Stablecoin: The Regulation Debate
“If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system.” Report on Stablecoins, President’ Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, November 2021.
“My point with stablecoins was that they’re like money funds, they’re like bank deposits, and they’re growing incredibly fast, but without appropriate regulation. If we’re going to have something that looks just like a money market fund or a bank deposit or a narrow bank and it’s growing really fast, we really ought to have appropriate regulation and today we don’t." FRB Chair Jerome Powell, Before the Senate Banking Committee (recording at 2:14:06), July 15, 2021
Last month, the President’s Working Group on Financial Markets (PWG) called for the introduction of a regulatory framework for “payment stablecoins”—private crypto-assets that (unlike the highly volatile Bitcoin) are pegged 1:1 to a national currency and “have the potential to be used as a widespread means of payment.” Consistent with earlier recommendations from the Financial Stability Board (FSB) and the Financial Action Task Force (FATF), the PWG is pushing for a comprehensive framework that addresses a range of concerns about stablecoins—from consumer protection and concentration to financial stability and illicit finance. The goal of the authorities is to support innovation consistent with an efficient and resilient financial system.
Most notably, to limit the risk of runs, the Report calls for legislation restricting stablecoin issuance to insured depositories (see citation above). Furthermore, to control other risks to the payment system, the Report seeks federal oversight of “wallet” providers—entities that store and transfer stablecoins. Not surprisingly, this brought the simmering public discussion about stablecoin regulation to a boil.
The PWG-proposed framework is very far from current reality. Today, stablecoins are issued by nonbanks without any broad legal or regulatory framework (see, for example, Chairman Powell’s quote above). Hoping to attract the potentially lucrative business of nonbanks who facilitate the issuance and use of stablecoins, some state regulators are stepping into the vacuum.
In this post, we first document the rapid growth of stablecoin usage. We then highlight the features which make stablecoins subject to run risk that, in the absence of appropriate governmental controls, could destabilize the financial system. Next, we consider the three regulatory approaches that Gorton and Zhang (GZ) propose for making stablecoins resilient: the first, and the one favored by the PWG, is to limit stablecoin issuance to insured depositories; the second is to require 1:1 backing of stablecoins with sovereign securities (in the case of the United States and the U.S. dollar, these would be U.S. Treasury issues); and the third is to require 1:1 backing with central bank reserves. We conclude with a brief discussion of whether central bank digital currencies are an appropriate means to displace stablecoins.
To foreshadow our conclusions, we view the PWG proposal as the preferred alternative. However, absent near-term prospects for legislative action, we hope that the Financial Stability Oversight Council (FSOC) will consider—as GZ suggest—using its powers under the Dodd-Frank Act to designate the issuance of payments stablecoins as an activity that is “likely to become” systemically important. FSOC designation would authorize the Federal Reserve to promote uniform standards without waiting years for legislation that authorizes a new regulatory framework.
Rapid Growth of Stablecoins. According to Coinmetrics, since the start of 2020, the market capitalization of leading stablecoins grew from $5.6 billion to $140 billion (see chart)! That is an increase of nearly 25 times over two years—meaning that, on average, the value of outstanding stablecoins doubled every five months. (For comparison, as of October 31, 2021, U.S. assets of institutional plus retail prime money market funds totaled $368 billion.) Given how young this market is, we can expect further growth, with the pace sensitive to the possibility of new entry associated with large tech firms (such as Meta’s Diem). The stablecoin with the largest market capitalization today, Tether (gray shading), was launched only in 2014. The second largest, USD Coin (red shading), followed in 2018.
Top stablecoins: market capitalization (Billions of dollars), 1 Jan 2020 – 9 December 2021
Source: Coinmetrics. Note: According to coingecko.com, as of 9 December 2021, Tether and USD Coin account for about 54 percent of total stablecoin capitalization of $161.5 billion.
Stablecoin trading volume is growing rapidly and is now large. According to Mizrach, a narrow measure of trading—limited to transactions on the Ethereum network itself—grew from the first quarter of 2020 to the second quarter of 2021 by a factor of 16, reaching a daily average of $19.4 billion by the middle of this year. However, Mizrach’s estimates imply that trading internal to digital wallets and exchanges is far larger than that on the network, consistent with the view that current demand for stablecoins largely reflects their use to clear trades in other cryptocurrencies (see table below). On a combined basis, Tether dominates stablecoin trading volume: its second-quarter daily average ($127.3 billion) exceeds the latest 10-day moving average of trading on the New York Stock Exchange ($71 billion) and approaches the volume on NASDAQ ($148 billion).
Estimated Daily Average Trading Volume of Stablecoins (Billions of dollars), 2Q 2021
Source: Mizrach, Tables 2 and 11.
What is driving this the rapid increase of stablecoin trading? As the latest FSB Progress Report makes clear, stablecoins currently are “not being used for mainstream payments on a significant scale.” Instead, as far as we can tell, stablecoin volume has two parts. The first reflects the aforementioned transactions in other digital coins (such as Bitcoin or Ether). As their market value rises, the volume of stablecoin trading for this purpose also increases. The second factor is the activity of high-frequency traders (HFT) who, as Mizrach notes, are trying to profit from “small price discrepancies on an exchange or across exchanges.” On the Binance exchange, for example, Mizrach estimates that HFT trading accounts for 57% of Tether volume.
Stablecoin fragility. Like bank deposits, or most money market mutual funds (MMMFs), stablecoins aim at preserving a fixed asset value where one token is worth one unit of national currency. For this purpose, the coin issuers maintain reserves that in theory can be sold to reduce the supply of stablecoins should demand decline. The fact that the liquidity and creditworthiness of these reserves is not always clear means that stablecoin holders could come to doubt the value of the issuer’s assets. Such doubts create first-mover advantage that can trigger a run exactly analogous to the sort we have seen in uninsured bank deposits for centuries and in MMMF shares in recent years. Notably, recent analysis of a 17th century proto-stablecoin—the guilders issued by the Bank of Amsterdam for settling wholesale transactions—shows that a lack of transparency can delay, but ultimately not prevent, the impact of deteriorating reserve quality on confidence (see Frost, Shin and Wierts).
In the case of Tether, the largest and most actively used stablecoin pegged to the U.S. dollar, it is not difficult to imagine how doubts could arise. First, according to Tether’s 2016 Whitepaper, the reserves are held in Hong Kong, not in the United States. Second, the “independent accountant’s” report regarding the reserves is from the Cayman Islands firm Moore Cayman (not a leading U.S. accounting entity). Third, the latest attestation (September 30, 2021) shows that only 40 percent of the reserves are composed of generously defined cash equivalents—cash, bank deposits and MMMFs of unknown geography, and Treasury bills (black portion of the pie chart below). A majority of Tether’s reserves are in the form of commercial paper and certificates of deposit (red, with an average duration of 141 days), secured loans (blue), corporate bonds, funds and precious metals (green) and other instruments (orange; including digital tokens) that are of lesser liquidity. Fourth, to the extent that holders of the stablecoin have any legal claim in bankruptcy on the issuer’s equity, Tether’s gearing ratio (using the ratio of reported assets to the gap between assets and liabilities) is a whopping 473! We question whether this thin slice of capital (0.2% of assets) is adequate even to compensate for operational risk, let alone market risks that affect the value of the reserves. Finally, the CFTC has fined the issuing firm for past misrepresentation of Tether’s collateral, while the New York State Attorney General has banned New York-entity use of Tether products.
Tether: reported composition of reserves (Billions of dollars), September 30, 2021 at 11:59PM UTC
Source: Tether “Consolidated Reserves Report.”
Highlighting the lack of industry (let alone regulatory) standards, USD Coin (issued by Circle) provides significantly greater disclosure than Tether. For example, a top-10 U.S. accounting firm (Grant Thornton) provides a monthly attestation regarding the value and composition of the reserves backing USD Coin. Reserve assets reportedly are held “in segregated accounts” with “U.S. regulated financial institutions.” Moreover, in contrast to Tether, the latest report (October 29, 2021) declares that USD Coin reserves contain no corporate bonds, no foreign bank CDs, and no commercial paper. Instead, USD Coin reserves include bank deposits and other “highly liquid” instruments in a category labeled “cash and cash equivalents.” However, the exact composition of these liquid and cash assets, such as the share held as U.S. Treasury securities, is not specified.
Because they serve as a means of payment in asset trading, stablecoins also have the potential to trigger much broader disruption. Importantly, were trading that is now reliant on a small number of stablecoins to extend well beyond the current use in crypto-asset transactions, then a run on these instruments also could lead to widespread market dysfunction that undermines financial conditions and threatens otherwise healthy financial (and nonfinancial) firms. Put differently, the network externalities that naturally favor concentration of payments in a few instruments also make the financial system more fragile should those instruments fail to provide steadily the liquidity services necessary to keep markets operating. It is precisely for that reason that regulators focus on ensuring payments functionality in all states of the world.
In our view, capital and liquidity requirements will be needed to ensure stablecoins are resilient. Stablecoin advocates argue that such bank-like regulation will stifle innovation or shift it off-shore. However, history is strewn with examples where “financial innovation”—such as the introduction of MMMFs—amounted to little more than the repackaging of risky activity to shift it outside the regulatory perimeter, sometimes leading to a crisis bailout. Indeed, the strongest evidence that stablecoins are a valuable innovation would be if they could flourish under effective prudential regulation.
The regulatory remedies. Gorton and Zhang (GZ) suggest three alternatives for containing the run risk on stablecoins:
Limiting stablecoin issuance to insured depositories
Requiring 100% backing by sovereign securities
Requiring 100% backing by central bank reserves
None of these approaches are problem-free. The PWG has selected the first option. From our perspective, this framework ought to have been applied decades ago to fixed-net-asset-value MMMF shares, which are functionally equivalent to demand deposits (see our earlier post). From an economic perspective, stablecoins are the same as MMMF shares, albeit with the additional feature of being easy to use to settle financial transactions.
Limiting stablecoin issuance to insured depositories would naturally introduce prudential oversight—including common auditing and disclosure standards as well as capital and liquidity requirements. Regarding capital and liquidity, regulators can set these requirements proportionate to the risks to the financial system that particular stablecoins present, in the same way they do for banks.
The claim of stablecoin advocates that prudential oversight would snuff out innovation ignores the massive investments that private banks routinely make to promote efficiency and better serve their customers. Indeed, if the claimed technological benefits of stablecoins make their issuance lucrative in the absence of regulatory arbitrage, we expect that profit-seeking banks would invest aggressively to exploit the opportunity. The claim that prudential oversight will shift innovation abroad merely highlights the need for international cooperation and coordination to avoid criminal exploitation of the payments system and preserve the ability of authorities to monitor and address systemic threats (see our earlier post).
In our view, the key problem with forcing stablecoin issuers to be insured depositories is that, at least in the United States, it requires Congressional action that could take years. In the interim, until appropriate legislation creates a credible regulatory framework, a continued rapid expansion of stablecoin use would pose a growing risk to financial resilience and make it increasingly difficult to restore a level playing field among payments providers. Indeed, stablecoins already have created a powerful constituency that could hinder effective regulation. As the history of MMMFs demonstrates, once fragile payments instruments proliferate and become large enough, it becomes very difficult to change them. Even after two federal bailouts (in 2008 and 2020), MMMFs retain widespread political support, and there remains little progress toward reforms (including capital and liquidity requirements) that would make them resilient (see our earlier post). Lacking such reform, MMMFs will continue to enjoy an implicit federal guarantee at the cost of U.S. taxpayers (and their prudentially regulated competition).
Option 2—100% sovereign backing—requires that government debt managers ensure an adequate supply of suitable collateral both in normal times and in periods of financial stress. More specifically, the supply of very short-term sovereigns would have to increase sufficiently to satisfy stablecoin use, in addition to current uses. Moreover, that supply would need to be highly elastic to accommodate sudden changes in trading activity that boost or diminish stablecoin use. We note that in the United States, very short-term Treasuries enjoy a convenience premium that implies scarcity. Increasing the supply massively to satisfy stablecoin needs eventually could lead to large (potentially unacceptable) rollover risk for the federal debt.
Option 3—100% central bank reserve backing—creates narrow banks that, while themselves safe, could weaken the supply of bank credit and cause financial instability elsewhere. Narrow banking simply shifts runs elsewhere in the financial system. For example, if narrow bank stablecoins attract funds that otherwise would have flowed to legacy banks, who will provide the credit to households and businesses? Were that activity to shift to mutual funds, then these funds also would be vulnerable to runs by virtue of the illiquid assets that they hold. (For a discussion of the financial stability risks arising from a system of narrow banks, see our earlier posts here and here. For recent evidence on the fragility of mutual funds holding illiquid assets, see here.)
Finally, we should mention that some advocates of central bank digital currency (CBDC) argue that a key benefit of CBDC is that it would displace privately issued stablecoins. While CBDC could render private stablecoins useless, we see this as a poor motivation for introducing CBDC. First, as the PWG advocates, limiting stablecoin issuance to insured depositories ought to be sufficient to limit run risk and secure the payments system. Second, the introduction of CBDC would come with other serious risks—including the potential for disintermediation that would tempt central banks to become state banks and for currency substitution that could be destabilizing to many countries—that may well exceed the benefits (see our recent note and an earlier post).
Conclusion. Ultimately, we view the President’s Working Group proposal to require stablecoin issuers to be insured depositories as the solution most likely to both encourage innovation and safeguard stability. However, absent legislative prospects for reform, and following Gorton and Zhang’s suggestion, we encourage the Financial Stability Oversight Council to consider designating payments stablecoin issuance as an activity that is “likely to become” systemically important under the Dodd-Frank Act, thereby authorizing the Federal Reserve to promote uniform standards.
Acknowledgements: We thank Professor Bruce Mizrach for providing data on stablecoin trading volume and helping us to understand it. We also thank Ethan Cecchetti for explaining aspects of the Ethereum network and blockchain transactions.