President’s Working Group on Financial Markets Releases Report and Recommendations on Stablecoins

On Nov. 1, 2021, the Workplace of the Comptroller of the Foreign money and the Federal Deposit Insurance coverage Company (FDIC) joined with the president’s Working Group on Financial Markets (PWG) to launch the much-anticipated Report on Stablecoins (the “Report”). The Report (i) discusses the background of stablecoins and their capabilities, (ii) identifies and assesses the dangers and sure regulatory gaps of stablecoins, and (iii) makes sure legislative and different suggestions to handle such gaps and perceived dangers.

This GT Alert Covers the next:

  • What are stablecoins, and how they’re created, redeemed, transferred, and saved.

  • The dangers and regulatory gaps associated to stablecoins recognized within the Report.

  • PWG’s suggestions to Congress on laws to handle market dangers probably created by stablecoin transactions.

  • How the companies forming the PWG intend to proceed to make use of their current authorities to handle potential prudential dangers associated to stablecoins.

What Are Stablecoins?

Stablecoins are digital property backed by different property (resembling fiat foreign money (government-issued foreign money that isn’t backed by a bodily commodity, resembling gold or silver, however reasonably by the federal government that issued it), gold, or different reference property), which typically preserve a steady worth relative to such reference property. The market capitalization of stablecoins issued by the most important stablecoin issuers exceeded $100 billion as of November 2021. This quantity displays a virtually 500% improve over the previous 12 months. SeeTotal Stablecoin Supply, The Block (Oct. 18, 2021). Within the U.S. market right this moment, stablecoins are primarily used to facilitate buying and selling, lending, or borrowing of different digital property, predominantly on or by way of digital asset buying and selling platforms

  1. Creation and Redemption: Stablecoins typically are created, or “minted,” in trade for fiat foreign money {that a} stablecoin issuer receives from a person or third celebration. Some stablecoin issuers supply to customers a promise or expectation of redeeming a stablecoin at par, thus sustaining a steady worth relative to fiat foreign money.

  • Redemption rights differ relying on the association, with some customers having no limitations on the quantity of stablecoins that will redeemed for a fiat foreign money, whereas others have minimal redemption quantities that have to be met earlier than the issuer processes a redemption request.

  • In some stablecoin preparations, reserve property embody deposits at insured depository establishments, however this doesn’t imply that deposit insurance coverage presently extends to the stablecoin person. For instance, if the stablecoin issuer deposits fiat foreign money reserves at an FDIC-insured financial institution and does so in a way that meets all the necessities for “pass-through” deposit insurance coverage protection, the deposit typically solely could be insured to every stablecoin holder individually for as much as $250,000. With out “pass-through” safety, the deposit typically would solely be insured to the stablecoin issuer as much as the $250,000 restrict.

  • Even when the supposed worth of stablecoins in circulation is the same as the worth of the reserve property, different collectors might have a declare on the reserve property that competes with the unsecured claims of stablecoin holders.

  1. Switch and Storage: Stablecoin preparations usually facilitate the switch of cash between or amongst customers of the stablecoin association by having issuers and different contributors document the switch both “on the books” of the pockets supplier (for transactions between customers of the identical pockets supplier) or on the distributed ledger (for transactions involving customers of various wallets).

  • Contributors in stablecoin preparations could possibly course of stablecoin transfers internally. For instance, a pockets supplier may maintain stablecoins on behalf of consumers and permit its prospects to ship or obtain stablecoins with out interacting with the distributed ledger.

  • At varied levels of the switch course of, the profitable switch of stablecoins would possibly rely on pockets suppliers, node operators, and varied different intermediaries and applied sciences.

The Report acknowledges that stablecoins, if nicely designed and appropriately regulated, may turn out to be extensively utilized by households by offering sooner, extra environment friendly, and extra inclusive fee choices. In keeping with Secretary of the Treasury Janet L. Yellen, “absent appropriate safeguards, stablecoins present potential risks to users, the financial system, and the economy.” See “Remarks by Under Secretary for Domestic Finance Nellie Liang to the Stanford Graduate School of Business” (Nov. 1, 2021).

Stablecoins Dangers and Regulatory Gaps

The Report identifies the next dangers and regulatory gaps associated to stablecoins:

  1. Cost System Dangers: Funds associated to stablecoin transactions face most of the similar fundamental dangers as conventional fee techniques, together with:

  • credit score danger;

  • liquidity danger;

  • operational danger;

  • dangers arising from improper or ineffective system governance; and

  • settlement danger.

The foregoing can pose dangers not solely to contributors of stablecoin transactions but in addition to the broader monetary system. For instance, not like conventional fee techniques the place danger is managed centrally by the fee system operator, some stablecoin preparations function decentralized decision-making and advanced operations the place no single group is accountable or accountable for danger administration and resilient operation of the whole association. Moreover, deficiencies in data techniques or inner processes, human errors, administration failures, and disruptions from exterior occasions are operational dangers that will consequence within the discount, deterioration, or breakdown of service and, subsequently, disrupt the power of customers to make funds, which might in flip disrupt financial exercise.

  1. Lack of Worth – Dangers to Stablecoin Customers and Stablecoin Runs: Whereas the arrogance in stablecoins as a dependable technique of fee or retailer of worth might come up partially from their redeemability, the Report identifies the next elements that the drafters contend might undermine person confidence in stablecoins:

    1. use of reserve property that might fall in value or turn out to be illiquid (which can be amplified by an absence of transparency with respect to the composition of reserve property);

    2. failure to appropriately safeguard reserve property;

    3. lack of transparency relating to the redemption rights of stablecoin holders (resembling whether or not holders have a direct declare on reserve property or whether or not holders turn out to be collectors with a competing declare on such property); and

    4. operational dangers associated to cybersecurity and the amassing, storing, and safeguarding of knowledge.

A mix of those elements may result in a stablecoin’s failure to carry out in keeping with expectations and hurt customers of that stablecoin. The mere prospect of a stablecoin not performing as anticipated may lead to a “run” on that stablecoin, leading to hearth gross sales of reserve property.

  1. Dangers of Scale – Systemic Danger and Focus of Financial Energy: The Report highlights three units of coverage issues provided that the expansion of stablecoins might replicate economies of scale and scope:

  1. the mixture of a stablecoin issuer or pockets supplier and a industrial agency may result in an extreme focus of financial energy in just a few market contributors; and
  1. a stablecoin issuer or a key participant in a stablecoin association (resembling a custodial pockets supplier) may pose systemic danger – that means that the failure or misery of that entity may adversely have an effect on monetary stability and the true economic system;

  2. a single stablecoin that turns into extensively adopted, absent interoperability requirements for stablecoins and stablecoin preparations, presents issues about anti-competitive results, for instance, if customers of that stablecoin face undue frictions or prices within the occasion they select to modify to different fee services or products. 

The Report asserts that the mixture of those coverage issues might have detrimental results on competitors and result in market focus in sectors of the true economic system.

  1. Digital Asset Buying and selling Platforms and DeFi Dangers: Digital asset buying and selling platforms and decentralized finance (DeFi) rely on stablecoins to facilitate borrowing, lending, and buying and selling. (DeFi is a system by which monetary merchandise turn out to be obtainable on a public decentralized blockchain community, making them open to anybody to make use of, reasonably than having to undergo middlemen like banks or brokerages.) Nevertheless, the Report contends that these digital asset buying and selling platforms and DeFi preparations current dangers of specific focus to companies such because the U.S. Division of Justice (DOJ), U.S. Securities and Change Fee (SEC), and the Commodity Futures Buying and selling Fee (CFTC), together with:

dangers of fraud, misappropriation, and conflicts of curiosity, together with these arising from deceptive disclosures to the market, misuse of inside data, and manipulative buying and selling actions;
  1. cash laundering and terrorist financing dangers; and

  2. extreme leverage facilitated by use of stablecoins as collateral on unregulated or noncompliant buying and selling platforms.

  3. extreme leverage facilitated by use of stablecoins as collateral on unregulated or noncompliant buying and selling platforms.

  1. Regulatory Gaps: The Report notes that stablecoin preparations should not topic to a constant set of prudential regulatory requirements that deal with the dangers highlighted above, and the variety of completely different key events, coupled with the operational complexity of those preparations, pose challenges for supervisory oversight. For instance, even when an issuer of stablecoins is a financial institution, perception into the actions of key entities within the association relies upon on the construction of the connection and the character of the companies, if any, offered to the issuer financial institution as shopper.

Report Recommendations

To handle these dangers, the Report recommends that Congress act promptly to enact laws to make sure that fee stablecoins are topic to a federal prudential framework on a constant and complete foundation. The Report’s suggestions embody the next:

  1. Laws:

    1. Laws ought to require stablecoin issuers to be insured depository establishments, that are topic to applicable supervision and regulation, on the depository establishment and the holding firm stage to protect in opposition to stablecoin runs.

    2. Laws ought to deal with issues about fee system danger and require custodial pockets suppliers to be topic to applicable federal oversight, in addition to present the federal supervisor of a stablecoin issuer with the authority to require any entity that performs actions crucial to the functioning of the stablecoin association to satisfy applicable risk-management requirements.

    3. Laws ought to deal with systemic danger and financial focus of energy and require stablecoin issuers to adjust to actions restrictions that restrict affiliation with industrial entities – a Glass-Steagall-like rule. Supervisors ought to have authority to implement requirements to advertise interoperability amongst stablecoins.

  2. Different Measures Really useful within the Report: Within the absence of laws that addresses the dangers related to fee stablecoin preparations, the companies forming the PWG intend to proceed to make use of their current authorities to handle these prudential dangers to the extent potential, together with:

    1. Banking companies will search to make sure that candidates deal with the dangers outlined by the Report, together with dangers related to stablecoin issuance and different associated companies carried out by the banking group or third-party service suppliers.

    2. The Financial Stability Oversight Council ought to take steps to handle the dangers outlined within the Report, resembling designating sure actions carried out inside a stablecoin association as, or as more likely to turn out to be, systemically necessary fee, clearing, and settlement actions. Such designation would allow the suitable company to ascertain risk-management requirements for monetary establishments that interact in designated actions, together with necessities in relation to the property backing the stablecoin, necessities associated to the operation of the stablecoin association, and different prudential requirements.

    3. The DOJ, SEC, and CFTC will think about the appliance of federal securities legal guidelines and/or the Commodity Change Act (7 U.S.C. § 1) to stablecoin preparations within the context of these stablecoins which are securities, commodities, and/or derivatives.

    4. The DOJ might think about whether or not or how Part 21(a)(2) of the Glass-Steagall Act (12 U.S.C. § 378(a)(2)) (which typically prohibits sellers in securities in addition to people or associations from partaking in banking enterprise) might apply to sure stablecoin preparations.

    5. The U.S. Division of the Treasury’s Financial Crimes Enforcement Community (FinCEN) might think about the appliance of federal anti-money laundering/combating the financing of terrorism obligations underneath the Financial institution Secrecy Act (BSA) (12 U.S.C. § 1724; 12 U.S.C. § 1813; 15 U.S.C. § 78a) to stablecoin preparations that additionally supply “money transmission services.”

Conclusion

Whereas the scope of the Report is proscribed to stablecoins, U.S. monetary regulatory companies and Congress proceed their examine of digital property and different improvements associated to cryptographic and distributed ledger know-how. The Biden administration and the U.S. monetary regulatory companies have said that they’ll proceed to collaborate carefully on methods to foster accountable monetary innovation, promote constant regulatory approaches, and determine and deal with potential dangers that come up from such innovation.

Nevertheless, debate continues all through trade and the monetary regulatory regime as to what stage of oversight and regulation could also be applicable. On Nov. 17, 2021, at a convention held by the Federal Reserve Financial institution of Cleveland and the Workplace of Financial Analysis, Federal Reserve Governor Christopher Waller warned in opposition to extreme regulation of stablecoins, noting that “regulatory oversight can insulate banks from some forms of direct competition” and “limit free entry into at least some of the markets in which banks operate.” Congress and regulators might want to stability the necessity for oversight with the danger of stifling innovation and driving enterprise outdoors of the US.

William E. Turner II additionally contributed to this text.

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