Stablecoins: Background and Policy Issues

Stablecoins: Background and Policy Issues

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November 10, 2021
Stablecoins: Background and Policy Issues
Stablecoins are digital assets generally designed to maintain
Stablecoins’ Investment Fund-Like Structure
a stable value by linking the value to a national currency or
Stablecoins often have reserve asset portfolios that hold
other reference assets. The term stablecoin does not affirm
assets backing the coins’ values. Many industry observers
that a particular coin actually achieves a stable value. Some
and some regulators believe that the general processes
consider terms such as private asset-linked tokens as better
involving stablecoins’ creation, distribution, and
descriptors considering the nature of the instruments. The
redemption and the mechanism of keeping the stablecoin
top four stablecoins by value (Tether, USD Coin, Binance
price in line with the value of the reserve basket is similar
USD, and Dai) reached around $128 billion in market
to certain common types of investment structures, such as
capitalization as of November 10, 2021, according to
ETFs and MMFs, which are regulated by the Securities and
CoinMarketCap.
Exchange Commission (SEC).
Many stablecoins have different operational structures and
Some stablecoins’ perceived investment fund structure has
reserve compositions (Figure 1). Reserve assets backing
captured congressional attention in recent years. For
stablecoins could include fiat currencies, traditional
example, the Meta Platforms–backed stablecoin Diem
financial assets, or other digital assets and algorithms.
(formerly known as Facebook-backed Libra) has attracted
Many stablecoins at the current stage of development are
congressional inquiries since its announcement in 2019. At
primarily used for payments functions to facilitate digital
related congressional hearings, Facebook received multiple
asset trading and lending. Although stablecoins represent a
questions regarding whether Libra was an ETF and how it
small fraction (5%) of the digital asset industry’s total
should be regulated. Facebook argued at the time that Libra
value, they facilitate more than 75% of trading on all digital
was a payment tool instead of an investment vehicle
asset trading platforms as of October 31, 2021. Stablecoin-
because “you cannot use an ETF for payments” and
related policy concerns include issues related to market
believed it did not meet the legal criteria used to determine
integrity, investor protection, financial stability, monetary
if a financial instrument is a security. In the ensuing years,
policy, payments, and illicit activity prevention.
the firm also launched its digital wallet pilot program
(Novi) and paired it with USDP, an existing stablecoin from
Figure 1. Stablecoin Reserve Composition
Paxos. Five Senators wrote a letter to Facebook in October
2021 to urge the company to “immediately discontinue your
Novi pilot and to commit that you will not bring Diem to
market.”
If a stablecoin were to be deemed an ETF or MMF (either
through interpretation of the existing legal frameworks and
SEC authorities or the creation of new frameworks and
authorities through legislation), it would be required to
comply with the SEC’s regulatory regime governing
securities, investment advisors, and investment companies.
In this case, SEC approval would be required to launch
stablecoin projects.

Stablecoins’ Money and Payment Features
Source: CRS based on data from International Monetary Fund,
Some observers also consider stablecoins to offer parallels
Global Financial Stability Report Chapter 2, October 2021, p. 8,
to money and payment systems. They view stablecoins as a
https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/
new form of private money that closely resembles the
English/ch2.ashx.
“wildcat” banknotes of the mid-19th century. During the
Functions and Structures
“wildcat” or “free banking” era (1837-1863), state-
Stablecoins’
chartered banks issued their own currencies and sometimes
use could find parallels in traditional payment
refused to redeem the currency for precious metals as they
systems, banking, or other forms of financial infrastructure
had promised they would. This era ended with the National
service. In addition, stablecoins’ management and
Bank Act of 1863, which established the Office of the
structuring of the reserve funds resemble existing practices
Comptroller of the Currency (OCC) and charged it with
at money market mutual funds (MMFs) and exchange-
responsibility for nationally chartered banks and a uniform
traded funds (ETFs).
national currency. When discussing stablecoins, some
regulators reference the wildcat era, questioning the “long-
term viability for five or six thousand private forms of
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Stablecoins: Background and Policy Issues
money.” Some academic researchers argue that to function
the Financial Crimes Enforcement Network (FinCEN), a
as money, the financial instrument must satisfy the “no-
bureau of the Treasury Department that implements the
question-asked” principle (NQA), which requires the
Bank Secrecy Act, the main federal anti-money-laundering
money to be accepted in a transaction without due diligence
law. For example, money transmitters are required to obtain
on its value. Stablecoins (in their current forms) appear to
and verify customer identity and record beneficiary
have challenges satisfying the NQA principles.
information and file “Suspicious Activity Reports” for
certain transactions. Some transactions are also subject to
How Stable Are Stablecoins?
tax reporting. In addition, the Consumer Financial
Stablecoins have attracted discussions regarding potential
Protection Bureau may have a consumer protection role for
fraud and manipulation and the need for disclosure and
certain stablecoin-enabled electronic payments.
transparency. The largest stablecoin, Tether ($74 billion in
market value as of November 10, 2021), for example, was
Custody regulation. Some stablecoin companies have
created in 2014 with the promise of a one-to-one backing
sought to be allowed to provide digital asset custody
with the dollar, its corresponding fiat currency. Reporters
services by obtaining state and federal trust or custody bank
and market participants have been seemingly unable to
charters. Custodians provide safekeeping of financial assets.
verify Tether’s portfolio holdings. An investigation by the
They are financial institutions that do not have legal
New York attorney general’s office subsequently revealed
ownership of assets but are tasked with holding and
that it was not fully backed as advertised at all times,
securing assets, among other administrative functions. Both
raising investor-protection concerns.
securities regulators and banking regulators have developed
custody regulation to impose requirements designed to
In addition to investor protection concerns for individual
protect client assets from the possibility of being lost or
stablecoin holders, industry observers and regulators have
misappropriated. The SEC’s custody rule obligates SEC-
voiced concerns about stablecoins’ potential systemic
registered investment advisers to engage with “qualified
risk—that losses or instability of stablecoins could generate
custodians,” which could include banks. Aiming to fulfill
distress in other markets. Even without the influence of
such requirements, certain stablecoins have been issued by
adverse market conditions, certain stablecoins have already
state-chartered trust companies. For example, stablecoins
displayed run-like behavior (e.g., a large number of
Binance Dollar and Paxos Dollar are issued by Paxos Trust
investors withdrawing their investments simultaneously,
Company, and the Gemini Dollar is issued by Gemini Trust
which could potentially trigger negative feedback loops and
Company. These stablecoin trust company issuers would
contagion effects). For example, a run-like scenario already
have to comply with certain prudential supervision and
occurred in June 2021 involving stablecoin Iron and its
examination requirements at the state level. Paxos has also
reserve asset Iron Titanium token (Titan). Titan saw its
reportedly received “preliminary conditional approval” for
price crash to near zero from around $60 within one day,
a U.S. national trust charter from the OCC that could
and stablecoin Iron traded off the peg at $0.69. In addition,
subject the company to federal level regulation if fully
certain stablecoins, including the fourth-largest stablecoin,
approved.
Dai, can be susceptible to the use of financial leverage,
which could multiply risk and return and in turn draw
Policy Recommendations
financial stability concerns when used excessively.
Many observers have acknowledged the gaps in the existing
stablecoin regulatory frameworks and suggested policy
In response to the rapidly developing conditions, the
alternatives. The PWG report and the Stablecoin
Financial Stability Oversight Council (FSOC) added
Classification and Regulation Act of 2020 (STABLE Act;
stablecoins to its November 2021 meeting agenda, and the
H.R. 8827 in 116th) recommended that Congress subject
President’s Working Group on Financial Markets (PWG)
certain stablecoins to banking regulation. The Managed
published a report on stablecoins in November 2021.
Stablecoins are Securities Act of 2019 (H.R. 5197 in 116th)
suggested heightened regulation through securities laws.
Applicable Stablecoin Regulation
Policy alternatives for stablecoins include potentially
Investment regulation. Depending on design features and
regulating them as (1) MMFs, (2) MMFs plus heightened
other factors, a particular stablecoin may legally be a
prudential measures such as capital and liquidity
security, commodity, and/or derivative and thus subject to
requirements, (3) special bank charters, (4) insured
federal securities laws (primarily implemented by the SEC)
depository institutions, (5) FSOC-designated systemically
or the Commodity Exchange Act (primarily implemented
important entities, and (6) under a separate new framework
by Commodity Futures Trading Commission [CFTC]). The
with one designated regulator for digital asset markets.
SEC chairman said in a speech that stablecoins may be
securities and investment companies that fall under the
CRS Resources
agency’s oversight. The CFTC has asserted its jurisdiction
CRS Report R46208, Digital Assets and SEC Regulation,
by taking enforcement actions against Tether for “making
by Eva Su.
untrue or misleading statements and omissions of material
fact.”
CRS Report R46486, Telegraphs, Steamships, and Virtual
Currency: An Analysis of Money Transmitter Regulation,
Payment regulation. The digital asset trading platforms
by Andrew P. Scott.
stablecoins currently transact on are often state-registered
enterprises called money transmitters. Money transmitters
Eva Su, Analyst in Financial Economics
are subject to registration and reporting requirements from
IF11968
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Stablecoins: Background and Policy Issues

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https://crsreports.congress.gov | IF11968 · VERSION 1 · NEW