The report addresses the market risks and regulatory challenges presented by stablecoins and urges Congress to act quickly.
On November 1, 2021, the President’s Financial Markets Task Force (PWG) in conjunction with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) released its long-awaited report on stable coins (the report). Regulators around the world have become keenly aware of how stablecoins function as a bridge between traditional financial markets and digital asset markets. As a result, regulators seek to respond to the risks, opportunities and regulatory gaps presented by this growing asset class.
The report first describes the operation of stable payment coins, before identifying the main weaknesses of the prudential authority on stable coins in the American financial system. It then presents recommendations to address these gaps.
While the report focuses on the risks and regulatory loopholes associated with stablecoins designed to maintain a stable value against fiat currency, the opportunities for well-designed arrangements are mentioned up front. Benefits include the ability to support faster, more efficient, and more inclusive payment options.
The alleged risks posed by stablecoins to users, the financial system and the economy at large may, however, include the following:
- Failure of stablecoins to maintain a stable value against a national currency or other benchmark asset, especially during times of market stress
- Potential for rushes due to loss of confidence in reserve assets, massive buyouts and destabilizing fire sales of reserve assets
- Potential for contagion in digital asset markets or even the wider financial system due to stablecoin runs
- Disruptions in the payment system due to failure of the mechanisms for storing or transferring stable coins could lead to a loss of payment efficiency and adversely affect functioning in the wider economy.
- Concentration of economic power and anti-competitive effects due to the ability of stable agreements to evolve rapidly
- Market integrity and investor protection issues, including fraud and misconduct in digital asset trading (e.g. market manipulation, insider trading, front running)
- Operational risks related to cybersecurity and the collection, storage and safeguarding of customer data
- Concerns about illicit money transfer and financing services related to non-compliance with anti-money laundering and anti-terrorist financing rules
Digital Asset Trading Platforms and DeFi
Because the use of stablecoin is so intertwined with the borrowing, lending, and trading that takes place on digital asset trading platforms and decentralized finance (DeFi), the report spends considerable time describing the risks involved. to stablecoin presented by these platforms and the regulatory powers of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in the oversight of these platforms when their respective authorities are involved. The unique risks associated with these platforms include:
- Dependence on stablecoin arrangements on a platform, so that a platform failure or disruption could threaten the stablecoin, and vice versa
- Excessive leverage facilitated by the use of stable coins as collateral on unregulated or non-compliant trading platforms
- Interconnections between digital asset trading platforms and stablecoins, including ownership of stablecoin platforms (and potential mixing with client funds)
- Risks arising from unique aspects of distributed ledger-based arrangements, including governance issues, interoperability, scalability, smart contract and protocol vulnerabilities, cybersecurity, and other operational issues
- Risks arising from new custody and settlement processes that lack standardization and quality control
The report highlights the range of risks posed by stablecoins to better determine where agencies such as the SEC, CFTC, and the Financial Action Task Force (FATF) have these risks under control, and where further action is needed to address these risks. from legislative or regulatory authorities. .
At the top of the report’s list of recommendations is the need for Congress “to act swiftly to enact legislation to ensure that stable payment coins and stable payment coin agreements are subject to a federal framework over a period of time. coherent and complete basis ”. The report recommends that Congress enact forward-looking and flexible legislation to:
- Require issuers of stable payment coins to be insured depository institutions and prohibit other entities from issuing stable coins. Insured deposit-taking institutions such as state and federal chartered banks and savings associations are subject to appropriate supervision and regulation, both at the deposit institution level and at the holding company level. . They are also covered by the services provided by the FDIC (deposit insurance) and the Board of Governors of the Federal Reserve (access to emergency cash)
- Subject custodian wallet providers to appropriate oversight, including the ability of the federal supervisor to prevent such service providers from lending stablecoins to clients
- Give the federal supervisor of a stablecoin issuer the power to require any entity that carries out activities essential to the operation of the stablecoin agreement to comply with appropriate risk management, liquidity and security requirements. capital
- Require stablecoin issuers to comply with activity restrictions that limit affiliation with business entities
- Grant regulatory authorities the ability to implement standards to promote interoperability between stablecoins
The report says its recommendations build on the work of international fora, such as the Financial Stability Board (FSB) High-Level Recommendations for the Supervision of Global Stable Coins released in October 2020. The report further recommends that authorities continue to engage in international forums (e.g. FSB and the Payments and Market Infrastructures Committee of the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO)) to promote comprehensive and consistent monitoring of stablecoin agreements. The report acknowledges a recent CPMI-IOSCO report and consultation on the regulation of stablecoin agreements titled “Applying Financial Market Infrastructures Principles to Stablecoin Agreements”. Although the report does not specify to what extent the FSB recommendations or the CPMI-IOSCO principles were used in its drafting, there is considerable overlap in the risks that are noted. (See this Latham article for more information on the CPMI-IOSCO consultation.)
Congress must take the next step
The report makes it clear that legislation is urgently needed to address the many risks described. Announcing the report, Treasury Secretary Janet Yellen said, “[w]While Congress considers action, regulators will continue to operate within their mandates to address the risks of these assets. The report itself states that since the business related to stablecoins or digital assets falls under the purview of the SEC or CFTC, these agencies have extensive enforcement, regulatory and oversight authorities. which may apply depending on the facts and circumstances. SEC Chairman Gary Gensler, in a statement supporting the report, asserted that the SEC and CFTC “will deploy all the protections of the federal securities laws and the Commodity Exchange Act for these products and arrangements, where applicable. applicable ”.
The risk, however, is that in the interim of any Congressional action – which could take months (if not years) – the disparate patchwork of regulatory oversight leaves markets vulnerable to the many risks and regulatory loopholes outlined in the report. This is especially true where existing legal obligations are limited, ambiguous or non-existent. Indeed, according to related remarks by Under Secretary of the Treasury for National Finance Nellie Liang, the prudential supervision of stablecoins in the United States is inconsistent, with some stablecoins “effectively outside the regulatory scope”.
The report raises the possibility that in the absence of legislation, the Financial Stability Supervisory Board (FSOC) could designate stablecoin agreements as systemically important payment, clearing and settlement (PCS) activities. Such a designation “would allow the appropriate agency to establish risk management standards for financial institutions that engage in designated PCS activities”. However, if FSOC members operate in an “incomplete or fragmented” supervisory environment to begin with, it can be difficult to determine which laws are applicable and which agency is appropriate for a given and complex stable agreement. At least one prominent senator has expressed concern that the fragmented environment could cause regulators to “expand existing laws with the aim of expanding [their] regulator ”, which President Gensler has indicated he is prepared to do. Until the legislation is enacted, regulatory fragmentation (and agency competition to fill the loopholes) may continue to cast a shadow over stablecoins deals as well as the entire digital asset market.