The Future of Payments Includes Stablecoins
Stablecoins present a generational opportunity to upgrade and meaningfully expand the payment system for the digital age. However, some recent regulatory actions and aspects of current legislative proposals would shoehorn crypto payment instruments into existing banking and securities frameworks — despite technological advancement around the world and continuing customer demand in today’s digital economy — and would be a step back.
Instead, if legislative efforts in this area continue to move forward they should track three key objectives:
- To address risks to users of U.S. dollar-pegged stablecoins, legislation could require centralized issuers of U.S. dollar-pegged stablecoins to meet appropriate risk-management standards. For fiat-backed stablecoins, where the issuer makes claims about guaranteed redemption at par, this may include the holding of reserve assets, including attestation that they match the balance of stablecoins outstanding one-to-one, consist of central bank liabilities or short-dated Treasuries, are segregated from the issuer’s own-assets, are protected from creditor process, and are subject to assessments or audits. Importantly, these issuers do not need to be banks, nor be subject to the full panoply of bank-like oversight.
- To foster growth and competitiveness, legislation could prioritize orderly and effective competition among stablecoins and related services — as well as with incumbent banks. This includes setting clear guardrails to ensure that the stablecoin regulatory framework, as well as traditional payment infrastructure regulations, have objective, risk-based, and publicly-disclosed eligibility for licensure, which permit fair and open access — for both banks and regulated nonbank entities at both the state and federal levels. Access for end-users, whether businesses or individuals, should also be open.
- To encourage responsible stablecoin innovation, legislation could enable a broad range of payments and related services to be available to consumers and businesses, while meeting baseline safety requirements. Instead of prescribing that all stablecoins must be pegged to the U.S. dollar or broadly prohibiting algorithmic stablecoins or stablecoins that are overcollateralized with on-chain collateral, regulation should explicitly permit experimentation and innovation within baseline consumer protections and additional rules commensurate with the level of risk, complexity, and scale of the stablecoin.
While recent U.S. Congressional proposals on stablecoins allow for issuance beyond banks, the ongoing policy discussions around appropriate guardrails tend to be generally keyed to traditional safety and soundness principles of bank supervision and regulation, such as capital requirements, or risk management frameworks associated with securities such as money market funds (MMFs).
But given unique risks and current use cases for stablecoins, traditional banking and securities law frameworks are a poor model for stablecoin regulation. If policymakers are going to seize the opportunity to craft regulation that meets the moment, they should do so by promoting openness and competition more than current banking or securities frameworks.
Specifically, while it is critical to ensure that prudential risk and market risk are addressed, we believe the regulatory framework must also allow payment stablecoins to function and thrive. Regulatory guardrails can help preserve confidence in stablecoins as a form of money — and ensure that the power to dictate our system of money does not fall into the hands of a few market participants.
3. What are stablecoins?
Stablecoins are digital dollars issued on public, permissionless blockchains. They enable dramatic improvements to the digital payments ecosystem, thanks to specific characteristics of blockchains.
- Reliable, shared infrastructure. Public blockchains are data and network infrastructures with more open access and high uptime that require very limited upfront capex for use in payments and tokenization.
- Programmability. Thanks to smart contracts, programmability is native to most public blockchains where complex code can be transparently executed according to arbitrary conditions set by users, and tailored to their preferences.
- Composability. Applications and protocols built on public blockchains can be combined and used interoperably to create new functionality.
These features make it possible to design electronic payment systems that significantly reduce intermediation by bank balance sheets and create new paths for payments to efficiently flow.1 Stablecoins that use a different mechanism for maintaining stability, such as on-chain collateral mechanisms, feature even less reliance on the banking system and balance sheet intermediation.
At the same time, trust and confidence are essential features of money. For these reasons, a regulatory infrastructure that ensures trust and confidence in stablecoins could help stablecoins thrive. However, if stablecoins are shoehorned into the ill-fitting regulatory framework for banks or MMFs, they will end up looking like banks or MMFs and will, by extension, have the same inefficiencies as existing financial services.
4. Stablecoins are not bank deposits in terms of risk
Banks serve a central role in the financial system and broader economy: they hold on their books the savings of households and businesses around the country. Beyond taking deposits, they also lend to individuals, businesses, government entities, and a range of other customers.2 If businesses were limited to finance themselves or individuals could use only their cash on hand to, for example, purchase a home or a car, then commercial activity would be quite constrained.
The business of banking can also be highly risky. Banks take deposits from customers, which can be withdrawn by a customer at any time, and make loans or invest in bonds or other assets which tend to be long-term (engaging in so-called maturity transformation) and may be susceptible to losses from poor judgment. If all customers of a bank try to withdraw their deposits at once, the bank may not have sufficient assets immediately on hand. This can lead to panics, bank runs, and fire sales. If a bank is mismanaged and suffers losses from bad loans or poor investment choices, this also can impact its ability to pay back customers if they all try to withdraw their deposits. Even the perception of this can create run risk.3
Stablecoins do not inherently pose these same risks. Issuers of U.S. dollar-pegged stablecoins that, by their terms, are redeemable at par on demand, might hold a reserve of assets to back up their redemption promises. These reserve assets might match the stablecoins outstanding one-to-one, consist of central bank liabilities or short-dated Treasuries, are segregated from the issuer’s own-assets, are protected from creditor process, and are subject to assessments or audits.4 Federal regulation implemented under new legislation can require specific safeguards. If so, then unlike bank deposits, there would be no duration mismatch between short-term liabilities (a stablecoin holder can redeem at any time at par on demand) and long-term or risky assets.
More generally, even for stablecoins that are not pegged to the U.S. dollar or do not promise redemption at par, issuers are not inherently engaging in maturity transformation as banks are. Here, safeguards can also be put in place to ensure that consumers are protected and financial stability is maintained. These guardrails might include required disclosures, third-party audits, or even baseline consumer protection rules around liability and educational resources for centralized service providers that choose to offer or promote such stablecoins to their customers.
In essence, the risk management framework applicable to stablecoins should be designed to manage the unique risks associated with stablecoins, which are different from those that arise in traditional banking.
5. Stablecoins are different from MMFs in practice
Certain regulators, including representatives of the SEC, have stated that some stablecoins resemble money market funds (MMFs), particularly when they hold a variety of assets like government securities, cash, and other investments as reserves to support their stable value, and thus should be regulated as MMFs.5 We do not believe this is an appropriate form of regulation, because it is inconsistent with the actual market usage of stablecoins.
MMFs are open-end management investment companies that are subject to the securities laws. They invest in high-quality, short-term debt instruments, such as commercial paper, Treasury bills, and repurchase agreements. They pay dividends that reflect prevailing short-term interest rates, are redeemable on demand, and are required under SEC rules to maintain a stable net asset value per share (or “NAV”), typically $1.00 per share.6 Like other mutual funds, they are registered with the SEC and regulated under the Investment Company Act of 1940. Interests in MMFs are publicly listed investments that are purchased and traded through securities intermediaries (e.g., a broker or bank accessing an exchange).
Over the years, a variety of types of MMFs have been introduced to meet the different needs of investors with varying investment goals and tolerances for risk. As the SEC cataloged almost ten years ago, most investors have invested in prime MMFs, which generally hold a variety of short-term obligations issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper.7 In contrast, government MMFs principally hold obligations of the U.S. government, including obligations of the U.S. Treasury, as well as repurchase agreements collateralized by government securities8 Compared to prime funds, government MMFs generally offer greater safety of principal but historically have paid lower yields.
The combination of principal stability, liquidity, and short-term yields offered by MMFs bears some resemblance to U.S. dollar-pegged stablecoins. Importantly, though, stablecoins are used for very different purposes in practice from MMFs, and most stablecoins would lose their utility if they are regulated as MMFs.
In practice, stablecoins are primarily used as a means to pay the U.S. dollar leg in a crypto transaction, rather than as an investment option or a cash management vehicle. For the largest U.S. dollar-pegged stablecoins, holders do not receive any return based on the reserves. Rather, the stablecoins are used as the equivalent of cash itself. A holder of a U.S. dollar-pegged stablecoin generally would not seek to redeem the value of their stablecoin holdings from the issuer and then use the proceeds in a crypto transaction. They would simply transfer the stablecoin itself as the U.S. dollar payment leg in the crypto transaction. This would not be possible or pragmatic if the holder is required to sell through a broker or a bank, should stablecoins be regulated as MMFs.
We believe it would be a mistake to force-fit stablecoins into the MMF regulatory framework, particularly where there is an opportunity for legislation to create a framework more tailored to the risks posed by stablecoins and the actual market behaviors around them. Indeed, where a comprehensive legal framework governing the use of an arrangement such as a bank deposit or pension plan is already in place, the Supreme Court has declined to extend the scope of SEC authority to such instruments.9
In other words, just as MMFs are regulated differently from other investment companies because they have a different structure and purpose, stablecoins should be regulated in a way that is consistent with their unique structure and purpose.
We believe that an over-fixation on existing banking and securities law frameworks for stablecoins would also overlook critical payment system principles, particularly those regarding fair and open access. Unique to payment systems are the dynamics of network effects, where a user’s benefit from a system increases as the number of other users on the system grows.10 Together with barriers to entry, including in the form of unduly burdensome and strict bank-like oversight of stablecoin issuers, these factors tend to limit competition and confer concentrated market power on a few dominant parties. Left unchecked, this could lead to lower levels of service to customers, higher prices, or under-investment in risk management systems.11
This concentration of power would also be anathema to crypto’s freedom of choice and decentralization. A stablecoin issuer or service provider with concentrated market power could potentially make governance decisions for a public blockchain, and also have discretion to affect the competitive balance among other participants. It could choose to disadvantage some participants (and their customers) by throttling or otherwise limiting access to its services and reward other favored crypto service providers with preferential treatment, reinforcing its market power.
For these reasons, we urge Congress to act promptly to enact legislation to address risks arising from stablecoin arrangements while still allowing payment stablecoins to function and innovation to continue. Under these principles, such legislation would address key concerns while still allowing the stablecoin’s workability:
- protecting users of stablecoins by setting reasonable risk-management requirements for centralized providers;
- prioritizing competition by ensuring there is a viable pathway for nonbank issuers at the federal and state level; and
- promoting innovation by making it possible for stablecoins to take on a variety of forms as long as baseline consumer protections are met and risks are appropriately managed.
Acknowledgements: Special thanks to Jess Cheng for assistance with this piece.
Adams, Austin and Lader, Mary-Catherine and Liao, Gordon and Puth, David and Wan, Xin, On-Chain Foreign Exchange and Cross-Border Payments (January 18, 2023), available at SSRN: https://ssrn.com/abstract=4328948 or http://dx.doi.org/10.2139/ssrn.4328948 ↩
12 U.S.C. § 24 (providing corporate powers of national banking associations); NationsBank of North Carolina, N.A. v. Variable Life Assurance Annuity Co., 513 US 251 (1995) (noting that the National Bank Act gives banks “all such incidental powers as shall be necessary to carry on the business of banking…”). ↩
Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank, Board of Governors of the Federal Reserve System, Letter and report dated April 28, 2023, available at https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf (noting that “the combination of social media, a highly networked and concentrated depositor base, and technology may have fundamentally changed the speed of bank runs.”). ↩
See, e.g., Sommer, Joseph H., Special Deposits, 76 Bus. Law. 841 (2020-21). ↩
Securities and Exchange Commission, Prepared Remarks of Gary Gensler On Crypto Markets at Penn Law Capital Markets Association Annual Conference (April 4, 2022), available at https://www.sec.gov/news/speech/gensler-remarks-crypto-markets-040422 (“Stablecoins, though, in offering features similar to and potentially competing with bank deposits and money market funds, raise three important sets of policy issues. First, stablecoins raise public policy considerations around financial stability and monetary policy. Such policy considerations underlie regulations that banking regulators have with respect to deposits and that we at the SEC have with respect to money market funds and other types of securities.”); Former SEC Chairman Jay Clayton: “A stablecoin that promises $1 back to you, in exchange for the coin, and is backed by cash is one item. Such a coin that is backed by commercial paper, whether it’s 30, 60 or 90 days, sure looks like a money market mutual fund to me. So the second element really looks like a security. We have decided that a pooled vehicle of commercial paper that you use for daily liquidity is a money market mutual fund and should be regulated as such.” See Steven Ehrlich, “Exclusive: Former SEC Chairman Jay Clayton On Stablecoins, DeFi, And Bitcoin ETFs” (Oct. 6, 2021), available at https://www.forbes.com/sites/stevenehrlich/2021/10/06/exclusive-former-sec-chairman-jay-clayton-on-stablecoins-defi-and-bitcoin-etfs/?sh=77b07b8661b1. Federal Reserve Chair Jerome Powell: “Stablecoins are like money market funds, are like bank deposits, but they’re to some extent outside the regulatory perimeter and it’s appropriate that they be regulated. Same activity, same regulation.” See Matthew Fox, “The Fed has ‘no intention’ to ban cryptocurrencies, Jerome Powell tells Congress” (Sept. 30, 2021), available at https://finance.yahoo.com/news/fed-no-intention-ban-cryptocurrencies-193120137.html. ↩
Securities and Exchange Commission, Money Market Fund Reform; Amendments to Form PF, 79 FR 47735 (Aug. 14, 2014). ↩
Marine Bank v. Weaver, 455 US 550, 559 (1982) (“Congress intended the securities laws to cover those instruments ordinarily and commonly considered to be securities in the commercial world, but the agreement [for certificate of deposit] is not the type of instrument that comes to mind when the term “security” is used, and does not fall within “the ordinary concept of a security.”); Teamsters v. Daniel, 439 US 551, 570 (1979) (finding that the Securities Act and the Securities Exchange Act do not apply to a noncontributory, compulsory pension plan). ↩
Cheng, Jess, and Joseph Torregrossa (2022). “A Lawyer’s Perspective on U.S. Payment System Evolution and Money in the Digital Age,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, February 04, 2022, https://doi.org/10.17016/2380-7172.2964. ↩