November 2, 2021
Yesterday, November 1, 2021, the President’s Working Group (PWG) released a long-awaited report on stablecoins (the “Report”).1 The Report outlines a number of significant legislative recommendations for Congress to consider as well as a number of interim measures that agencies should adopt under their existing authorities to protect against prudential risks in the near-term.
Stablecoins are digital assets designed to maintain a stable value by having their value pegged to the value of another asset, often the US dollar. The largest three stablecoins by market cap are Tether, USDC, and Binance USD. As of November 1, 2021, these stablecoins had market capitalizations of approximately $70 billion, $33 billion and, $13 billion, respectively.2 Since the beginning of 2021, the aggregate market capitalization of stablecoins has jumped from about $31 billion to about $115 billion, a nearly 300% increase.3 Stablecoins could potentially contribute to “payment arrangements that are faster, cheaper and more inclusive than present arrangements.”4 On the other hand, stablecoins “may facilitate those seeking to sidestep a host of public policy goals connected to our traditional banking and financial system: anti-money laundering, tax compliance, sanctions, and the like” and “may be securities and investment companies.”5
As the market capitalization of stablecoins has soared, this particular class of digital assets has garnered increasing attention by the industry and regulatory agencies in the last year. For example, in October 2020, the Office of the Comptroller of the Currency (OCC) issued Interpretive Letter 1172. This letter confirmed the authority of national banks to hold deposits that serve as reserves for stablecoins. The OCC then went a step further in January 2021 when it released Interpretive Letter 1174. This letter clarifies the authority of national banks and federal savings associations to use stablecoins to conduct payment activities and other bank-permissible functions. While these Interpretive Letters are reportedly under administrative review, the conclusions in the letters are largely aligned with the Report’s recommendations in terms of limiting stablecoin issuance to federally insured depository institutions and otherwise subjecting participants in stablecoin arrangements to a bank-like regulatory framework.
Part I of the Report provides detailed background on stablecoins, including the mechanisms that support the creation and redemption of stablecoins, the transfer and storage of stablecoins, and the activities and participants involved in stablecoin arrangements. Interestingly, as part of the overview of stablecoins, the Report highlights in a footnote that stablecoins should be eligible for deposit insurance at the holder level if the stablecoin issuer deposits fiat currency reserves at an FDIC-insured bank and in a manner that meets statutory requirements for “pass-through” deposit insurance coverage. While this may sound like an encouraging acknowledgement, the actual requirements for maintaining pass-through insurance coverage do not align with the typical use cases for stablecoins6—though it does align very closely with stablecoin issuers being insured depository institutions, which is one of the seminal recommendations outlined in the Report.
The Report emphasizes the urgent need for Congressional action as the primary means to address the prudential risks inherent in stablecoins. These prudential risks are discussed in Part II, which includes the prudential regulatory gaps, and Part III describes the PWG’s recommendations for addressing these risks.
Primary Stablecoin Risks
The Report groups the risks related to stablecoins into three broad categories: (1) loss of value – risks to stablecoin users and stablecoin runs; (2) payment system risks; and (3) risks of scale – systemic risk and concentration of economic power. According to the Report, market integrity and investor protection risks are the key risks presented by stablecoins and stablecoin-related activities. These risks “encompass possible fraud and misconduct in digital asset trading, including market manipulation, insider trading, and front running, as well as a lack of trading or price transparency.”
The Report also highlights that stablecoins pose a variety of illicit finance concerns and risks to financial integrity, which includes concerns related to anti-money laundering (AML) and countering the financing of terrorism (CFT). The risk of a “run” on stablecoin arrangements, analogized to runs on banks, is highlighted as another significant risk, in addition to the overarching systemic payment system risk.
Distinguishing stablecoins from traditional payments systems—such as ACH, credit and debit transactions—the Report emphasizes that the lack of involvement by traditional financial institutions creates significant risk of fraud and an inability to properly allocate losses. Not surprisingly, the proposed solution for addressing these risks generally involves new legislation clarifying prudential regulatory authority as well as updating payment regulations to more effectively address stablecoin arrangements.
Loss of Value: Risks to Stablecoin Users and Stablecoin Runs
At the outset, the Report urges Congress to enact legislation requiring stablecoin issuers to be insured depository institutions, i.e., a bank or credit union, in order to mitigate risks to stablecoin users and guard against stablecoin runs. This would, according to the findings in the Report, limit the likelihood that confidence in a stablecoin is undermined by failing to perform according to expectations. The failure to perform as expected is highlighted as the likely culprit in triggering a “run” on the stablecoin at issue—which is described as “a self-reinforcing cycle of redemptions and fire sales of reserve assets.” The Report highlights deeper concerns that a run on one stablecoin would trigger subsequent runs on other, possibly unrelated, stablecoins. In a press release issued by the OCC in connection with the Report, Acting Comptroller Hsu characterizes the Report as “identif[ying] the risk of stablecoin runs as the top concern.”7
Payment System Risk
According to the Report, stablecoins that are used primarily for payments pose the same risks as traditional payment systems, which includes credit risk, liquidity risk, operational risk, as well as risks arising from improper or ineffective governance systems, and settlement risk. The decentralization of many stablecoin networks, a key benefit highlighted by the industry, is designated as the primary driver of payment system risk because there is “no single organization [that] is responsible or accountable for risk management and resilient operation of the entire arrangement.”
Risks of Scale: Systemic Risk and Concentration of Economic Power
The potential for stablecoin arrangements to scale rapidly, another primary benefit noted by industry participants, is deemed to raise significant issues related to systemic risk and concentration of economic power. While the Report acknowledges that stablecoins are still small compared to traditional forms of private and public money, the exponential rate of adoption of stablecoins as well as the digital-native nature that enables rapid scaling has led to significant concerns that they will pose a systemic risk.
The actual legislative recommendations in the Report, which spans twenty-three pages, are condensed into just two pages and can be summarized as follows:
The Report repeatedly emphasizes that legislation should ensure issuance is limited to insured depository institutions that have access to emergency liquidity and Federal Reserve services. While not mentioned in the Report, this creates significant uncertainty on the ability of entities that have received newly created state bank charters or trust-only charters from being able to issue stablecoins where those bank charters may not result in entities being eligible for deposit insurance or access to the Federal Reserve.
Acknowledging that it will take some time as Congress develops the appropriate legislative framework, the Report urges regulators to leverage their existing authorities to mitigate risks in the stablecoin industry. This should include “efforts to ensure that stablecoins and related activity comply with existing legal obligations, as well as continued coordination and collaboration on issues of common interest.”
Unlike last year, when the OCC took it upon itself to press forward with providing regulatory clarity for bank activity with respect to cryptocurrencies, the Report makes it clear that the PWG agencies are committed to acting in unison to regulate the stablecoin industry while Congress considers the appropriate regulatory framework. The Report also encourages other relevant authorities, including the Department of Justice, to consider whether section 21(a)(2) of the Glass-Steagall Act applies to certain stablecoin arrangements—this lesser known section of the Glass-Steagall Act prohibits any entity from taking deposits without being regulated like a bank.13
The Report emphasizes that the Consumer Financial Protection Bureau (CFPB) and consumer financial protection laws also serve to provide various safeguards against stablecoin-related risks, including those established under the Electronic Fund Transfer Act. While not a member of the PWG, the CFPB quickly followed with its own press release establishing its commitment to take steps related to the stablecoin market that align with the recommendations set forth in the Report. The CFPB says it is “actively monitoring and preparing for broader consumer adoption of cryptocurrencies.” Among other potential consumer regulatory implications, the CFPB believes stablecoins could trigger obligations under the federal consumer protection laws, including the prohibition on unfair, deceptive, or abusive acts and practices.14
The Report notes that “digital asset trading platforms and other intermediaries also play a key role in providing access to and enabling trading of stablecoins, as well as in the stabilization mechanisms of stablecoin arrangements.” To the extent that the stablecoin activities or arrangements implicate the jurisdiction of the SEC and/or CFTC, such activity must be comply with applicable provisions of the federal securities laws and Commodities Exchange Act. Shortly after the Report was released, SEC Chair Gensler issued a press release emphasizing that “the SEC and our sibling agency, the [CFTC], will deploy the full protections of the federal securities laws and the Commodity Exchange Act to these products and arrangements, where applicable.”15 Just last month, the CFTC imposed a $41 million civil money penalty on Tether, claiming that Tether violated the Commodity Exchange Act when it falsely claimed the Tether was “100% backed by fiat assets.”16
Last week, the Financial Action Task Force (FATF) issued updated guidance on the application of FATF’s AML/CFT recommendations to virtual assets and virtual asset services providers (VAPSs).17 Relevant to the stablecoin discussion, FATF clarified that the updated guidance applies to any governance body that maintains influence or control over the administration of a stablecoin, particularly where “the governance body carries out other functions in the stablecoin arrangement.”
As highlighted in the Report, the “Treasury will continue leading efforts at the [FATF]18 to encourage countries to implement AML/CFT standards and pursue additional resources to support supervision of domestic AML/CFT regulations.” Any legislation proposed by Congress and actions taken by the federal prudential regulators will likely take into account both the FATF and Report recommendations. Additionally, the Report notes that most stablecoins are considered “convertible virtual currencies” as defined by the Financial Crimes Enforcement Network (FinCEN) and are thus subject to FinCEN’s regulations.
The Report concludes the interim measure recommendations by urging the Financial Stability Oversight Council (FSOC) to consider designating certain activities conducted with stablecoin arrangements as systemically important payment, clearing, and settlement activities. The FSOC could potentially designate certain stablecoin arrangements as systemically important financial market utilities or “systemically important financial institutions,” thus subjecting such arrangements to a consolidated supervision and examination framework. According to the Report, any such designation “would follow a transparent process.”
Reaction from the members of Congress to the Report was mixed. Senator Sherrod Brown, a Democrat from the state of Ohio and Chair of the Senate Banking Committee stated in a press release that the Report “highlights the risks that the rapid growth of stablecoins present to families and the economy” and that “[w]e must work to ensure that any new financial technologies are subject to all of the laws and regulations that protect investors, consumers, and markets, and that they compete on a level playing field with traditional financial institutions.”19 In contrast, Senator Cynthia Lummis, a Republican from the state of Wyoming, put out a statement against a chartering requirement for stablecoin issuers: “I agree with many of their recommendations, including the need for Congressional legislation and prudential risk management. However, proposing that only insured depository institutions may issue a stablecoin is misguided and wrong.”20
Banks, FinTechs and other companies are taking increasing notice of stablecoins and considering what role, if any, stablecoins should play in their business. The law around stablecoins is complex and unsettled, and the prospects for near-term change in the legal regimes surrounding stablecoins is high. Businesses that are interested in integrating stablecoins into their operations must consider a number of legal issues including (i) the permissibility of the activity under applicable bank regulatory law, (ii) issues associated with the negotiability or commercialization of stablecoins under applicable UCC law, (iii) the applicability of securities and commodities laws, (iv) federal and state prohibitions against the unauthorized receipt of deposits, and (v) anti-money laundering, sanctions and privacy laws.
As one final thought, entities that currently issue stablecoins, play a significant role in stablecoin arrangements, or that are actively working on issuing stablecoins, should carefully consider whether it makes sense to pursue a bank charter.
1 The President’s Working Group was established in 1988 as part of Executive Order 12631 and consists of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission, and the Chairman of the Commodities Futures Trading Commission. The PWG solicited feedback from market participants, trade associations, as well as various experts and advocates to inform the work for the Report.
4 Bank for International Settlements, G7 Working Group on Stablecoins, Investigating the Impact of Global Stablecoins, October 2019, page ii, available at https://www.statista.com/statistics/1255835/stablecoin-market-capitalization/.
5 Remarks of SEC Chair Gary Gensler before the Aspen Security Forum, August 3, 2021, available at https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.
6 Although it is somewhat unclear, pass-through insurance is typically available if the intermediary holds cash in a custodial or fiduciary role. Most stablecoin operators book cash received for stablecoin purposes as liabilities on the stablecoin issuer’s balance sheet. The specific requirements for pass-through insurance coverage are contained in 12 C.F.R. Part 330. See also https://www.fdic.gov/deposit/diguidebankers/documents/financial-institution-employees-guide-to-deposit-insurance.pdf.
9 The Report emphasizes interoperability multiple times, which signifies that this is considered a critical element for new stablecoin-related legislation.
10 Stablecoin holders can earn interest by lending their stablecoins out, generally through decentralized applications. However, it is also possible for stablecoin holders to borrow against their stablecoins, something that is currently more common with cryptocurrencies such as Bitcoin and Ether.
11 As an example for appropriate risk-management standards, the Report references the Principles for Financial Market Infrastructures report issued by the Bank for International Settlements Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions, available at: https://www.bis.org/cpmi/publ/d101a.pdf.
12 Referencing the definition of “Insured depository institution” in the Federal Deposit Insurance Act.
13 12 U.S.C. § 378(a)(2). While this statute is technically a part of the Federal Reserve Act, the Federal Reserve takes the position that, because this statute contemplates criminal penalties for violations of this provision, interpretive authority for this statute properly lies with the Department of Justice. Additionally, state banking laws generally have a state law equivalent that prohibits the unauthorized business of banking in their state. See, e.g., Cal. Fin. Code § 560 and N.Y. Banking Law § 131(1). When cash management accounts were introduced by broker-dealers in the late 1970s, there was significant state opposition on the basis that cash management accounts ran afoul of these state laws. Stablecoin issuers should keep these provisions in mind when structuring their issuances (we note that at least one company has characterized stablecoin related liabilities as “deposits” in its public financial statements).
14 Traditionally, the CFPB has relied on its UDAAP authority as a catch-all authority to pursue conduct it deems objectionable, and for which no clear violation of law exists.