We must regulate stablecoin providers as banks
Cryptocurrency markets have suffered major setbacks in recent months. The combined values of cryptocurrencies have fallen by more than half since they peaked at about $3 trillion in November 2021. Cryptocurrencies have followed the same downward trajectory as speculative technology stocks, thereby failing to provide an effective hedge against the risks of those stocks.
Stablecoins play a central role in the crypto ecosystem by serving as the principal medium of payment for trades, loans and other transactions involving cryptocurrencies. An asset-backed stablecoin promises to maintain a 1:1 parity with a designated fiat currency (typically the U.S. dollar) by holding investment reserves. An algorithmic stablecoin commits to maintain a similar parity based on a cross-trading arrangement between the stablecoin and a connected cryptocurrency.
Stablecoins proved to be anything but stable during the recent market turmoil. Terra, an algorithmic stablecoin, and its associated Luna cryptocurrency collapsed during the second week of May, inflicting over $40 billion of losses on investors. Tether, the largest asset-backed stablecoin, declined to a per-coin value of 95 cents on May 12 before regaining parity with the U.S. dollar. Between April 29 and May 31, the total value of Tether coins fell from $83 billion to $77 billion, and the combined values of Tether and 14 other leading stablecoins dropped from $181 billion to $155 billion.
Terra’s collapse and Tether’s wobbles provide clear warnings about the risks that stablecoins pose to our financial system and our economy. Holders of stablecoins are likely to suffer large losses during investor runs triggered by concerns about their coins’ ability to maintain parity with the designated fiat currency. The investor run that destroyed Terra resembled the destabilizing runs that occurred in money market funds in 2008 and 2020. Like stablecoins, money market funds do not have government guarantees, and their investors are likely to panic if the market values of their reserves decline substantially.
Many institutional investors hold cryptocurrencies, and cryptocurrency markets have established extensive links to traditional financial intermediaries and the payments system. Those connections will become pervasive if stablecoins are widely accepted as a form of payment for consumer and commercial transactions. The collapse of a major stablecoin such as Tether could unleash a systemic panic in financial markets, undermine the payments system and inflict widespread losses on consumers, businesses, investors and financial institutions.
Stablecoins are “shadow deposits” that serve as a functional substitute for bank deposits. Many stablecoin providers are “shadow banks” because they offer lending, trading, and other financial services that mimic the activities of banks. But stablecoin providers are not required to be chartered as banks or to comply with banking laws that safeguard the stability and integrity of the banking system. If stablecoins continue to grow, they will soon become a systemically important category of “private money” like money market funds, which do not have explicit government backing but rely on the widely-held assumption that governments will bail them out during serious financial disruptions.
We must compel issuers and distributors of stablecoins to come out of the shadows and follow the rules that govern banks. We must require stablecoin providers to obtain bank charters and fulfill requirements for government deposit insurance, including the payment of deposit insurance premiums. Stablecoin providers must be examined and supervised as banks, and they must satisfy bank safety and soundness standards, including capital and liquidity requirements. They must observe consumer protection laws and be subject to the insolvency regime that governs bank failures. Owners of stablecoin providers must comply with the restrictions and responsibilities that apply to owners of banks under the Bank Holding Company Act and other laws.
Some policymakers argue that it would be sufficient to require stablecoin providers to follow the rules for money market funds. That would be a huge mistake. Our regulations for money market funds are clearly inadequate, and they should not be extended to stablecoin providers.
Money market funds, like stablecoin providers, accept “shadow deposits” without complying with banking laws. Money market funds have experienced major problems whenever the market values of their reserves failed to maintain parity with the U.S. dollar or another designated fiat currency. Governments have bailed out money market funds twice during the past 14 years on both sides of the Atlantic. We should not follow the same failed strategy with stablecoins.
Many stablecoin providers probably could not qualify for bank charters or comply with banking rules. Those providers would have to leave our financial system, and their departure would be a welcome development. If we want to maintain a stable financial system that avoids systemic crises and protects investors and consumers, we must require providers of deposit-like services to comply with the laws that safeguard banks and their customers.
The time is ripe for policymakers around the world to regulate stablecoins in the same manner as bank deposits, thereby advancing the objectives of financial stability, depositor protection, market integrity and avoidance of government-financed bailouts.
President Biden signed an executive order in March 2022 requiring federal agencies to assess the risks and benefits of digital assets and to recommend regulatory approaches that “reduce the risks that digital assets could pose” to consumers, investors and businesses as well as the stability and integrity of the U.S. financial system. In April 2022, the UK government announced plans to recognize stablecoins as a valid form of payment, as part of a wider agenda to make Britain a global hub for digital asset technology and investment. The European Union’s pending proposal for a Regulation on Markets in Crypto-assets aims to establish a regulatory framework and common supervisory architecture for issuers and providers of crypto-assets. Requiring stablecoin providers to be regulated as banks should be a central component of all three initiatives.
Rosa Lastra is the Sir John Lubbock Chair of Banking Law at Queen Mary University of London. Arthur E. Wilmarth, Jr. is professor emeritus of law at George Washington University Law School.