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:
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.
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.
Guidehouse can help financial institutions, fintechs, and technology companies that transact in stablecoins identify and mitigate their risks associated with:
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.