Making Stablecoins More Stable

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Scholar emphasizes the need for regulatory safeguards for stablecoins.

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Stablecoins make up several hundred billion dollars of the total cryptocurrency market. But they also can pose serious risks in the event of economic downturns, such as occurred with the recent collapse of the cryptocurrency market. Although the recent collapse did not significantly affect other financial sectors, one scholar argues a future crash of stablecoin providers could have drastic repercussions on the larger economy.

According to law professor Arthur E. Wilmarth, Jr., stablecoins’ risks will only continue to increase without sensible regulatory safeguards. Specifically, he argues that requiring banks that are insured by the Federal Deposit Insurance Corporation (FDIC) to be the sole distributors of stablecoins is the only way to ensure that consumers are sufficiently protected.

In a recent comment letter submitted to the U.S. Department of the Treasury, Wilmarth describes stablecoins’ risks as stemming from their connection to cryptocurrency more generally. These stablecoins are a type of cryptocurrency whose value is intended to be tied to the value of a traditional currency.

Wilmarth points to two main types of stablecoins: asset-based and algorithmic, the latter of which depend on arbitrage trading.

The majority of stablecoins are asset-based and tied to the value of the U.S. dollar—making the risk of investing in these type of stablecoins appear relatively modest, at least as long as the dollar retains its value.

The value of algorithmic stablecoins, however, is based on complex trading activities—posing greater risk of volatility, similar to cryptocurrencies such as Bitcoin.

Regardless of the type of stablecoin, the perception of stability can be deceiving to consumers unaware of their potential dangers. Wilmarth argues that stablecoins of both types pose several risks that call for regulatory oversight.

One type of risk relates to a financial collapse. In the lead-up to the recent cryptocurrency collapse, the largest arbitrage-based stablecoin on the market, Terra, went bankrupt. Terra’s bankruptcy, Wilmarth notes, caused the bankruptcy of a large hedge fund that invested in Terra—Three Arrows—and the ensuing “domino effect” led three major cryptocurrency exchanges to declare bankruptcy as well.

This scenario, Wilmarth suggests, has the potential for disastrous ramifications in a future crypto crisis that could lead to a full-blown economic downturn. This is due not only to the new significance of stablecoins as a backbone of the crypto market, but also because of the increase of connections to other financial market actors such as Three Arrows, Wilmarth argues.

Connections between traditional markets and crypto markets will continue to increase, Wilmarth explains. He points, for example, to mass market crypto advertising such as during the 2022 Super Bowl as well as to the increase in investments in crypto corporations and digital assets by more traditional investors. The three biggest stablecoins comprise 90 percent of the stablecoin market. If one would fail, a “generalized panic” could ensue, Wilmarth worries.

In addition, if a particular stablecoin is used widely in everyday financial transactions, the collapse of that stablecoin can send ripple effects throughout the economy. Companies such as PayPal have reported an interest in developing stablecoins for everyday transactions. If that were to develop, one major stablecoin provider going bankrupt could significantly bring down the value of PayPal—or worse. Stablecoin distributors could also become a sort of “shadow bank”.

Wilmarth cautions that these shadow banks may seem like banks to consumers by offering deposits and traditional banking services, but they would be exempt from compliance with banking regulations designed to protect consumers.

Regulations such as the prohibition on the dual functions of commerce and banking for commercial companies that distribute stablecoins prevent perverse incentives. Allowing a bank both functions runs afoul of the foundational policy of separation of commerce from banking in the United States, according to Wilmarth. A corporation that combines these functions by taking deposits and issuing stablecoins would gain access to information on consumers’ spending and saving habits. These corporations would then have perverse incentives to exploit that information to the detriment of consumers, Wilmarth emphasizes.

Wilmarth argues that the best solution to mitigate the current and future risks stablecoins pose to the financial market and society at large is for Congress to require stablecoin distributors to be FDIC-insured banks. Wilmarth’s solution would also require labeling stablecoins as deposits and making stablecoin transactions fall under banking laws and regulations.

Mandating stablecoins only be distributed by federally insured banks would further allow federal regulators to provide oversight, which would mitigate anticompetitive behavior and ensure consumer protections from predatory business practices. Furthermore, Wilmarth contends that FDIC insurance protects against the possibility of an unfettered investor run on stablecoin deposits. This is similar to runs on traditional banks that led to the creation of the FDIC in 1913.

Runs on banks also caused financial turmoil in the 1930s and could cause serious disruptions or large scale devaluations of crypto markets without FDIC protections, Wilmarth argues. This solution also would prevent stablecoin distributors from engaging in the dual function of banking and commerce that is currently legal.

Wilmarth concludes by cautioning Congress against allowing uninsured banks to distribute stablecoins and allowing stablecoin distributors to be regulated as anything other than a bank.

Wilmarth’s comment letter comes in response to President Joseph R. Biden’s executive order on digital assets issued in March 2022. The order sought comments to aid in the creation of plans for the development of digital asset markets with proper consumer protections. According to Wilmarth, the only way to protect consumers is to limit stablecoin distribution to FDIC-insured banks exclusively.