Paradigm: Stablecoins Should Not Be Included Under Banking and Securities Regulatory Frameworks

Originally written by Brendan Malone, Paradigm

Original compilation: Luffy, Foresight News

Stablecoins represent a once-in-a-lifetime opportunity to upgrade and expand payment systems in the digital age. However, despite technological advancements around the world and growing customer demand in the digital economy, some recent regulatory actions and legislative proposals that would shoehorn crypto payment instruments into existing banking and securities frameworks are a step backwards.

If legislation in this area is to move forward, lawmakers should focus on three key goals:

• To address the risks faced by users of USD stablecoins, legislation may require centralized issuers of USD stablecoins to meet appropriate risk management standards. For fiat stablecoins that the issuer claims to guarantee redemption at face value, the issuer must hold reserve assets proving that they match outstanding stablecoin balances. Reserve assets, which can consist of bank deposits and short-term treasury bills, are segregated from the issuer's own assets, protected from creditor proceedings, and subject to appraisal or audit. Importantly, these issuers do not have to be banks or be regulated like banks.
• To foster growth and competition, legislation could prioritize stablecoins and related services and orderly and effective competition with incumbent banks. This includes setting clear guardrails to ensure that stablecoin regulatory frameworks, as well as traditional payment infrastructure regulations, have objective, risk-based, and publicly disclosed licensing eligibility, allowing banks and regulated non-bank entities to act fairly at the state and federal levels obtain permission. Access rights for end users (whether corporate or personal) should also be liberalized.
• To encourage responsible stablecoin innovation, legislation could enable a wide range of payments and related services for consumers and businesses. Instead of mandating that all stablecoins must be pegged to the U.S. dollar, or prohibiting algorithmic and on-chain overcollateralized stablecoins, regulation should allow experimentation and innovation within consumer protection and additional rules commensurate with the level of risk.

background

While recent US Congressional proposals for stablecoins allow issuance by entities other than banks, policy discussions around appropriate guardrails tend to focus primarily on traditional safety and soundness principles of banking regulation, such as capital requirements or securities-related risk management frameworks.

Given the unique risks and current use cases of stablecoins, the traditional banking and securities law framework is flawed for stablecoin regulation. Policymakers should develop a new framework that promotes openness and competition more than the current banking or securities frameworks.

Specifically, while ensuring that prudential and market risks are addressed is critical, we believe that the regulatory framework must allow payment stablecoins to function and thrive. Regulatory guardrails can help maintain confidence in stablecoins as a form of money and ensure that power in our monetary system does not fall into the hands of a few market participants.

What is a stablecoin?

Stablecoins are digital dollars issued on public, permissionless blockchains. Due to the nature of blockchains, they are able to significantly improve the digital payment ecosystem.

• Reliable, shared infrastructure. Public blockchains are data and network infrastructure with more open access and high uptime, requiring very limited upfront capital outlay for payments and tokenization.
• Programmability. Thanks to smart contracts, most public blockchains are programmable, transparently executing complex code based on arbitrary conditions set by users.
• Composability. Applications and protocols built on public blockchains can be used in combination with each other to create new capabilities.

These capabilities enable the design of a new generation of electronic payment systems that can significantly reduce the intermediation of banks' balance sheets and create new paths for the efficient flow of payments. Using a different mechanism to maintain stability, stablecoins rely less on the banking system and balance sheet intermediaries.

At the same time, trust and confidence are fundamental characteristics of money. A regulatory infrastructure that maintains trust and confidence in stablecoins can help stablecoins thrive. However, if stablecoins are shoehorned into a regulatory framework that is not suitable for banks or money market funds, they will end up looking like banks or money market funds, and they will be as inefficient as existing financial services.

From a risk perspective, stablecoins are not bank deposits

Banks play a central role in the financial system and the wider economy. Their books hold the savings of countless households and businesses. In addition to taking deposits, they also make loans to individuals, businesses, government entities and a range of other customers. If businesses can only finance themselves, or individuals can only use cash on hand to buy things like a house or a car, then business activity will be severely limited.

Banking can also be highly risky. Banks take customer deposits (which customers can withdraw at any time) and make loans or invest in bonds or other long-term assets (performing so-called maturity transformation). In this process, banks may suffer losses due to misjudgment. If all of a bank's customers concentrate their withdrawals, and the bank may not have enough assets on hand, this could lead to panics, bank runs, and fire sales. If a bank is mismanaged and suffers losses from bad loans or bad investments, that can also affect its ability to repay customer deposits.

Stablecoins inherently face different risks than banks. Issuers of USD stablecoins (which, depending on their terms, can be redeemed at face value on demand), may hold reserve assets to cover customer redemptions. These reserve assets, which may be matched to issued stablecoins, consist of central bank liabilities or short-term treasury bills, which are segregated from the issuer's own assets, are not subject to creditor procedures, and are subject to evaluation or audit. Federal regulations implemented under the new legislation may need to include specific safeguards. If so, then unlike bank deposits, there is no maturity mismatch between short-term liabilities (which stablecoin holders can redeem at par at any time) and long-term or risky assets.

More generally, even for stablecoins that are not pegged to the U.S. dollar or promise redemption at par, issuers are inherently less involved in maturity transformation than banks are. Here, safeguards can also be put in place to ensure that consumers are protected and financial stability is maintained. These guardrails could include disclosures, third-party audits, and even basic consumer protection rules for centralized facilitators offering or promoting such stablecoins to clients.

In essence, a risk management framework applicable to stablecoins should aim to manage the unique risks associated with stablecoins, which differ from those of traditional banking.

Stablecoins are not the same as MMFs in practice

Regulators, including the SEC, say certain stablecoins are similar to money market funds (MMFs), especially when they hold various assets such as government securities and cash as reserves to maintain their value. Therefore, these stablecoins should be regulated as money market funds (MMFs). We think this is an inappropriate way to regulate, because MMF is not the same as the actual market use of stablecoins.

MMF is an openly managed investment firm regulated by securities laws. They invest in high-quality, short-term debt instruments such as commercial paper, Treasury bills, and repurchase agreements. They pay interest reflecting prevailing short-term interest rates, are redeemable on demand, and maintain a constant net asset value per share, typically $1.00 per share, in accordance with SEC rule MMF requirements. Like other mutual funds, they are registered with the SEC and regulated by the Investment Company Act of 1940. MMFs are publicly listed investments purchased and traded through a securities intermediary, such as a broker or bank that is eligible to trade on an exchange.

Over the years, various types of money market funds have been launched in the market to meet the different needs of investors with different investment objectives and risk tolerance. As classified by the SEC nearly a decade ago, most investors invest in high-quality money market funds, which typically hold a variety of short-term debt issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper. By contrast, government money market funds primarily hold U.S. government debt, including that of the U.S. Treasury Department, and repurchase agreements backed by government securities. Government money market funds typically offer greater security of principal but lower yields than premium funds.

The combination of principal stability, liquidity and short-term yield offered by money market funds shares some similarities with USD stablecoins. But importantly, stablecoins have a very different practical use than money market funds, and most stablecoins will lose their utility if they are regulated as money market funds.

In practice, stablecoins are primarily used as a means of payment in crypto transactions, rather than as an investment option or a cash management tool. Holders of USD stablecoins do not receive any returns for their reserves. Instead, stablecoins are used as cash equivalents. Holders of U.S. dollar stablecoins typically do not seek to redeem the value of their stablecoin holdings from the issuer and then use the proceeds in cryptocurrency transactions. They simply transfer the stablecoin itself as the USD payment portion of the cryptocurrency transaction. This would not be possible or practical if stablecoins were regulated as money market funds (MMFs) and required holders to sell through brokers or banks.

We believe it would be wrong to mandate the inclusion of stablecoins in the MMF regulatory framework, especially if legislation has the opportunity to create a more suitable framework. In fact, the Supreme Court declined to extend the SEC's authority to such tools.

In other words, just as money market funds are regulated differently from other investment firms because of their structure and purpose, stablecoins should be regulated consistent with their unique structure and purpose.

in conclusion

We believe that confining stablecoins to the framework of existing banking and securities laws ignores key payment system principles, particularly those related to fairness and open access. What is unique about payment systems is the dynamic nature of the network effect, i.e. the benefit that users receive from the system increases with the number of users of the system. Combined with barriers to entry, including overly onerous and strict bank-style regulation of stablecoin issuers, these factors tend to limit competition and concentrate market power in a few dominant parties. If left unchecked, this could lead to lower levels of customer service, higher prices, or underinvestment in risk management systems.

This concentration of power would also be anathema to the freedom of choice and decentralization of cryptocurrencies. A stablecoin issuer or service provider with centralized market power may make governance decisions for a public blockchain and can also influence the competitive balance among other players. It may choose to disadvantage certain players (and their customers) by restricting access, while rewarding other favored crypto service providers with preferential treatment, thereby enhancing its own market power.

For these reasons, we urge Congress to act now to enact legislation that addresses the risks posed by stablecoins while still allowing payment stablecoins to function and continue to innovate. Based on these principles, such legislation would address key issues while still allowing for the operability of stablecoins:

• Protect stablecoin users by setting reasonable risk management requirements for centralized service providers;
• Level the playing field by ensuring that non-bank issuers at the federal and state levels have viable avenues;
• As long as consumer protection benchmarks are met and risks are properly managed, stablecoins can take on a variety of models, thereby fostering innovation.

Acknowledgments: Special thanks to Jess Cheng for his help with this article.