The collapse of the cryptocurrency exchange FTX is causing all of Washington to rethink its approach to regulating crypto assets, yet Congress is poised to consider a bill that does not adequately address stablecoins' run risk. Failing to provide issuers with government-backed insurance would be detrimental to the wider economy.
Stablecoins are crypto tokens that aim to maintain a stable value, and like bank deposits, they pose risks to the financial system. Stablecoin issuers are just like banks in that they both exchange money for claims on assets and also engage in maturity transformation by using those short-term assets to make longer-term loans. Like banks, stablecoin issuers can experience runs.
Since 1933, the United States has had a very effective structure of bank regulation that includes supervision by examiners, capital requirements and deposit insurance. Examiners review management practices, lending processes and procedures, assets and liabilities, and compliance with the law to ensure that banks are operating in a safe and sound manner to stop trouble from brewing before it can boil over. Capital requirements ensure that if trouble does occur shareholders absorb the first losses. And deposit insurance provided by the Federal Deposit Insurance Corp. makes depositors whole up to $250,000 per person per institution if a bank does fail.
The benefits of deposit insurance are many. Deposits may be lent far and wide into the non-financial economy, allowing borrowers to make use of the cash rather than having it sit under a mattress or in a vault. Small depositors, who cannot adequately assess the credit risks of the banks with which they trust their savings, are protected against loss while larger depositors who can review banks' balance sheets bring some market discipline to depository institutions. And because depositors know they will be made whole, they are unlikely to demand immediate withdrawal of their funds at the first sign of stress — deposit insurance effectively prevents runs.
Proposed stablecoin legislation ignores the well-known advantages of deposit insurance and would oversee stablecoins in a different manner. The bill most likely to be considered is being co-authored by the top Democrat and Republican on the House Financial Services Committee. Their bill would subject stablecoin issuers to oversight by banking regulators and impose capital requirements, but would not provide stablecoins with deposit insurance. Instead, it would limit stablecoin reserves to insured bank deposits — permitting pass-through FDIC deposit insurance — and highly liquid assets. It would also provide issuers access to the Federal Reserve's lender-of-last-resort facilities.
This framework has significant problems, and although permitting pass-through insurance at first glance appears positive, it would cause significant customer losses. First, FDIC pass-through insurance only works when issuers know who owns the deposited assets, meaning that stablecoins would lose their insured status when transferred to a crypto wallet unknown to the issuer. Accordingly, although stablecoins would be advertised as insured, they would not be unless recipients registered their crypto wallets with each and every stablecoin issuer.
Second, the proposed framework allows the same banks to offer functionally equivalent deposit accounts and stablecoins — both may be used for payments, pay interest, and be redeemable for cash at an ATM — but only accounts would be FDIC insured. Remember that customers of the crypto bank Voyager Digital believed both their dollars and stablecoins were safe following the company's collapse. However, only the dollars were FDIC-insured, and neither were safe, as it was Voyager, not an insured bank, that collapsed. Holders are likely to erroneously believe their stablecoins to be insured if the issuer fails.
Finally, limiting all other stablecoin reserves to high quality liquid assets would prevent funds from being an engine of economic growth. Banks' ability to turn deposits into long-term loans helps drive the real economy, but Congress restricts stablecoin issuers to using customer assets to buy Treasury bonds and short-term government repurchase agreements, investments will be limited. Instead, customer deposits should be borrowed and put to good use by the private sector.
In the face of these significant problems, only legislation that includes supervision, capital and liquidity requirements, as well as insurance for stablecoin issuers, would allow the government to ensure that issuers' maturity transformation benefits the economy, small customers' savings are protected, and runs are thwarted.
Providing insurance to stablecoins will not be easy. Whereas the FDIC can easily determine the value of bank accounts so as to provide them with appropriate insurance payments up to the ceiling in the case of failure, self-custodied crypto wallets make this process much more difficult. Further, regulators would be required to stop foreign, uninsured stablecoins from becoming a part of the U.S. financial system. However, if stablecoin legislation fails to provide insurance, it would either allow stablecoins to impose risks on the financial system or be drags on the economy.
For nearly a century, deposit insurance has allowed for both economic growth and risk mitigation. Enacting stablecoin legislation without it would be a mistake.
