The Future of Stablecoin Regulation
Report Says Stablecoin Issuers Should be Regulated as Banks
The President’s Working Group on Financial Markets (PWG), which includes the SEC, Treasury, and Federal Reserve, released its much-anticipated stablecoin report on November 1, 2021. The report touched on risks inherent to stablecoins and put forth recommendations on how to address them. Per our analysis, the report seemed well researched and thoughtful, and the recommendations presented seemed in line with expectations of the crypto market. Chiefly, the report calls for implementing legislation that would allow regulators to manage potential risks from the rapid growth and evolution of stablecoins. It calls on Congress to enact this legislation, but in absence of this, recommends the Financial Stability Oversight Council (FSOC) consider taking action to address the risks.
The report states that stablecoins used to facilitate speculative digital asset trading lead to market integrity and investor protections risks, specifically possible fraud and misconduct, market manipulation, insider trading, front running, and a lack of trading or price transparency. Other risks posed by stablecoins include illicit finance, such as AML and terrorism financing.
Stablecoin runs could occur when users lose confidence in a stablecoin issuer’s ability or intent to honor redemption requests, which could reverberate to the broader financial system. Specifically, a situation in which users lose confidence in a stablecoin could lead to fire sales of reserve assets, which the report says “could disrupt critical funding markets”.
Moreover, if stablecoins are used as payments, there is risk stemming from any potential disruptions to the system (blockchains) they are present on. There is operational risk present as well as transaction validation and settlement risk on the blockchains they are on.
The report also mentioned systemic risk and concentration of economic power. A stablecoin that becomes very large could pose systemic risk from the failure of one of the participants involved in the stablecoin arrangement. Further, there could be too much economic power concentrated with a stablecoin issuer if it is also a commercial firm. There could also be possible anti-competitive effects if a stablecoin becomes a leading method of payment.
Key recommendations from the report include the following:
- Legislation to require stablecoin issuers to be insured depository institutions.
- Legislation to require custodial wallet providers to be subject to appropriate federal oversight, given their role in a stablecoin arrangement.
- Legislation that would allow regulators authority to ensure entities critical to the functioning of a stablecoin meet appropriate risk-management standards.
- Legislation that would require stablecoin issuers limit affiliation with commercial entities.
If the recommended legislation is enacted, current stablecoin issuers such as Circle and Tether would essentially need to become banks, likely through creating or acquiring banking units, to continue offering their stablecoins. Being under federal oversight, insured, and subject to risk-management requirements would make stablecoins potentially far more transparent and help eliminate the risk of a stablecoin run scenario. The legislation would also position big banks to issue their own stablecoin or facilitate a digital dollar.
However, it is unclear whether such regulations would have much impact on algorithmic stablecoins, such as DAI and UST, which have continued to grow in light of potential regulatory scrutiny, just as their centralized stablecoin peers. It could lead to these seeing less demand, marked as “gray” stablecoins, or being relegated to use exclusively in DeFi, which is outside the banking system in its current state.
Legislation that would require stablecoin issuers to not be affiliated with commercial entities will restrict the abilities of companies like Facebook to launch their own stablecoins. It seems that such measures are aimed keeping the power of stablecoin issuance within the government and regulated entities.
It is important to note that such legislation is just recommendations and that without action from Congress, these may well remain just that, given how divided Congress has been. While the report suggests the FSOC, which is comprised of the members of the PWG, step in if there is no Congressional action, this group has been reported as moving slowly in the past but could move to designate certain activities conducted within a stablecoin arrangement as systemically important, which could allow regulators authority to further intervene.
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