US President’s Working Group urges bank-like regulation for stablecoins

On November 1, 2021, the United States President’s Working Group on Financial Markets (PWG), joined by the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), released its “Report on Stablecoins” (report). Citing the significant financial risks associated with the use of stablecoins, the report calls for Congress to enact sweeping legislation that would prevent anyone except insured depository institutions from issuing stablecoins and would regulate custodial wallet providers and other parties that perform critical activities of the stablecoin arrangement. If Congress does not promptly act, the report urges the Financial Stability Oversight Council (FSOC) to step in to address certain risks including designation of certain activities as, or as likely to become, systemically important payment, clearing and settlement activities. There have been mixed reactions to the report across the industry.

The report noted that stablecoin market capitalization has skyrocketed over the past year, from approximately US$22 billion in October 2020 to US$128 billion in October 2021, in part because stablecoins are used to facilitate trading, lending and borrowing of other digital assets.

The recommendations are intended to apply to “payment stablecoins” which are defined as “those stablecoins that are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.” While each stablecoin differs in the level of risk associated with its reserve assets, there are currently no standards regarding the composition of these reserve assets or what information about them is released publicly, or when.

Risks identified

The report spends a significant portion discussing risks inherent in the use of stablecoins including loss of value risk, payment system risk and risks of scale.

Loss of value risk

The report emphasizes the risk of losing consumer confidence in a particular stablecoin that could result in a “run” on that stablecoin and ultimately pose systemic risk. The report identifies four factors that could undermine confidence in a stablecoin: use of reserve assets that could fall in price or become illiquid; a failure to appropriately safeguard reserve assets; a lack of clarity regarding the redemption rights of stablecoin holders; and operational risks related to cybersecurity and the collecting, storing and safeguarding of data. The PWG believes such a run “occurring under strained market conditions” could have drastic effects on the general economy and overall financial system.

Payment system risk

Because stablecoin payment arrangements utilize different technologies, transaction processes and governance structures, they are susceptible to a wide array of potential risks if transactions fail and no single entity is responsible for risk management for the system as a whole. The report contrasted this to the traditional centralized payment systems, where system risk is managed by the payment system operator and features robust risk management protocols.

The report also noted that stablecoin payment systems face unique operational risks, primarily related to validation and confirmation of transactions, as well as the management and integrity of the distributed ledger. An unregulated web of entities may lack the incentives to validate or process transactions, leaving users to wait for settlement, resulting in network congestion. These are in addition to operational risks that traditional payment systems suffer from, such as payment errors or fraud.

Further, the report identified certain settlement risks (when a payment system does not settle a transaction as expected) and liquidity risks (when settlement processes are slowed down). Many stablecoin arrangements do not clearly define when settlement becomes final, creating uncertainty and credit pressures for users. Also, where blockchain networks are public, consensus-based settlement mechanisms could potentially be manipulated, without any central entity responsible for management. Slowdowns in settlement processes can cause quantity shortages in the amount of stablecoins available to facilitate purchases.

Risks of scale

Finally, the report identified three sets of potential systemic risks, stemming from the potential for stablecoins to rapidly scale in value. First, the failure of a highly capitalized stablecoin entity could adversely affect the stability of the “real economy”. Second, the combination of a stablecoin issuer and a commercial firm could create an excessive concentration of economic power, analogous to the risks associated with institutions who mix banking and commerce, leading to negative competition effects and market concentration. Third, a widely adopted payment stablecoin could be put under pressure and become anticompetitive if users face excessive costs in choosing to switch to other payment products, at least absent standards for interoperability among different coins.

Recommendations

The report calls on Congress to promptly take legislative action as a “consistent and comprehensive regulatory framework is needed both to increase transparency into key aspects of stablecoin arrangements and to ensure that stablecoins function in both normal times and in stressed market conditions.” The PWG recommends the following:

• To address risks of stablecoin runs: require stablecoin issuers to be insured depository institutions, which are subject to appropriate supervision and regulation, at the depository institution and the holding company level
• To address payment system risk: require custodial wallet providers to be subject to appropriate federal oversight and provide the federal supervisor of a stablecoin issuer with the authority to require any entity that performs activities that are critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards
• To address systemic risk and concentration of economic power: require stablecoin issuers to comply with activities restrictions that limit affiliation with commercial entities and implement standards for custodial wallet providers, such as limits on affiliation with commercial entities or on use of users’ transaction data

If Congress does not act quickly, the report urges the FSOC to take action including considering to designate certain activities “as, or as likely to become, systemically important payment, clearing and settlement (PCS) activities.” This would, supposedly, enable appropriate agencies to establish risk-management standards for any financial institution engaging in designated PCS activities, “including requirements in relation to the assets backing the stablecoin, requirements related to the operation of the stablecoin arrangement and other prudential standards.” Such institutions could also be subject to “an examination and enforcement framework.”

Industry reactions

Proponents of the report emphasized this was a large step forward in the recognition and further adoption of stablecoins. Regulation around digital assets is lacking in the US and getting Congress to focus on these issues is important.

Critics, however, have highlighted that imposing such regulations on all stablecoin payment systems hinders innovation. The recommendations, as currently written, would also single out stablecoins compared to other traditional payment systems and it is unclear how the recommendations will fit with current digital asset state regulation. For example, New York currently issues BitLicenses to those who engage in virtual currency business activity and Wyoming has granted special purpose depository institution charters to approved banks to support digital asset banking activities. Further, critics argue that using the FSOC’s authority to designate PSC activities is a slippery slope for other payment systems and it has not successfully exercised this authority previously.

Finally, industry participants have pointed out the lack of guidance with respect to whether stablecoins are securities and were disappointed the report did not explicitly state that most payment stablecoins are not securities. The report emphasizes that its recommendations “are not intended to affect any analysis under the federal securities laws or the [Commodity Exchange Act]” but also repeatedly notes that stablecoins could be securities, commodities and/or derivatives subject to the jurisdiction of the Securities and Exchange Commission (SEC) and/or the Commodity Futures Trading Commission (CFTC). Such critics have noted that in order to meet the definition of a security under the US federal securities laws, there must be an “expectation of profit”. Payment stablecoins, as inherently designed, generally do not increase in value, leading critics to conclude that there cannot be (or should not be) any expectation of profits.