Neither stable nor genius: the misguided legislative attempt to regulate stablecoins

Bills moving through Congress would leave consumers and taxpayers exposed to volatile crypto products

Photo by Alejandro Barba on Unsplash

The Senate Banking Committee recently cleared legislation to establish a framework for bringing stablecoins—a form of cryptocurrency that purports to maintain a one-to-one peg with the US dollar—into what financial policymakers call the “regulatory perimeter.” The legislation and its House companion, which is set to move forward soon, create a process for chartering and regulating the issuance of stablecoins. Unfortunately, the legislation under consideration—the STABLE Act in the House and the GENIUS Act in the Senate—has shortcomings that expose the public, regulated financial institutions, and the entire financial system to potentially significant risk.

Stablecoins are not a “coin”

Physical “coins” are useful for payments because they are bearer instruments that can be readily transferred, the holder is the owner, and they maintain their face value. By contrast, stablecoins have not proven to be useful for payments because there is some risk they will lose their dollar peg, the fees for making transactions are higher than traditional payments, and the technology of transferring between myriad crypto entities is clunky. Americans who are familiar with crypto are also skeptical of its legitimacy. Surveys show that households that do use cryptocurrencies are overwhelmingly doing so for investment and speculation, not to make everyday payments.

The same is true of stablecoins whose predominant use is serving as a source of collateral to facilitate the trading of other crypto assets. I’ll say more about the risks of this model in a moment, but it’s important to understand that a regulatory regime that centers stablecoins’ ostensible use as a payment instrument obscures the clear risks raised by their actual use cases and leads to a framework with blind spots and embedded arbitrage opportunities. Take the GENIUS Act’s definition of “payment stablecoin” which includes digital assets “designed to be used” for payment or settlement. Putting aside the issue that settlement and payment are different economic functions raising different risks, the distinction between a financial instrument’s design and its actual use is important and relies on something like an intent-based test that can swallow the ostensible limitation.

Stablecoins are not necessarily “stable”

Stablecoins have not proven themselves to be stable and several have broken their dollar peg. The GENIUS Act seeks to address this issue through reserve requirements, but it allows stablecoin issuers to invest in a variety of assets, including Treasury-backed repurchase agreements (or “repo”), Treasury bills and securities subject to maturity limits, and shares in money market mutual funds that invest in government securities. While many of these assets are considered high-quality and liquid, they’re nonetheless vulnerable to rollover risk, liquidity risk, interest rate risk, and counterparty risk. For example, stablecoin issuers can invest in Treasuries with a remaining maturity of less than 93 days, meaning one could potentially purchase off-the-run Treasuries with a remaining maturity under the 93-day limit that are not sufficiently liquid. Further, allowing government money market funds piles one potentially fragile funding model upon another—in 2008 and again in 2020, money market funds have “broken the buck” and required financial support from their parent sponsors and the US Treasury.

These potential risks are compounded by the bill’s limits on prudential regulation. Regulators are allowed to establish capital standards solely for the purpose of addressing operational risk. This is not a best practice for capital regulations. Trading strategies that employ stablecoins involve embedded leverage that can create contagion during times of stress, as illustrated by the 2022 bankruptcies of crypto lending platforms Celsius and BlockFi. The bill’s activity limitations read as fairly easy to expand through supervisory interpretation, as the Office of the Comptroller of the Currency (OCC) and Fed have done with permissible bank activities, meaning that stablecoin issuers can engage in other activities besides issuance that raise additional risks.

The stablecoin business model seeks to arbitrage existing regulations

If the predominant use case for stablecoins is as a means to trade crypto-assets, there is a prospective use for them that raises distinct, but no less concerning, risks. In 2019, a corporate consortium led by Big Tech giant Meta brought these risks into sharp relief when it announced its plan to issue a global stablecoin, first called “Libra” and then later renamed “Diem.” The project drew backlash from policymakers, alarmed by its potential to facilitate illegal transactions and threaten financial stability. In addition to these very legitimate concerns, such a project also raises issues of political economy based on its potential to create a “globally dominant, private monetary system controlled by Meta and built on top of its social-media platform.” This is not just an issue for commercial companies, it is also problematic if a large and lightly regulated payment company—think PayPal or Visa—elects to issue its own lightly regulated stablecoin.

This is why we have a longstanding tradition of separating banking and commerce and maintaining firewalls between traditional banks and nonbank financial companies. But the stablecoin legislation has no such separation of banking and commerce or other activity and affiliation restrictions like those contained in the banking laws, such as limits on inter-affiliate transactions, management interlocks, and insider transactions. Whittling away these walls raises safety and soundness, antitrust, financial stability, and data privacy concerns. Issuers with sufficient market power could trap customers in so-called “walled gardens,” requiring them to use company-issued coins to pay for basic products and services or to steer them into high-cost credit and other financial products. They could use their customers’ financial data to engage in predatory pricing schemes or sell the data to third parties. They could use their financial business to subsidize their commercial businesses and provide preferential treatment to affiliated people and entities. The potential conflicts of interest are not speculative—the crypto business run by the Trump family recently announced its intent to create its own stablecoin. What financial agency is going to feel comfortable regulating financial products issued by their boss, the President of the United States?

Consumers and the public bear the costs of inadequate stablecoin regulation

Why should we care if stablecoins and other crypto assets are insufficiently regulated? These issues matter because consumers, investors, and the public ultimately pay the price when stablecoin trading goes awry. In the “crypto winter” of 2022, for example, there were at least seven different runs on crypto assets that resulted in at least five crypto platforms declaring bankruptcy, with more than four million customers filing claims to recover their lost or frozen funds.

Clarity about the status of stablecoins, the ability of customers to redeem them, and their status when crypto issuers, platforms, and custodians are insolvent have been significant issues in the crypto world. Unfortunately, the legislation does not allow agencies to regulate these policies in any meaningful sense—mere disclosure is required which has proven insufficient. While customers of Celsius’s lending program, for example, believed assets they deposited at Celsius still belonged to them, a bankruptcy court ruled they belonged to Celsius—and by extension its creditors. The legislation contemplates bankruptcy as the appropriate insolvency process for stablecoin issuers, but experiences in the banking context have shown us the slow-moving bankruptcy claims process is not the right resolution regime for entities that issue money-like claims that people expect to be able to redeem at par, on demand. (The bill also prohibits stablecoin issuers from claiming they are federally insured, but that is already illegal.)

Those are the risks for consumers, and they are significant. But what about the public? We have seen in recent years that the risks from stablecoins ultimately come back to the public safety net—the structure of supports like federal deposit insurance and Federal Reserve emergency lending that stands behind the banking system. In 2023, three banks that engaged in crypto activities—Silvergate Bank, Silicon Valley Bank (SVB), and Signature Bank—all experienced deposit runs and had to be placed into voluntary liquidation or receivership. In the cases of SVB and Signature, federal regulators had to invoke a “systemic risk exception” to guarantee all of the deposits at both banks, in excess of the normal limit of $250,000. The stablecoin issuer Circle was SVB’s largest external depositor, with $3.3 billion in deposits held in the bank, all of which ended up being protected by deposit insurance. (Under the legislation, stablecoin issuers appear to have the ability to commingle customers’ funds and create omnibus accounts, which raises both customer protection and safety and soundness issues.) During this period, Circle’s stablecoin, USD Coin (or “USDC”), lost its peg and fell as low as 87 cents.

Following the 2022 crypto bankruptcies and the 2023 crypto bank failures, the Federal banking agencies took steps to limit banks’ exposures to crypto, including managing the liquidity risks of holding deposits linked to stablecoins. But one of the first deregulatory steps taken by Trump Administration regulators has been to loosen restrictions on banks’ crypto activities, including managing stablecoin reserves and accepting stablecoins as a form of payment. This means the taxpayer-backed banking system is exposed to the risks posed by stablecoins and other crypto assets.

Conclusion

There are more foundational issues about the potential for a race-to-the-bottom if states are allowed to continue chartering and supervising stablecoin issuers, as the legislation permits. For example, Wyoming offers a special state-issued bank-like charter to crypto companies and is reportedly planning to create its own state-issued stablecoin. Letting states establish their own standards without setting a strong federal floor would create a backdoor that, if crafted poorly, could swallow a large part of the other protections in the bill. To the extent that federal chartering by the OCC is supposed to serve as a backstop, state-federal competition contributed to the deregulatory pressure and supervisory failures that ended in the Global Financial Crisis. Sanctioning the creation of private forms of money equivalents raises broader issues of monetary sovereignty and the government’s control over the money supply. And there are well-documented concerns about crypto’s use as a tool for money laundering, sanctions evasion, and cybercrime. The point here is that there are many problems that these stablecoin bills would either leave unaddressed or exacerbate.

During the Biden Administration, the Treasury Department and the financial regulatory agencies proposed limiting stablecoin issuance to only chartered and insured depository institutions, like banks, that are well-regulated and subject to activity and affiliation restrictions. (Treasury also proposed setting up a federal chartering framework for payments companies more broadly.) Why doesn’t the stablecoin legislation take this route? I suspect the answer is adequate regulation—truly stable reserves, meaningful capital requirements, activity and affiliation limits—would make the business model for issuing stablecoins uneconomical, either because they would wring embedded leverage out of the system or prevent data sharing and cross-subsidies. That should tell us everything we need to know about the social utility of the business model. And that is the fundamental question policymakers should be asking themselves: why would they want to clear a path for, and provide a public safety net to, speculative trading in assets that have so far provided little in the way of demonstrated social value?