On November 1, 2021, the President’s Working Group on Financial Markets, the Federal Deposit Insurance Company and the Office of the Comptroller of the Currency issued an interagency report on stablecoins, outlining the agencies’ recommendations to Congress regarding a prudential framework governing the use of stablecoins and the agencies’ policy recommendations for such legislation.

It is clear from the report that the agencies’ main concerns are the risks related to “market integrity” and “investor protection” stemming from increased popularity and usage of stablecoins. As such, the report is focused on recommendations designed to reduce fraud and misconduct in digital asset trading, including money laundering, terror financing, market manipulation, insider trading, front running and lack of trading/price transparency.

The report also notes the myriad of risks posed to retail consumers in the form of “bank runs” on a stablecoin following a loss of confidence and confusion regarding whether such stablecoins are FDIC insured.

The report is divided into three sections: (I) background on the creation and redemption of stablecoins, (II) the current risks and regulatory gaps pertaining to stablecoins, and (III) the agencies’ policy recommendations.

BACKGROUND

The report first outlines that most stablecoins are created, or “minted,” in exchange for fiat currency that an issuer receives from a user or third-party (often termed as “collateralized” stablecoins). These stablecoins are named as such because they are backed 1:1 by reserve assets, which vary from coin to coin, but are most commonly backed by a fiat currency, such as the U.S. Dollar (USD).

The report also notes that there is a smaller subset of “algorithmic” stablecoins that maintain their par value using an algorithm that ties the coin to the value of another coin or asset (the most notorious example being TerraUSD, which was tied to the LUNA coin).

The discussion in the report and in this blog focuses on collateralized stablecoins.

Next, the report notes that currently there are no standards regarding the composition of stablecoin reserve assets, i.e, whether an issuer must back a stablecoin with a certain combination of cash reserves or other asset, like a Treasury Bond, or with riskier assets such a corporate bond or another cryptocurrency.

In this vein, the report explains that some stablecoin issuers deposit their reserve assets at an insured depository institution (i.e, a bank insured by the FDIC), but this does not mean that deposit insurance will extend to the stablecoin user. For instance, if the stablecoin issuer deposits fiat currency reserves at an FDIC-insured bank and does so in a manner that meets all the requirements for “pass-through” deposit insurance coverage under 12 C.F.R. § 330.5, the deposit would generally only be insured to each stablecoin holder individually for up to $250,000. But without pass-through coverage, the deposit at the bank would be insured only to the stablecoin issuer itself, up to $250,000. The report then cautions that such a situation poses a risk to consumers who may be under the mistaken impression that their stablecoins are insured by the FDIC.

The report also notes that there is no uniformity among stablecoins as to who may present a stablecoin to an issuer for redemption and whether there are any limits on the quantity of coins that may be redeemed.

Next, the report correctly notes that stablecoins are underpinned by blockchain networks and that there is a divergence between coins that operate on an open public blockchain (such as Ethereum) and a permissioned blockchain (such as Corda). The report opines that each has its own trade-offs in terms of transparency, security and access.

Finally, the report explains that another difference between stablecoins is that some users may directly hold and spend their stablecoins without relying on a custodial wallet provider, whereas in other arrangements users can only access their stablecoins by having an account with the wallet provider.

In sum, this section of the report sets the stage for the agencies’ later policy recommendations.

RISKS AND REGULATORY GAPS

This section of the report goes into more detail about the risks that were briefly described above and sets the stage for its policy recommendations.

The first risk addressed by the report is titled “Loss of Value: Risks to Stablecoin Users and Stablecoin Runs.”

Essentially, the report opines that users’ confidence in a stablecoin is partly attributed to its redeemability (which as noted above varies between coins) and the belief that such redeemability is supported by a stabilization mechanism that will effectively function during normal market conditions and in times of stress.

Accordingly, the failure of a stablecoin to perform effectively, or in other words, to maintain its 1:1 value with its underlying asset, could result in the loss of confidence and the crypto equivalent of a “bank run” on that stablecoin. An example of this is the rapid collapse of the TerraUSD stablecoin, which lost its peg to the USD, causing thousands of individuals to redeem and fire sell TerraUSD, leading to its collapse. See How $60 Billion in Terra Coins Went Up in Algorithmic Smoke. Many individuals lost thousands and even millions of dollars in this collapse. For instance, suppose an individual had 50,000 TerraUSD (supposedly redeemable 1:1 with USD) and TerraUSD subsequently loses its peg and collapses to fifty cents in a matter of hours (which is what happened). That individual now has coins worth $25,000 instead of $50,000. This clearly poses a risk for consumer confidence in stablecoins and raises financial safety concerns.

The next risk the report examines is titled “Payment System Risks,” and is divided into operational, settlement and liquidity risks.

First, the report explains the operational risks involved, which include deficiencies in information systems or internal processes, human errors, management failures, or disruptions from external events, all of which could lead to disruptions in economic activity and disrupt the ability of users to make payments.

In laymen’s terms, the concern here is that an individual who relies on a stablecoin to buy staples, such as groceries, may not be able to if the underlying payment system runs into problems like network congestion, human error, technological blockchain issues, etc.

Second, the report explains that settlement risks entail the risk that transactions may not settle properly due to unclear rules about the point in time when a settlement is final, causing a lack of confidence in the stablecoin.

Lastly, the report explains that liquidity risks may arise from “misalignment of the settlement timing and processes between stablecoin arrangements and other systems.” An example of this would be if a stablecoin operates 24/7, but a payment system used for funding the stablecoin issuance and returning fiat currency upon redemption only keeps regular business hours. This would cause a temporary shortage in the quantity of stablecoins available to make payments.

The final risk the report examines is titled “Risks of Scale: Systemic Risk and Concentration of Economic Power.”

Namely, systemic risk could result from the failure or distress of a key participant in a stablecoin arrangement, such as a custodial wallet provider, which could then adversely affect overall financial stability and the greater economy. In this vein, the report also notes that the combination of a stablecoin issuer and a commercial firm (like a bank) could lead to excessive combination of economic power.

Finally, the report explains that a widely adopted stablecoin could present concerns about “anti-competitive effects,” in that it may be difficult for users to switch to other payment products or services due to friction and costs.

The report then dovetails into the final section containing the agencies’ recommendations regarding the risks outlined above.

RECOMMENDATIONS

The report’s first recommendation is a call to Congress to enact legislation “to ensure that payment stablecoins are subject to appropriate federal prudential oversight on a consistent and comprehensive basis.”

The report states that generally, the legislation should:

• provide regulators flexibility to respond to future developments and adequately address risks across a variety of organizational structures;

• provide for supervision on a consolidated basis;

• provide prudential standards;

• provide access to appropriate components of the federal safety net;

• require custodial wallet providers to be subject to appropriate federal oversight;

• provide the supervisor of a stablecoin issuer with authority to require any entity that performs activities critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards;

• require stablecoin issuers to comply with activities restrictions that limit affiliation with commercial entities. (the report also notes that supervisors should have the authority to implement standards to promote interoperability among stablecoins and limits on custodial wallet providers’ affiliation with commercial entities or on custodial wallet providers use of user transaction data may also help address these issues); and

• require stablecoin issuers to be insured depository institutions, which are subject to appropriate supervision and regulation, at the depository institution and the holding company level.

The last point is likely to draw the most reaction, given that it suggests limiting stablecoin issuance to insured depository institutions, which are “state and federally chartered banks and savings associations, the deposits of which are covered, subject to legal limits, by deposit insurance, and which have access to emergency liquidity and Federal Reserve services.”

Finally, the report also spells out the current and potential “interim measures” in place while Congress contemplates action. Namely, that regulatory entities (such as the FDIC, Treasury, OCC, DOJ, CFPB, etc.) continue to use their existing authorities to address these risks and designate certain activities conducted within stablecoin arrangements as, or as likely to become, “systemically important payment, clearing, and settlement activities,” which would permit the appropriate agency to establish risk-management standards for financial institutions that engage in these activities.

Overall, the report comprehensively addresses the risks and regulatory gaps identified by the agencies and their recommendations to Congress. It remains to be seen what proposed legislation will look like, but the report offers a glimpse.

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