U.S. President’s Working Group on Financial Markets Releases Its Stablecoin Report

Notable Takeaways:

• The Report requests “urgent” congressional action regarding oversight and regulation of  issuers, wallet providers, and related entities. In particular, the Report calls for legislation requiring:
  • Stablecoin issuers to be insured depository institutions regulated at both the depository institution level and the holding company level.
  • Wallet providers to be subject to federal oversight.
  • Any entity that performs activities critical to the functioning of stablecoin to be subject to appropriate risk management standards.
  • Various degrees of activities restrictions between commercial entities and stablecoin issuers and wallet providers.  
• Widespread adoption of stablecoins as a means of payment could occur rapidly. The Report focuses on the use of stablecoins as a means of payment yet notes that stablecoins are predominantly used in the United States to facilitate trading, lending, and borrowing of other digital assets. However, the PWG believes the promotion of stablecoins by “commercial” firms such as telecommunications or technology (or social media) companies could rapidly accelerate the use of stablecoins as payments. 
• Calls for enhanced regulation of custodial wallet providers. The recommendations with respect to custodial wallet providers are potentially far reaching and likely to drive material concern in the industry. The proposal regarding activity restrictions is particularly surprising given that the concerns regarding risks to the FDIC insurance fund that typically support such restrictions are not present for wallet providers, and such a restriction would treat custodial wallet providers differently than virtually all other financial services companies other than banks.
• The PWG (mostly) punts on the question of whether stablecoins are securities. The PWG qualifies the Report by stating that it “does not provide recommendations regarding issues or risks under the federal securities laws or the Commodity Exchange Act (CEA)” and that the Report’s recommendations “are not intended to affect any analysis under the federal securities laws or the CEA.” However, it is difficult to consider these issues in isolation. For example, the Report calls for issuers of stablecoins to be insured depository institutions (i.e., banks), yet securities issued by banks are exempt from the Securities Act under Section 3 of the Securities Act. Notwithstanding the qualification, the Report repeatedly states that stablecoins may be securities, commodities, and/or derivatives that are subject to the jurisdiction of the SEC or CFTC. Further, the Report cautions that certain digital asset issuers and platforms may be “investment companies” subject to registration or may be “investment advisers” subject to regulation.
• Certain stablecoin arrangements may qualify for deposit insurance. While the Report provides for the possibility of FDIC insurance if the requirements of “pass-though” deposit coverage are met, it does not address the technical and operational challenges of meeting those requirements or suggest whether the FDIC is close to approving potential solutions to those challenges.
• Regulators are focused on DeFi. Without making any recommendations specific to DeFi, the PWG commented extensively on DeFi activities and the role of stablecoins in DeFi. The Report cites a number of perceived risks related to DeFi of particular concern to the SEC and CFTC. Although the Report focuses on stablecoins convertible for underlying fiat currency (as opposed to “algorithmic” stablecoins), the Report presents data showing that an algorithmic stablecoin is most widely used for certain DeFi activities. 

Highlighted Risks

The Report identifies three main types of risk associated with stablecoins: (1) loss of value risk, (2) payment system risk, and (3) risks of scale. Notably, the Report fails to specifically define stablecoins. While the PWG acknowledges that stablecoins can include a broad manner of tokens designed to maintain stable value in relation to a reference asset, including algorithmic tokens, the Report focuses on those stablecoins that are minted in exchange, and may be redeemed, for fiat currency. For that reason, the Report emphasizes the use of stablecoins as a means of payment rather than for other purposes, and the risks highlighted by the Report reflect that emphasis.

1. Loss of Value Risk (i.e., Run Risk)

The Report emphasizes that an instrument requires public confidence in its value to serve as a reliable means of payment or store of value. With respect to stablecoins, the Report identifies four potential factors that may undermine the required confidence: use of reserve assets that may devalue or become illiquid, failure to properly safeguard the reserve assets, lack of clarity regarding redemption rights, and operational risks related to cybersecurity and privacy. The Report warns that a stablecoin failing to maintain the requisite confidence could pose a “systemic risk” of a run on a single stablecoin, or worse, a run on other stablecoins or other types of financial institutions or instruments believed to share a risk profile. As a result, the Report suggests that a “fire sale” of the underlying reserve assets could disrupt critical funding markets. The volume and liquidity characteristics of reserve assets sold would dictate the dynamics of a stablecoin run as well as its degree of risk on the broader economy.

2. Payment System Risk

a. Operational Risk

The Report considers stablecoin arrangements to “face many of the same types of operational risks as existing payment systems.” Although the Report acknowledges that stablecoins, in some respects, may be more operationally resilient than other payment systems, it identifies “novel operational risks” related to the validation and confirmation of transactions as well as the management and integrity of the distributed ledger. For example:

• Participants may not be adequately motivated to validate transactions to sufficiently respond to processing demand, resulting in network congestion.
• Operational risks may be difficult to manage or supervise when the supporting infrastructure is beyond the control of any one organization.

b. Settlement Risk

The Report raises concern with the “heightened uncertainty” and “credit and liquidity pressures” posed by some stablecoin arrangements not clearly defining the point at which settlement is final in their rules and procedures. In particular, the combination of open network access with consensus-based settlement mechanisms may lengthen time necessary for a technical settlement. The Report asserts that this, coupled with the lack of a single party held accountable for defining or ensuring legal settlement finality, may create questions about the reliability and finality of payments.

c. Liquidity Risk

Because the timing and processes of stablecoin arrangements may misalign with other systems, such as payment systems, the Report identifies a potential liquidity risk where a temporary shortage of available stablecoins may arise.

3. Risks of Scale

In the past year alone, stablecoins have shown the ability to grow rapidly at both an individual and an aggregate level. Citing this growth, the Report raises three sets of policy concerns associated with an individual stablecoin being able to scale rapidly:

• The failure of an issuer or key participant could pose systemic risk.
• The combination of a stablecoin issuer or a wallet provider with a commercial firm could lead to an excessive concentration of economic power.
• The widespread adoption of a single stablecoin as a means of payment could present concerns about anticompetitive effects.

In addition to these risk posed by the rapid scaling of an individual stablecoin, the Report also raises concerns about the effect of rapid scaling of stablecoins in the aggregate. In particular, the Report points to the possibility that insured depository institutions could lose retail deposits to stablecoins, resulting in material strains on the “real economy.”

While the exponential growth of stablecoins in the past year is significant, the use of stablecoins is still dwarfed by the traditional payment system, and the systemic threats cited in the Report seem to arise from a cloud of concern that a new stablecoin or market entrant could drive mass adoption of stablecoin at a scale far beyond current usage. While such a mass adoption would involve risks beyond those present today, the Report does not attempt to tailor its recommendations to limit burdens that may be placed on issuers that are not likely to pose the same systemic threats.

Recommendations

Citing a lack of “a consistent set of prudential regulatory standards” that address the abovementioned risks, the Report calls for action by Congress, regulatory agencies, and the Council.

The primary goal of the proposed legislation would be “to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.” The Report’s proposal would address the perceived risks in the following manner:

• Stablecoin runs:
  • Require stablecoin issuers to be insured depository institutions that are regulated at both the depository institution and the holding company level (i.e., no industrial bank issuers).
• Payment system risk:
  • Require custodial wallet providers to be subject to appropriate federal oversight.
  • Authorize “the federal supervisor of a stablecoin issuer” to impose appropriate risk-management standards on “any entity that performs activities that are critical to the functioning of the stablecoin arrangement.”
• Systemic risk and concentration of economic power:
  • Require issuers to comply with activities restrictions that limit affiliation with commercial entities.
  • Require custodial wallet providers to comply with some form of an activities restriction, such as limits on affiliation with commercial entities or on use of users’ transaction data.

The Report also calls for interim measures from the regulatory agencies and Council. Instead of identifying a regulatory agency to singlehandedly address stablecoin, the Report cites a “commitment” from the regulatory agencies more generally “to address risks falling within each agency’s jurisdiction and to continued coordination and collaboration on issues of common interest.” In discussing the role of each federal regulator, the Report notes that some stablecoins may be “securities, commodities, and/or derivatives” but does not provide any additional discussion of what standard would be applied to make such a distinction. Further, the Report remarks that “[r]elevant authorities, including the Department of Justice,” may consider whether Section 21(a)(2) of the Glass Steagall Act (12 U.S.C. § 378(a)(2), which sets forth certain conditions to engage in the business of receiving deposits) may apply to certain stablecoin arrangements. 

In the absence of congressional action, the Report also requests that the Council consider taking action. For example, designating certain activities “as, or as likely to become, systemically important payment, clearing, and settlement (PCS) activities” would enable a federal agency to establish risk-management standards for financial institutions engaging in such activities. These standards may include requirements regarding the assets backing the stablecoin and the operation of the stablecoin arrangement. The designation could also subject qualifying actors to an examination and enforcement framework.

In sum, the Report primarily calls for Congress to enact a sweeping new cryptocurrency regulatory scheme that goes beyond stablecoins, with virtually no factual support, coupled with policy recommendations that draw on bank regulatory principles that are not directly analogous to the stablecoin ecosystem. Together with its vague suggestion of enforcement under securities, commodities, or largely moribund banking laws, the Report serves as warning to the industry that broad, concerted action will be necessary to avoid developments that will adversely affect the growth of this nascent sector.

¹ The PWG consists of the Secretary of the Treasury, the Chair of the Board of Governors of the Federal Reserve System, the Chair of the Securities and Exchange Commission, and the Chair of the Commodity Futures Trading Commission (or their respective designees). See Executive Order 12631 (Mar. 18, 1988).

² President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, Report on Stablecoins (Nov. 1, 2021), available at https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf.