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June 07, 2022
The collapse of the TerraUSD stablecoin has significantly affected the crypto sector and broader financial markets. But perhaps even more important for community banks, the market instability is fueling the policymaker push for a regulatory structure to address crypto’s risks.
With policymakers looking to coordinate a policy response to a relatively new financial sector, multiple agencies are involved in the debate about how digital assets should be regulated and by whom.
In the wake of TerraUSD’s implosion, U.S. regulators said the incident confirmed their previous concerns about stablecoin vulnerabilities and risks within the crypto ecosystem. In Senate testimony, Treasury Secretary Janet Yellen said the run on TerraUSD “simply illustrates that this is a rapidly growing product and there are risks to financial stability.” She urged Congress to consider legislation that will address these issues through federal prudential oversight.
Securities and Exchange Commission Chair Gary Gensler separately opined that the three largest stablecoins—Tether, USDC, and Binance USD—were created by some of the largest cryptocurrency exchanges to facilitate trading on their platforms. This is significant because the SEC has repeatedly asserted that many cryptocurrencies are securities and should be subject to securities laws and regulations.
Gensler also cast doubt on stablecoins in an April 2022 speech by noting that “U.S. retail investors have no direct right of redemption for the two largest stablecoins by market capitalization.” Most recently, Gensler disclosed that several bank executives have expressed alarm about “the sheer number of depositors who have moved money from their bank accounts into crypto-related exchanges and wallets.”
The President’s Working Group on Financial Markets last fall released a long-awaited report recommending several steps to bring stablecoins within the regulatory perimeter, though it illustrates the difficulties policymakers have keeping up with the rapidly evolving crypto sector. For instance, the report did not consider the impact of algorithmic stablecoins or actions to address their unique vulnerabilities and risks.
International efforts are underway to tackle these issues with a collaborative approach. Pablo Hernández de Cos, chair of the Basel Committee on Banking Supervision, said the “cross-sectional nature of cryptoassets and its public policy questions…require close and effective collaboration across global standard-setting bodies and international forums” and that the Basel Committee is working closely with regulators from G20 nations.
Separately, International Organization of Securities Commissions Chair Ashley Adler indicated that a “joint body tasked with coordinating crypto regulation” may be formed in the coming months, but he did not reveal any specific details about the possible composition of such a group.
As more of these projects launch, policymakers will be faced with difficult questions about how to respond. The global nature of stablecoins, and the broader crypto ecosystem, complicates the task by opening countless opportunities for regulatory arbitrage.
The debate over crypto regulation includes various important policy questions. Foremost among them is how regulators might ensure that stablecoins will remain stable.
Money Market Fund Model
In some respects, stablecoins seem similar to money market funds—they both try to maintain stable prices of $1 using investments in short-term debt, and investors may redeem shares on demand. And like some stablecoins, money market funds also have a history of “breaking the buck” by falling short of their market price stability goals. Therefore, some have suggested that securities regulators should play a greater role in providing oversight for stablecoins.
A report by the Federal Reserve of New York on MMF weaknesses and risks found a “[high] portfolio overlap and large market footprints—combined with the very limited capacity of short-term funding markets to absorb secondary-market sales” can limit the ability of MMFs across multiple jurisdictions to meet redemption demands during periods of economic stress. The researchers determined that “MMFs repeatedly have proven vulnerable and have failed to measure up to either the banking or the mutual fund model” and recommend several potential actions for policymakers to consider.
The New York Fed researchers ended with a cautionary message: “Any vehicle that engages in liquidity transformation to provide money-like services presents similar challenges.” The “explosive growth in stablecoins,” they argue, will only heighten risks and underscore the need for policymakers to consider solutions.
Some researchers, such as Professor Arthur Wilmarth, have considered whether the SEC could regulate stablecoin issuers as investment companies, though that route may not address all the risks. In a paper published late last year, Wilmarth concluded that stablecoins more closely resemble “shadow deposits” that serve as a “functional substitute” for federally insured bank deposits. Therefore, he argued, the best way to mitigate these risks and close the gaps is to regulate stablecoins as deposits and limit issuance to insured financial institutions.
Bringing stablecoins within the regulatory perimeter by limiting issuance to insured depository institutions was the central recommendation from the President’s Working Group on Financial Markets.
While limiting stablecoin issuance to insured depositories may seem to address some of the perceived gaps with the MMF model, this regulatory model presents its own challenges for policymakers to consider, including:
1) Will banks issue stablecoins?
2) Will limiting issuance allow large national banks to dominate the marketplace and crowd out competing products from community banks?
3) How can the industry work toward interoperability standards to support stablecoin issuance on multiple blockchains?
4) How will FDIC deposit insurance factor into the equation? Should stablecoins qualify for pass-through insurance?
ICBA continues to monitor this space closely and remains concerned about risks that stablecoins, and the larger decentralized finance ecosystem, pose to consumers, the financial system, and U.S. national security.
ICBA is concerned that nonbank stablecoin issuers may disintermediate community banks, reducing deposits in the banking system and restricting access to credit in local communities. ICBA is committed to working with bankers to understand the full range of potential impacts to community banks and consider possible options by policymakers to address their risks.
Since fall 2021, ICBA has urged policymakers to:
These are just a handful of the difficult questions ICBA continues to deliberate. Banker feedback is essential, so please email me with any questions or concerns.ICBA will remain at the table to be a voice for community banks and provide updates on the latest developments in cryptocurrencies and stablecoins.