Should stablecoins be regulated like banks, exchange-traded funds, or both?
The push to impose federal safety and soundness regulations for stablecoins is gaining momentum. The recent Federal Reserve Board Financial Stability report cites stablecoins as a growing financial stability risk. According to the President’s Working Group (PWG), with the market value of the largest stablecoin issues now exceeding $127 billion, it is time for Congress to mandate uniform federal regulation for stablecoins and stablecoin issuers.
The PWG argues that stablecoins be treated like bank deposits and that stablecoin issuers comply with the rules and regulations that apply to banks. Ignoring the internet-blockchain aspect of stablecoins, stablecoins are financially similar to exchange-traded stable value funds (ETSVFs). For stablecoin regulation to be consistent with current regulatory practices, stablecoins should be able to be offered in either a bank-centric or securities-centric federal regulatory environment. Offering stablecoins the choice to organize under either bank or securities law will provide the competition needed to keep regulatory costs in check and promote the widest selection of safe, competitive-yielding stablecoins alternatives for the investing public.
Stablecoin cryptocurrencies are digital coins that can be traded over the internet and used as a store of value and a means of payment. They are designed to trade at stable values relative to a reference fiat currency like the U..S dollar, but there is no guarantee they will maintain a stable value.
For a stereotypical stablecoin, the dollar proceeds from a newly-issued stablecoin are used to purchase an equivalent value of high-quality, short-term, liquid dollar-denominated assets held by the stablecoin sponsor as a “reserve.” Should the stablecoin trade below its target value, the sponsor can liquidate reserve assets and purchase outstanding stablecoins from cryptocurrency exchanges to push the stablecoins market price towards the targeted market value. Should the stablecoin trade above the target value, the stablecoin sponsor can increase the supply of stablecoins by issuing additional coins.
The PWG’s justification for treating stablecoins like deposits and their issuers like banks turns on the idea that stablecoins are designed to function as a substitute for currency or insured bank deposits. According to the PWG, “[w]hile today stablecoins are primarily used to facilitate trading of other digital assets, stablecoins could be more widely used in the future as a means of payment by households and businesses.” If the market value of stablecoins continues to grow and they become widely accepted as a means of payment, stablecoins could become an important component of the money supply.
In order to instill confidence and prevent the possibility of panic-driven stablecoin redemptions that could destabilize the traditional financial system, the PWG recommends that stablecoins, like bank deposits, be insured by the FDIC. In order to qualify for deposit insurance, stablecoin issuers would be required to satisfy the same rules and requirements that apply to all other insured depository institutions.
While the PWG’s approach makes sense, it is not the only sensible way that the federal government might regulate stablecoins. An equally appealing approach is to regulate stablecoins as ETSVFs.
An ETSVF is created when a financial institution deposits a portfolio of well-diversified high-quality short-term liquid assets like bank deposits, Treasury Bills and investment-quality commercial paper into a trust. In exchange for the portfolio of assets, the trust issues the institution a sufficient number of pro-rata claim certificates or shares so that each share has a target net asset value that will be maintained over time, for example, $100. The institution would then sell the shares to retail customers who can then trade them on organized and regulated exchanges.
The net asset values of ETSVF shares are monitored by third parties and disseminated to the public at a high frequency. If the market value of a share materially diverges from the net asset value of the assets in the trust, the sponsoring institution can profit from the difference by adding assets and increasing ETSVF outstanding shares or retiring ETSVF shares and withdrawing assets from the trust. Exchange-traded funds have been trading since the early 1990s and have proven to be popular investment vehicles.
From a purely financial perspective, stablecoins and ETSVF shares are very close substitutes. Unlike stablecoins, ETSVF shares have never been promoted as a medium of exchange, but there is nothing I am aware of that would prevent ETSVF shares from being used as a means of payment. Unlike existing stablecoins, ETSVFs distribute interest payments earned on fund assets net of management fees to shareholders. In the future, if interest rates normalize, I expect competition will force stablecoins to also pass along some of the interest earned on the stablecoins reserve assets to coin holders especially if stablecoins are subjected to federal safety and soundness regulations.
The conceptual differences between stablecoins and ETSVF shares turn on regulations related to issuance, custody, trading, clearing and settlement.
ETSVF shares are securities subject to all U.S. Securities and Exchange Commission (SEC) regulations that pertain to securities issuance, exchange trading, broker-dealer intermediation, trade settlement and account custody. In contrast, stablecoins issuers are, for the most part, regulated by individual state law, an exception being stablecoins that meet the Howey definition of securities that are subject to SEC regulation. One reason existing stablecoins do not pass interest earned on reserve assets through to coin holders is to avoid being classified as securities and becoming subject to SEC regulation. If Congress defined stablecoins as securities it would close this loophole.
When it comes to the cryptocurrency exchanges that trade stablecoins, SEC Chairman Gary Gensler argues that there is little or no regulation. Stablecoins balances are kept in “virtual wallets” that are, with a few exceptions, maintained by firms that are not regulated as fiduciaries. Stablecoin transactions are settled on the internet using public or private permissioned distributed ledgers with no regulatory oversight. The absence of SEC-style regulations surrounding the issuance, trading, settlement and custody of stablecoins creates the potential for fraud and market manipulation that could destroy investor confidence in the value of outstanding stablecoins.
While the President’s Working Group’s bank-deposit model for regulating stablecoins seems like a plausible alternative, it seems just as reasonable that stablecoin regulations might also be designed to mirror those that apply to ETSVFs. Stablecoins could be designated securities by Congress which could also mandate that they be traded on federally-regulated exchanges using intermediaries, permissioned ledger processes and account custodians that are subject to SEC regulation.
There is more than one way to fit stablecoins into the existing quilt of federal financial system regulation. The precedent for offering both bank-centric and securities-centric regulatory options is the coexistence of money market deposit accounts offered by banks, and money market mutual fund shares offered by firms in the securities industry. History shows that the availability of alternative regulatory paths — a.k.a. regulatory competition — is an important force for limiting the cost of federal regulation and maximizing the safe investment options available for retail investors.
Paul H. Kupiec is a senior fellow at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.