On November 1, 2021, the President Biden’s Working Group on Financial Markets (PWG)—an interagency group consisting of representatives from the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Federal Reserve System (Fed), and chaired by the secretary of the Treasury—released its long-awaited Report on Stablecoins. As Guidehouse has written previously, use of stablecoins has grown rapidly over the past several quarters. In response, regulators and some legislators have called for greater oversight and regulatory clarity across the sector. This report, which consists of recommendations and does not represent new regulatory policy, is the first clear indication of the Biden administration’s intent to address stablecoin risks and gaps in regulatory oversight through Congressional legislation. The scope of the report covers “payment stablecoins,” defined as “stablecoins that are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.”
The Report considered the three main categories of risks of stablecoins:
Market and integrity and investor protection risk, which are addressed by current SEC and CFTC rulemaking and enforcement authority
Illicit financing risk, which the Treasury Department, in cooperation with the Financial Action Task Force, are working to address
Prudential risk, which involves protections for stablecoin users, the financial system in general, and the broader economy. Here, the PWG found key gaps in prudential authority over the use of stablecoins for payments purposes.
Recommended Legislative Action
The report’s most significant recommendation, to address the gaps in prudential regulation, is the call for legislation requiring all stablecoin issuers to be regulated as Insured Depository Institutions (IDIs).1 This would subject stablecoin issuers to supervision by the Fed and other federal banking authorities, entailing the establishment of consistent capital and liquidity standards along with enhanced prudential standards. Furthermore, it would require stablecoin issuers to offer federal deposit insurance for holders of issued stablecoins and establish oversight to ensure that depositor redemption claims are honored in a timely and consistent fashion.
Prudential Risks Outlined by PWG Report
The report outlines three key risk areas associated with “stablecoin arrangements”2 to make its case for the legislative action proposed:
Prudential Risks: Payment Stablecoins are typically pegged to a fiat currency, often the US dollar, and are redeemable for this underlying asset. How this peg is maintained varies across stablecoin issuers: some hold the vast majority of their reserves in cash or cash equivalents, while others may hold significant portions of their reserve in commercial paper of mixed quality. A drop in the value of these riskier assets could cause a stablecoin issuer to be undercapitalized relative to the amount of stablecoins it has issued. Today, there are no enforceable guidelines at the federal level defining capital reserving and liquidity requirements. The report argues that issuers could suffer runs during times of market stress, harming depositors who are not protected with respect to redemption rights should an issuer default.
Payment System Risks: Today, stablecoins are largely used as an on- and off-ramp for trading cryptocurrencies, but they also have the potential to scale as payments technology. The report acknowledges these potential benefits but outlines a number of potential risks. These include operational risks arising from inconsistent technology standards or ineffective governance; settlement risks arising from the misalignment between traditional payment rails and highly distributed, “always on” crypto networks; and credit and liquidity risks. The report acknowledges that many of these risks exist in legacy payment systems. However, they are unique insofar as transactions related to stablecoin arrangements may be “highly distributed and complex” across governance, reserve management, custody, settlement, and distribution. This complexity may make it difficult to manage credit, liquidity, and operational risk, particularly as some of the participants are unregulated.
Systemic Risks: While stablecoins have a market capitalization of over $130 billion, the market remains in its infancy. The report argues that the continued growth of stablecoins could give rise to one dominant market player based on economies of scale and first-mover advantages. A systemic failure on the part of the dominant stablecoin could cause major economic disruptions depending on how integrated the stablecoin is into the wider economy. The report argues that a dominant market player could give rise to anti-competitive concerns and it notes the potential danger of excessive concentration of economic power from the mixing of banking and commerce.
DeFi Risks: Finally, the report calls out several risks related to DeFi applications which “are of particular focus to…the CFTC and SEC.” The report echoes our last report on stablecoins: If DeFi continues its rapid growth, protocols holding significant stablecoin assets locked in their contracts may pose systemic risk should they suffer failure for any reason. This risk is exacerbated by the overleveraged positions of some of these trading and derivatives applications. The report notes that the distributed nature of DeFi presents unique counterparty, technological, and market integrity risks.
The report calls for a holistic solution to manage stablecoin risks, noting that regulation of stablecoin issuers as IDIs alone will lead to gaps in regulatory oversight due to the distributed and open nature of stablecoin arrangements. The report recommends custodial wallet providers be subject to federal oversight, giving regulators the authority to mandate risk management standards, including capital and reserve requirements, and to limit the issuance of financial products tied to stablecoins (e.g., yield-generating lending products). To cast as wide a net as possible, the report states that regulators should have authority to supervise any entity that “performs activities that are critical to the functioning of the stablecoin arrangement.” Finally, in a point likely directed to large Web2 companies poised to enter the stablecoin market, the report recommends the establishment of standards that limit issuer and custodians’ affiliation with commercial entities and their use of customer transaction data.
First, the report’s recommendations do not represent a major deviation from policy statements signaled by federal regulators and some legislators over the past 6-12 months. That stablecoin issuers will be subject to greater oversight through legislation is likely to be welcomed by many industry participants, some of which have been calling for more transparency from their peers and more clarity from regulators. On the other hand, some critics have suggested that regulation of stablecoin issuers as banks misses the fact that payment stablecoins, by definition, are fully collateralized and if properly supervised may not face the same risks as fractionally reserved banks. Interestingly, the report suggests that, “If banks lose retail deposits to stablecoins and the reserve assets that back stablecoins do not support credit creation, the aggregate growth of stables could increase borrowing costs and impair credit in the real economy.” The implication of this statement is that the report authors believe that stablecoins, absent federal oversight, may pose an existential risk to the traditional banking sector.
Second, it is clear that the report authors view DeFi as a novel terrain laden with risks, which will be challenging to mitigate through traditional regulation due to financial infrastructure and transaction flows that are decentralized and contingent on the operation and interaction of multiple counterparties. While this report proposes legislation to regulate the stablecoin nexus points it can identify, that is, centralized issuers and custodial wallet providers, it leaves the thornier questions related to the regulation of open DeFi protocols, applications, and project teams unanswered.
Finally, the report does not clarify the remit of specific regulatory agencies with any degree of specificity, but states that the SEC, CFTC, or other regulators have the ability to regulate stablecoins “depending on whether they constitute securities, commodities, or derivatives.” The report acknowledges that digital assets have multivalent properties, and that the same asset could fall within the regulatory fence of multiple agencies at the same time, depending on its usage. Importantly, the report clarifies the administration’s belief that the supervision and regulation of stablecoins should occur at the federal level rather than solely relying on today’s fragmented state-by-state approach and that supervision guidelines should be established through legislation, not by regulatory agency fiat.
How Can Guidehouse Help?
Guidehouse can help financial institutions, fintechs, and technology companies that transact in stablecoins identify and mitigate their risks associated with:
AML and sanctions compliance across multiple digital assets and protocols.
Operational, compliance, and legal risks associated with financial products tied to stablecoins.
Processes and controls for reporting assets under management across multiple stablecoins and cryptocurrencies.
Stablecoins, including native DeFi tokens, which may represent securities with additional compliance requirements.
Fraud prevention and detection across stablecoin transaction flows.
As the calendar year ends with Congressional attention focused elsewhere, the prospect of stablecoin legislation appearing soon is unlikely. In the meantime, the stablecoin industry will continue to innovate and grow, while regulatory agencies will use the resources at their disposal to enforce discipline in the market. During this period, it will be important for financial institutions involved in stablecoin activity to take the appropriate risk management measures to stay ahead of the curve and ensure prudential, AML/CFT, operational, and consumer risks are accounted for and managed.
Special thanks to Nicholas Bohmann for co-authoring this article.
1 The term "Insured Depository Institution" means any bank or savings association the deposits of which are insured by the Federal Deposit Insurance Corporation, as defined in the Federal Deposit Insurance Act of 1950. 2 The report uses the term “stablecoin arrangement” to cast a wide net in defining what entities may fall under the legislation and regulatory guidelines defined in the report (e.g., stablecoin issuers, exchanges, etc.).