The 2021 start of the Northern Hemisphere summer may go down as the moment in which U.S. regulators suddenly woke up to the reality of stablecoins.
The pendulum from neglect to laser focus may now have swung too far. The risk now is that regulators are moving too fast and might apply a blunt, catch-all solution to a complex issue that demands nuance.
The wake-up started late last month when Eric Rosengren, president of the Federal Reserve Bank of Boston, detailed what he saw as the risks these stable-value tokens pose to the financial system. Rosengren’s take was followed by an almost diametrically opposed position from Randal Quarles, the Fed’s vice governor, who gave a surprisingly forward-thinking speech calling on the U.S. to encourage stablecoin innovation.
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Then, this week, U.S. Treasury Secretary Janet Yellen convened a meeting of the President’s Working Group on Financial Markets to discuss stablecoin regulation. It included top-ranking officials from the Treasury, the Fed, the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp.
Not much has been forthcoming from those talks, but one attendee, SEC Chairman Gary Gensler, suggested some stablecoins whose prices depend on the performance of traditional securities might themselves be securities and so subject to his agency’s oversight. Gensler’s staff is working to meet a demand from Sen. Elizabeth Warren (D-Mass.) that the SEC lay out a broader framework for crypto regulation by July 28.
Systemic risks?
It’s not just letters from U.S. senators that have stirred regulators into action. It’s also the remarkable growth of stablecoins.
As you’ll see below in the newsletter’s chart section, the total value outstanding from the top 10 stablecoins – including Tether’s USDT, Circle’s USDC, Binance’s BUSD and MakerDAO’s DAI – now stands at $108.7 billion. That’s up fourfold from the start of this year and three times more than the $35.6 billion that PayPal Holdings held on account for its PayPal and Venmo customers at the end of the first quarter.
This explosive growth – along with the aggressive investigation of leading stablecoin issuer Tether by the New York attorney general’s office, which ended in a settlement requiring greater transparency from the company on the breakdown of the reserves that back its tokens – has raised concerns about “systemic risk.”
That’s a phrase that conjures memories of the 2008 financial crisis, when investors were dumping assets to cover their rapidly evaporating mortgage investments, creating a de facto “bank run” on the financial system. The fear is that in a world where reserve-backed stablecoins are ubiquitous, doubts about the size, quality and liquidity of the assets backing the tokens could exacerbate a financial crisis. Mass stablecoin redemptions could bankrupt their issuers, critics say, and create a similar effect of panic and cascading credit risks across the economy.
It is the legitimate responsibility of governments to mitigate such risks. In fact, boosting confidence in that way would likely be a boon for stablecoin usage, much as the provision of federal deposit insurance did for the U.S. banking system in 1933.
So regulation should be welcome by the industry. But what will that regulation look like? Will it encourage or restrict innovation and access? And will the right rules be applied to the right scenarios? Or will a one-size-fits-all approach be applied that does more harm than good?
Haste is not conducive to the kind of nuanced regulatory approach that’s needed. Nor are alarmist analogies such as “bank runs,” which for various reasons don’t really apply here.
History lessons
Some of the urgency was stoked this week by Gary Gorton, an economist at the Yale School of Management, and Jeffery Zhang, an attorney at the Fed. In a paper that was no doubt placed in front of all members of the President’s Working Group, they called on the U.S. government to extend “public money” control over “private money” stablecoins – either by compelling them to be federally regulated as banks or by replacing them with a central bank digital currency.
“If policymakers wait a decade” to act, the paper authors argued, “stablecoin issuers will become the money market funds of the 21st century – too big to fail – and the government will have to step in with a rescue package whenever there’s a financial panic.”
Haste and hurry can only bear children with many regrets along the way.
To make their point, the authors used the United States’ 19th-century experience with underegulated “wildcat banking,” when different banknotes issued by private banks circulated, sometimes at varying prices relative to their nominal at-par value. But the Cato Institute’s Selgin, a monetary historian and a guest on our podcast this week, tore apart the analogy in a convincing tweet thread. Reading it, one is left with the idea that that past experience with “private money,” if stripped of 19th-century constraints around geographic and information transparency that shouldn’t exist in the digital age, shows its potential for the 21st century.
For the most part, Selgin wrote, the private banknotes traded at par within the states to which the banks belonged and were discounted only when they were carried across state lines to places far from where they could be physically redeemed in those banks’ branches.
Selgin noted that a 10% federal tax was needed to stop people from using the state banknotes, which meant that “despite their inability to pass at par everywhere,” users considered them “good as if not better for certain purposes than their national counterparts.”
Contrary to popular myth, Selgin continued, shutting the so-called wildcat banks did not deliver efficiency payoffs to many poorer Southern states, whose post-Civil War development was held back for decades because of insufficient credit in the wake of the state banks’ closures.
Fast forward to the more transparent, digitally ubiquitous model that the internet affords, and it’s hard to see how discounting, by itself, is a big enough problem to offset the optionality and innovation that stablecoins offer to users. If everyone recognizes that a sought-after token is not the equivalent of national fiat currency but is merely expected to hold close to its value, then people will continue to use it for convenience, programmability and ease of access.
Certainly, if you look at the 90-day trading price for USDT and that of USDC on CoinGecko, that’s what the market is telling us. The prices vary by a few cents with the ebb and flow of demand and supply, but average around $1.00. Is that a problem? Every major user has known the questionable state of Tether’s reserves for months, if not years. But they don’t worry about it because they can see the price any time and adjust their contracts accordingly.
What kind of regulation?
This is not to argue regulation wouldn’t be valuable. Rules to compel transparency could further breed overall confidence in the system so that price spreads narrow even further.
And it might be that a heavier-handed bank charter model, one that removes all doubt about the par value of 100%-reserved tokens, is needed to get large compliance-constrained corporates to use stablecoins and ramp up their usage across the economy.
Certainly, that’s what Long, the other guest on this week’s podcast, is betting on. Long is the founder and CEO of Avanti Bank, which took advantage of Wyoming’s new crypto-friendly special purpose depository institution (SPDI) bank charter and is using that to lobby the Fed backing for its new digital dollar token, Avit.
Yet stablecoins and digital dollars come in many flavors. A one-size-fits-all solution would be problematic.
As Gensler noted, some stablecoins could be securities. And as Gorton and Zhang note, Tether’s terms and conditions give it equity issuer-like optionality on how and when to honor redemptions, unlike other reserve-backed stablecoin issuers, which treat their customers’ fund deposits as debt obligations. Perhaps Tether should be regulated as a money market fund, but the others as deposit takers. How will that distinction affect the market?
And what about “synthetic” stablecoins such as Dai, an ERC20 token whose value is managed algorithmically by smart contracts over the Ethereum blockchain – and which got no mention in Gorton and Zhang’s paper. They aren’t reserve-backed at all. Are they now illegal? Who’s the regulated person or entity in a case where the system is run by a decentralized community? The thousands of geographically scattered Ethereum nodes that execute the smart contracts?
One could take the argument of Rohan Grey – an assistant professor of Willamette University College of Law who drafted a bill for Rep. Rashida Tlaib (D-Mich) calling for all stablecoins to require banking licenses that the developers of MakerDAO protocol behind Dai. But as difficult as that already is to enforce, it is about to become even harder now that the legal entity they formed, the Maker Foundation, is shutting down and turning over governance to a decentralized autonomous organization.
If regulators are serious about promoting innovation, financial access for all and the freedom to produce code, regulators will have to work through these issues deliberately and carefully.
As an African proverb says, “Haste and hurry can only bear children with many regrets along the way.”
UPDATE (23 July 18:47 UTC): Corrects a formatting error in the first paragraph.