Systemic risk seen as potential route to stablecoin regulation
Congress seen unlikely to pass legislation
Federal regulators will consider added regulation on issuers of stablecoins if Congress doesn’t act on a recommendation for legislation to restrict the activity to banks, according to both regulators and legal experts.
Neither the Securities and Exchange Commission nor the Commodity Futures Trading Commission appears to be planning any related rule-making in the near future, leaving uncertainty in a hot area of financial markets. But government comments late last year raise the prospect that the Federal Reserve could be the most likely entity to take over supervision, at least for some stablecoin activity.
Stablecoins are digital assets designed to achieve the “stable” part of their name because they are backed by cash or its equivalent. They account for 5 percent of all digital assets and about 75 percent of overall trading in cryptocurrencies, according to SEC Chair Gary Gensler.
Proponents of stablecoins say they offer better speed and efficiency than traditional transactions.
The President’s Working Group on Financial Markets, a panel of regulators led by the secretary of the Treasury, recommended in November that Congress enact legislation to restrict the issuers of stablecoins to deposit-taking banks. They added that if Congress doesn’t act then regulators should consider designating stablecoins or related activity as systemically important, a move that would put them under the authority of the Federal Reserve.
Regulators reiterated this position on Dec. 17 in the annual report of the Financial Stability Oversight Council, also led by the Treasury.
Anand Sithian, a counsel with the law firm Crowell & Moring LLP, said he expects regulators to consider classifying some aspects of the stablecoin business as systemically important to the financial system.
“If there is no congressional action, they are probably going to take a view that certain activities warrant regulation as systemically important under the authority they have, so if FSOC acts, it would not necessarily be regulating a stablecoin-issuing company per se, but regulating certain activities by that company,” Sithian said in an interview.
For example, the systemic designation would not apply to an entire exchange offering stablecoin trading, he said, adding that it could apply only to the stablecoin activity.
Regulators are considering regulation “to address the potential systemic risk that could arise if there is a run or an inability to redeem,” Sithian said. They will evaluate the risk from the redemption of stablecoins and from the process of backing them with currency, he said.
He said he expects the regulatory agencies to continue with enforcement actions.
Stablecoins are here to stay, according to Sithian. “Even if there is an attempt by Congress to prohibit stablecoins in the United States, stablecoin issuers might just move offshore,” he said.
Questioning the bank rationale
Jai Massari, a partner with law firm Davis Polk & Wardwell LLP, questioned whether banks would find it economically feasible to issue stablecoins.
“The banking regulations are designed to regulate institutions that take deposits and make investments in long-term and illiquid instruments — not where liabilities are backed one to one by short-term, liquid assets,” she said in an interview.
Banks make a profit by accepting deposits and then lending that money. To address the risk that they might not have adequate liquidity to meet withdrawal demands, regulations impose capital and leverage ratios on the banks.
Massari questioned whether such regulations would allow banks to issue stablecoins and make a profit. Bank regulators generally require new banks to have a leverage ratio of 4 percent or 5 percent, she said.
The effect would be that a bank issuing $100 billion in stablecoins would need to maintain $104 billion in cash or cash equivalents, she outlined in an example during an appearance before the Senate Banking Committee on Dec. 14. This buffer would come from the stockholders. The leverage ratio would treat the assets the same, regardless of risk.
"Bank leverage ratios do not distinguish between risky and less risky assets held by banks," Massari said. "This results in a true stablecoin business model being uneconomical for a bank because the short-term, liquid assets held as the stablecoin reserve do not generate the same kinds of returns as riskier investments, and yet the bank must hold the same amount of capital under currently applicable leverage ratios for those assets as it would for riskier assets."
Congress might have to act here, she added. "And it may be difficult for bank regulators to address this issue to accommodate stablecoin issuance by a bank without additional direction or authority from Congress."
In the meantime, the agencies are likely to continue to use enforcement actions in the stablecoin and crypto worlds, according to both Sithian and Massari.
SEC Chair Gensler has indicated in speeches that many crypto activities are likely in violation of some federal regulations and his agency is focused on them.
The lack of rule-making in the SEC’s agenda does not mean the agency is sitting still, according to Dan Gorfine, a board member of the Digital Dollar Project, which advocates for a U.S. central bank digital dollar.
“Existing ambiguity on how crypto flows through the securities laws framework, including with respect to custody and registered digital asset securities offerings, may slow the pace of innovation in this space. That said, it is possible that the SEC will engage on some of these issues through publication of guidance and use of other regulatory tools,” Gorfine said in an email.
Gorfine is a veteran of the CFTC, where he worked on crypto issues.
As for the President’s Working Group’s call for legislation that would allow only banks to issue stablecoins, this is not likely to happen, two key members of Congress — Reps. Tom Emmer, R-Minn., and Jim Himes, D-Conn., both members of the House Financial Services Committee — said during a video appearance in December.
Emmer criticized the lack of stablecoin and crypto items on the upcoming SEC agenda.
“Chair Gensler is more than happy to opine on topics like crypto and stablecoins, but their omission from the SEC’s agenda further proves he has no intention to provide any meaningful regulatory clarity for this budding industry,” he said.
“If Chair Gensler were committed to upholding the mission of the SEC — to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation — he would stop regulating through enforcement actions and conclusory public statements and instead facilitate capital formation opportunities for Americans through clear and coherent regulatory guardrails.”
Despite the bipartisanship in Emmer and Himes' opposition, an alternative path to House legislation restricting stablecoin activity to banks may be taking shape, but the approach would treat them as commodities.
The ranking Republican on the House Agriculture Committee, Pennsylvania Rep. Glenn "GT" Thompson, is working on a draft bill that would let stablecoin issuers voluntarily accept federal regulation and in turn avoid state money transmission laws, which apply to much stablecoin activity and were written before the digital currency era.
Stablecoin issuers could come under the authority of the CFTC and would face requirements intended to ensure that they properly back up the coins with currency and are able to meet redemptions.