Why Washington worries about stablecoins

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Stablecoins could be the most ironic innovation of the cryptocurrency era, at least in the eyes of many Washington regulators and politicians.

These digital currencies promise to maintain their value, which is generally pegged to a government currency such as the dollar or the euro, by relying on stable financial support such as bank reserves and short-term debt. They are becoming increasingly popular because they are a convenient and inexpensive way to trade in cryptocurrency. Stablecoins have moved from virtual nonexistence to a. developed more than $ 120 billion Market in a few years, with most of that growth in the past 12 months.

But many are built more like slightly risky investments than the dollars and cents cash they claim to be. And so far they have slipped through regulatory cracks.

The rush to oversee stablecoins – and the industry’s lobbying to either avoid regulation or go on its profitable side – could be the top conversation in Washington financial circles this year. How officials deal with sensitive questions about a relatively new phenomenon will set the precedent for a technology that is likely to endure and grow, and effectively write the first draft of a set of rules that will determine the future of money.

The debate about how to deal with stablecoins is also inevitably intertwined with another heated discussion: whether the Federal Reserve should offer its own digital currency. A Fed offer could compete with private sector stablecoins depending on its characteristics, and the industry is already preparing for the possibility.

Below is an overview of what stablecoins are, why they can be risky, the possible regulatory solutions, and the likely next steps the government can take when it comes to overseeing them.

A stablecoin – stable value coin if you’re feeling right – is a type of cryptocurrency that is usually tied to an existing government-backed currency. To promise holders that every $ 1 they deposit will be worth $ 1, stablecoins hold a bundle of assets in reserve, usually short-term securities like cash, government bonds, or commercial paper.

Stablecoins are useful because they allow people to more seamlessly trade in cryptocurrencies that act as investments, such as. B. Bitcoin. They build a bridge between old world money and new world crypto.

However, many stablecoins are backed by short-term debt, which is prone to illiquidity, meaning that it can be difficult or impossible to trade during difficult times. Despite this somewhat shaky support, the stablecoins themselves promise to function like absolutely safe stocks.

That makes it the kind of financial product that “macroeconomic disasters usually stem from,” said Morgan Ricks, a professor at Vanderbilt University Law School and a former Treasury policy advisor. “There’s a lot at stake here.”

However, some people – including George Selgin, director of the Center for Monetary and Financial Alternatives at the Cato Institute – argue that because stablecoins are used as a niche currency rather than an investment, they are less susceptible to runs in which investors are trying to get their money on take off once. Even if their support is questioned, people won’t want the potential taxes and paperwork that comes with converting stablecoins into actual dollars.

Given that the technology is still emerging, it’s hard to know who is right. However, regulators fear they could find out the hard way.

Stablecoins are not all created equal. The largest stablecoin, Tether, says it’s roughly half invested in a type of short-term corporate bond called commercial paper based on its recent revelations. The commercial paper market collapsed in March 2020, forcing the Fed to step in to fix things. If this type of vulnerability recurs, it could be difficult for Tether to quickly convert its holdings to cash to cover withdrawals.

Other stablecoins claim different support, which gives them different risks. However, there are big questions about whether stablecoins are actually holding the reserves they have claimed.

Circle company had said its USD coin, or USDC, was supported 1: 1 through cash equivalents – but then it was announced in July that 40 percent its holdings were actually in US Treasuries, certificates of deposit, commercial papers, corporate bonds, and municipal bonds. A Circle representative said USDC will hold all reserves in cash and short-term US Treasuries starting this month.

The New York Attorney General investigates Tether and Bitfinex, a cryptocurrency exchange, which in part claimed that Tether had at some point obscured the reserves of stablecoins. The comparison of the companies with the state included a fine and transparency improvements.

Tether stated in a statement that it never refused a withdrawal and changed its disclosures in the wake of the New York Attorney General‘s investigation.

The common thread is that without standard disclosure or reporting requirements, it is difficult to know exactly what is behind a stablecoin. Hence, it is difficult to estimate how much risk is involved.

It’s also difficult to keep track of how stablecoins are being used.

Stablecoins “can make it easier for those trying to circumvent a variety of public goals related to our traditional banking and financial system: combating money laundering, tax compliance, sanctions and the like,” said Gary Gensler, who heads the Securities and Exchange Commission, said Senator Elizabeth Warren in a letter this year.

The problem with stablecoins is that they slip through the regulatory cracks. They are not classified as bank deposits, so the Fed and the Auditor’s Office have limited ability to monitor them. The SEC has some authority when they are defined as securities, but that is a Subject of active debate.

State-level regulators have managed to exercise some oversight, but the fact that significant offerings – including Tether – are based overseas could make it difficult for the federal government to exercise authority. The regulators are now examining their options.

The Treasury Department, the Fed, and other financial regulators have a few options. It is not clear what they will choose, but the issue is clearly in the foreground: the Treasury Department-anchored President’s Working Group on Financial Markets is expects to issue a report on the subject immediately. A forthcoming Fed report Central bank digital currencies could also affect stablecoin risks.

Some of the main regulatory options are:

  • Label them as systemically risky. Since stablecoins are intertwined with other important markets, the Financial Stability Oversight Council could describe them as a systemically risky payment system and thus subject them to stricter supervision.

    While the market may not currently be large enough to be considered systemic risk, the Dodd Frank Act gives regulators the ability to apply this designation to a payment activity if it could pose a threat to the system in the future. If so, the Fed or other regulators would need to develop a plan to deal with the risk.

  • Treat them like securities. The government could also label some stablecoins securities, which would result in higher disclosure requirements. Mr Gensler told lawmakers during a recent hearing that stablecoins “Could well be securities”, which would give his institution broader supervision.

  • Regulate them as if they were mutual funds in the money market. Many financial experts point out that stablecoins work similarly to money market funds, which also act as short-term savings vehicles that offer quick repayments while investing in slightly risky assets. But money funds themselves have needed two government bailouts in just over a decade, suggesting their regulation is imperfect.

    “Stablecoins don’t look new,” says Gregg Gelzinis, who focuses on financial markets and regulation at the Center for American Progress. “I see them either as an unregulated money market fund or an unregulated bank.”

  • Treat them like banks. Given the flaws in monetary fund oversight, many financial regulation enthusiasts would prefer to treat stablecoins as bank deposits. If so, the tokens could be subject to supervision by a banking regulator such as the Office of the Comptroller of Currency, Gelzinis said. You could also potentially benefit from deposit insurance that would protect individuals if the company backing the stablecoin goes to its knees.

  • Try to compete with the central bank’s digital currency. Fed chairman Jerome H. Powell has signaled that overcoming stablecoins could be an appeal from a central bank digital currency – a digital dollar tied directly to the Fed like paper money.

    “You don’t need any stablecoins, you don’t need any cryptocurrencies if you had a digital US currency. I think that’s one of the strongest arguments for it, ”Mr Powell said during this year’s testimony.

    But how a digital central bank currency is designed would be decisive for whether it has succeeded in replacing stablecoins. And industry experts point out that as stablecoin users prioritize privacy and government independence, a new form of government-backed currency could do little to replace them.

  • Cooperate internationally. If everyone agrees on one point in the conversation, different jurisdictions must work together for stablecoin regulation to work. Otherwise, coins can move abroad if they are exposed to unattractive supervision in a particular country.

    the Board of Directors for Financial Stability, a global oversight body, is working to set standards and plans for collaboration related to stablecoin that should be finalized in 2023.

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