On November 1, 2021, the President’s Working Group on Financial Markets (PWG), joined by the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) — collectively referred to as the government agencies — released its highly-anticipated report on stablecoins.
The report focuses on analyzing risks posed by stablecoins used as means of payments and provides recommendations for overcoming these risks and addressing regulatory gaps. The recommendations of the report primarily cover payment stablecoins, which are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.
Amidst the rising use of stablecoins, the government agencies are pushing for stablecoin issuers to be held to the same standards as insured depository institutions such as state and federally chartered banks.
Stablecoins are predominantly used in the U.S. to facilitate trading, lending, and borrowing of other digital assets. Recently, Merkle Science published a blog post analyzing differences between stablecoins & CBDCs, role of stablecoins in crypto landscape and global regulatory approach to stablecoins.
The report does not specify under which federal regulatory agency’s jurisdiction stablecoin trading will fall; however, it states that Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), enjoys “broad enforcement, rulemaking, and oversight authorities” to address investor protection, market integrity, and illicit financing concerns attached to stablecoins.
Major Prudential Risks Associated with Stablecoins
Though the report focuses on analyzing prudential risks attached to payment stablecoins such loss of value, payment systems risks, and risks of scale, it also highlights other important risks such as market integrity and investor protection, illicit financing, and DeFi risks. Some of the risks outlined in the report include:
Loss of Value: These are the risks related to stablecoin users in case of a run. Increased use of stablecoins may lead to increased prudential concerns such as the use of reserves assets that may fall in price or become illiquid, failure to appropriately safeguard reserve assets, lack of clarity regarding the redemption rights of stablecoin holders, and operational risks related to cybersecurity and the collecting, storing, and safeguarding of data.
Further, the mere prospect of a stablecoin not performing as expected could result in a “run” on that stablecoin, which may occur when many stablecoin holders try to liquidate their holdings, resulting in a “fire sale” of reserve assets. Fire sales of reserve assets is especially detrimental as it may lead to disruption of critical market functions, depending on the type and volume of reserve assets involved. The report warns that runs could rapidly and contagiously spread from one stablecoin to another.
Payment System Risks: Payment stablecoins can also face the same basic payment systems risks plaguing traditional payment systems. These risks include credit risk, liquidity risks, settlement risks, and risks arising from improper governance systems. However, unlike traditional payment systems that are centralized, some types of stablecoins, such as algorithmic stablecoins, may be decentralized. This means that no single entity is responsible for risk management and operational resilience of the entire arrangement. As a result, payment system risks of stablecoins would also include risks such as operational risks and stablecoin arrangement risks.
Operational issues caused due to factors such as reduction, deterioration, or breakdown of services that can disrupt the ability of users to make payments fall under payment risks. These risks have the ability to disrupt the payment activities.
Stablecoin arrangement risks are caused by those stablecoin arrangements that do not clearly define the point at which settlement is final in their rules and procedures pose heightened uncertainty and create credit and liquidity pressures for arrangement participants.
Risks of Scale: Rapid scaling from the increase in demand of an individual stablecoin will lead to three sets of policy concerns.
Firstly, stablecoin issuers or key participants such as custodial wallet providers could cause systematic risks. For example, if the custodial wallet provider fails, financial stability of the market can be adversely affected. Secondly, the combination of stablecoins held by a stablecoin issuer or wallet provider and a commercial firm could lead to an excessive concentration of economic power. Thirdly, stablecoins that become widely adopted as a means of payment could present concerns about anti-competitive effects. For instance, users of a stablecoin may face undue frictions or costs in the event they choose to switch to other payment products or services.
Other Important Risks Affecting Consumer and Investor Protection
Market Integrity and Investor Protection: These risks encompass possible fraud and misconduct in digital asset trading, including market manipulation, insider trading, and front running, as well as a lack of trading or price transparency. Further, digital asset trading platforms and other market participants such custodians or exchanges play a key role in providing access to stablecoins and liquidity in the market for stablecoins. To this extent, the jurisdiction of SEC and CFTC will be applied.
Illicit Financing Risks: Stablecoins also pose illicit finance concerns and risks to financial integrity, including concerns related to compliance with rules governing AML/CFT activities.
DeFi Risks: Digital asset trading platforms and DeFi arrangements present risks of particular focus to the agencies, and most notably to the SEC and CFTC. Among others, these risks include increased reliance of stablecoin arrangements on digital asset trading platforms and vice versa. Potential AML/CFT risks and risks may arise from unique aspects of distributed ledger-based arrangements. These include governance issues, interoperability, scalability, protocol and smart contract vulnerabilities, cybersecurity, and other operational issues.
Recommendations: Congress to Enact a Prudential Federal Legislation
The report recognizes that there are key gaps in prudential authority over stablecoins used for payments purposes. In order to adequately address these risks, the agencies have urged Congress to promptly enact legislation bringing stablecoin under federal oversight. The report sets out following recommendations:
- To protect the users against stablecoin runs, among other things, legislation should require stablecoin issuers to be insured depository institutions. These institutions will be subject to appropriate supervision and regulation,at the depository institution and the holding company level.
- To address concerns about payment system risk, in addition to the requirements for stablecoin issuers,custodial wallet providers are subject to appropriate federal oversight. It should also appoint a federal supervisor, who ensures that entities critical to stablecoin arrangements have adequate risk management standards in place.
- To address additional concerns about systemic risk and economic concentration of power, legislation should require stablecoin issuers to comply with activity restrictions that limit affiliation with commercial entities. Supervisors should have authority to implement standards to promote interoperability among stablecoins.
How Can Merkle Science Help?
To enable access to potential benefits of stablecoins while mitigating the risks they pose to users, investors, and the financial system, the regulatory oversight over stablecoins is increasing. In order to protect themselves from exposure to the AML/CFT risks, VASPs should proactively put compliance frameworks in place to monitor all transactions surrounding stablecoins and to mitigate AML/CFT risks.
Merkle Science provides a predictive crypto risk and intelligence platform, setting the standard for the next generation of financial safeguards and criminal detection. We are creating the infrastructure necessary so that a full range of individuals, entities, and services may transact safely with crypto. Merkle Science’s highly customizable platform and proprietary Behavioral Rule Engine is easy-to-use, allowing institutions to detect illicit activity beyond the blacklists and detected suspicious activity that could have previously been undetected.