A new interagency report from the President’s Working Group (PWG) on Financial Markets regarding stablecoins was intended to provide policymakers a clear path forward in handling this fledgling industry. Instead, it raises more questions than it answers. 

The report does an excellent job of laying out the benefits and risks of stablecoins to financial markets and recommends intriguing legislative proposals. However, when it comes to the most pressing issue facing stablecoin markets, a discordant and perplexing regulatory regime, the report adds to the confusion. At the same time as the PWG encourages federal agencies to consider regulating stablecoin issuers as banks, it also asserts that stablecoins fall under the jurisdiction of the Securities and Exchange Commission (SEC) and/or Commodities and Futures Trading Commission (CFTC) “depending on the facts and circumstances,” encouraging the existing system of regulation through enforcement. 

Treasury Secretary Yellen, who sits on the PWG, issued a statement that, “[c]urrent oversight is inconsistent and fragmented, with some stablecoins effectively falling outside the regulatory perimeter.” Even the report itself claims that “stablecoin arrangements are not subject to a consistent set of prudential regulatory standards.” Yet their report sustains the fragmentation of stablecoin regulation by offering no serious proposals for regulatory reform. Instead, it supports a continuing discordant regime of regulation through enforcement. Absent Congressional action, it is unclear whether stablecoins will achieve overdue regulatory clarity.         

Understanding Stablecoins

In order to understand the significance of the PWG report, it is helpful to understand what stablecoins are and how they differ from traditional cryptocurrencies. In the simplest of terms, stablecoins are digital assets that attempt to achieve price stability by pegging their value to some existing collateral asset or basket of assets.  

Since inception, traditional cryptocurrencies have had relatively high price volatility. While this has been a benefit for investors who have made millions speculating in the crypto market, it has also been an impediment to wider adoption for crypto’s intended use as a decentralized medium of exchange. To some, stablecoins are the solution to price volatility and the lagging adoption that comes with it. Rather than creating value through the pure faith of the market like traditional cryptocurrencies, stablecoins use real world assets as backing, directly tying their value to the value of the assets they hold. While their value is still subjective, as with most assets, backing stablecoins with real world assets reduces the amount of speculation that is present with most cryptocurrencies. 

The most valuable stablecoin in terms of market capitalization, Tether (USDT), is backed one-to-one by US Dollars. In fact, most of the top stablecoins are backed by US Dollars, but they do not have to be. PAX Gold (PAXG) is a digital token backed by one fine troy ounce of gold stored in a bank vault. 

When we compare the price volatility of Bitcoin to that of Tether, it is clear that, at least in the short term, stablecoins may have the capacity to provide a stabler alternative to traditional cryptocurrencies. 

The price stability of stablecoins is their obvious benefit, but they also come with some unique risks. Most notably, federal regulators are particularly concerned about the possibility of “stablecoin runs.” In this scenario, loss of confidence in a particular stablecoin due to issues with its reserve asset backing could lead to fire sales of reserve assets, disrupting both the stablecoin and the reserve asset market. The PWG report warns that “a run occurring under strained market conditions may have the potential to amplify a shock to the economy and the financial system.” Other risks less unique to stablecoins highlighted by the PWG relate to payment system shocks and issues of scale.   

Stablecoins and Regulatory Instability

As with the larger crypto market, one of the largest impediments to stablecoin adoption is a total lack of regulatory clarity. The PWG report notes: “Because responsibilities within many of these arrangements are widely distributed, and currently fall within the jurisdiction of different regulatory agencies, or outside of the regulatory perimeter altogether, there is a risk of incomplete or fragmented oversight.” 

This “incomplete or fragmented oversight” has led to much confusion and issues of overlapping jurisdiction. While regulators like the SEC have issued some clarifying guidance for digital assets, they have historically handled such questions on a case by case basis. This only adds to the chaos. 

Take Tether, for example. Just last month, the Commodities and Futures Trading Commission (CFTC) levied a $41 million fine against Tether for misrepresenting to customers that they “maintained sufficient U.S. dollar reserves to back every USDT in circulation.” This filing even went so far as to declare that “Digital assets such as bitcoin, ether, litecoin, and tether tokens are commodities.”

Meanwhile, just one month earlier, the SEC was engaged in its own probe of Tether, presumably for securities violations. Although not much has been made public about this inquiry, and it is unclear whether or not charges will be brought, the mere fact that two separate regulators were investigating the same stablecoin under distinct jurisdictions demonstrates the haphazard regulatory approach to stablecoins.

Regulating Through Enforcement   

The issue here is not whether the SEC and CFTC should be regulating stablecoins. Rather, the issue is how the federal government has approached the matter. For years, federal regulators have chosen to regulate through enforcement actions instead of through rulemakings or guidance.       

The SEC’s enforcement action against the cryptocurrency Ripple (XRP) is case in point. Operating since 2013, the SEC only brought charges against Ripple in December of 2020. Such delayed action by regulators has become commonplace, and has left both investors and issuers guessing whether particular assets might become the target of future enforcement action. 

Many crypto investors see the case against Ripple as the breaking point. As Roslyn Layton wrote for Forbes:

The uprising against the SEC is not particularly pro-Ripple but a backlash against regulation by enforcement and deliberate market confusion that has exasperated investors and driven developers overseas. The main points of the SEC’s lawsuit demonstrate why the case was the last straw for crypto enthusiasts. The agency alleges not only that Ripple’s distribution of the cryptocurrency XRP has been “one long unregistered securities trade” since 2013, but that the digital asset itself – a token that operates on a fully decentralized ledger – is a security with no utility other than as an investment contract in a single company. Further, the agency insists that every market participant on Earth should have known that XRP is a security for the last eight years even though the agency admits it wasn’t clear on its status until the day it filed the lawsuit.  

To be clear, Ripple is not a stablecoin, but many of the same arguments against the SEC’s enforcement action apply to stablecoins which have also been subject to regulation through enforcement, as was the case with Tether. Only the courts can decide whether or not Ripple operated an unregistered security, but the SEC’s delayed action speaks volumes about how federal regulators have approached digital assets.  

Considering that the Chairs of both the SEC and CFTC sit on the PWG, one would think that they could resolve the issue of regulating through enforcement. The PWG could have settled this matter by recommending that the SEC and CFTC issue unified guidance on the nature of stablecoins. Instead, in stating that “stablecoin arrangements and activities may implicate the jurisdiction of the SEC and/or CFTC,” the PWG further muddied the waters by allowing both agencies to continue their current path.

The result is that stablecoins like Tether are caught in between two giant financial regulators, forcing them to guess at what their legal status is and comply with multiple regulatory regimes or face the consequences. Considering this, taken with the PWG’s recommendation that stablecoin issuers be regulated as banks by the Office of the Comptroller of the Currency, it is no wonder that stakeholders are practically begging the White House for a unified regulator and thorough guidance.     

Initial indications that the PWG report would bring much needed clarity to the debate surrounding stablecoin regulation turned out to be much ado about nothing. It is clear that the federal government, led by the SEC and CFTC, intend to be more aggressive in their handling of stablecoins and continue regulating through enforcement. Absent a unified plan from the White House, it is likely that the individual actions taken by these agencies will create more confusion amongst holders of stablecoins and the industry.

Congressional Recommendations

While neglecting the current regulatory inconsistency with which stablecoins are being treated, the PWG report proposes a relatively thorough legislative agenda. Though short, this legislative proposal primarily focuses on issues related to stablecoin issuers, but also provides recommendations on custodial wallet providers and other parts of stablecoin arrangements. These recommendations are directed at addressing the “prudential risks” described in the report, including user protection and run risks, payment system risks, and the concentration of economic power.

The most concrete statutory change proposed by the PWG is to “limit stablecoin issuance, and related activities of redemption and maintenance of reserve assets, to entities that are insured depository institutions.” In effect, this would treat stablecoin issuers as banks, making them subject to supervision and regulation of their reserve assets and requiring them to have Federal Deposit Insurance Corporation (FDIC) coverage. 

Bringing stablecoin issuers under this regime could have certain benefits. The CFTC’s action against Tether demonstrates that the reserve backing component of stablecoins presents a very real risk of being utilized to defraud investors. However, the Tether case also demonstrates that existing mechanisms already exist that can address this risk, namely laws that protect against market manipulation and providing false information to investors. In order to address the risks inherent in stablecoins’ reserve backing, it would be preferable to simply strengthen these existing mechanisms.  

The primary concern with limiting stablecoin issuers to only insured depository institutions is that it would further entrench incumbent issuers and create significant barriers to entry for nascent firms. Meeting the regulatory requirements placed on insured depository institutions is neither cheap nor easy. While large firms like Tether Limited, Paxos Trust, and Binance might be able to comply with new requirements with relative ease, smaller issuers might not have the same luxury. What’s more, the high regulatory burden could end up preventing individuals and firms from entering the market with innovative stablecoins.

One of the primary issues with Tether outlined by the CFTC filing is that Tether neither conducted an audit of their reserves nor employed any automated process to accurately track reserves “from at least June 1, 2016 to February 25, 2019.” While requiring Tether to be an insured depository institution would have prevented this, other mechanisms could achieve the same result with fewer regulatory burdens. For example, Congress could require stablecoin issuers to conduct regular, independent audits of their reserve assets and publish the results publicly. Alternatively, as Coinbase put forward in their Digital Asset Policy Proposal, creating a dedicated self-regulatory organization akin to the Financial Industry Regulatory Authority (FINRA) could potentially provide the oversight necessary to adequately protect investors.

The other legislative proposals outlined by the PWG are both less comprehensive and less controversial. Subjecting custodial wallet providers to “appropriate federal oversight” to include “authority to restrict these service providers from lending customer stablecoins, and to require compliance with appropriate risk-management, liquidity, and capital requirements” might be prudent. Indeed, some wallet providers are likely already subject to such oversight as securities exchanges or money transfer services. Of course, the devil is in the details, and any legislation to this effect should be narrowly tailored.

Finally, the PWG’s recommends that Congress grant the federal supervisor of stablecoin issuers with the authority to require other entities in stablecoin arrangements to meet certain risk-management standards. The report also suggests granting supervisors “the ability to adopt standards to promote interoperability among stablecoins.” In theory, both of these would be positive developments to provide investors with greater protection from fraud and abuse, but the impact of such measures would depend entirely upon how Congress chose to implement them. In particular, greater interoperability among stablecoins could be a boon for the market, improving competition and driving innovation.                   

Since federal regulators seem incapable or unwilling to work together on clarifying their handling of stablecoins, hopefully Congress will develop a unified legislative approach to stablecoins.