US President’s Working Group Releases Report Recommending Payment Stablecoin Regulation
On November 1, 2021, the US President’s Working Group on Financial Markets, along with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (together, the “Agencies”) released its Report on Stablecoins (the “Report”). In the Report, the Agencies identified potential risks posed by, and potential regulatory gaps relating to, payment stablecoins (stablecoins used as a means of payment that are designed to maintain a stable value relative to a fiat currency) and provided recommendations for a regulatory framework to address those risks and regulatory gaps.
Notably the Agencies recommended that “Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.” This legislation would supplement and complement applicable requirements under anti-money laundering (“AML”) and securities laws.
The Report comes in the context of increasing global focus on stablecoins, including a report from the G7 Working Group on Stablecoins, a report from the Bank for International Settlements, a report from the Financial Stability Board and recent guidance from the International Organization of Securities Commissions (“IOSCO”) and the Committee on Payments and Market Infrastructures (“CPMI”) on the application of the Principles for Financial Market Infrastructures (“PFMIs”) on stablecoin arrangements.
Prudential Risks of Payment Stablecoins
The Report identified three main risks posed by payment stablecoins: (1) the potential for destabilizing runs, (2) disruptions to the payment system, and (3) systemic risks and concentration of economic power.
- Loss of Value: Risks to Stablecoin Users and Stablecoin Runs
One of the key risks identified by the Report is the potential for a run on a stablecoin if users lose confidence in the stablecoin’s redeemability or in its reverse assets. Users’ confidence may be undermined by a number of factors, including reserve assets becoming illiquid, the stablecoin issuer failing to safeguard the reserve assets, uncertainty regarding redemption rights, or operational errors. A run on a stablecoin could result in unstable values for the stablecoin and could also pose a systemic risk to other stablecoins and to the broader financial system.
- Payment System Risks
Secondly, the Report highlights that stablecoins face many of the same risks as traditional payment systems, including operational risk, settlement risk, and liquidity risk. However, these risks may present in novel ways due to stablecoin arrangements’ use of different technologies, transaction processes and governance structures. Additionally, stablecoins may face novel risks, including operational risks relating to the validation of stablecoin transactions and the management of distributed ledgers; settlement risks arising from the coordination of decentralized networks; and liquidity risks if the timing of the settlement of stablecoin transactions is misaligned with other payment systems. When not managed comprehensively, these risks can make payment systems less reliable and may create financial shocks.
- Risks of Scale: Systemic Risk and Concentration of Economic Power
The market for stablecoins has grown rapidly, increasing by almost 500% in the past year. The Report highlights three policy concerns raised by this rapid growth of stablecoins. Firstly, the failure of a stablecoin issuer or a key participant in the stablecoin arrangement (e.g., wallet providers) could adversely affect financial stability and the real economy. Secondly, mergers between stablecoin issuers or wallet providers and commercial firms could lead to an excessive concentration of economic power. And lastly, mass adoption of one stablecoin over others could present concerns about anti-competitive effects in the market.
The Report also specifically outlines the “central” role of stablecoins in facilitating trading, lending, and borrowing activity in decentralized finance (“DeFi”) arrangements, and notes a number of risks associated with DeFi arrangements, including risks of fraud, mutual reliance between stablecoins and trading platforms, leverage, information asymmetries and market integrity risks.
Recommended Regulatory Framework
To address the risks and fill the regulatory gaps relating to stablecoins, the Report recommends the prompt enactment of legislation to ensure that stablecoins and stablecoin arrangements are subject to a consistent and comprehensive federal regulatory framework. The Report recommends that the federal legislation should:
- Require all entities that issue stablecoins, or are engaged in related activities of redemption and maintenance of reserve assets, to be insured depository institutions. Such entities would be subject to supervision and regulation at the depository institution level and at the holding company level.
- Require stablecoin issuers to comply with restrictions that limit their affiliation with commercial entities.
- Require custodial wallet providers to be subject to appropriate federal oversight. Such oversight could include: restricting custodial wallet providers from lending customer stablecoins; requiring compliance with appropriate risk-management, liquidity, and capital requirements; and limits on custodial wallet providers’ affiliation with commercial entities and use of users’ transaction data.
- Provide the federal supervisor with the authority to:
- require any entity that performs activities that are critical to the functioning of stablecoin arrangements to meet appropriate risk-management standards (such as the PFMIs as adapted to stablecoin arrangements); and
- implement standards to promote interoperability among stablecoins or between stablecoins and other payment instruments.
- Provide appropriate regulatory agencies with examination and enforcement authority with respect to stablecoin arrangements.
Given that stablecoins are rapidly developing, the Report recommends that the legislation should provide regulators with flexibility to be able to respond to future developments and adequately address risks across a variety of organizational structures. The Report also recommended that this legislation to be complementary to existing authorities with respect to market integrity, investor protection and illicit finance.
Recommended Next Steps
The Report expressed the view that legislation is urgently needed to comprehensively address the prudential risks posed by stablecoin arrangements. Until such federal legislation is enacted, the Agencies stated that they are committed to continued collaboration on issues of common interest and to taking action to address the risks that fall within their jurisdiction, including efforts to ensure that stablecoins and related activities comply with existing legal obligations.
In the absence of a federal regulatory framework, the Report recommends that the Financial Stability Oversight Council (“FSOC”) consider taking steps to limit the risk of stablecoins, including designating certain stablecoin activities as systemically important payment, clearing, and settlement activities. Such a designation would allow for the establishment of risk-management standards applicable to stablecoin activities, including requirements relating to the assets that back stablecoins and the operations of stablecoin arrangements.
In Canada, the Bank of Canada has issued a staff discussion paper outlining a proposed three-step framework that authorities can use to assess the risks of a stablecoin arrangement:
- “classifying the stablecoin arrangement into three parts—coin structure, related transfer system(s) and related financial service(s)—and categorizing the attributes of each part
- identifying specific risk scenarios that are relevant to the stablecoin arrangement
- quantifying the range of probable loss and possible frequency associated with the identified risk scenarios”
Existing regulatory frameworks would also apply, including securities laws, AML laws and existing federal legislation addressing financial stability and/or systemic risk concerns, including in connection with designated clearing and settlement systems and the potential application of PFMIs.
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