The Senate Banking Committee met late last year to discuss stablecoins. Among others, Chairman Sherrod Brown (D-Ohio) and Sen. Elizabeth Warren (D-Mass.) voiced strong criticisms of stablecoins and decentralized finance (DeFi). Few likely expected the hearing to yield concrete policy proposals. That was until Ranking Member Pat Toomey’s (R-Pa.) opening remarks.
A noted advocate for the DeFi industry, Sen. Toomey took an important step towards promoting regulatory clarity in stablecoin markets by offering a new set of principles to guide future legislation.
How Stable are Stablecoins?
As outlined in a previous blog, stablecoins are a particular subset of cryptocurrencies that seek to achieve price stability by pegging their value to some existing asset or basket of assets. Stablecoins are typically backed by fiat currency like dollars or euros, or exchange-traded commodities like gold. There are currently dozens of stablecoins holding various types of reserve backing with the top 5 stablecoins accounting for over $150 million in market capitalization.
Proponents of stablecoins argue that they are the solution to price volatility found in traditional cryptocurrencies like Bitcoin. However, stablecoins do present some unique risks. One concern is the theoretical risk of a run. In such a scenario, illiquidity of the stablecoin or its reserve backing could spark a lack of confidence among investors. Seeking to “cash out” before a total collapse of confidence, investors might then begin redeeming their stablecoins en masse, leading to fire sales of reserve assets in an attempt to maintain price stability for the stablecoin.
The Biden administration recently warned of this prospect. The Presidential Working Group’s (PWG) Stablecoins report outlined, “Runs could spread contagiously from one stablecoin to another, or to other types of financial institutions that are believed to have a similar risk profile.” This would, in turn, create negative ripple effects throughout financial markets. There is no clear way to address all of the risks that could lead to a stablecoin run, but stricter disclosure and other transparency measures would create stronger barriers to a run by instilling greater investor confidence in stablecoins’ backing.
To some members of the Senate Banking Committee, these risks create an existential problem for stablecoins. The most vocal critic, Sen. Warren, highlighted the prospect of runs and other risks during her questioning saying that these issues “could ultimately crash our whole economy.” Sen. Warren has previously gone so far as to state that banning all cryptocurrencies - not just stablecoins - is something “worth considering.” Chairman Brown expressed similar concerns, referring to investments in stablecoins as “gambling” and encouraging the Biden administration to put “strong watchdogs in place.” The PWG report highlighted these same concerns and recommended strong regulations for stablecoin issuers.
The Democratic Senators’ comments exemplify the heavy-handed approach that some crypto skeptics in Congress are seeking to implement. To them, only a heavy-handed regulatory regime can protect investors and financial markets from the risks posed by stablecoins and other crypto assets.
But aggressive regulation of cryptocurrency and stablecoins would likely have negative downstream effects. Sen. Toomey - who has invested in cryptocurrency himself - took a different, light-touch approach that seeks to protect investors while ensuring room for future innovation.
“Given that stablecoins disrupt the status quo, they have naturally drawn skepticism from incumbent industries and regulators,” Sen. Toomey said. Citing the PWG report that recommended regulating stablecoins as banks (insured depository institutions), Sen. Toomey urged his colleagues to be cautious before expanding regulations: “[W]hatever Congress does, let’s be sure that we don’t stifle innovation in an evolving digital economy, or undermine our own country’s competitiveness. Let’s have the humility to recognize that many of our views about how financial services are delivered and how investments work are quickly becoming outdated.”
Highlighting the “tremendous potential benefits, including greater payment speed, lower payment costs, expanded access to the payment system, and programmability,” Sen. Toomey’s principles for stablecoin market regulation outline a clear framework that embraces innovation while addressing concerns about instability, security, and investor protection.
Toomey’s Stablecoin Principles Outlined
The framework has seven key pillars:
1. Stablecoin issuance should not be limited to insured depository institutions.
2. Stablecoin issuers would choose from at least three regulatory regimes based on their business models.
3. All stablecoin issuers should have to adopt clear redemption policies, disclosure requirements regarding the assets backing the stablecoin, and potentially meet liquidity and asset quality requirements.
4. Commercial entities should be eligible to issue stablecoins, provided they choose one of these regimes.
5. Non-interest bearing stablecoins should not necessarily be regulated like securities.
6. Regulation should protect the privacy, security, and confidentiality of individuals utilizing stablecoins, including allowing customers to opt out of sharing any information with third parties.
7. Financial surveillance requirements under the Bank Secrecy Act should be modernized, including for existing financial institutions, in light of emerging technologies like stablecoins.
The Details
Principle #1
Sen. Toomey’s assertion that stablecoin issuers should not be regulated as insured depository institutions (IDIs) is a direct response to the proposal put forward by the PWG. Interestingly, all four of the expert witnesses testifying before the committee seemed to agree with Sen. Toomey on this point.
Acquiring a federal bank charter is a time-consuming and cost-intensive barrier for nascent issuers. Requiring stablecoin issuers to register and be regulated as banks would entrench incumbent issuers and create significant barriers to entry for new, innovative issuers. In an industry as ripe with rapid innovation as DeFi, Congress should understand that excessive regulation would have the potential to prevent consumers from accessing new financial products that have the capacity to free them from traditional financial instruments that are oftentimes inaccessible and cost-prohibitive.
Principle #2
The second principle - allowing stablecoin issuers to choose among at least three regulatory regimes depending on their business model - would similarly protect innovative projects from unnecessary regulatory burdens while also protecting the public. In Sen. Toomey’s scenario, issuers that wish to could register as banks with the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC). Having the option for large stablecoin issuers to operate under a conventional bank charter would provide increased transparency and protection for investors backed by the full faith and credit of the United States government. In allowing for stablecoin issuers the option to be insured depository institutions, Sen. Toomey’s approach allows for appropriate regulation for major issuers without being impractical for nascent firms.
As Sen. Toomey’s principles imply, registering as a conventional bank may not be the best option for all issuers depending on their business model. Small and nascent stablecoin issuers may not immediately have the resources necessary to fully register as a bank at launch. Providing other alternatives like a special-purpose banking charter or registering as a money transmitter might be a better option depending on the circumstances. These quasi-regulatory sandboxes could be set up to furnish adequate transparency and investor protections without the heavy costs and regulatory burdens that come with a conventional bank charter.
Undue regulatory burdens and a lack of clarity have already pushed many DeFi projects offshore. As Circle CEO Jeremy Allaire told the Senate Banking Committee in 2019, “The result of the uncertain and restrictive regulatory environment has led many digital asset projects and companies to domicile outside of the United States and to block US persons and businesses from accessing products and technologies.” Future legislation on stablecoins should heed this warning and consider Sen. Toomey’s principle. Any one-size-fits-all approach to stablecoins and digital assets is bound to severely damage the industry’s capacity to innovate within the bounds of the law, further undermining our country’s competitiveness in this burgeoning industry.
Principle #3
Senator Toomey’s third principle is to require issuers to adopt clear redemption policies and disclosure regimes around their reserve backing, as well as implementing liquidity and asset quality requirements. This would address many of the present concerns about stablecoins. The Commodities and Futures Trading Commission’s (CFTC) recent enforcement action against Tether (USDT) highlighted these concerns.
Tether is a stablecoin that is “1-to-1 pegged to the dollar” and backed by reserves of “traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties.” The CFTC settled a $41 million fine against Tether Holdings et al. because it “misrepresented to customers and the market that Tether maintained sufficient fiat reserves to back every USDt in circulation ‘one-to-one’ with the ‘equivalent amount of corresponding fiat currency’ held in reserves.” In their filing, the CFTC alleged that Tether conducted neither an official audit nor employed any automated process to track their reserves “from at least June 1, 2016 to February 25, 2019.” In other words, Tether did very little to be transparent about the quantity and quality of its reserve assets.
This case demonstrates that some regulation of stablecoin issuers may be needed, as Sen. Toomey’s principles suggest. Without transparency and disclosure requirements, holders of USDT were entirely reliant on voluntary reports to determine the status of their reserve assets. Establishing clear disclosure requirements for reserve assets would effectively eliminate this issue.
Similarly, another piece of the Tether case was their use of commercial papers, funds held by third parties, and other non-fiat assets as reserves. Liquidity and asset quality requirements would similarly bring further transparency and quality assurance to investors who are often left in the dark as to what exactly is backing a particular stablecoin. However, such requirements should be drafted broadly. Requiring all stablecoins to be backed 1-to-1 by fiat currencies, for example, would significantly hamper the innovation of new financial instruments that are intended to be independent from traditional finance.
Establishing clear rules surrounding the quality and quantity of reserve backing would also provide necessary transparency around asset liquidity. Holding reserves that are not liquid enough to meet redemption demands is one of the primary concerns that could lead to a run on stablecoins. In the example of Tether, issues with the liquidity of its reserve backing led the company to briefly stop allowing most redemptions in early 2018. Fortunately, this scenario did not lead to a run on Tether, but it demonstrates the necessity of transparency around reserve assets. For investors, clear redemption policies are important for transparency.
Reserve asset transparency and redemption requirements could also help address the increasing prevalence of so-called “rug-pull” scams where malign issuers create a new cryptocurrency or stablecoin, pump the price, then “pull the rug” and abscond with the majority of the profits leaving investors behind with an illiquid market and significant losses. Ensuring that investors know precisely what is backing the stablecoin they are investing in would reduce the likelihood that issuers could succeed in such scams.
Other Principles
Sen. Toomey other four principles are more straightforward:
First, the assertion that commercial entities should be eligible to issue stablecoins is another direct repudiation of the PWG’s belief that only insured depository institutions should be able to issue stablecoins. As stated above, all four of the hearing witnesses criticized the PWG’s position as unworkable and overburdensome. While there is a good case to be made that commercial stablecoin issuers should be subject to many of the same requirements as insured depository institutions, such disclosure, and other regulatory requirements, could be narrowly tailored and implemented outside of - or parallel to - the existing bank charter regime. Doing so would establish regulatory clarity without imposing unnecessary burdens on nascent firms.
Second, Sen. Toomey’s belief that non-interest-bearing stablecoins should not necessarily be regulated like securities is squarely based on existing securities law. The SEC’s own guidance for determining whether a digital asset like a stablecoin is a security is firmly based on the Howey Test (from the Supreme Court’s opinion in SEC v. Howey Co.). According to the Howey Test, for something to be considered a security, there must be a “reasonable expectation of profits derived from the efforts of others.” While lawyers can argue about whether some particular stablecoin meets this requirement, most stablecoins are intended to be a stable medium of exchange and not an investment for profit. Any legislative attempt to classify all stablecoins as securities for regulatory purposes would run counter to existing securities law.
Third, affirming that any regulation of stablecoins and their issuance should protect customers’ privacy, security, and confidentiality is common-sense consumer protection. Allowing individuals to opt-out of sharing information with third parties unnecessarily would further protect customers from data breaches. Any disclosure regulations that Congress wishes to implement should be narrowly tailored to only that information that is most necessary (reserve asset holdings, transaction volume, etc.) and should not include personal information of customers. After all, malicious hackers cannot steal information that isn’t being provided. Authorizing federal agencies to create industry best practices for securing private information should also be considered as a way to protect consumers.
Finally, modernizing financial surveillance requirements under the Bank Secrecy Act for existing financial institutions should be a priority for Congress regardless of legislative action on stablecoins. The advent of cryptocurrencies and stablecoins has enabled new, more complex systems of money laundering and financing of illicit activities like terrorism, drug trafficking, and human trafficking. Updating anti-money laundering laws to reflect the new technological reality would be an important step towards disempowering unlawful activity both domestically and internationally.
Conclusion
The Banking Committee hearing highlighted the current divide on Capitol Hill about how to approach regulating stablecoins.
While Senators Brown and Warren may push for new regulatory schemes in the short-term, many lawmakers may wish to strike a balance between ensuring appropriate government oversight and user protections while allowing innovation. For these lawmakers, Senator Toomey’s principles should serve as a reasonable outline for future legislation.
Not only does Senator Toomey’s proposal address the most pressing policy issues surrounding stablecoins, it also appropriately considers technological feasibility. This framework should spur legislation that will provide stablecoin issuers and consumers with the regulatory clarity they deserve.