Financial Markets

US regulators appear prepared to accept stablecoin issuers provided they meet tough criteria, implying that a US dollar CBDC might not be needed. By Justin Pugsley

Stablecoins, which are digital tokens normally backed by fiat currencies, have seen their assets explode by nearly 500% in a year to $127bn as of October 2021. This placed them firmly in the crosshairs of regulators, who fear they could become a systemic risk.  

Simultaneously, there has been an intense debate over whether the US should launch a central bank digital currency (CBDC), which could marginalise dollar stablecoins. Although regulators are wary of stablecoins, they recognise their innovative value. But policy-makers are far from unanimous on the topic. 

Noises from some senior members of the US Federal Reserve Board have been confusing. For example, Lael Brainard has stated she “couldn’t wrap her head around the US not having a CBDC” if other countries have them. Christopher Waller believes the US does not need CBDCs. Both are members of the board of governors. Congress also has divided opinions. 

But the mist is starting to clear. On November 1, the President’s Working Group on Financial Markets (PWG), along with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency, released their long-awaited stablecoins report. 

It is a list of risks coupled with a wish list of powers the regulators want Congress to “urgently” grant them to oversee stablecoin issuers. And though these recommendations may pave the way for official acceptance of stablecoins, they come at a high price for issuers. 

“What this market desperately needs is a first non-volatile step into the blockchain. That is absolutely critical,” says David Kay, executive chairman and chief investment officer at Liti Capital, a specialist blockchain litigation funding firm. He believes that having federally insured stablecoin issuers would be a massive boost for the industry. However, he also thinks some of them will struggle with the regulation, but that the industry will adapt.  

The most important demands are for stablecoin issuers to be treated as insured depository institutions, for wallet-providers to come under federal oversight, and for issuers to have limited commercial affiliations. 

Being overseen by the FDIC comes with hefty costs and reporting requirements. This surprised some in the industry, believing it would be more appropriate to regulate stablecoin issuers like money market funds given their similar characteristics. 

“I think what probably tilted this was that it is more for payments. Money market funds really are short-term investment vehicles. So you really have a payment clearance and settlement issue with stablecoins,” says Ignacio Sandoval, a partner at law firm Morgan Lewis. He adds that the experience of money market funds breaking the buck during the 2007-9 global financial crisis may have influenced the PWG’s thinking. 

Systemic risks

Charley Cooper, managing director, public and government relations at R3, a business blockchain provider, explains that prudential regulators believe the impact of stablecoins stretches beyond investor protection and conduct and are concerned that they could threaten financial and market stability. 

“The long-term impact of stablecoins is far bigger than even some of the industry might actually be looking at,” says Mr Cooper. He explains that if stablecoins become commonplace, it could have implications for the control exercised by prudential and monetary authorities. Currently, stablecoins are mainly used by investors to switch between fiat and crypto currencies. 

“I think there’s a lot of concern around reserves,” says Alan Konevsky, chief legal officer at tZERO, a blockchain-based asset exchange. He explains that this worry is focused on the accuracy of reserves and whether investors would get their money back if they all lost confidence in stablecoins. “[Regulators] look at the closest proxy that they have had historically and that is a regulated, insured depository institution” he says.  

“There’s going to be a huge barrier to entry,” adds Mr Sandoval. “The regulatory costs in my opinion will probably far exceed any sort of profitability of the institution.” He warns there is a risk that it will simply drive the activity offshore. But he explains the legislation has yet to be drafted and that if Congress wants to retain innovation, it might decide to apply a more proportionate regulatory regime for stablecoin issuers.

“The business model can operate under FDIC-like regulations, provided the complexities are understood,” says Viktor Prokopenya, founder of trading platform Capital.com. He explains that these include stablecoin issuers maintaining sufficient liquidity while accounting for costs such as processing fees. 

Mr Prokopenya believes stablecoins could be an opportunity for some banks. “If a major bank were to launch their own coin, this would undoubtedly generate a lot of positive traction,” he says. But he warns there would still be the issue that it would connect the bank to the world of cryptos, which remains under-regulated. He says that, as a consequence, the bank would come under even more scrutiny from regulators. Long-term, however, he thinks banks and governments will all get dragged into crypto. 

“A conversation needs to be had with prudential regulators around what is the right capital adequacy model and risk-based model for these innovations,” says Dante Disparte, chief strategy officer and head of global policy at Circle, which issues the USDC stablecoin. Prior to the report, Circle had applied to become a bank and is transparent about the assets used to back USDC. 

“All of USDC’s reserves are cash and short-term treasuries: in my view, the two safest assets you can get. They’re also entirely inside the care, custody and control of US-regulated financial institutions,” says Mr Disparte.

He explains that Circle has a fully reserved business model with no lending or maturity transformation. “The premise is purely to guarantee price stability to the underlying reference asset,” he says. Some industry sources argue that stablecoin issuers should have a relatively simple and proportionate prudential regulatory regime. 

The PWG is clearly concerned that big tech will use data from tracking the circulation of stablecoins to analyse consumer spending habits, as it already does with social media, for example. This would increase the likelihood of their imposing competitive advantages.

Therefore, the PWG recommends preventing stablecoin issuers from having close commercial affiliations with other companies. This echoes the Glass-Steagall Act of the 1930s, which separated investment banking from traditional banking.

“I think it’s part of the country’s broader immune system reaction to Facebook’s, now Meta’s, digital currency effort,” says Marco Santori, chief legal officer at Kraken, a crypto exchange, who believes the regulatory process has become politicised. Meta, a big tech firm, tried to launch its Libra stablecoin last year, which was blocked by the authorities and has since been reincarnated as Diem. But it has yet to launch. 

Mr Santori explains that in terms of risk, not much separates stablecoin issuers from, say, payments firm Paypal, yet there is no suggestion that it should be treated as a Federally insured bank.  

Mr Sandoval thinks the recommendation stems from a concern that a ‘black swan’ event could lead to a collapse of a stablecoin operator or trigger some sort of payment or settlement issue. “They want it to be siloed so any fallout can be contained,” he says. 

Getting Congress onside 

However, the PWG now wants to get its wish list into law, which is unlikely to happen any time soon. Nor is the eventual outcome obvious. 

“I think if [the report] produces a balanced dialogue between industry and the government, that could be productive,” says tZERO’s Mr Konevsky, who believes this is preferable to regulation by enforcement.  

“What this report actually translates into in terms of actual legislative action, or regulatory rule writing at the agency level, I think remains to be seen,” says R3’s Mr Cooper.

Nonetheless, he is surprised that so many people have been blindsided by the Biden administration’s tough regulatory stance on stablecoins, given that the instinct of many of these policy-makers is to apply heavier regulation. Also, Meta may have negatively coloured the policy debate around stablecoin issuers. 

“There is great suspicion on the part of many members of Congress, on both sides of the aisle, about the power of big tech,” says Mr Cooper, despite the fact that stablecoin issuers are smaller firms. “The problem is, every time people hear stablecoin, they think of Libra or Diem.” 

He believes policy-makers want to shoehorn stablecoins into existing regulatory structures rather than create new ones. 

However, the PWG report authors anticipated that Congress, which has a heavy legislative workload and faces mid-term elections next year, might be too busy to come up with rules anytime soon. 

The agencies will therefore work closely together to make sure stablecoin issuers can’t slip though any regulatory cracks. Industry sources believe that the agencies already have considerable power to regulate stablecoin issuers and can use their enforcement powers, much like the US Securities and Exchange Commission (SEC) has been doing in its domain. 

More dramatically, the report suggests that the Financial Stability Oversight Council could, if necessary, declare some stablecoin issuers as systemically important. This would trigger extra capital and supervisory requirements. 

A US CBDC? 

From one perspective at least, many of the risks posed by stablecoins could easily be tackled with a CBDC. That would answer concerns about backing, payment issues and so on. Also, policy-makers sometimes draft unworkable legislation to kill off an activity rather than ban it directly for reasons of political expediency. 

The Boston Fed has been investigating CBDCs for some time with the help of MIT. “I think the US is still not supportive of stablecoins,” says Sky Guo, founder of Cypherium, a decentralised smart contracts platform, citing the struggles Meta faces with launching its stablecoin project. “So we don’t know when it’s going to launch, probably it’s not going to launch at all. Also, we are seeing the SEC treating stablecoins not like currencies, but more like securities.” He also highlights that US regulators have been hitting stablecoin issuer Tether with regulatory sanctions, accusing it of misleading information and of not properly backing its coins. 

Mr Guo thinks it is possible that the US is planning to launch its own CBDC and that it ultimately doesn’t want dollar stablecoins to exist. There has been speculation that the Fed won’t be in a position to launch a CDBC for about five years, but Mr Guo thinks it could come much sooner, possibly within two years. 

But there are some strong arguments against CBDCs. “One of the choices they’d have to make is picking a tech standard that would last 100 years, and these technologies are not standing still. And so erring on the side of open source technology platforms is an important part of the kind of consistent upgrading these innovations can produce,” says Mr Disparte. He cites other reasons why he believes CBDCs are a bad idea. One is that they could disintermediate the banking system. This could be an issue during times of banking stress, which could be made worse if depositors rush to the safety of CBDCs held at the central bank. The central bank would effectively be competing with the banks it oversees. 

He says central banks issuing digital currencies would be like the US Federal Aviation Administration (FAA) deciding to build jet engines or to fly planes when its role is to make aviation safe.  

“Then you enter the Orwellian discussion of censorship resistance, privacy erosion, geo-referencing. There is an air gap between the central bank bank, payment systems and innovators in your wallet. I think it’s an important feature we should preserve while promoting competition,” explains Mr Disparte.

Returning to the FAA analogy, he says regulators should be able to describe what safe conduct looks like, irrespective of the technology stack, allow operators to live within those parameters, and then build free airspace and open skies. 

Another issue is that CBDCs may only be usable domestically, while stablecoins are using blockchain technology, which is borderless and could drive down payment costs. 

“If I was at a central bank again, I would think that financial innovation is good and we should not kill it,” says Kimmo Soramäki, founder and CEO at Financial Network Analytics. “If this new innovation provides the same activity and the same risks, like stablecoins instead of bank accounts, then it should be regulated the same way.” 

He explains that this means a stablecoin issuer can either be supervised as an electronic money institution, in which case it holds its funds at a supervised bank, or it becomes a bank and uses the money within the banking regulatory framework. 

Liti Capital’s Mr Kay believes the US authorities are taking the right approach by not rushing out a digital dollar. “OK, allow some private enterprises to go out, watch the market develop and then once there’s a better framework, step in and immediately become the provider,” he says. In other words, stablecoin issuers could be just an interim step towards a Fed CBDC. 

Lacking vision

Nonetheless, there is a feeling among some in the industry that the report could have gone further. 

“Where there’s work to continue is in laying out the understanding of what the open version of these innovations mean, on the technology stacks themselves, and how those are also consistent with a lot of public policy goals, promoting competition and promoting innovation,” says Mr Disparte, who believes the report should have laid out a longer-term vision for stablecoins and explored the potential opportunities more deeply. 

Also, the issue is bigger than the PWG report, with international standard-setters also weighing in with their views. Mr Disparte cites the example of the Principles for Financial Market Infrastructures, a global standard for financial infrastructures, which states that stablecoin arrangements should conform with their requirements from start to finish. “That by default is the equivalent of picking technology winners and losers,” says Mr Disparte, explaining that this could see stablecoin issuers dealing with the whole value chain from issuance through to the user experience, which is a more proprietary approach. 

“The purpose of that value chain is to build an open innovation standard,” he says. “But if you want a stablecoin issuer to own that entire value chain, then effectively you’re going to build a digital twin of the very walled garden payments environment that we’re trying to compete with.”

It is still early days, but it appears US regulators are willing to accept stablecoins provided they pose no threat to the financial system. The challenge now is whether they can make them safe without stifling valuable innovation.