The report addresses the market risks and regulatory challenges presented by stablecoins and urges Congress to act quickly.
On November 1, 2021, the President’s Working Group on Financial Markets (PWG) in conjunction with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) published its long-anticipated Report on Stablecoins (the Report). Regulators worldwide have become acutely aware of how stablecoins function as a bridge between traditional financial markets and digital asset markets. As a result, regulators are seeking to address the risks, opportunities, and regulatory gaps presented by this burgeoning asset class.
The Report first describes how payment stablecoins function, before identifying key gaps in prudential authority over stablecoins in the US financial system. It then presents recommendations for addressing those gaps.
While the Report focuses on the risks and regulatory gaps related to stablecoins designed to maintain a stable value relative to a fiat currency, the opportunities of well-designed arrangements are mentioned at the outset. The benefits include the potential to support faster, more efficient, and more inclusive payments options.
The purported risks posed by stablecoins to users, the financial system, and the wider economy, however, may include the following:
- Failure of stablecoins to maintain a stable value relative to a national currency or other reference asset, especially in periods of market stress
- Potential for runs due to loss of confidence in reserve assets, mass redemptions, and destabilizing fire sales of reserve assets
- Potential for contagion in the digital asset markets or even the wider financial system due to stablecoin runs
- Disruptions in the payment system due to a breakdown in mechanisms that allow stablecoins to be stored or transferred could lead to a loss of payments efficiency and undermine functioning in the broader economy
- Concentration of economic power and anti-competitive effects due to stablecoin arrangements’ ability to rapidly scale
- Market integrity and investor protection issues, including fraud and misconduct in digital asset trading (e.g., market manipulation, insider trading, front running)
- Operational risks related to cybersecurity and the collecting, storing, and safeguarding of customer data
- Illicit finance and money transmission services concerns related to non-compliance with rules governing anti-money laundering and countering the financing of terrorism
Digital Asset Trading Platforms and DeFi
Because stablecoin use is so intimately connected with the borrowing, lending, and trading that takes place on digital asset trading platforms and decentralized finance (DeFi), the Report devotes considerable time to describing the stablecoin-related risks presented by such platforms and the regulatory powers of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in supervising these platforms when their respective authorities are implicated. Unique risks associated with these platforms include:
- Reliance of stablecoin arrangements on a platform, such that a failure or disruption to the platform could threaten the stablecoin, and vice versa
- Excessive leverage facilitated by use of stablecoins as collateral on unregulated or noncompliant trading platforms
- Interlinkages between digital asset trading platforms and stablecoins, including in platforms’ ownership of stablecoins (and potential co-mingling with customer funds)
- Risks resulting from unique aspects of distributed ledger-based arrangements, including governance issues, interoperability, scalability, protocol and smart contract vulnerabilities, cybersecurity, and other operational issues
- Risks resulting from novel custody and settlement processes that lack standardization and quality control
The Report highlights the gamut of risks posed by stablecoins to better ascertain where agencies such as the SEC, the CFTC, and the Financial Action Task Force (FATF) have a handle on those risks, and where further action is needed by legislative or regulatory authorities.
At the top of the Report’s recommendation list is the need for Congress to “act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal framework on a consistent and comprehensive basis.” The Report recommends that Congress enact forward-looking and flexible legislation to:
- Require payment stablecoin issuers to be insured depository institutions, and prohibit other entities from issuing stablecoins. Insured depository institutions such as state and federally chartered banks and savings associations are subject to appropriate supervision and regulation, at both the depository institution and the holding company level. They are also covered by services provided by the FDIC (deposit insurance) and the Board of Governors of the Federal Reserve System (emergency liquidity access)
- Subject custodial wallet providers to appropriate oversight, including the ability of the federal supervisor to restrict these service providers from lending customer stablecoins
- 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 comply with appropriate risk-management, liquidity, and capital requirements
- Require stablecoin issuers to comply with activities restrictions that limit affiliation with commercial entities
- Grant regulatory authorities the ability to implement standards to promote interoperability among stablecoins
The Report states that its recommendations build on the work of international forums, such as the Financial Stability Board’s (FSB’s) high-level recommendations for supervising global stablecoins published in October 2020. The Report further recommends that authorities continue to engage in international forums (e.g., the FSB, and the Bank for International Settlements’ (BIS) Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO)) to promote comprehensive and consistent oversight of stablecoin arrangements. The Report acknowledges a recent CPMI-IOSCO report and consultation on the regulation of stablecoin arrangements titled “Application of the Principles for Financial Market Infrastructures to stablecoin arrangements.” While the Report does not elaborate on to what extent the FSB recommendations or CPMI-IOSCO principles were employed in its drafting, there is considerable overlap in the risks that are noted. (See this Latham post for more information on the CPMI-IOSCO consultation.)
Congress Must Take the Next Step
The Report makes clear that legislation is urgently needed to address the many risks outlined. In announcing the Report, Treasury Secretary Janet Yellen stated that “[w]hile Congress considers action, regulators will continue to operate within their mandates to address the risks of these assets.” The Report itself states that to the extent activity related to stablecoins or digital assets falls under the jurisdiction of the SEC or the CFTC, these agencies have broad enforcement, rulemaking, and oversight authorities that may apply depending on the facts and circumstances. SEC Chair Gary Gensler, in a statement supporting the Report, asserted that the SEC and the CFTC “will deploy the full protections of the federal securities laws and the Commodity Exchange Act to these products and arrangements, where applicable.”
The risk, however, is that in the interim of any congressional action — which could take months (if not years) — the disparate patchwork of regulatory oversight leaves markets vulnerable to the numerous risks and regulatory gaps delineated in the Report. This is especially true where existing legal obligations are limited, ambiguous, or nonexistent. Indeed, according to related remarks by Under Secretary of the Treasury for Domestic Finance Nellie Liang, prudential oversight of stablecoins in the US is inconsistent, with some stablecoins “effectively falling outside the regulatory perimeter.”
The Report raises the possibility that in the absence of legislation, the Financial Stability Oversight Council (FSOC) can designate stablecoin arrangements as systemically important payment, clearing and settlement (PCS) activities. Such designation “would permit the appropriate agency to establish risk-management standards for financial institutions that engage in designated PCS activities.” However, if FSOC members are operating in an “incomplete or fragmented” oversight environment to begin with, determining which laws are applicable and which agency is the appropriate one for any given complex stablecoin arrangement may prove difficult. At least one prominent Senator has voiced concern that the fragmented environment may cause regulatory agencies to “to stretch existing laws in an effort to expand [their] regulatory authority,” which Chair Gensler has indicated a willingness to do. Until legislation is enacted, regulatory fragmentation (and agency competition to fill the gaps) may continue to cast a shadow over stablecoin arrangements as well as the entire digital asset market.