A much-anticipated policy paper commissioned by former US president Donald Trump and finished on the watch of US president Joe Biden has punted the issue of stablecoin regulation to Congress—and several former regulators believe doing so amounts to a gift for the cryptocurrency industry.
Though some watchdog agencies are eager to jump in, there currently are no regulations for stablecoins, a central part of the crypto markets that’s designed to hold the value (and stability) of another financial asset, usually the US dollar. It’s a niche product today, but the policy paper was written under the pretense that the $130 billion stablecoin market could become systemically important as it grows and becomes intertwined with the real economy.
The report, prepared by the President’s Working Group on Financial Markets, outlined the potential risks that stablecoins might pose to “market integrity and investor protection,” such as “possible fraud and misconduct in digital asset trading, including market manipulation, insider trading, and front running, as well as a lack of trading or price transparency.”
But the group left it up to Congress to introduce regulatory oversight to the stablecoin market.
The working group is composed of the heads of the US Treasury Department, Federal Reserve, Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC), or their representative. For this report, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) also were included in the group.
Crypto’s “safe” asset
Stablecoins serve as an easy avenue for crypto traders to move between volatile cryptocurrencies with a stable digital asset. They make for very speedy international payments and are also easier to use in trading because they’re already on blockchain, said Noelle Acheson, head of market insights at Genesis Trading.
Aside from the technical advantages, stablecoins have become a critical part of the cryptocurrency markets because of banks’ historical unwillingness to take on crypto firms as clients. The heavily regulated banking industry has high standards for so-called know-your-customer and anti-money-laundering regulations, which makes it difficult for them to work with crypto firms. (A select few banks in the US have been crypto-friendly for several years including Silvergate Bank in La Jolla, California, Signature Bank in New York, and BankProv in Amesbury, Massachusetts.)
“Back in the day, crypto exchanges couldn’t get banking relationships to handle incoming fiat payments,” Acheson said. “So many of the offshore banks and offshore crypto exchanges had no choice but to use stablecoins.”
But are stablecoins safe for the financial system?
Stablecoins also have been championed by Facebook (now Meta), which aims to issue a stablecoin called Diem through Silvergate Bank. This project sparked regulators’ concerns that stablecoins could become part of payments for businesses and households more broadly.
Another risk that has regulators on guard is the asset backing of stablecoins. While the coins are purported to be pegged in value to the US dollar, the most popular stablecoins are actually backed by commercial paper (like Tether) and US Treasury debt (USD Coin)
As such, regulators are concerned that stablecoins look a lot more like money-market funds than currencies that can reliably be used as a means of payment—especially if there is a run on stablecoins during times of uncertainty.
There isn’t an immediate systemic risk tied to stablecoins, said Steven Kelly, a research associate at the Yale Program on Financial Stability, which is focused on understanding financial crises.
“The entire crypto universe could go to zero tomorrow, and the financial system would stay standing,” Kelly said.
But issues would arise if stablecoins—as one part of the crypto ecosystem—become the primary link between traditional markets and crypto markets, Kelly added. The risks in the crypto markets are myriad: They can include anything from Elon Musk (or Snoop Dogg or Gene Simmons) tweeting about a specific crypto asset to hacks of various crypto protocols, the basic set of rules underpinning blockchains.
“If crypto investors get unwound and stablecoins are forced to dump their investments, that to me is a bigger risk than a stablecoin holder parsing the balance sheet of Tether’s bank in the Bahamas and deciding that they don’t like what they see,” Kelly said. “That to me is not really a risk.”
Plus, unlike a run on a bank, in which depositors would have trouble getting their money out, crypto traders can easily move into other stablecoins or even other cryptocurrencies if investors lose confidence in one coin or another.
“The big danger that the regulators seem to be worried about is if the stable coin in question is not backed sufficiently to be able to realize that level of liquidity,” Acheson said, adding that “there’s no sign that it wouldn’t be able to realize that level of liquidity.”
Treating stablecoins like bank products
The report argues that stablecoins could pose a risk to the payments system—and then recommends that Congress pass legislation that would only allow banks to issue stablecoins. It would put custodial wallet providers (the companies that would be holding the stablecoins) under the oversight of a federal agency. Stablecoin issuers also would be limited by federal regulators as to whom they could do business with and would have to remove friction between moving from one stablecoin to another.
The agencies also recommended that the Financial Stability Oversight Council consider designating certain stablecoin activities (i.e. payments, clearing, settlement) as systemically important.
While regulators arguably have oversight of some aspects of stablecoins already—after the working group’s paper was released, SEC chair Gary Gensler said his agency and the CFTC “will deploy the full protections of the federal securities law and the Commodity Exchange Act to these products and arrangements, where applicable”—they don’t have jurisdiction over every part of the stablecoin market that could go wrong, Treasury officials note. They wouldn’t, for example, have the ability to set all of the risk-management standards that the working group would hope to see in regard to the holding and transfer of the coins.
The report identified a variety of risks, including the potential for fraudulent transactions, uncertainty about when settlement is final in a stablecoin payment, and the limited business hours of entities that are responsible for turning stablecoins into fiat money and vice versa.
The paper also noted that stablecoins could deplete retail deposits from traditional financial institutions, which could hurt credit availability in the overall economy if the assets backing the stablecoins aren’t suitable for lending.
The paper recommends that Congress pass legislation that only allows banks to issue stablecoins and calls for the reserve assets backing stablecoins to also be held at banks.
What surprised some former regulators wasn’t that regulation would need to be applied to the burgeoning stablecoin market, but that the paper’s authors would punt the issue to Congress. While the report acknowledges the SEC and CFTC’s authority, it did not address stablecoin issues under the framework of any securities or commodities law.
“It’s problematic that this report doesn’t really talk about what the regulators can be doing now, and it jumps to the conclusion that legislation is necessary,” said Todd Phillips, a former FDIC lawyer who is now the director of financial regulation and corporate governance at the Center for American Progress.
Treasury officials, speaking on the condition that they not be named, said the decision to recommend legislation was not meant to limit the authority of the SEC or any other agency, but rather to establish oversight for the currently unassigned issues of financial stability that could be raised by stablecoins.
Phillips argued, however, that the working group missed out on applying existing frameworks to this new asset class. The report could have discussed regulating stablecoins like money-market funds or weighed the merits of giving eligible stablecoins deposit insurance, for example.
But “[t]hey didn’t do that, and they may have made the overall situation worse,” Philips said. Instead, “[t]hey made a very specific recommendation to Congress, and while I think that recommendation makes sense from a policy standpoint, I don’t think a bill to do exactly those things and nothing else is possible in this Congress.”
The crypto lobby will set its sights on Congress
Tyler Gellasch, a former SEC lawyer who is now the executive director of the Healthy Markets Association, an investor trade group, said the report drudges up longstanding differences between banking regulators and the SEC and CFTC over who gets to regulate money-market funds, amounting to an agency turf war. Congressional legislation, he added, might have the potential to take stablecoins out of the purview of the SEC and CFTC and under the realm of the Federal Reserve, OCC, and FDIC if stablecoin issuers become banks and stablecoins become bank products.
“It’s a report largely written by banking regulators urging for banking regulators to have more authority over a hot area,” Gellasch said. “I think that what’s surprising is a bunch of regulators would come together and say, we would actually prefer to sideline a regulator or a couple of regulators who have authority right now in favor of potentially an act of Congress.”
Gellasch also said that passing the baton to Congress opens stablecoin regulation up to the influence of the crypto lobby. “They would rather cast their lot with the vagaries of Congress that’s been subject to newly minted [crypto] billionaires and newly minted billionaire lobbyists,” Gellasch said.
There is a potential, Gellasch said, for Congress to treat stablecoins like they treated swaps in the Commodity Futures Modernization Act, which deregulated swaps that later had a starring role in the 2008 financial crisis.
The implications of the policy paper could also interfere with upcoming enforcement actions from the SEC. “SEC investigations and enforcement cases often take years to develop,” Gellasch said. “They have to request documents. If you’re a defendant in an investigation, you slow-walk the SEC right now.”
No supervision like bank supervision
Yale’s Kelly said he worries that regulating stablecoins as money-market funds would be a “partial” solution that would also become a systemic risk to money-market funds themselves.
“It was [in] May of this year that [bitcoin] lost like 40% of its value in a day and nothing happened and everyone had cake,” Kelly said. “I think we would sort of be giving up that happy medium.”
Having stablecoin issuers become banks would give them access to the Federal Reserve, which would allow them to back stablecoins with reserves parked at the Fed and make money in the overnight repurchase agreement (or repo) market like other banks do so that they wouldn’t have to rely on a yield from Treasury notes or commercial paper to keep their business running, Kelly explained.
Meanwhile, as Phillips at the Center for American Progress noted, the paper doesn’t prohibit new rules from being created by other financial regulators. “The SEC still has authority to regulate money-market funds,” Phillips said. “And a lot of these stablecoins really look like money-market funds, so I think investors and users can expect that there will be some regulation coming soon.”
Editor’s note: Because of an editing error, an earlier version of this article mischaracterized Steven Kelly’s observation about the broader financial risks of stablecoins. The sentence containing the mischaracterization has been deleted.