Paradigm: Stablecoins should not be subject to banking and securities regulatory frameworks

Written by: Brendan Malone, Paradigm

Original Title: 《The Future of Payments Includes Stablecoins》

Compiled by: Luffy, Foresight News

Stablecoins present a unique opportunity to upgrade and expand payment systems in the digital age. However, despite ongoing technological advancements and growing customer demand in the digital economy worldwide, recent regulatory actions and legislative proposals will force crypto payment tools into existing banking and securities frameworks, which is a step backward.

To move forward with legislative efforts in this area, lawmakers should focus on three key objectives:

• To address the risks faced by users of dollar stablecoins, legislation may require centralized issuers of dollar stablecoins to meet appropriate risk management standards. For issuers claiming to guarantee redemption at par value for fiat-backed stablecoins, they must hold reserve assets that demonstrate they match the outstanding stablecoin balances. Reserve assets can consist of bank deposits and short-term government bonds, which should be isolated from the issuer's own assets, unaffected by creditor proceedings, and subject to assessment or audit. Importantly, these issuers do not have to be banks and do not need to be regulated like banks.
• To promote growth and competition, legislation could prioritize orderly and effective competition between stablecoins and related services and existing banks. This includes establishing clear guardrails to ensure that the regulatory framework for stablecoins and traditional payment infrastructure regulations have objective, risk-based, and publicly disclosed licensing criteria, allowing banks and regulated non-bank entities to obtain licenses fairly at both state and federal levels. Access for end users (whether businesses or individuals) should also be liberalized.
• To encourage responsible stablecoin innovation, legislation could provide a broad range of payment and related services for consumers and businesses. Regulation should not mandate that all stablecoins must be pegged to the dollar or prohibit algorithmic stablecoins and on-chain over-collateralized stablecoins, but should allow experimentation and innovation within consumer protection and risk-commensurate additional rules.

Background

While recent proposals in the U.S. Congress allow entities other than banks to issue stablecoins, discussions around appropriate guardrails often focus primarily on traditional safety and soundness principles of bank regulation, such as capital requirements or securities-related risk management frameworks.

Given the unique risks and current use cases of stablecoins, traditional banking and securities law frameworks are inadequate for regulating stablecoins. Policymakers should develop a new framework that promotes openness and competition more than the current banking or securities frameworks.

Specifically, while ensuring that prudent and market risks are addressed is crucial, we believe that the regulatory framework must allow payment stablecoins to function and thrive. Regulatory guardrails can help maintain confidence in stablecoins as a form of currency and ensure that the power of our monetary system does not fall into the hands of a few market participants.

What are Stablecoins?

Stablecoins are digital dollars issued on public, permissionless blockchains. Due to the characteristics of blockchains, they can significantly improve the digital payments ecosystem.

• Reliable, shared infrastructure. Public blockchains are data and network infrastructures with more open access and
• longer uptime, requiring very limited upfront capital expenditures for payments and tokenization.
  Programmability. Thanks to smart contracts, most public blockchains have programmability that allows for the transparent execution of complex code based on conditions set by users.
• Composability. Applications and protocols built on public blockchains can be combined to create new functionalities.

These features make it possible to design a new generation of electronic payment systems that can significantly reduce the intermediation of bank balance sheets and create new pathways for the effective flow of payments. By using different mechanisms to maintain stability, stablecoins rely less on the banking system and balance sheet intermediation.

At the same time, trust and confidence are fundamental characteristics of currency. A regulatory infrastructure that maintains trust and confidence in stablecoins can help them thrive. However, if stablecoins are forced into regulatory frameworks unsuitable for banks or money market funds, they will ultimately resemble banks or money market funds, becoming as inefficient as existing financial services.

From a Risk Perspective, Stablecoins are Not Bank Deposits

Banks play a central role in the financial system and the broader economy. They hold the savings of countless households and businesses on their books. In addition to absorbing deposits, they also provide loans to individuals, businesses, government entities, and a range of other customers. If businesses could only self-fund, or individuals could only use cash on hand to purchase homes or cars, commercial activity would be severely constrained.

Banking can also be high-risk. Banks take in customer deposits (which customers can withdraw at any time) and issue loans or invest in bonds or other long-term assets (engaging in what is known as maturity transformation). In this process, banks may incur losses due to poor judgment. If all of a bank's customers withdraw their funds at once, and the bank may not have enough assets on hand, this can lead to panic, bank runs, and fire sales. If a bank is poorly managed and suffers losses from bad loans or investments, this will also affect its ability to repay customer deposits.

Stablecoins, by their nature, face different risks than banks. The issuers of dollar stablecoins (which can be redeemed at par on demand according to their terms) may hold reserve assets to meet customer redemptions. These reserve assets may match the issued stablecoins and consist of central bank liabilities or short-term government bonds, isolated from the issuer's own assets, unaffected by creditor proceedings, and subject to assessment or audit. Federal regulations implemented under new legislation may require specific safeguards to be included. If so, unlike bank deposits, there is no maturity mismatch between short-term liabilities (which stablecoin holders can redeem at par at any time) and long-term or risk assets.

More generally, even for stablecoins that are not pegged to the dollar or do not commit to redeeming at par, issuers do not essentially engage in maturity transformation like banks. Here, safeguards can also be put in place to ensure consumer protection and maintain financial stability. These guardrails may include information disclosure, third-party audits, and even basic consumer protection rules for centralized service providers offering or promoting such stablecoins.

Essentially, the risk management framework applicable to stablecoins should be designed to manage the unique risks associated with stablecoins, which differ from those in traditional banking.

Stablecoins are Different from MMFs in Practice

Regulators, including the SEC, have indicated that certain stablecoins are similar to money market funds (MMFs), particularly when they hold a variety of assets such as government securities and cash as reserves to maintain their value stability. Therefore, these stablecoins should be regulated as money market funds (MMFs). We believe this is an inappropriate regulatory approach, as the actual market use of MMFs differs from that of stablecoins.

MMFs are open-end management investment companies regulated under securities law. They invest in high-quality short-term debt instruments, such as commercial paper, treasury bills, and repurchase agreements. The interest they pay reflects current short-term rates and can be redeemed on demand, maintaining a stable net asset value per share, typically at $1.00 per share, according to SEC rules. Like other mutual funds, they are registered with the SEC and regulated under the Investment Company Act of 1940. MMFs are publicly traded investments purchased and sold through securities intermediaries (such as qualified brokers or banks).

Over the years, various types of money market funds have been launched to meet the differing needs of investors with various investment goals and risk tolerances. As classified by the SEC nearly a decade ago, most investors invest in prime money market funds, which typically hold a variety of short-term debt issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper. In contrast, government money market funds primarily hold U.S. government debt, including Treasury debt, as well as repurchase agreements collateralized by government securities. Compared to prime funds, government money market funds typically offer greater principal safety but lower yields.

The combination of principal stability, liquidity, and short-term yields provided by money market funds bears some resemblance to dollar stablecoins. However, it is important to note that the practical use of stablecoins is fundamentally different from that of money market funds; if stablecoins are regulated as money market funds (MMFs), most stablecoins will lose their utility.

In practice, stablecoins are primarily used as a means of payment in crypto transactions, rather than as an investment choice or cash management tool. Dollar stablecoin holders do not earn any returns on their reserves. Instead, stablecoins are used as cash equivalents. Dollar stablecoin holders typically do not seek to redeem the value of their held stablecoins from the issuer and then use the proceeds for cryptocurrency trading. They simply transfer the stablecoins themselves as the dollar payment portion in a cryptocurrency transaction. If stablecoins are regulated as money market funds (MMFs) and require holders to sell through brokers or banks, this would be impossible or impractical.

We believe that forcing stablecoins into the MMF regulatory framework is a mistake, especially when legislation has the opportunity to create a more suitable framework. In fact, the Supreme Court has rejected the expansion of the SEC's authority to such tools.

In other words, just as money market funds are regulated differently from other investment companies due to their structure and purpose, stablecoins should also be regulated consistently with their unique structure and purpose.

Conclusion

We believe that limiting stablecoins to existing banking and securities law frameworks would overlook key principles of payment systems, particularly those related to fairness and open access. The uniqueness of payment systems lies in the dynamic nature of network effects, where the benefits users derive from the system increase as the number of users grows. Coupled with entry barriers, including overly burdensome and stringent bank-like regulation on stablecoin issuers, these factors often restrict competition and concentrate market power in a few dominant players. If left unchecked, this could lead to a decline in customer service levels, rising prices, or underinvestment in risk management systems.

This concentration of power would also curse the freedom of choice and decentralization of cryptocurrencies. Stablecoin issuers or service providers with centralized market power could make governance decisions for public blockchains and could also influence the competitive balance among other participants. They could choose to disadvantage certain participants (and their customers) by restricting access while rewarding other favored crypto service providers with preferential treatment, thereby enhancing their own market power.

For these reasons, we urge Congress to take immediate action to enact legislation that addresses the risks posed by stablecoins while still allowing payment stablecoins to function and continue to innovate. Based on these principles, such legislation would address key issues while still allowing for the operability of stablecoins:

• Protecting stablecoin users by setting reasonable risk management requirements for centralized service providers;
• Ensuring that non-bank issuers have viable pathways to compete fairly at both the federal and state levels;
• Allowing stablecoins to take various forms as long as consumer protection benchmarks are met and risks are appropriately managed, thereby fostering innovation.

Acknowledgments: Special thanks to Jess Cheng for her assistance with this article.