Stablecoin Regulation is a much-needed step but also a politically charged one. Calls to regulate the nascent stablecoin ecosystem are gaining momentum following the recent Terra UST stablecoin debacle. Not one to let a good crisis go to waste, Janet Yellen, the Treasury Secretary, has, for instance, urged for stricter stablecoin regulation following the unmooring of the UST from its USD peg.
Speaking in a Senate Banking Committee on May 10, Yellen flagged the TerraUSD (UST) loss of price parity to the dollar, crashing its $1 peg to lows of $0.05 per coin. She told Congress that the collapse of the Terra Luna ecosystem was proof that the sector needs strict regulations to avoid bank runs.
“A stablecoin known as TerraUSD experienced a run and had declined in value… I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability, and we need a framework that’s appropriate”, Yellen said.
Several regulators have proposed bank-like regulations on the stablecoins sector to prevent bank run events. The law will bring deposit insurance oversight and bank regulators and enforce liquid reserve assets for fiat-backed stablecoins. That said, stablecoin regulation is still in its discussion and legislation stage.
Stablecoin regulation in the US
The Terra event has injected a sense of urgency regarding stablecoin regulation in the US. The Biden administration, via the President’s Working Group (PWG) on Financial Markets, has released a report that suggests that these digital assets issuers should apply for bank charters.
The PWG released the recommendations on stablecoin regulation on Nov 1, 2021, asking Congress to enact proper legislation and create a clear regulatory framework. Amongst its recommendations is a stablecoin regulatory framework under the FDIC.
The PWG also advocated for risk management standards and federal oversight of stablecoin wallet providers. The group that comprises members of the FDIC and the Office of the Comptroller of the Currency (OCC) also suggests that commercial entities should limit their affiliations with the stablecoin ecosystem.
The House Financial Services Committee (HFSC) held a hearing on Feb 8, 2022, to consider legislative recommendations on the PWG report. However, some members of the HFSC opposed limiting stablecoin issuance to mainstream banking institutions.
This law, they said, would kill innovation and competition in the sector. They also expressed concerns that the bank issuance of stablecoins would introduce the racial bias prevalent in the legacy financial sector to the racial-neutral crypto sector.
If the PWG recommendations were to sail through Congress, stablecoin could fall under the regulatory oversight of the Financial Stability Oversight Council (FSOC) or the Securities and Exchange Commission. Possible outcomes of stablecoin regulation would be;
Stablecoin issuers regulated as Systemically Important Financial Institutions (SIFIs)
If stablecoin firms undergo an FSOC review, they could, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, be regarded as SIFIs. The FSOC must prove they are “likely to become systemically important.”
The Federal Reserve has supervision of SIFIs. Other firms that have received the SIFI delineation in the past are American International Group and the General Electric Capital Corporation. That said, only nonbank financial companies have held this title.
Stablecoin issuers as financial market utilities (FMUs)
The FSOC could identify stablecoin issuers as FMUs under the Dodd-Frank Act. The FSOC would prove that stablecoins have payment, clearing, and settlement (“PCS”) activity.
The National Securities Clearing Corp and The Clearing House Payments Company are FMUs. Accordingly, these firms are subject to strict banking supervisory and compliance provisions.
Stablecoins as securities
The Securities and Exchange Commission chair, Gary Gensler, proposes the regulation of these digital assets as securities or money market funds. However, stablecoins are payment devices, and many Republicans have resisted Gensler’s proposal, saying it was heavy-handed.
As an illustration, Pat Toomey, a Republican sitting on the Senate banking committee, advocates for regulation in the sector. He, however, is against the strict measures advocated by the Biden administration.
Speaking of Gensler’s idea, Toomey says, “He (Gensler) is attempting to use the enormous power he has and enforcement actions to compel an industry to do what he wants basically. This is no way to handle a new technology.”
Stablecoin issuers as insured depository institutions
Under the Tlaib, García, and Lynch Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act, stablecoin issuers would have to hold banking charters. Additionally, these firms would operate via the appropriate banking regulations.
On top of that, they would require approval from the FDIC, the Fed, and other appropriate banking agencies for half a year before their operations. These entities must also obtain FDIC insurance or maintain reserves with the Fed to ensure stablecoin to USD convertibility.
Republicans have, however, fought this recommendation. Limiting stablecoin issuance to nationally regulated financial institutions would exclude issuers such as the Centre consortium that issues the USD coin and Tether Limited.
“The idea that the only permissible issuers should be insured depository institutions is way too constraining… There is no logical reason why you have to be an insured depository institution to do this,” says Pennsylvania Republican senator Pat Toomey.
Enforcement of disclosure and redemption requirements
The Stablecoin TRUST Act, introduced by Senator Patrick Toomey in April 2022, has a friendlier stance on US stablecoin regulation debate. The “Stablecoin Transparency of Reserves and Uniform Safe Transactions Act of 2022 draft bill proposes a state money transmitter or Office of the Comptroller of the Currency (OCC) license for payment stablecoins.
These OCC licenses will allow banks to issue stablecoins. It also gives them regulatory oversight over the sector. The draft bill describes payment stablecoins as a medium of exchange that does not offer interest on deposits.
The Stablecoin TRUST Act provides regulatory certainty but is not bank-centric. It clarifies that these digital assets are neither investment assets nor securities. In addition, they are not subject to SEC laws. Federal or state regulators can oversee legal entities that issue payment stablecoin under this act, eliminating the need for a single regulatory framework.
Stablecoin regulation in Europe
European Union policymakers have made headway in stablecoin regulation, creating the Markets in Crypto Assets Regulation (“MICA”) draft bill. MICA identifies stablecoins as “asset-referenced tokens” that peg their value to diverse fiat currencies, crypto assets, or commodities.
The bill also describes stablecoins as “electronic money tokens” that maintain their stability by referencing one fiat currency. However, the bill does not consider algorithmic stablecoins as ‘asset-referenced tokens’ as long as they do not stabilize their value by referencing other assets.
Should the parliament enact MICA rules, stablecoin issuers will undergo a stringent operating authorization rule. Then every stablecoin operator will require a credit institution or e-money license. They will also need a member state banking license and pay hefty compliance and ongoing capital fund deposit costs.
Stablecoin regulation in the UK
The United Kingdom has a relaxed stance toward stablecoin regulation. Their proposed regulations identify stablecoins as “a recognized form of payment.” The UK could regulate stablecoins as payment devices.
Stablecoin issuers will therefore undergo regulation under the Financial Services and Markets Bill. The HM Treasury’s regulatory approach is that the “UK regulatory framework for stablecoins needs to be flexible enough to respond to rapid innovation.”
Britain seeks to become an international hub for digital asset technology and, therefore, will adopt a long-term investment outlook on the sector.
Stablecoin regulation in Asia
Asian countries have diverse outlooks on the crypto sector. India, for instance, does not have stablecoin regulation laws, but China has placed a ban on crypto-asset development. Hong Kong and Singapore are creating a regulatory framework that will govern stablecoin issuance.
Japan, on the other hand, is developing the DCJPY. The DCJPY is a yen-denominated digital currency that will enhance digital settlements and transactions.
Algorithmic stablecoin regulation is in limbo.
The catch, however, is that the ongoing regulatory wave does not offer any stabilization proposals for the algorithmic stablecoin sector. As a result, Stablecoins such as Terra or MakerDAO’s decentralized DAI stablecoin could remain unregulated.
DAO-governed stablecoins do not have a central issuer and are not directly redeemable by the issuer. Consequently, the PWG act does not consider its regulatory framework. The UK report on stablecoin regulation also excludes algorithmic stablecoins on any other stablecoin that tracks the value of commodities rather than fiat assets.
On the other hand, the Sept 24, 2020, MiCA framework does not identify algorithmic stablecoins as asset-referenced tokens. Consequently, coins like UST do not fall under its regulatory framework, designed to govern the issuance of e-money tokens or asset-referenced tokens.
Therefore, the EU MiCA framework might subject algorithmic stablecoins to general crypto market regulation.
To this end, regulators that are beefing up their enforcement efforts following the Terra failure may still not offer regulatory respite for algorithmic stablecoin issuers. The only way to keep the stablecoin industry free of bank runs and failures, such as the Terra ecosystem crash, is education on the importance of decentralization and security.
Decentralized stablecoins do not pose systemic risk
As US regulators grapple with the handful of stablecoin draft bills in Congress, a rather positive outcome of the Terra crash is that the resultant fallout did register a blip in the traditional finance sector.
Consequently, it has become clear that decentralized and algorithmic stablecoins performance may not affect the financial stability of the legacy banking system.
Financial regulators have pushed for oversight, fearing that banks may get burnt by the stablecoin industry. However, they have concrete evidence that decentralized ecosystem failures have little or no effect on the legacy system since banks do not have these crypto-backed assets on their balance sheets.
This outcome may discourage Congress from embracing draft bills that seek to place stablecoins on bank balance sheets.
Conclusion
After regulation, licensed stablecoin issuers will be subject to new liquidity, capital, and other banking requirements. More so, stablecoin issuers will no longer use illiquid commercial assets as stablecoin collateral.
Regulations will enforce the use of highly liquid assets to ensure that users can fully redeem their fiat-backed coins should there be a bank-run event. More so, stablecoin issuers will not issue credit on stablecoins. Regulation will change centralized stablecoin operations but could give them the much-needed acceptance to enhance mass adoption.