U.S. Senate Hearing: "Technological Innovation" vs. "Time Bomb," How Should Stablecoins Be Regulated?

Organizer: Nianqing, Chain Catcher

On December 14 at 10 AM EST, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on stablecoins, titled "Stablecoins: How They Work, How They Are Used, and What Are Their Risks?"

Four witnesses attended the meeting: Alexis Goldstein, Director of Financial Policy at the Open Markets Institute; Dante Disparte, Chief Strategy Officer and Global Policy Head at Circle; Jai Massari, Partner at Davis Polk & Wardwell LLP; and Hilary J. Allen, Professor at American University Washington College of Law.

Chain Catcher distilled and organized the speeches of the two legally trained witnesses, Jai Massari and Hilary J. Allen, on the core issue of "how to regulate stablecoins."

1. What Risks Are Associated with the Use of Stablecoins?

Like previous innovations in public and private currencies, stablecoins face the same core regulatory issues as early currencies: including consumer protection, systemic stability, security, and combating illegal finance , among others. However, thoughtful regulation may allow stablecoins to provide more benefits, such as lower costs, faster services, new programmable smart contract services, opportunities for greater financial inclusion, enhanced traceability, and the potential to increase operational resilience through the use of distributed networks.

Stablecoins can be divided into two types: one is pegged 1:1 to the U.S. dollar and backed by actual assets; the other relies on computer algorithms to adjust supply. Currently, algorithmic stablecoins are not widely used, so today's discussion mainly focuses on the regulation of the former type, but algorithmic stablecoins should also be on the radar of regulators.

Jai Massari believes that stablecoins are not new; they are akin to a form of a "narrow bank" because they do not engage in maturity and liquidity transformation and are generally considered safer than partially reserved banks. The basic business model of stablecoins is as a payment tool, primarily used for cryptocurrency trading and decentralized finance (DeFi) applications.

Currently, stablecoins are still on the fringes of the banking system and the real economy. However, as stablecoins are applied more broadly in retail payments, blockchain-based payments will complement existing payment systems. Thus, stablecoins will provide a way to decouple payment services from credit services, increasing competition from new entrants, expanding services, lowering consumer costs, and creating greater opportunities for financial inclusion.

However, if the issuance of stablecoins approaches a certain scale, especially as their relationship with traditional finance deepens, various issues will emerge, such as the risks of poorly designed reserve operations, risks associated with the operation of payment systems, scale risks, and risks arising from regulatory gaps.

2. Why Is the PWG's Requirement That "Stablecoin Issuers Be Insured Depository Institutions" Unnecessary?

Based on the risks associated with stablecoins, the President's Working Group on Financial Markets (PWG) released a stablecoin report last month, identifying some risks related to stablecoins and proposing three recommendations to address these risks. One of the recommendations in the PWG report is as follows:

To address the risks of stablecoins and guide their proper functioning, legislation should require stablecoin issuers to become insured depository institutions .

In response, Jai Massari stated that subjecting stablecoin issuers to regulation similar to FDIC-insured banks is "unworkable" and "unnecessary." She noted that these companies have been able to limit the risks of their stablecoin reserves to "short-term liquid assets and require that the market value of these reserves not be less than the face value of the issued stablecoins."

If the existing banking regulatory framework is not adjusted, the requirement for insured deposits is unfeasible because banks are affected by leverage and risk-based capital ratios, which are calibrated based on the assumption that most of their assets are relatively illiquid compared to cash equivalents and carry higher risks. In particular, leverage supports risk-weighted capital requirements.

For example, a stablecoin issuer with a leverage ratio of 4% would need to hold $1.04 billion in cash and cash equivalents to issue $1 billion in circulating stablecoins, buffering $400 million of required capital in the form of shareholder equity. The assets of a stablecoin issuer may be limited to cash, bank deposits, and short-term U.S. Treasury bonds, lacking the capacity of traditional banks to engage in credit card loans, real estate loans, and commercial loans to cover the required capital costs.

Therefore, unless Congress recalibrates the ratios, the business model of stable issuers is uneconomical for insured depository institutions.

Hilary J. Allen argues that if legislators and regulators view stablecoins as regulated insured depository institutions, the legitimization of stablecoins would significantly boost the growth of DeFi. However, DeFi is a fragile shadow banking system, and if it reaches a large scale, it could undermine the real economy.

DeFi heavily relies on centralized crypto services (including stablecoins), which in turn depend on traditional financial services. A recent article in The Economist mentioned: "The problem is that, so far, all this peculiar financial engineering has not served a 'real' economy. Instead, it supports an intangible casino: most users of DeFi do so to facilitate or leverage their bets on one of many speculative tokens."

Now, anyone with computer programming knowledge can create assets out of thin air, and the unrestrained supply of financial assets means opportunities for asset bubbles to grow, with more assets being sold off during depreciation periods. More assets also mean more transactions, leading to more contractual relationships between counterparties, thereby transmitting shocks through the system.

As noted in the PWG report, asset-backed stablecoins may be susceptible to runs. In the event of a hack causing panic, holders would redeem their stablecoins, forcing the issuer to begin liquidating the asset reserves backing the stablecoins, depressing the market value of these assets and losing the ability of stablecoins to function as a medium of exchange.

However, the regulation of stablecoins differs from that of bank deposits. There are two important aspects: first, the expectations of both parties regarding the use of deposits differ; second, the role of intermediary capital is different. Due to these differences, stablecoins should not fall under banking regulation but should be monitored by the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) for their expectations and changes.

Furthermore, once stablecoins are incorporated into the banking regulatory system, large tech companies with extensive user bases, such as Meta (Facebook), would quickly adopt stablecoins as a new payment system, with immeasurable influence that could reshape the economic system of the real world. At that point, the monopolization by corporate giants would pose a real threat to financial stability.

Professor Hilary J. Allen also suggested that requiring "stablecoin issuers to be insured depository institutions" is overly micro-prudential. Regulation should not focus solely on individual stablecoin institutions and should not simply assume that if one institution is stable, the entire financial system will benefit. However, a key lesson from the 2008 financial crisis is that financial stability regulation should be "macro-prudential," meaning we should consider the systemic consequences of regulatory decisions.

3. How Should Stablecoins Be Regulated?

1. Moderately Expand the Role and Function of the U.S. Federal Government

Jai Massari stated that today, U.S. stablecoin issuers and digital wallet service providers are primarily regulated under state currency issuance regimes and trust company authorities. Regulatory policies differ among U.S. states; for example, New York has established a special licensing process for virtual currencies for specific purposes, under which stablecoin activities can be regulated; Wyoming has developed its own special-purpose bank license to accommodate cryptocurrency custody and payment activities.

However, expanding the federal role is likely appropriate and useful. A new federal charter needs to be designed that can accommodate a business model based on issuing stablecoins, entirely reliant on short-term liquid assets and providing related payment services. This charter could impose requirements on reserve asset portfolios while adjusting leverage ratios or risk-based capital requirements according to the nature of the business model. It may also limit stablecoin issuers from engaging in higher-risk activities to minimize claims on reserve assets.

2. Comprehensive Ban or Licensing of Operations

Professor Hilary J. Allen suggested that given the inherent fragility of stablecoins, their limited utility outside the DeFi ecosystem, and the potential to undermine monetary policy, Congress should consider banning stablecoins. If Congress does not wish to implement a comprehensive ban, it could consider a licensing system for stablecoins, requiring issuers to demonstrate the following to obtain a license:

1) The stablecoin has a purpose related to real economic growth (i.e., growth outside the DeFi ecosystem); 2) The issuer has the ability to manage risks associated with stablecoin reserves and technology; 3) The stablecoin will not affect financial stability; 4) The stablecoin will not pose a threat to U.S. monetary policy.

3. More Macro, Limited Interventions

Hilary J. Allen has consistently opposed placing stablecoins under banking regulation, which would make stablecoins more fragile. To limit the impact during the stablecoin issuance process, the following measures should be considered:

• Limit investor expectations regarding the stability of stablecoins;
• Monitor the usage and dynamic changes of stablecoins;
• Prevent large tech companies and regulated depository institutions from issuing stablecoins;
• Prevent regulated depository institutions from accepting deposits from stablecoin issuers.

Additionally, Professor Hilary J. Allen proposed some more practical suggestions:

(1) The SEC and CFTC should continue to oversee stablecoins within their jurisdiction to ensure investor protection. Specifically, the SEC and CFTC should prevent stablecoin issuers from promoting "stablecoins to be more stable" and enforce disclosure of the reserve contents backing any stablecoin under their jurisdiction. Furthermore, the Office of Financial Research and the Financial Stability Oversight Council should be responsible for monitoring the growth of stablecoins.

(2) The regulatory agencies of insured depository institutions and their holding companies should issue guidelines clearly stating that holding deposit reserves in deposit accounts and investing in any crypto assets is a violation of safety regulations.

(3) Insured custodial institutions should not issue their own stablecoins.

Finally, we conclude with part of Senator Pat Toomey's (R-Pa.) remarks at the hearing. Toomey stated that the issuance of stablecoins should not be limited to insured depository institutions: first, the business model of stablecoin issuers differs from that of traditional banks; second, requiring all stablecoin issuers to become banks would stifle innovation; third, regulation of payment activities should create a level playing field.

All stablecoin issuers should adopt clear redemption policies, disclose requirements regarding the assets backing stablecoins, and potentially meet liquidity and asset quality requirements. Regulation should protect the privacy, security, and confidentiality of individuals using stablecoins, including allowing customers to choose not to share any information with third parties. In light of emerging technologies like stablecoins, the financial oversight requirements under the Bank Secrecy Act should be modernized, including requirements for existing financial institutions.