The not-so-stable state of stablecoin regulation

Biden administration officials are calling for tough governance for stablecoins, but the uncertainty of congressional action, the number of agencies responsible for oversight and clashes over interim regulations could delay new rules for months, if not longer.

"There are a lot of cooks in the kitchen here," Carol Van Cleef, counsel at Bradley Arant Boult Commungs, a Birmingham, Alabama, law firm, said during a recent Women in Housing and Finance-hosted virtual panel on stablecoins. "For many years, anytime he issue of federal oversight came up for stablecoins, there was a reluctance in D.C."

Stablecoins are a digital asset designed to offset the volatility of cryptocurrency, usually by backing the stablecoin's value with that of a traditional currency such as the U.S. dollar. This structure is meant to make stablecoins more palatable for mainstream payments, but there are still concerns such as how stablecoins are managed and how easily consumers can exchange them for cash.

The President's Working Group on Financial Markets issued a report on stablecoins in November. The PWG recommends Congress pass legislation to strengthen oversight of stablecoins, likely requiring nonbank issuers to follow rules similar to banks, and to clarify responsibility for different regulators. But anticipating Congress may not act right away, the report also lays the groundwork for direct federal regulation, a course that faces opposition from the stablecoin industry and Republicans.

"It's clear from the PWG report that [the regulators] would prefer congressional action that would provide roles for the different regulators," Douglas Landy, co-head of the New York-based White & Case's Financial Institutions Industry Group and head of the law firm's U.S. Financial Services Regulatory practice, said in an interview. "It's also clear that the regulatory agencies are not going to wait if Congressional action does not come about."

The PWG report is a step toward the Financial Stability Oversight Council's classifying certain nonbank stablecoins as systemically important financial institutions under the Dodd-Frank Act, according to the White & Case analysis. That designation would signal that stablecoin issuers are likely to become large or influential enough to pose a risk to overall financial stability if they were to fail. SIFIs are subject to consolidated supervision by the Federal Reserve and face enhanced requirements to guard against liquidity risk that are in line with federally regulated banks. Only four nonbank companies have been designated SIFIs, including American International Group, General Electric Capital Corp., Prudential Financial and MetLife. The SIFI designation was later removed for these companies and no nonbanks are currently classified as SIFIs.

The FSOC may also designate nonbank stablecoin issuers as financial market utilities under Dodd-Frank. FMUs are also subject to heightened supervisory provisions in line with banking, including providing advance notice of changes to operations that could affect their risk. The organizations typically designated as FMUs move massive volumes of payments, such as The Clearing House Payments Company, the Chicago Mercantile Exchange and the National Securities Clearing Corp.

The capitalization of the stablecoin market was about $130 billion in October, according to the U.S. Treasury, adding that's up from less than $30 billion over the previous 12 months. It's also a fraction of the total payments market, according to Van Cleef. Stablecoins are growing quickly enough to attract regulatory attention, she added.

"There's a concern among regulators about the ability to redeem stablecoins. If there's no confidence in redemption, that can cause consumers harm," said Will Giles, a senior attorney at Cravath, Swaine & Moore, a New York-based law firm, during the Women in Housing and Finance roundtable. "And that can create a financial stability risk if the stablecoin is large or if it creates a contagion or a domino effect if one were to fail."

A FSOC designation would likely be aimed at nonbank-issued stablecoins that are closely tied to payments, said Giles.

"We'll see discussions on the" FSOC designations, Giles said, adding that like legislation, an interim FSOC move would also take time. "It will be a multistep process. It's an authority that isn't used often."

The FSOC includes the Department of the Treasury, Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Reserve, the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corp., the National Credit Union Administration, the Federal Housing Finance Agency and an independent member who has insurance expertise.

"The [PWG] has asked Congress to limit stablecoin issuance to depository institutions. That would take an act of Congress," Landy said. "But if the goal is to limit stablecoins to banks, subjecting nonbank entities to banklike regulations but not giving them banklike benefits would accomplish the same thing."

Two-thirds of the FSOC members, including the Treasury secretary, must vote to designate an entity as a systemically important financial institution or a financial market utility. Voting members of the FSOC participating in the PWG report included the Treasury Department, the Federal Reserve, the SEC, the CFTC, the FDIC and the OCC.

Classifying nonbank issuers of stablecoins as FMUs or SIFIs would subject them to banklike regulations, but without access to FDIC deposit insurance, access to the Federal Reserve's discount window, the Fed Account Service and other services, Landy said.

"The nonbank stablecoin issuers would be getting the bad stuff of regulation without all of the good stuff," Landy said.

Stablecoin issuers are mostly in favor of regulation, but many balk at the notion that only FDIC-insured institutions should be allowed to issue stablecoins. The blockchain firm Ripple, which has sparred with the SEC over the commission's push to regulate the XRP token as a security, is pushing for a collaborative effort among blockchain providers, cryptocurrency companies, stablecoin issuers and regulators.

"Imposing rules designed for a legacy banking system on the innovation underlying cryptocurrency assets doesn’t seem to be the answer," said Stuart Alderoty, Ripple's general counsel. "Any policy framework designed to regulate cryptocurrency should be built on an active dialogue between regulators and market participants. Public-private collaboration will lead to more tailored and effective policy outcomes for the industry, markets and consumers alike and should be formally encouraged and facilitated."

Circle, which issues the USDC stablecoin, is pursuing a banking license, partly to support its strategy to build financial services for its stablecoin users.

“We are fully supportive of the call for Congress to act and establish federal banking supervision for stablecoin issuance. The rapid scaling and strategic importance of this to dollar competitiveness in the age of crypto and blockchains is critical,” Jeremy Allaire, a Circle co-founder and its CEO, said in an email. Circle did not comment on the potential for an FSOC designation for stablecoin issuers.

In a recent speech, Federal Reserve Gov. Christopher Waller, a Trump appointee, warned against excessive regulation of stablecoin providers, saying regulatory oversight of stablecoin providers can insulate banks from some forms of direct competition.

And in a recent letter, Sen. Pat Toomey, R-Pa., the ranking member of the Senate Banking Committee, argued that Congressional action would provide clarity on the jurisdiction that federal agencies have over stablecoins, while relying on direct regulatory action would "stretch existing laws … or take advantage of ambiguities" to regulate stablecoins.

There is a bill written to regulate stablecoins, but it has languished. The Stable Act, a bill introduced in the U.S. House of Representatives in late 2020 by Rep. Rashida Tlaib, D-Mich., would require any prospective issuer of a stablecoin to obtain a banking charter, as well as notify and obtain approval from the Federal Reserve, FDIC and appropriate banking agency six months prior to issuance. Republicans have voiced opposition to the Stable Act, contending it would hinder financial inclusion. Some cryptocurrency companies also objected.

Congress is the most appropriate avenue to regulate stablecoins, said Ron Hammond, director of government relations for the Blockchain Association, a Fairfax, Va.-based organization that contributed to the PWG report. The Blockchain Association, whose members include Ripple, Circle, and several dozen other firms, disagrees with a potential FSOC designation of stablecoin issuers as systemically important. The Blockchain Association would not directly comment on the Stable Act, but its position is that nonbanks should be permitted to issue stablecoins.

"The risks outlined by the PWG in their recent report on stablecoins can be addressed by regulatory solutions other than granting an exclusive right to banks to issue stablecoins," said Hammond, adding that states such as New York and Wyoming have already established such solutions. New York offers a license to crypto firms and states such as Nebraska and Wyoming have special purpose bank charters for firms active in digital currencies.

Discussions about regulating stablecoins picked up in the spring of 2021. Eric Rosengren, president of the Federal Reserve Bank of Boston, listed the stablecoin Tether as being among a list of firms that pose "financial stability challenges." The issuer of Tether was fined $41 million in October over false claims that its stablecoin was entirely backed by U.S. dollars and euros. Tether's reserves included unsecured receivables and nontraditional currency in its reserves, potentially creating a shortfall if all Tether holders tried to cash out simultaneously.

SEC Chairman Gary Gensler and Federal Reserve Chairman Jerome Powell called for tighter regulations for stablecoins earlier this year. It took three months to produce the PWG report Giles said, suggesting that's a slow pace that would result in a long wait for stablecoin regulation.

Hammond was also part of the Women in Housing and Finance stablecoin panel, and during the session said Congress would likely need to pass stablecoin regulations by June 2022 before the focus turns to campaigns for the midterm elections. There is also a tendency to group stablecoin regulation with other digital asset issues, such as central bank digital currencies and cryptocurrencies, which could further bog down the stablecoin legislative process in Congress, Hammond said.

"There are a lot of notions out there that you need to have either stablecoins or central bank digital currencies," Hammond said during the event. "But these things exist in the same environment and there needs to be more clarification."