-anticipated EU crypto regulation is expected to completely change the crypto landscape. But how and at what scale will greatly depend on the attitude of regulators in both the US and the UK.

The provisional agreement by EU regulators is a welcome step in the right direction. It is still questionable if other regulators will follow suit and work together with industry leaders to deliver a clear and effective global framework which will allow the sector to flourish.

What is sure is that the rules plant Europe firmly ahead of the major crypto centres US and the UK in the race to regulate crypto.  These countries have yet to approve similar rules. The Bank of England’s Financial Policy Committee has called for “enhanced regulation” of the crypto asset market to mitigate against potential risks.

The question if they are prepared to cooperate or if they use crypto regulation as a way to compete in this promising market is still open. Here is a great task for international bodies like the G7, the G20, the BIS and others to teak a lead.

The significant crash of TerraUSD that lost more than 90% of their value in a few days and the resulting crypto market turmoil however has put stablecoins in the regulatory spotlights. Regulators worldwide are prompting new calls for regulation highlighting the risk of certain cryptocurrencies and especially algorithmic stablecoins.

In this blog I want to highlight why TerraUSD, also called UST,  dropped below its target value, what the risks are of the various stablecoins, how regulators should react and what investors can learn from the crash of TerraUSD.

TerraUSD collapse

TerraUSD, also called UST, a so-called algorithmic stablecoin, had been another popular option for cryptocurrencies and was even the third largest stablecoin in the world at the threshold of the collapse. That system appeared to work well until then.

But TerraUSD was not able to withstand a panic outburst amongst investors, this notwithstanding they were providing a 20% interest. Sparked by a massive drop in the value of the crypto markets overall, investors lost faith resulting in a mass sell-off in the TerraUSD stablecoin. Luna Foundation Guard (LFG) tried to stop this slide by liquidating part of its 10 billion Bitcoin holdings.

The collateral, partly existing of Bitcoin, was insufficient to maintain its one to one peg to the dollar. As a result it slipped far from its $1 target price and dropped in value beginning May 9, 2022, hitting a low value of $0.015 at the time of publication of this blog.

As of this writing, the combined market capitalization of TerraUSD and partner stablecoin Luna was just over $4.5 billion, indicating a market decline of approximately $14 billion.

How did the  markets react?

Cryptocurrencies
In the wake of the TerraUSD collapse, other signs of the crypto sector’s vulnerabilities have emerged. When the Luna Foundation Guard sold almost its entire holdings of Bitcoin following the crash early May, as a result the price of Bitcoin, that lost already more than half of its value since last November from $64.000, sank to a 16-month low below $28.000 per coin. But also other cryptocurrencies were hit, triggered by  higher inflation and fears of raising interest rates. TerraUSD’s woes contributed to a slide in crypto markets that saw over $357 billion or more than 30% of digital asset market capitalization wiped out week-on-week. 

Stablecoins
While the TerraUSD collapse has spelled trouble for Bitcoin and other cryptocurrencies, the chaos is somewhat contained in the stablecoin sector. That especially goes for the fiat collateralised segment, where most of the stablecoins such as Tether and Binance have the backing of actual cash and other valuable assets. TerraUSD  is however different from most of its stablecoin peers.

Investors fled TerraUSD into more trusted stablecoins such as DAI and USDC, which drove the price of TerraUSD further down. This increased demand for DAI and USDC temporarily increased their price and were shortly after arbitraged back to $1.

DeFi
The failure of TerraUSD’s peg already has sent shocks through the decentralised finance (DeFi) sector, with a key saving and lending protocol, Anchor, seeing massive liquidation of TerraUSD-collateralised loans and the pricing of other crypto tokens also being affected. This has led to further liquidation triggers throughout the ecosystem. ‘Bouts’ of volatility will probably continue as the cryptosector digests the repercussions of the failure of the TerraUSD peg, while US policy rate increases and equity volatility may pressure so-called ‘high-beta assets’.

Regulated financial markets
Recently the Financial Stability Board (FSB) pointed to the increased intertwining of the crypto world with the traditional financial world. Up till recently links between crypto markets and regulated financial markets remained weak. The potential for crypto market volatility to spill over and cause wider financial instability was limited. But that has changed.

A growing number of regulated financial entities have increased their exposure to cryptocurrencies, DeFi and other forms of digital finance in recent months. If crypto market volatility becomes severe the risks for the financial stability of the real economy could as a result escalate.

But not all stablecoins are the same

Stable coins are cryptocurrencies designed to be protected from the wild volatility of crypto currencies like Bitcoin and Ethereum. They attempt to maintain a constant exchange rate with fiat currencies, mostly through a 1:1 US dollar peg.

Stablecoins are often used for transactions within the crypto world and between cryptocurrencies and the traditional financial system. They have played a crucial role for cryptocurrency traders, allowing them to hedge against spikes in Bitcoin’s price or to store idle cash without transferring it back into fiat currency.

Regulators should however be aware that not all stable coins are the same. Some stablecoins are more vulnerable than others. The stablecoin sector is a critical and complex part of the crypto ecosystem. Stable coins are an umbrella term. They are not a monolithic asset class and every stablecoin operates differently.

Stablecoin models

Stablecoins can be divided into two broad groups based on how they choose to pursue price stability: collateralised stablecoins and non-collateralised stable coins. Collateralised stablecoins can be split into fiat-collateralised and crypto–collateralised. The newest group of non-collateralised stablecoins are so-called algorithmic stablecoins like TerraUSD.

Fiat collateralised
The value of fiat-collateralised stablecoins is backed by reserves comprising assets, such as fiat currency, mostly the dollar, as collateral assuring stablecoin’s value. Collateral can also consist of bonds, commercial paper, commodities like gold and silver as well as crude oil. But most fiat-collateralised stablecoins have reserves of US dollars.

Dollar-based collateralised stablecoins like Tether and true USDC use a more fluid collection of traditional assets to secure its stable coin. Most of these reserves consist of treasury bills, certificates of deposit, and cash deposits to match the value of outstanding tokens that are maintained by independent custodians and audited regularly to ensure that holders of these stablecoins guarantee they can redeem them for actual fiat money, at some point.

Crypto-collateralised 

Another category of stablecoins are crypto-collateralised stablecoins, with their underlying collateral being another cryptocurrency or basket of cryptocurrencies. Because the reserve cryptocurrency may be subject to high volatility, such stablecoins are often over-collateralised, whereby the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued. The Dai stablecoin for instance which is pegged to the US dollar uses a basket of crypto assets as collateral at a ratio of 150% of the value.

Non-collateralised stable coins
And there is the newest group of stablecoins which are algorithmic or ‘decentralised’ stablecoin. While most stablecoins are reserve backed and are supposed to always be exchanged for one dollar, algorithmic stablecoins ‘forgo this failsafe’ and attempt to maintain their pegs through other means. Their primary distinction from collateralised stablecoins is the strategy of keeping the value of their stablecoin by controlling the supply through an algorithm and smart contracts to control the supply of tokens.

TerraUSD (UST)

TerraUSD, which trades with the symbol UST, is one of those algorithmic or decentralised stablecoins. To get somewhat more insights in this new type of stablecoin, let’s go more deeply into how it works.

The purpose of TerraUSD was to create a “crypto-native” dollar – with all of the supposed benefits of blockchains, like censorship resistance – that would be cheaper to use than a fully or partially collateralized option. It was intended to be worth exactly one dollar, enabling transactions to process with predictable results and giving cryptocurrency investors and traders an option to store their assets in cryptocurrency without the risk and volatility associated with typical digital currencies. Its peg to the dollar was supposed to be maintained by a complex algorithmically driven mechanism rather than by reserves of dollars or other assets, as is typical for stablecoins.

As TerraUSD’s popularity took off, its partner stablecoin Luna increased in value as well. The coin popped from around $5 in July 2021 to a high of $116 in early April 2022. Before its collapse TerraUSD was the third-largest stablecoin by market capitalization with about $18 billion and the largest algorithmic stablecoin.

How does TerraUSD work?

TerraUSD as an algorithmic stablecoin, is fundamentally different from most of its peers. Their value is assured not by financial collateral in the traditional markets – though owner Kwo diversified earlier this year their backing by purchasing $10 billion in Bitcoin – but backed by lines of computer code so-called algorithms to stay pegged to the dollar.

This stablecoin used a sophisticated but complex automated system of arbitrage to maintain its valuation at the 1:1 level. This mechanism relies on two coins: the TerraUSD stablecoin and the Luna governance token. It involved swapping TerraUSD coins with this free-floating cryptocurrency Luna to control supply.

The value-protecting transactions are executed by smart contracts on the Terra network. A computer algorithm thereby creates (mints) and destroys (burns) both TerraUSD and Luna to bring the price back into equilibrium. When the price of TerraUSD drops below $1, traders can burn TerraUSD—removing it from circulation, thereby reducing the overall supply —and raise the price back up. If the value of TerraUSD goes higher than $1, traders can burn Luna for TerraUSD, increasing the overall supply and lowering the price. This creates trading margins and supply and demand models that help keep the coin pegged to $1.

Another key part of the Terra ecosystem is the interest rates on TerraUSD deposits. These are offered through Anchor Protocol, a decentralized finance (DeFi) platform, which can garner annual percentage yield rates of 20 percent on TerraUSD tokens that could be borrowed by investors in need of dollar-like capital. The Terra decentralized finance (DeFi) network incentivized traders, holders, and users to either use, lend, or stake these crypto assets. This system worked reasonably well in practice from the inception up till early May.

Regulations

As things stand nowadays, stablecoins are very lightly regulated. A significant part lays outside the control of regulators. Given the explosive growth of the $130 billion market and its potential to affect the broader financial system, it is not strange that stablecoins have come under growing scrutiny by regulators. The recent turmoil has reignited calls in virtually every major financial market in the world for increased regulation of the crypto asset market in general and of stablecoins in particular.

Common themes in the discussions are the volatility, the lack of transparency with regards to crypto operations and the reserves they are supposed to hold, the overly optimistic promised returns and investors that are not well informed with regards to what is being purchased.

Reactions
Politicians have increased calls for tighter regulation of stablecoins. The falls in cryptocurrencies and the collapsing value of TerraUSD have further alarmed policymakers in both the EU and the US such as Treasury Secretary Janet Yellen and Securities and Exchange Commission Chair Gary Gensler.

US Treasury Janet Allen
US Secretary of the Treasury Janet Yellen has cited risks to broad financial stability due to stablecoins. She told a Senate Committee that the TerraUSD debacle has reinforced the need for proper oversight and for a “consistent federal framework” for regulating stablecoins and said that stablecoin guidance could come as early as this year.

“A stablecoin known as TerraUSD experienced a run and declined in value” “I think that this simply illustrates that this is a rapidly growing product and there are rapidly growing risks.” Janet Yellen

Fed semi-annual Stability Report
In its recent published semi-annual Stability Report, the Fed discussed the uncertainty of what is actually backing stablecoins and the lack of oversight in that market. The Fed repeated its concerns that stablecoins are vulnerable to investor runs because they are backed by assets that can lose value or become illiquid in times of market stress. The increasing use of stablecoins to meet margin requirements in leveraged crypto trades may further heighten redemption risks. A lack of transparency around the assets may exacerbate those vulnerabilities. A run on the stablecoin could therefore spill over into the traditional financial system by creating stress on these underlying assets, according to the report.

What sort of regulation

There are however still different visions on how to regulate stablecoins. Some regulators are preparing rules for stablecoins to make them look and function more like banks. Some others come up with proposed regulation that will look like more as governance tokens being considered securities. According to them, as tokens have claims against assets, or claims against cash flows, they are looked at the easiest target for regulators.

The International Organization of Securities Commissions (IOSCO) said stablecoins should be regulated as financial market infrastructure like banks alongside payment systems and clearinghouses. The proposed rules should focus on stablecoins deemed systemically important by regulators, with the potential to disrupt payment and settlement transactions.

The ECB is also increasingly worried about the risks for the financial stability of crypto investments. They are urgently calling for accelerating the implementation and acceptance of regulation to implement constraints to crypto currencies and stable coins. The EU’s Markets in Crypto Assets regulation, that would enter into force from 2024 onwards, is expected not not permit the issuance of algorithmic stablecoins and would require crypto providers to have a (bank-like) license and systemic stablecoin issuers  be backed by enough reserves.

What issues for regulators to consider?

There are important lessons to be learned from this crypto collapse, that regulators should keep in mind when designing legal frameworks for cryptocurrencies in general and for stablecoins in particular.

Like all new technologies, these assets — including dollar-backed, crypto-collateralized and algorithmic models — deserve a smart and thoughtful conversation around potential regulation, in order notto  frustrate financial innovations.

Regulators should thereby be aware that this collapse of TerraUSD is not a reflection of all stablecoins, because they weren’t all built the same under the same philosophy. As has been described before algorithmic stablecoins are very different compared to the collateralised stablecoin types.

Stablecoins in general should therefore not be forbidden but should be firmly regulated to prevent that a collapse like TerraUSD will happen again.  Buyers should understand what the risk are especially of these algorithmic stable coins. It therefore needs standards

Factors to keep in mind for regulators

There are a number of important factors policymakers and investors should keep in mind as stablecoins continue to develop and mature. This latter group take deposits without any insurance that customers rely upon to know their money is protected.

Regulators should likely pay more scrutiny to the risks surrounding stablecoins and their reserve attestations especially algorithmic stablecoins, given that UST’s problems have sparked wider crypto market volatility.

Stablecoins backed by reserve assets with clear fiat currency value however face a fundamentally different set of credit issues to algorithmic stablecoins, in our view. In such cases, the stablecoin’s stability risks can be more manageable, depending on various factors, notably the safety and liquidity of the reserve assets.

Asset-backed stablecoins therefore should become transparent about what is in their reserves. With traditional stablecoins, regulators also want to know that their operators have sufficient assets to pay out customers in the case of a run on the system.

Factors relevant to the credit profiles of issuers of reserve-backed stablecoins should include regulatory risk, counterparty risk (including reserve custodians), transparency over reserves and the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, as well as governance and operational risks.

In the case of algorithmic stablecoins, they should, in regulatory terms, not be [backed] one-to-one, but being over-collateralized because these are inherently more risky. Other issues to keep in mind that are relevant for regulators are:  what are the permissible reserves?;  who can issue a stablecoin?; how should an issuer and the reserved be audited?; and, what kind of disclosures are made to consumers?”

Factors relevant to the credit profiles of issuers of reserve-backed stablecoins should include regulatory risk, counterparty risk (including reserve custodians), transparency over reserves and the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, as well as governance and operational risks.

Final remarks

It is clear that regulation of stablecoins is urgently needed to prevent collapses like that of TerraUSD. There are still many open questions.

It is however still unclear how this new regulation will look like and what impact this new upcoming regulation will have for the future of stable coins in general and algorithmic stablecoins specifically. But also what would it mean for the further development of underlying technologies.

What is clear is that stablecoins are here to stay but in a more regulated framework. It does seem very likely that many more investors will choose collateralized stablecoins in the future. This will most likely result in a growing number of stablecoins with lower risks.

In the end this may further benefit the crypto industry as thanks to lower risks and increased transparency it may attract more players from the traditional financial world.