On July 26, 2021, Senator Elizabeth Warren wrote to Treasury Secretary Janet Yellen to urge the Financial Stability Oversight Council (“FSOC”) to “act with urgency and use its statutory authority to address cryptocurrencies’ risk and ensure the safety and stability of our financial system.” On November 1, 2021, the President’s Working Group on Financial Markets, joined by the Federal Deposit Insurance Corporation (“FDIC”), and the Office of the Comptroller of the Currency (“OCC”), addressed part of Senator Warren’s concerns by issuing a Report on Stablecoins (“Report”). The Report left many issues unresolved unfortunately.
The Report highlights the benefits of stablecoins [1] to support faster, more efficient, and more inclusive payment options. The Report also identifies market integrity and investor protection risks which, in the view of the Working Group and under the right circumstances, could pose systemic risk to the “real” economy, cause excessive concentration of economic power, and potential anti-competitive effects where interoperability standards are lacking. The Report compares stablecoins with elements of traditional finance and concludes that Congress should overlay the current bank regulatory regime to stablecoins.
Summary Conclusion and Business Considerations
The Report seeks to bring stablecoins within the existing banking system. The current regulatory scheme, however, is patchwork which may lead to jurisdictional battles and competing priorities. The likelihood that this Congress will act with alacrity to create a coherent federal regulatory regime is unlikely. Accordingly, businesses interested in integrating stablecoins into their operations must carefully handicap: (1) the future regulatory treatment of digital assets; (2) uncertainty around consumer protection laws; (3) what activities regulators will deem permissible; (4) what the SEC and CFTC will conclude about stablecoin products; and (5) anti-money laundering, terrorist financing and sanctions laws.
Risks and Regulatory Gaps. The Working Group outlined a set of perceived risks that stablecoins present to the financial industry and consumers, including: (1) loss of value, or risks to stablecoin users and stablecoin runs; (2) payment system risk; and risks of scale, or systematic risk and concentration of economic power.
Loss of Value: Risk to Stablecoin and Stablecoin Runs. The Report highlights that stablecoins can be a useful means of payment or store of value when it retains the trust and confidence of its users, particularly in times of stress. Confidence may be undermined when: (1) the price of the underlying reserve assets falls or become illiquid; (2) assets are not safeguarded; (3) redemption rights are unclear; and (4) unresolved operational risks related to cybersecurity remain. The failure of a stablecoin to perform as expected may cause a “run” on that stablecoin, which may adversely impact reserve assets and lead to fire sales. Such circumstances could metastasize to other stablecoins and the traditional economy.
Payment System Risks. Stablecoins may become less reliable as a payment system when risks related to credit, liquidity,[2] operations,[3] ineffective governance, and settlement[4] remain unaddressed. The different technologies, transaction processes, and governance structures coupled with the decentralized nature of certain stablecoins, might create financial shocks or operate as a channel through which financial shocks spread.
Risks of Scale: Systemic Risk and Concentration of Economic Power. Wide adoption of a stablecoin raises three policy concerns for the Working Group. First, a stablecoin issuer or key participant that provides services to the issuer, such as a custodial wallet provider, may pose systemic risk due to a failure or distress impacting the issuer or key participant and jeopardize stability of the traditional economy. Second, a combination of a stablecoin issuer and commercial firm could lead to an excessive concentration of economic power, an argument similar to those raised about mixing banking and commerce. Third, a widely adopted stablecoin raises concerns about anti-competitive effects, particularly if a stablecoin user seeks to switch to other payment products or services.
Recommendations
The Report recommends the following to Congress:
- Limit Stablecoins to Insured Depository Institutions. Establish a federal prudential oversight framework for payment stablecoin arrangements that is consistent, comprehensive and sufficiently flexible to ensure regulators can respond to current and future developments across organizational structures. Supervision should be on a consolidated basis, linked to prudential standards, and provide access to the federal safety net. The Report recommends that Congress limit stablecoin issuance, and redemption and maintenance of reserve assets, to insured depository institutions (“IDIs”) only. Moreover, regulators should have authority to set standards to promote interoperability among stablecoins.
- Apply Current Framework to Stablecoin Issuers. The Federal Reserve should regulate stablecoin issuers that are insured IDIs at the holding company level and banking regulatory agencies should regulate issuers at the entity level. Institutions would need to comply with capital and liquidity standards to address safety and soundness issues, and larger institutions must be subject to enhanced prudential standards to mitigate financial stability concerns.
- Limit Custodian Activities. Subject custodial wallet providers to federal oversight, including prohibiting providers from lending stablecoins to customers, and requiring compliance with appropriate risk management, liquidity, and capital requirements. The Report further recommends limiting affiliations between wallet providers and commercial entities or the use of user’s transaction data. Federal regulators should have supervisory authority to require entities that perform activities critical to stablecoin arrangements to meet appropriate risk management standards, be subject to examination and enforcement authority in connection with stablecoin activities of these entities.
The Report proposed interim measures using existing authority, such as:
- Collaboration to Knit Together a Patchwork Regulatory Scheme. Federal financial regulators with jurisdiction over digital assets, including stablecoins, will continue to collaborate. The federal banking agencies will use their respective charter application processes to extract concessions from stablecoin issuers to ensure that they will implement prudential standards anticipated by congressional legislation. Where appropriate, regulators such as the SEC, CFTC, and CFPB will rely on their statutory frameworks to provide market integrity, investor protection, and transparency. The Report notes that the Department of Justice (“DOJ”) may consider whether or how section 21(a)(2) of the Glass-Steagall Act (intended to separate investing activities from deposit activities) may apply to certain stablecoin arrangements. Meanwhile, FinCEN will work to ensure that AML/CTF and BSA regimes are not triggered.
- Statistically Important Designation. Designating certain activities by stablecoin issuers to be systematically important to payment, clearing and settlement (“PCS”), which would provide regulatory agencies with authority to impose risk management standards for reserve assets, operational requirements related to interoperability, and prudential standards. The regulatory agencies have the right to examine and bring enforcement actions against entities engaged in PCS activities.
The Report left several issues unaddressed, including:
- Who Can be a Stablecoin Issuer? The Report does not adequately explain who can be a stablecoin issuer. Even if only IDI can be stablecoin issuers, not all IDIs are suited to do so. The Report references ancillary activities that are important to issuing stablecoins that the IDI may not have the capabilities or desire to do. It would be helpful for the Working Group to say more about this. Moreover, the Report does not provide a clear, compelling rationale for why non-IDIs should not be allowed to issue stablecoins.
- SEC and CFTC Issues Not Addressed. The Report does not address issues or risks arising under federal or state securities laws or the Commodity Exchange Act related to digital assets, digital asset trading platforms, decentralized finance, or stablecoins, and the interactions between each of them. This appears to be a missed opportunity given the forceful pronouncements and enforcement activity by the SEC and CFTC. This silence can lead to jurisdictional skirmishes. For example, if certain stablecoin issuers, which happen to be IDIs, are subject to the jurisdiction of the SEC and CFTC because the stablecoin is a security, commodity, or derivative thereof, the Report expressed no view on whether the SEC and CFTC will have examination and enforcement authority over the insured depository institution.
- Custody Arrangements Unclear. In recent Interpretive Letters the OCC concluded that a national bank’s custody of digital assets to be part of the business of banking but required the bank to develop strong risk management protocols. The Report does not address whether other banking agencies support the OCC’s approach, and if they do not, inconsistent requirements might occur, leading to regulatory uncertainty.
- Cursory Analysis of Consumer Protection. The Report offers limited guidance on investor and consumer protection or market integrity, two issues at the heart of SEC and CFTC regulatory regimes. With regard to the former, the current Congress has a strong pro-consumer orientation, and the Report’s failure to say more about how to fulfill these obligations should be concerning for market participants. Moreover, there is little meaningful reference to how state regulatory schemes may impact digital assets, including stablecoins.
[1] Stablecoins are digital assets designed to maintain a stable value relative to a national currency or other reference assets. Stablecoins are used primarily to facilitate trading, lending or borrowing of other digital assets, predominately on or through digital asset trading platforms. [back]
[2] Risk based on misalignment of the settlement timing and process between stablecoin arrangements and other systems, which may cause a temporary shortage in the quality of stablecoins available to make payments. [back]
[3] Risk that deficiencies in information systems or internal processes, human errors, management failures, or disruptions from external events will result in the reduction, deterioration, or breakdown of services. [back]
[4] Risk that settlement in a payment system will not occur as expected. [back]
