Key Takeaways from Stability in the Cryptosphere: Exploring the promise, reality, and regulation of stablecoins

Stablecoins — pegged to a dependable fiat currency such as the US dollar — have become a cornerstone of the crypto ecosystem. Further, there has been an increase in the issuance of stablecoins, and the market cap has grown 20-fold in the last 20 months. The stablecoin market cap is currently, $159.42 billion. With an increase in the popularity of stablecoins, regulatory scrutiny around stablecoins is also increasing. Our panelists, Flavia Naves (General Counsel, Circle), Jamie Whetzel (Deputy General Counsel, PNC), and Rick Levin (Chair, FinTech & Regulation Practice, Nelson Mullins) sat down with Merkle Science’s President, Americas & Global Chief Legal Officer, Mary Beth Buchanan, to discuss the possibilities and limitations of the approach that the U.S. regulators may take towards stablecoins regulations.

1] Panelists warn Congress against lumping all stablecoins together

Flavia Naves stated that all stablecoins can’t be lumped together, she explained that there are different types of stablecoins, identified by their underlying collateral structure and categorized by the different assets backing them. For example, stablecoins like Circle’s USDC — backed and redeemable 1:1 for U.S. dollars — will be categorized as fiat-backed stablecoin whereas DAI is an algorithmic stablecoin issued by MakerDao, which uses a target rate feedback mechanism to maintain a 1:1 ratio with USD. These stablecoins she noted “can vary dramatically in their function, on how they are built and what they're meant to do. So I believe that there may be different regulators, depending on what it is that the stable coin is meant to do.”

Further, Jamie Wetzel, noted that the capabilities of a stablecoin will determine which regulatory agency or agencies are best- suited to regulate that particular stablecoin offering. He stated that stablecoins can be regulated under different verticals, for instance, they can be regulated under banking laws or as securities under the SEC depending on the structures and functions of stablecoins. 

To explain how different stablecoins may fall under banking law, Jamie Whetzel referred to the statement made by the Federal Deposit Insurance Corp (FDIC) Chairman Jelena Mcwilliams, stating “that the FDIC put out a statement last week. Chairman Williams is looking at FDIC insurance for stablecoins and that naturally takes you down a banking regulatory vertical and then the OCC charter and obligations that come therewith. Chairman Williams referred to it (FDIC insurance for stablecoins) as one island in an archipelago of regulatory verticals.”

Rick Levin turned to the speech made by Securities Exchange Commission’s (SEC) Chairman Gary Gensler’s at the Securities Enforcement Forum to explain how SEC may be looking to regulate stablecoins under the existing security laws. To that end, Rick Levin noted that the stablecoins industry will see a lot of enforcement action from the SEC.

2] The stablecoins industry seeks further clarity, but cautions against overly stringent regulations

Flavia Navis stated that primarily, stablecoin issuers want clarification around asset-backing and the permissibility of investments of those assets. In particular, the stablecoin issuers require regulatory clarity regarding what is considered to be a permissible investment of the assets backing stablecoins due to the existence of varying state laws. Flavia Navis explained that “under the existing money transmission law system, states within the U.S. have put in place different regimes for permissible investments and how you can allocate those resources.” She gave an example of the conservative approach adopted by Circle, wherein full assets of reserves backing USDC are either held in cash or short-term US Treasuries (90 days or shorter).

Secondly, stablecoins issuers also seek clarity around what having FDIC insurance means for the industry. They also require some guidance around how they can comply with a myriad of strict regulatory requirements put in place by FDIC. Rick Levin, noted if stablecoin issuers are deemed an FDIC-insured depository institution they'd be subject to consolidated supervision, prudential standards including leverage and risk-based capital requirements, activity restrictions, and limitations on affiliations with commercial entities.” Additionally, placing the same regulatory requirements on stablecoin issuers as traditional banks can be counterproductive. “Trying to place the existing constructs of traditional banks on stablecoin issuers may have the effect of simply banning the entire industry altogether. I am sure this is not the desired intent of the regulators, but it may just go in that direction” warned Flavia Navis

3] Prudential and operational risks posed by stablecoins are at the heart of Congress’ concerns

The panelists highlighted the main concerns that members of Congress seem to have about the stablecoins. Following a rapid rise in the market cap and the stablecoin report released by President’s Working Group, Congress is concerned about the broader financial structure. Some senators are especially concerned about the individual impact on everyday consumers as they engage in digital assets more and more. 

Rick Levin pointed out that in both the House and Senate hearings, the members of congress were particularly concerned about the prudential risks (such as liquidity or operational risks) posed by stablecoins, and oftentimes that discussion leaked into Decentralized Finance (DeFi). He highlighted Senator Elizabeth Warren’s concerns — “what we heard from Senator Warren, in particular, is that when you're thinking about stablecoins as the engine of DeFi, there is a concern that the growth of stablecoins and the growth of decentralized finance in general presents a risk to the sovereign authority of the entity in whatever country you're dealing with, and their ability to make monetary interest rate policy and the like.”

Interaction of DeFi arrangement with stablecoins may present risks of particular focus to the agencies, and most notably to the SEC and CFTC. Among others, these risks include increased reliance on stablecoin arrangements on digital asset trading platforms and vice versa. This is problematic because, in case of overreliance, a disruption in stablecoins can threaten the functions of digital asset trading platforms. Stablecoins can cause various prudential risks such as financial stability risks, risks of scale, credit risks and liquidity risks amongst others. Therefore, at the highest level, he observed that “you're dealing with regulators that are concerned about how they oversee the safety and soundness of a fiscal policy apparatus (stablecoins) that is having new capabilities, threats introduced. So I think that was a common theme that you heard perhaps coming more from Senator Warren.”

The panelists pointed out that members of Congress are also equally concerned that stablecoins may pose illicit finance concerns and risks to financial integrity, including concerns related to compliance with rules governing AML/CFT activities. Stablecoins can also raise potential market integrity and consumer protection concerns. 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.

4] Greater education on the nuances of stablecoins is needed to ensure effective regulation 

Rick Levin noted that some of the concerns coming out of Congress may be driven by the lack of understanding when it comes to the different types of stablecoins. Some are more sound than others and are, therefore, open to regulation by the SEC, the U.S. Department of Treasury, and Consumer Financial Protection Bureau (CFPB). Therefore, when it comes to regulations and concerns surrounding stablecoins, Congress must not take the one size fits all approach. 

A lot of the debate around stablecoins surrounds its structure, and in turn, its regulatory categorization. Congress is constantly debating whether stablecoins are “similar to notes or instruments issued by Wildcat banks before the standardization of American currency, or whether they're just product innovation.” Those stablecoins that are similar to instruments issued by Wildcat banks may present more risks and may be harder to regulate. However, products like Circle’s USDC also exist in the market. Presently, USDC is regulated by 48 regulations in the U.S. Circle is considered to be a money transmitter and USDC is classified as a store of value under the money transmission laws in the United States. In addition to complying with regulations of 46 states and territories within the U.S., Circle also has attained various international licenses and licenses in countries such as Bermuda and the U.K.”

In order to sufficiently address their concerns, ensure financial stability, and consumer protection, certain senators' proposed measures such as  only allowing central banks or certain financial institutions to issue stablecoins. However, given the nuances within the stablecoin category, Congress should not take the one size fits all approach and make an effort to understand the risks, operational structure, and functionalities of each stablecoin.

5] Time is of the essence as Congress is split over stablecoins legislation

Flavia Naves explained that for the regulators to draft a comprehensive stablecoins legislation, regulators need to really understand all the risks surrounding stablecoins. As such, the timing for that remains uncertain. To prevent regulatory clampdown and ensure that all the stakeholders are sufficiently represented, the stablecoin industry should proactively work with policymakers. 

Even if the regulators do release a stablecoins legislation, the stablecoin industry will need time to analyze the effects of such regulations. Flavia Naves noted: “if the Office of Comptroller of the Currency (OCC) releases a charter stating that private entities issuing stablecoins have to become chartered institutions with the OCC — to continue to promote technological advancement, fostering of better products and services for our customers, we will need to understand what are the risks and what we're looking to do.”

According to Rick Levin, due to the partisan split over the stablecoins issue, the chances of the stablecoin industry seeing stablecoins legislation in the next 12 months is slim. In such a situation the onus may fall on regulatory agencies to determine how to effectively regulate stablecoins. In order to promote the continued growth of stablecoins and ensure consumer protection, he encouraged the stablecoins industry to work together with regulators and provide them with technical expertise, so that they can figure out effective ways to regulate stablecoins under the existing regulatory regime.

Jamie Wheztel remains more hopeful in terms of the timing of the release of the stablecoins legislation. He stated that there is a high degree of concern amongst the members of Congress that the regulators are unable to keep up with the stablecoin industry, which is growing at an extremely fast pace. Congress is worried that by the time they come up with comprehensive inter-agency solutions the problems surrounding the stablecoins industry will also increase. Since timely regulations are the need of the hour and are a priority for Congress, Jamie Whetzel stated that the stablecoin industry may see something in the shorter run but not in the short-immediate term.

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 detect suspicious activity that could have previously been undetected.