5 ways Washington could shake up the stablecoin sector

August 26, 2021 2:04 PM

WASHINGTON — The tremendous growth in stablecoin issuers such as Tether and Circle's USD Coin has drawn the attention of virtually every U.S. financial regulator as well as the Biden administration, raising the likelihood that the emerging sector will eventually fall subject to federal rules and enforcement.

What approach regulators ultimately take is far from certain, but officials and outside observers have floated a number of possible scenarios, from regulating stablecoins like bank deposits to treating them more like a security. Meanwhile, the Federal Reserve is weighing a separate policy — whether to issue its own digital currency — that could shake up the competitive landscape for stablecoins.

Most policymakers agree that the ecosystem of stablecoins — a type of cryptocurrency that generally pegs itself to other forms of fiat money to maintain a set value — is not quite large or significant enough yet to constitute an immediate threat to financial stability.

In July, senior officials from the Treasury Department, Fed, Securities and Exchange Commission, Commodity Futures Trading Commission, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency attended a meeting of the President’s Working Group on Financial Markets. The group specifically convened to discuss “the rapid growth of stablecoins, potential uses of stablecoins as a means of payment, and potential risks to end-users, the financial system, and national security,” according to a Treasury press release.

A debate is emerging among economists, lawyers, academics and fintech advocates on what is the appropriate government response. While some have called on the SEC to treat stablecoins broadly as an investment vehicle, cryptocurrency advocates fear that bank-caliber regulation could squash the sector’s innovative potential before it can develop.

Here are five potential scenarios for regulatory policy — none of them mutually exclusive — that would have a direct or indirect impact on stablecoins.

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Stablecoins are regulated like bank deposits

Some economists argue stablecoins have a striking similarity to the function of bank deposits. When a customer buys a certain quantity of stablecoins, there is an expectation that they will someday be able to exchange that amount of cryptocurrency back for an equivalent amount of cash.

And as with bank deposits, customer trust and confidence plays an integral role in the transaction. If a critical mass of customers suspect their stablecoin holdings are at risk of becoming devalued or even worthless, a rush of withdrawal demands can overwhelm an institution and push the value of a stablecoin token to zero. That’s exactly what happened to Iron Finance’s TITAN coin in June.

As a result, some experts believe that if policymakers want stablecoins to play a role in the mainstream financial system, they will require rules like those that govern bank deposits.

That could carry significant regulatory implications. One could be stricter requirements for the types of assets that can back a given stablecoin, like Treasury bills or central bank reserves from the Fed. Some stablecoin issuers have been criticized for backing their products with riskier assets, including commercial paper. Circle, the second-largest stablecoin issuer, announced this week that it would shift its reserves to cash and Treasurys.

Regulators could go even further and limit stablecoin issuance to FDIC-insured banks, effectively bringing the product into the existing regulatory fold through institutions that are steeped in the compliance requirements that come along with deposit insurance, for instance. The result of such reforms “would effectively turn stablecoins into public money,” Gary Gorton and Jeffery Zhang argued in a paper published in July from Yale University.

But the pair also warned that approach may not cover the entire stablecoin ecosystem, particularly stablecoins that have been structured to resemble money market funds which, unlike deposits, are treated by the law today as a form of equity, rather than debt.

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Stablecoins are regulated like securities

The push from some policymakers to regulate stablecoins akin to bank deposits has coincided with some arguing that they are in fact a type of security, which would invite oversight from the SEC. While many stablecoins are designed to eliminate price volatility, others have been marketed explicitly as investments with potential for a payout.

Gary Gensler, the agency’s Biden-appointed chair, has said that some stablecoins, at a minimum, will need to be regulated as securities for the sake of investor protection.

“Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities,” Gensler said in prepared remarks to the American Bar Association in July. “These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.”

Beyond greater investor protections, it’s less clear how exactly existing securities law would apply to stablecoins. Gensler has said he believes the SEC requires more explicit power from Congress to properly supervise the sector, writing in an August letter that “we need additional authorities to prevent transactions, products, and platforms from falling between regulatory cracks.” But at a minimum, a regulated U.S. security is required to be properly registered with the government, subject to oversight from the SEC, and prohibited from specific kinds of conduct.

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Private stablecoins face competition from Fed-backed cryptocurrency

The desire to regulate existing stablecoins as either deposits or securities is focused around what regulators can do to incorporate private companies focused on digital assets into the financial system. But on the other end of the policy spectrum is a very different approach aimed at a very different outcome: creating a central bank digital currency for the U.S. dollar, which would compete directly with private-sector stablecoins.

The Fed has publicly mulled such a move and is expected to release a report on the subject sometime in September. Analysts widely believe that the U.S. development of CBDC would have ramifications across the financial system, but privately issued stablecoins would be among the most directly impacted.

“The central bank digital currency … is explicitly aimed at private-sector alternatives,” said Bruce Mizrach, professor in the economics department at Rutgers University.

That’s not to say that a CBDC would vaporize private stablecoin firms. But experts say it would be difficult for anyone to compete with a cryptocurrency backed by the full might of the U.S. government.

“The private-sector alternatives, to remain in business, if they can, would have to compete on speed, they would have to compete, perhaps equally on transparency, because we know that the central bank digital currency is never going to fail,” Mizrach said. “Whereas every stablecoin, in my mind, still has some risk of failure, just in the same way that a perfectly collateralized bank can also fail.”

FSOC designates stablecoins as a systemic payment activity

Since the passage of Dodd-Frank, the regulators have had the authority to designate certain institutions and activities as “systemically important” through the Financial Stability Oversight Council, made up of the heads of all the regulators and chaired by Treasury Secretary Janet Yellen. Some experts, including Gorton and Zhang, say that the FSOC could attempt to classify stablecoin issuance as a “systemic payment activity” as a way to allow the Federal Reserve to regulate the sector directly.

“I think FSOC can be a place where good thinking and sound policy options can be coordinated,” said Stephen Gannon, an attorney at Murphy & McGonigle. But all of the council’s past designations of nonbank behemoths were overturned, either through de-designation or the courts, as happened with MetLife in 2016.

“Whether they would want to ... try to expand their regulatory perimeter to capture stablecoins as something that was systemically important after they got burned in the MetLife case — they wouldn’t have an appetite for that, because it would run a risk of creating a distraction that they don’t need,” Gannon said.

The FSOC may also have a difficult time arguing that the stablecoin industry is a source of systemic risk. The cryptocurrency analysis firm CoinMarketCap estimates that the industry’s market capitalization stands at less than $90 billion as of Aug. 23 — a figure representing less than 2% of the $4.52 trillion money-market fund sector.

“I think it's hard for even the FSOC to make that leap [for stablecoins] without doing something about money-market funds before,” said Steven Kelly, a research associate at the Yale Program on Financial Stability. “Money-market funds are both more systemic due to their size and their investor base, and they're already better regulated than stablecoins.”

Nothing more happens in the short term

It may seem unlikely after months of intense scrutiny from the country’s top financial watchdogs that regulators would do nothing further to regulate the stablecoin sector. But it’s possible that a hard look at the industry could lead the government to conclude that it’s simply too early to act decisively.

It remains to be seen just how much traction stablecoins will generate as a significant mainstream payments or investment vehicle.

Regulatory inaction would be a welcome development for the cryptocurrency industry at large, which has feared that hasty policymaking could strangle whatever potential for innovation it has in the U.S. Jerry Brito, executive director of the crypto research and advocacy nonprofit Coin Center, argued in congressional testimony this summer that the existing regulatory regime in the U.S. for crypto is adequate for now.

“[T]he prescription for an enlightened policy environment that balances the risks and benefits of cryptocurrency is essentially the regulatory regime at which the United States has arrived after years of policy evolution.” Brito wrote in testimony submitted to the Senate Banking Committee. “The U.S. regime is not perfect, it can improve, but it gives regulators and law enforcement the tools they need to sensibly address risks and criminal behavior.”