President’s Working Group on Financial Markets Issues Report on Stablecoins
The President’s Working Group on Financial Markets (PWG),1 joined by the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (OCC), released a Report on Stablecoins (Report) on November 1, 2021. The Report: provides a detailed description of stablecoins; identifies potential risks and regulatory gaps; and sets forth recommendations for legislation and interim action to address those gaps.
The Report defines “stablecoins” as “digital assets that are designed to maintain a stable value relative to a national currency or other reference assets.”2 Although stablecoins have the potential to support faster and more efficient means of payment, they present a number of risks and concerns, which are described later in this OnPoint.
According to the Report, stablecoins are intended primarily to facilitate trading, lending or borrowing of other digital assets, often for a speculative or an income-producing purpose, on or through digital asset trading platforms. Stablecoins allow holders to move value between digital asset platforms and applications, reducing the need for conversion to and use of fiat currencies and reliance on traditional financial intermediaries.
Although certain stablecoins are advertised as being backed by “reserve assets,” there currently are no regulatory standards governing such assets, which can range on the risk spectrum from insured bank deposits and Treasury bills to commercial paper, corporate and municipal bonds and other digital assets. Indeed, in October 2021, the CFTC took enforcement action against the issuers of US Dollar Tether (USD Tether) for allegedly making untrue or misleading statements about USD Tether’s reserves.3
The Report distinguishes stablecoins that purportedly are pegged to a national currency from “synthetic” or “algorithmic” stablecoins that use other means to attempt to stabilize the value of the instrument; however, it does not establish or recommend a position regarding the characterization of stablecoins under federal securities or commodities laws. Depending on the facts and circumstances, the Report points out that a stablecoin may be a security, a commodity and/or a derivative within the jurisdiction of the SEC and subject to the U.S. federal securities laws, or potentially subject to the jurisdiction of the CFTC under the Commodity Exchange Act.
Risks And Concerns Identified by Report
· Loss of Value: Risks to Stablecoin Users and Stablecoin Run. The Report states that when confidence in the value of stablecoins is undermined because they fail to perform according to expectations, users would be harmed, resulting in potentially systemic risk. In this respect, the Report indicates that the mere prospect of a stablecoin not performing as expected could result in a “run” on that stablecoin (i.e., a self-reinforcing cycle of redemptions and fire sales of reserve assets). Such runs could spread not only from one stablecoin to another, but also to the broader financial system.
· Payment System Risks. The Report refers to basic risks faced by stablecoin payment systems (e.g., credit risk, liquidity risk, operational risk, risk arising from improper or ineffective system governance, and settlement risk) that could make payment systems less available and less reliable if not well-managed. The Report notes that, unlike traditional payment systems, the decentralized structure of stablecoin payment systems makes them more vulnerable to such risks.
· Risks of Scale: Systemic Risk and Concentration of Economic Power. The Report refers to three sets of policy concerns raised by the potential for a stablecoin to scale rapidly: the failure or distress of a stablecoin issuer or a key participant in a stablecoin arrangement could adversely affect financial stability and the real economy; the combination of a stablecoin issuer or wallet provider and a commercial firm could lead to an excessive concentration of economic power; and a widely adopted stablecoin could present concerns about anti-competitive effects.
The Report notes the lack of a consistent set of prudential regulatory standards to address these risks. Further, the Report indicates that, on account of the number of different parties that may be involved and the operational complexity, these arrangements might pose additional challenges for supervisory oversight.
In addition to the risks discussed above, the Report briefly addresses market integrity and investor protection risks, as well as illicit finance risks (including risks pertaining to money laundering and terrorist financing).
The Report also specifically touches on gaps in regulation for custodial wallet providers, which is central to the functioning of any stablecoin arrangement (and also to a wide range of other cryptocurrency activity). Custodial wallet providers currently are subject to varying levels of state regulation and oversight in the United States, depending on where they operate and the location of the customers they serve. The Report notes that this lack of standardized regulation governing features such as risk management, capital and liquidity could exacerbate the risk that the failure of a custodial wallet provider could have systemic impacts.
PWG’s Recommendations for Legislation
To address the prudential risks, the Report recommends that Congress act “promptly” to enact legislation to ensure that payment stablecoins are subject to a federal prudential framework on a consistent and comprehensive basis.
To protect users and address risks of stablecoin runs, the Report recommends that legislation should require stablecoin issuers to be insured depository institutions (IDIs). As IDIs, stablecoin issuers would be subject to: supervision and regulation at the depository institution level by a federal banking agency; consolidated supervision and regulation by the Federal Reserve at the holding company level; and the orderly resolution regime for IDIs under the Federal Deposit Insurance Act in case of failure.
To address concerns about payment system risk, the Report indicates that, in addition to the requirements for stablecoin issuers, legislation should subject custodial wallet providers to appropriate federal oversight, including: restrictions on lending customer stablecoins; requiring compliance with appropriate risk-management, liquidity, and capital requirements; and limitations on affiliation with commercial entities or on use of users’ transactions data.
To address additional concerns about systemic risk and economic concentration of power, the Report indicates that legislation should require any entity that performs activities critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards, and supervisors should have authority to examine, enforce and implement standards to promote interoperability among stablecoins.
The Report cautions that Congressional action is urgently needed and recommends that agencies continue to use their existing authorities to address the prudential risks falling within each agency’s jurisdiction to the extent possible while awaiting Congress response.
The Report recommends that the Financial Stability Oversight Council consider the steps outlined in the Report, including designation of certain activities conducted within stablecoin arrangements as, or as likely to become, systemically important payment, clearing and settlement activities.
Statement by SEC Chairman Gensler
On the same day the Report was issued, SEC Chairman Gary Gensler released a statement noting that “the use of stablecoins presents a number of public policy challenges with respect to protecting investors.... Further, stablecoins may facilitate those seeking to sidestep a host of public policy goals connected to our traditional banking and financial system: anti-money laundering, tax compliance, sanctions, and other safeguards against illicit activity.”4 Chairman Gensler further noted that “[w]hile Congress and the public evaluate this report, we at the SEC and our sibling agency, the [CFTC], will deploy the full protections of the federal securities laws and the Commodity Exchange Act to these products and arrangements, where applicable.”
Potential Impact of the Report
It is unclear whether legislators will move quickly to respond to the concerns and recommendations raised in the Report. Until Congress acts, the task of regulating stablecoins in the interim period likely will continue to be handled by regulatory bodies such as the SEC and CFTC, both of which have remained involved in assessing and regulating cryptocurrencies. However, the Report’s conclusions, if implemented, will have a significant impact on various players in the stablecoin market. Even if legislators and regulatory bodies do not adopt analogous measures, the general concerns raised by the Report have been highlighted by several entities over the past year.
Notwithstanding this lack of clarity regarding enactment of the Report’s recommendations, stablecoin issuers ought to be cognizant of the federal government’s growing interest in cryptocurrency regulation. Both the tone and content of the Report highlight the attention on stablecoins by federal regulators; although stablecoins to date have enjoyed a relatively loosely-regulated government scheme, future proposals for stablecoin oversight may follow under the current administration. The Report itself likely will not spur regulation on its own, but adds to calls from the Federal Reserve and other government actors for increased rule-making.
Accordingly, issuers should recognize that the Report advocates for increased compliance requirements that could present a burden to issuers. The proposed regulatory measures likely would impose a financial toll that could create issues for prospective stablecoin issuers, functioning to prevent smaller projects from entering the space. On the other hand, established stablecoin issuers should prepare to devote additional resources to compliance with new regulations, as well as adapt to potential limitations on business strategies in the event that restrictions are imposed.
Other market participants also may be affected by the Report if its recommendations are implemented. Commercial firms looking to partner with stablecoin issuers should consider the potential for limitations on such actions, as concern that too much centralization or consolidation of power in the stablecoin market may lead to prohibitions, although the forays by mainstream institutions into using stablecoin in various practices appear unlikely to cease in the near future. Additionally, any entity that provides necessary services for the maintenance or trading of cryptocurrency ought to prepare itself for the possibility of being incorporated into any new regulatory scheme. For example, the Report mentions that custodial wallet providers (wallet providers that control access to the wallet’s contents, rather than the user) may be subject to regulation, which would be a new facet of stablecoin regulation.
One aspect that the Report does not address is the looming question of whether a stablecoin is a commodity or a security. After the CFTC’s recent decision in the USD Tether case, where it stated that “[d]igital assets such as bitcoin, ether, litecoin, and tether tokens are commodities,” the Report represents an opportunity for further insight into the definition of stablecoins for regulatory purposes; however, that issue remains unresolved.
It is yet to be seen how the Report’s recommendations will be implemented. Even within the Federal Reserve, there is disagreement on the extent to which stablecoin issuers should be subject to regulation as IDIs. Speaking at a conference on November 17, 2021,5 Federal Reserve Board Governor Christopher Waller stated that “[t]he regulatory and supervisory framework for payment stablecoins should address the specific risks that these arrangements pose – directly, fully, and narrowly .... But it does not necessarily mean imposing the full banking rulebook, which is geared in part toward lending activities, not payments.”
The Report is a positive indication of regulators in various agencies beginning to coordinate closely to address novel challenges created by digital assets, and particularly, stablecoins. Hopefully, the Report will spark debate among regulators and the industry that results in thoughtful, balanced regulation, and any resulting regulations do not stifle innovation of this new technology, but rather serve as a first step towards educated reform.
The authors would like to thank Paul Capuano and Cindy Wu for their contributions to this OnPoint.
1) The PWG is chaired by the Secretary of the Treasury and consists
of the chairs of the Board of Governors of the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission.
2) Report on Stablecoins, The President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (Nov. 1, 2021). At times, this OnPoint tracks the Report without the use of quotation marks.
3) In the Matter of Tether Holdings Limited, Tether Operations Limited, Tether Limited, and Tether International Limited, CFTC Docket No. 22-04 (Oct. 15, 2021).
4) Statement of Chairman Gensler on the President’s Working Group Report on Stablecoins (Nov. 1, 2021).
5) Reflections on Stablecoins and Payments Innovations, Governor Christopher J. Waller, Board of Governors of the Federal Reserve System (Nov. 17, 2021).