Update 586 — Regulating Stablecoin:
Talking Dollar 2.0, Crypto, or Klepto?
Sunday’s Superbowl featured more crypto than anything else, suggesting a suddenly flush industry. What are the opportunities and risks that crypto presents? Stability is a rare quality in the world of cryptocurrencies, so where do stablecoins fit in? Are they currencies or securities? Who should regulate and how?
Congress is trying to come to grips with these questions and the possibility of regulating the burgeoning industry. Without regulation and oversight, there’s not much assurance customers/investors are buying what they’re sold. In this update, we break down what stablecoins are, what Congress and the Biden administration are doing about the issue, and what lies ahead for crypto rules of the road.
Stablecoin — Currency, Asset, Both?
In theory and sometimes in practice, stablecoins are a digital payment mechanism, backed by the US dollar, that enables users to store and redeem value outside the banking system and its fees. Since they are usually pegged to a fiat currency, stablecoins are intended to be steady in value. Stablecoins are created in exchange for fiat currency that an issuer receives from a buyer.
Unlike other crypto products, stablecoins are not an asset or investment vehicle nor are they used as a means of speculation, profit, or loss. They provide no formation of capital and serve merely as a medium of exchange on cryptographic platforms and do not offer a form of financial market utility or system of payments, clearance, and settlement. Another difference between stablecoins and other cryptocurrencies is that the former is commonly used to convert more volatile assets into something perceived as having a steady value. But like other cryptocurrencies, stablecoins still lack creditworthiness and have high costs relative to traditional banking, and present considerable environmental risks.
Top Stablecoins by Market Capitalization (in billions)
The growth of the stablecoin industry — market capitalization exceeded $127 billion in October 2021; a 500 percent increase when compared to the previous year — suggests a currency of the future, a USD 2.0. In theory, that eliminates all the risks and the need for regulation that securities, commodities, and derivative investment products face for stablecoin.
In practice, the proliferation of stablecoin issuers has resulted in a variety of approaches to the key dollar-backing that distinguishes stable payment systems from speculative currency exchange. The 1:1 ratio of the US dollar reference point is defined differently by each of the below stablecoin issuers. The backing provided involves different degrees of liquidity and security. The differences generate opportunities for arbitrage. In contrast, regulations require bank deposits to always be traded at par.
Stablecoin Reserve Composition
Proponents argue that stablecoins could help unbanked individuals gain access to the financial system. About 15 percent of U.S. adults in the bottom 40 percent of the nation’s income distribution are unbanked. But without sufficient backing, stablecoins could be subject to runs as banks are. Stablecoins may expose these vulnerable consumers to inordinate risk.
Aspects of stablecoins warrant additional scrutiny. First, confidence in a stablecoin can be undermined if reserve assets fall dramatically in price or suddenly become illiquid. Also, there is no independent review of the reserve assets to ascertain their sufficiency. Failure to meet these expectations could result in a run on certain stablecoins and even spread to others with similar risk profiles. Second, stablecoins deal with the same risks as traditional payment systems. While the risks may be similar, these can manifest variably as a result of stablecoins using decentralized technology. Decentralized structures mean no single organization is accountable for risk management. Lastly, the anonymity provided by stablecoins can encourage various forms of illicit activity.
Congress Contemplates Crypto
Over the last week, both the House Financial Services Committee and Senate Banking Committee called the Under Secretary of the Treasury for Domestic Finance Nellie Liang to testify on the Report on Stablecoins authored by the President’s Working Group on Financial Markets (PWG), the FDIC, and the OCC. The report analyzed stablecoins as an entity, identified the risks and regulatory gaps of stablecoins, and recommended a regulatory framework for both legislative and agency actions.
The HFSC hearing highlighted the divides on stablecoins, and the broader cryptocurrency conversation, between members of each party. Both Chairwoman Maxine Waters and Rep. Jim Himes highlighted the potential systemic risks posed by stablecoins, while other members championed the supposed benefit of increased financial accessibility through stablecoins. Rep. Blaine Luetkemeyer expressed concerns that stablecoins could threaten the global dominance of the US dollar, while a greater number of Republicans argued stablecoins could reduce payment costs. Regarding the claim of reduced payment costs, transactions services like Venmo have gotten cheaper to use over time and that has not been the case with cryptocurrencies.
There were also disagreements about stablecoins coexisting with a central bank digital currency (CBDC) and whether entities issuing stablecoins should be regulated as insured depository institutions, a.k.a. banks. Being regulated as an insured depository institution would result in stablecoins falling under the FDIC’s jurisdiction. Multiple Republicans cited the foundational principles for stablecoins and CBDC that they released in contrast to the PWG’s report, claiming a new framework for stablecoins is more responsible than regulating stablecoin issuers as banks.
Following the House hearing, Rep. Gottheimer introduced an early version of a discussion draft to set up the first series of guardrails and definitions around stablecoins. While the stablecoin industry has largely voiced support for Gottheimer’s proposal, it is likely that Chairwoman Waters and many other HFSC Democrats will be less likely to support given their concerns about systemic risk.
The Senate Banking Committee hearing also highlighted differences between Democrats and Republicans. Similar themes were discussed including the possibility of stablecoins being used as a means of payment and whether the rapid growth of this digital asset could pose a systemic risk. Chairman Sherrod Brown, and Senators Chris Van Hollen and Mark Warner expressed concerns that stablecoins are not required to disclose the assets that putatively back them. Senator Warner also questioned the stablecoin business model, which relies on investing reserve assets and charging considerable user fees, due to concerns that such revenue streams would make it challenging for some consumers to use stablecoins as a means of payment. Sen. Elizabeth Warren suggested stablecoins may pose a systemic risk due to rapid growth.
Senator Mike Rounds reiterated the desire of his HFSC counterparts to maintain the US dollar’s global dominance. Senator Bill Hagerty also took issue with the PWG report’s conclusion that the federal government should take a more active role in regulation and that state-level solutions were underrepresented. Under Secretary Liang pointed out that insured depository institutions can include entities regulated by state governments.
What Regulators Should Watch
While developing proper regulation for stablecoins, Congress will also have to assess whether stablecoins are a currency, security, or commodity and decide which agency (e.g. FDIC, OCC, CFTC, and SEC) is the most appropriate to lead the regulatory agenda for stablecoins. While Congress is months away from proposing any concrete regulatory proposals, there are certain areas that must be addressed to protect consumers.
The first area of focus for regulators should be transparency, primarily regarding reserve assets. There are no requirements that stablecoin issuers disclose their reserve assets or indicate what those reserve assets are. Tether, the largest stablecoin in the market, is an illustrative example. Tether claims to be backed by the US dollar, and there were about 69 billion Tethers in circulation as of October 2021. So the company issuing them ought then to possess $69 billion of assets, which would make it one of the top 50 banks nationwide.
Instead, it was revealed last year that Tether’s reserve assets included short-term loans to Chinese companies and loans backed by volatile assets like Bitcoin. Tether CFO Giancarlo Devasini also jeopardized reserve assets by investing them with the goal of increasing his own personal profit. As one former banking executive stated, Tether “is not a stablecoin, it’s a high-risk offshore hedge fund.”
After transparency is the problem stablecoins pose about illicit finance risks such as money laundering and terrorist financing (ML/TF). Per the PWG report, criminals prefer liquid forms of value for ML and TF, and the mass adoption of stablecoins may be attractive to such individuals.
Risks Clear, Rewards Less So
Congress has long sought ways to extend financial services to the roughly 40 million under- unbanked Americans. Is there realistic hope that stablecoins could ease access to the financial system for this large cohort? As Chairman Brown pointed out in yesterday’s hearing, it is difficult to increase access when only a handful of establishments accept cryptocurrency as an acceptable form of payment in exchange for their goods and services. Americans for Financial Reform (AFR) expressed skepticism about the viability of stablecoins as a more equitable payment mechanism in a letter to Treasury Secretary Janet Yellen. AFR argued that the primary use of stablecoins is for financing speculative investments in other cryptocurrencies. Cryptocurrency exchanges’ reliance on user fees can raise the costs on individuals withdrawing from such platforms in exchange for US dollars.
The growth of stablecoins presents an opportunity to increase access to the financial system and offers the potential for incredible innovation. However, the lack of structure, regulation, and oversight also mean that there is limited accountability and safety for consumers. Until that structure is in place, the consumer benefits will be minimal and the risk, some known, some not, will come to light.