The CLARITY Act poses a threat to the structure of the banking system

• Key insight: Right now, Congress is considering legislation called the CLARITY Act that could establish a permanent — and unlevel — playing field in the competition between banks and stablecoins.
• What's at stake: Congress is at risk of fundamentally, and potentially irreversibly, altering the structure of the banking system that supports businesses, households, and local communities.
• Forward look: Now is not the time to yield to legislative fatigue. There will be significant and long-lasting implications for our economy if Congress doesn't get this right.
  

Congress is at risk of fundamentally, and potentially irreversibly, altering the structure of the banking system that supports businesses, households and local communities. In recent years, crypto companies have used digital assets called stablecoins to replicate the banking business model by funding assets with short-term liabilities, but without being subject to the restrictions and safeguards that have long applied to banks. Stablecoins are a digital version of the old problem of companies seeking the benefits of operating like a bank with few, if any, of the obligations and requirements banks face. Right now, Congress is considering legislation called the CLARITY Act that could establish a permanent — and unlevel — playing field in the competition between banks and stablecoins.

Stablecoins are a form of crypto asset that promises to maintain a one-to-one peg with the U.S. dollar. Stablecoins, we are told, could someday revolutionize digital payments. In reality, stablecoins have fundamental flaws that make them difficult to use for payments, including high fees and vulnerability to runs and de-pegging. Instead, stablecoins are predominantly used as collateral to facilitate trading in other crypto coins. That's where so-called "yield" arrangements come in. They compete with traditional bank accounts by replicating the yield on bank deposits through interest-type payments that induce users to buy stablecoins, park them in crypto wallets, then use them as collateral for borrowing, lending, and trading other crypto assets.

While there are reasons to be skeptical about the utility of stablecoins, Congress has nonetheless encouraged their development in the name of innovation. Last year, the GENIUS Act created a novel federal chartering regime to promote stablecoin issuance, while prohibiting issuers from paying yield "solely in connection with the holding, use, or retention" of a stablecoin. Those limited restrictions have proven ineffective because they do not apply to the platforms that offer yield in today's crypto ecosystem, so the Senate is attempting to broaden these restrictions in the CLARITY Act.

Ironically, the problem with the CLARITY Act is that it's not clear enough. Crypto companies — a group known for aggressive legal interpretations — will easily get around its well-intentioned restrictions.

For starters, the legislation contains several loopholes, the biggest of which is that its restrictions don't apply to crypto intermediaries that pay rewards for the activities that stablecoins are actually used for. One part of the CLARITY Act only prohibits crypto platforms from paying yield or other rewards in relation to "holding" a "payment stablecoin" but exempts yield for trading, pledging, and lending. It's also worth noting that, under the GENIUS Act, "payment stablecoins" include digital assets "designed to be used" for payment or settlement, not merely those that are actually used for that purpose.

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Another CLARITY provision prohibits paying yield in a manner that is "economically or functionally equivalent" to yield on an interest-bearing bank deposit. Again, this condition arguably doesn't apply to stablecoins because, even though they mimic bank deposits, they are used for trading — not as passive balances that fund the equivalent of bank loans. Crypto firms could also avoid "equivalence" because their customer agreements are structured in ways that differ from those applicable to banks and their depositors, including redemption rights and insurance coverage. In other words, the very ways in which stablecoin intermediaries deprive their users of bank-like protections could allow them to continue paying deposit-like yields.

These legal distinctions matter because crypto firms will have little incentive to develop stablecoins that are useful for payments if these restrictions prove ineffective, undermining Congress' intended goal of promoting payment innovation.

More importantly, allowing the status quo to continue could undermine the banking system and the communities banks serve. Banks will feel increasing pressure to pay ever-higher interest rates on their deposits, creating the risk that the interest they pay on deposits will exceed the rates they charge on their loans, ultimately leading to bank failures. Alternatively, if banks don't (or can't) compete by paying higher yields than stablecoins, deposits could move out of the banking system, diverting funds that could be used to make loans to Main Street businesses into speculative crypto assets that have little social value. Even worse, sudden stablecoin flights could increase the risk of deposit runs out of banks and into nonbanks, causing lending and credit to contract and threatening financial stability.

Banks have been increasingly vocal about the competitive disadvantages and potential risks of letting crypto platforms exploit the loopholes in both the GENIUS and CLARITY Acts. They rightly argue that limiting stablecoins' ability to pay yield will ensure that banks and crypto companies are innovating and competing in ways that are safe and responsible. Yet, legislators seem to be letting their frustration get in the way of finding adequate solutions. One senator who has helped negotiate the compromise on stablecoin yield recently complained that it's time for banks to just "accept change."

As a former Senate staffer, I know that it can start to feel exhausting when two influential industries are waging a vocal lobbying campaign. But now is not the time to yield to legislative fatigue. There will be significant and long-lasting implications for our economy if Congress doesn't get this right.