US stablecoin regulation: bringing stablecoins into regulatory fold
Stablecoin risks and recommendations
Payment system risks
Risks of scale: systemic risk and concentration of economic power
Continued regulatory oversight and enforcement
DeFi – sign of things to come?
On 1 November 2021, the 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 a report on stablecoins.
The report focuses on stablecoins that are convertible for an underlying fiat currency, as opposed to a smaller subset of stablecoin arrangements that use other means to attempt to stabilise the price of the instrument (ie, "synthetic" or "algorithmic" stablecoins) or are convertible for other assets. It was released at a time when stablecoins are experiencing rapid, substantial growth in use and distribution. As noted, the market capitalisation of stablecoins issued by the largest stablecoin issuers exceeded $127 billion as of October 2021, reflecting a nearly 500% increase over the past year. Accompanying such growth, or perhaps in response thereto, is an increasing regulatory scrutiny of stablecoins and their issuers, as well as the cryptocurrency and blockchain spaces more generally.
Helpfully, the report provides a primer on stablecoins and their use cases before addressing their perceived risks. It also calls for congressional action in implementing legislation based on policy recommendations to address those risks. Even in the absence of such legislation, though, the report makes clear that the federal regulatory agencies of the PWG, the FDIC and the OCC (collectively, the "agencies") would continue using their regulatory, supervisory and enforcement powers to address the risks relating to stablecoins, and the agencies also recommend that the Financial Stability Oversight Council (FSOC) "consider steps available to it" to address such risks.
This article provides an overview of the report's assertions on stablecoin risks, its recommendations and their related implications for the stablecoin marketplace.
"Stablecoins" are defined in the report as "digital assets that are designed to maintain a stable value relative to a national currency or other reference assets". Stablecoins are primarily used in the United States to facilitate trading, lending or borrowing of other digital assets, predominantly on or through digital asset trading platforms. While redeemable for fiat currency, stablecoins do not create a right of immediate redemption. This can be contrasted against a demand deposit held at an insured depository institution, which is a claim on the issuing bank that provides the depositor with the right to receive US dollars upon request, insurance up to certain amounts and entitlement to preference in a resolution proceeding. The insured depository institution offering demand deposits may also access emergency liquidity if needed and is subject on an ongoing basis to supervision and regulation designed to limit the riskiness of its balance sheet and operations.
The agencies also outline a set of perceived risks that stablecoins present to the financial industry, the economy and consumers, specifically including:
- loss of value, or risks to stablecoin users and stablecoin runs;
- payment system risks; and
- risks of scale, or systemic risk and concentration of economic power.
Any means of payment or store of value is reliable only when there is confidence in its value, particularly in periods of stress. Public confidence in stablecoins is derived from their redeemability and support by a stabilisation mechanism that will consistently function regardless of market conditions. The agencies list certain factors that could undermine confidence in a stablecoin, including:
- 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 relating to cybersecurity and the collecting, storing and safeguarding of data.
Any failure of a stablecoin to perform according to expectations would harm users of that stablecoin and could pose systemic risk. Similar to concerns with respect to bank deposits in the lead up to the Great Depression, an indication that a stablecoin may not perform or is not performing as expected could trigger a "run" on that stablecoin. While some stablecoins utilise deposits at insured depository institutions for purposes of holding reserve assets, this does not necessarily mean that deposit insurance fully covers end users of those stablecoins and, in some circumstances, deposit insurance may not extend at all to end users of those stablecoins. For example, under current US regulations, if a stablecoin issuer deposits fiat currency reserves at an FDIC-insured bank in a manner that meets all the requirements for "pass-through" deposit insurance coverage, the deposit would generally only be insured to each stablecoin holder individually for up to $250,000. Without pass-through coverage, though, the deposit at the FDIC-insured bank would be insured only to the stablecoin issuer itself.
To address these risks and issues, the agencies recommend that Congress restrict the issuance of stablecoins – including the related activities of redemption and maintenance of reserve assets – to insured depository institutions. As recommended, such entities would be subject to the FDIC's special resolution regime, created to enable the orderly resolution of failed insured depository institutions, and regulating the holding companies of such institutions would ensure appropriate capital and liquidity standards.
As part of the report, the agencies also identify potential efficiencies in payment processing as presented by stablecoin arrangements. Stablecoins face many of the same kinds of risks as traditional payment systems, including credit risk, liquidity risk, operational risk, risks arising from improper or ineffective system governance and settlement risk. As further defined:
- "operational risk" is the risk that deficiencies in information systems or internal processes, human errors, management failures or disruptions from external events will result in the reduction, deterioration or breakdown of services;
- "settlement risk" is the risk that settlement in a payment system will not take place as expected; and
- "liquidity risk" is defined as a misalignment of the settlement timing and processes between stablecoin arrangements and other systems, causing temporary shortages in the quantity of stablecoins available to make payments.
In light of these risks, and citing the central role that custodial wallet providers play within a stablecoin arrangement, the agencies recommend that Congress subject custodial wallet providers to appropriate federal oversight, including potentially restricting these service providers from lending customers' stablecoins and requiring compliance with appropriate risk-management, liquidity and capital requirements. The agencies also recommend that Congress consider other standards for custodial wallet providers, such as limits with respect to commercial entity affiliation or use of users' transaction data. It should be noted, however, that the report does not specify which federal agency would serve as a custodial wallet supervisor. Setting aside the questions that this raises, it also underscores the likely delay in implementation given the complex process of delineating regulatory jurisdiction and the current political climate.
Noting the growth in stablecoin issuance and adoption, the agencies highlight potential systemic risk implicated by stablecoins, as well as the risk of concentration of economic power, as described via three policy concerns:
- A stablecoin issuer or a key participant in a stablecoin arrangement, such as a custodial wallet provider, could pose systemic risk. The agencies describe such risk as the failure or distress of that entity adversely affecting financial stability and the real economy.
- The combination of a stablecoin issuer or wallet provider and a commercial firm could lead to an excessive concentration of economic power. According to the agencies, this example is analogous to the risks traditionally associated with the mixing of banking and commerce, such as advantages in accessing credit or using data to market or restrict access to products.
- A stablecoin that becomes widely adopted as a means of payment could present concerns about anti-competitive effects. As an example, the agencies note that if users of a stablecoin face undue frictions or costs when switching to other payment products or services, this may be indicative of anti-competitive effects.
In order to address these policy concerns, the agencies make the following recommendations:
- Congress should require stablecoin issuers to comply with bank-like activity restrictions that limit their affiliation with commercial entities.
- Congress should provide the federal supervisor of a stablecoin issuer with the authority to require any entity that performs activities critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards.
- Congress should provide appropriate agencies with examination and enforcement authority over the stablecoin activities of issuers and entities that perform activities critical to the functioning of any stablecoin arrangement.
- Federal supervisors should have the authority to adopt standards to promote interoperability among stablecoins, as well as between stablecoins and other payment instruments.
In the absence of legislation, the agencies are prepared to continue using their regulatory oversight and enforcement powers to ensure that certain types of entities involved in stablecoin arrangements (eg, issuers and custodial wallet providers) comply with existing regulations or otherwise be subject to penalties if they do not. Indicative of this vigilance, the agencies have to date been highly cautious of blockchain and cryptocurrency projects generally, including stablecoin arrangements.
Regulators other than the agencies have also been focused on ensuring regulatory-compliant behaviour in the digital asset space. As the Securities and Exchange Commission (SEC) continues to focus on preventing offerings and sales of unregistered securities in the digital assets including cryptographic tokens, the Commodity Futures Trading Commission (CFTC) has asserted jurisdiction over fraud and manipulation within the cryptocurrency market (to the extent a particular cryptocurrency is a commodity) in addition to its more traditional regulation of derivative (and derivative-like) products based on digital asset commodity (or "virtual currency") underliers. Despite the jurisdictional divide, though, the two agencies have been engaging in a tug-of-war over whether certain digital assets constitute securities or commodities. In its recent order settling charges against Tether Holdings Limited, Tether Limited, Tether Operations Limited and Tether International Limited (together, "Tether"), the CFTC established that Tether introduced the US dollar tether token ("tether token") as a stablecoin in 2014, and stated, in no uncertain terms, that "[d]igital assets such as bitcoin, ether, litecoin, and tether tokens are commodities". Meanwhile, Gary Gensler, chairman of the SEC, has stated on numerous occasions that certain stablecoins could become subject to SEC regulation. As he noted in his remarks before the Aspen Security Forum:
It doesn't matter whether it's a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities, [t]hese products are subject to the securities laws and must work within our securities regime.
Interestingly, the report does not address this jurisdictional tussle, instead broadly waving away the issue in stating that "depending on the facts and circumstances, a stablecoin may constitute a security, commodity, and/or derivative". Absent legislation or some other regulatory accord resolving such ambiguity, the stablecoin marketplace is likely to continue to be subject to jurisdictional uncertainty.
In addition, the agencies confirm that bank regulatory agencies will continue scrutinising charter applications by stablecoin entities, as they will seek to ensure that applicants address the risks outlined in the report, including risks associated with stablecoin issuance and other related services conducted by the banking organisation or third-party service providers. Other federal bodies, such as the Consumer Financial Protection Bureau, the Treasury Department's Financial Crimes Enforcement Network and the Department of Justice, will continue to have a stake in ensuring that stablecoin arrangements comply with the laws over which such agencies have jurisdiction and enforcement power. Relatedly, the agencies reiterate the Treasury Department's commitment to continued efforts in the international regulatory arena, particularly with respect to the Financial Action Task Force, which is an international organisation of member countries' regulatory agencies that implement and enforce anti-money laundering and countering the financing of terrorism regulations.
In the absence of legislation, the agencies would like the FSOC to consider steps available to it to address the risks outlined in the report. Such steps include the designation of certain activities conducted within stablecoin arrangements as, or as likely to become, systemically important payment, clearing, and settlement (PCS) activities, the authority for which was provided in Title VIII of the Dodd-Frank Act and has yet to be exercised by the FSOC. However, in order to do so, the FSOC would have to identify and define the activity it is designating as a systemically important PCS activity. Notably, Title VIII of the Dodd-Frank Act explicitly excludes from the meaning of "PCS activities" any offer or sale of a security under the Securities Act 1933. A designation as a systemically important PCS activity could therefore be interpreted as precluding the SEC from asserting that a stablecoin arrangement, so designated, also constitutes an offer or sale of a security.
In any event, once a PCS activity is designated as systemically important, any financial institution that engages in that activity would be subject to risk management standards prescribed by the Federal Reserve (or the CFTC or the SEC in certain instances) with respect to that activity. This would capture any "financial institution" engaging in such activity, defined by Title VIII of the Dodd-Frank Act to include, among other types of entities, any company engaged in activities that are financial in nature or incidental to a financial activity, as described in section 4(k) of the Bank Holding Company Act 1956. Such a broad category of institutions would create the potential for a wide net to be cast with respect to the types of entities performing stablecoin-related activities that could be subject to such risk management standards.
The report provides an overview of decentralised finance, most commonly referred to as "DeFi", which it defines as a "variety of financial products, services, activities, and arrangements supported by smart contract-enabled distributed ledger technology". Stablecoins, in the agencies' view, are often used by DeFi platforms for the efficient and near immediate exchange of value, and can be central to the operation of such platforms, facilitating trading or as collateral for lending and borrowing. Relatedly, the agencies, along the lines of similar initiatives within the SEC and the CFTC, highlight certain risks that DeFi arrangements present, such as:
- risks of fraud, misappropriation and conflicts of interest, including those arising from misleading disclosures to the market, misuse of inside information and manipulative trading activities;
- reliance of stablecoin arrangements on digital asset trading platforms, such that a failure or disruption to a digital asset trading platform could threaten a reliant stablecoin; and
- money laundering and terrorist financing risks.
While the agencies acknowledge the SEC's and the CFTC's respective jurisdiction over certain kinds of stablecoins used within such DeFi arrangements, the report does not prescribe any new requirements, nor does it call on Congress to enact legislation that would create new requirements specifically for the DeFi market. Perhaps, most of all, this somewhat cryptic interjection of DeFi into the report could be seen as a harbinger of things to come as the SEC and CFTC gear up to focus on reining in non-compliant DeFi activities.
The report, while aspirational in its attempt to present clear recommendations to Congress for the regulation of stablecoin arrangements, is instructional at best. With a divided Congress approaching midterm elections, it is unlikely that legislation of the magnitude contemplated in the report will be passed in the near term. Instead, this report can be seen as reflective of the agencies' views on the risks associated with stablecoin arrangements and how such risks should and will be approached. Regardless of progress in the legislative sphere, though, entities involved in the issuance, custody, settlement and other essential activity with respect to stablecoin arrangements may find the report helpful in understanding the type of issues on which the agencies will focus. In case unclear for stablecoin issuers and related firms that were previously in doubt, regulatory scrutiny is no longer a matter of "if", but "when".
For further information on this topic please contact Mark Chorazak, Donna M Parisi, Le-el Sinai or Sean W Anderson at Shearman & Sterling LLP by telephone (+1 212 848 4000) or email ([email protected], [email protected], [email protected] or [email protected]). The Shearman & Sterling LLP website can be accessed at www.shearman.com.