How should the United States regulate stablecoins?

Author: Marcelo Prates, CoinDesk; Translator: Baishui, Golden Finance

In a recent podcast, Hilary Allen, a law professor at American University, portrayed stablecoins as a dangerous threat to the banking system and the public at large. In her view, stablecoins could destabilize banks and ultimately require government bailouts.

Her comments come as the U.S. Congress pushes to regulate stablecoins at the federal level. While the chances of any stablecoin bill becoming law in a presidential election year are slim, Allen worries that these bills “give public support for stablecoins.” For her, “stablecoins do not serve any significant purpose and, frankly, should be banned.”

Are her concerns justified? Only for those who are against competition and don’t like regulatory clarity. What Allen describes as a scary and useless trend is an updated version of one of the most revolutionary financial innovations of the past 25 years: electronic money issued by non-bank institutions, or e-money for short.

In the early 2000s, the European Union decided that it was time to give more people access to faster and cheaper digital payment methods. With this in mind, E.U. lawmakers created a regulatory framework for e-money and allowed startups to make the most of technology, so-called fintechs, to offer payment instruments in a regulated and secure way.

The idea behind it is simple. Since banks are complex institutions offering multiple services, subject to higher risks and stricter regulation, it is usually difficult and costly to open a bank account for digital payments. The solution is to create a separate licensing and regulatory regime for non-bank institutions, focused on one service: converting the cash they receive from customers into e-money that can be used for digital payments via prepaid cards or electronic devices.

In effect, e-money issuers operate like banks in a narrower sense. They are required by law to safeguard or insure the cash they receive from customers so that e-money balances can always be converted back into cash without loss of value. Because they are licensed and regulated entities, customers know that, barring egregious regulatory failures, their e-money is safe.

It is therefore easy to see that the vast majority of existing stablecoins, i.e. those denominated in sovereign currencies such as the dollar, are simply e-money with a certain feature: because they are issued on a blockchain, they are not constrained by national payment systems and can circulate globally.

Stablecoins are not a horrible financial product, but rather a true “e-money 2.0” that has the potential to continue to deliver on the original e-money promise of increasing competition in the financial sector, lowering costs for consumers, and promoting financial inclusion.

But to deliver on those promises, stablecoins do need to be properly regulated at the federal level. Without federal law, U.S. stablecoin issuers will continue to be subject to state money transmission laws that are not uniformly designed or consistently enforced with respect to segregation of customer funds and the integrity of reserve assets.

Given the EU’s decades of experience in the e-money space and improvements brought about by other countries, effective stablecoin regulation should be built around three pillars: granting non-bank licenses, direct access to central bank accounts, and bankruptcy protection for backing assets.

First, it is contradictory to restrict the issuance of stablecoins to banks. The essence of banking is the possibility of holding deposits from the public, but these deposits are not always 100% backed, traditionally known as "fractional reserve banking". This allows banks to make loans without using their capital.

On the other hand, For stablecoin issuers, the goal is that each stablecoin is fully backed by liquid assets. Their only job is to receive cash, provide stablecoins in return, safely keep the cash received and return the cash when someone brings the stablecoin to exchange. Lending money is not part of their business.

Stablecoin issuers, much like e-money issuers, are designed to compete with banks in the payments sector, especially in cross-border payments. They should not replace banks, or, worse, become banks.

That is why stablecoin issuers should obtain a specific non-bank license, just like e-money issuers in the EU, UK and Brazil: a license with simpler requirements, including capital requirements, proportional to their limited activities and lower risk. They do not need a banking license, nor should they be required to obtain one.

Second, to reduce the risk status quo, stablecoin issuers should be able to have a central bank account to hold their backing assets. Transferring cash received from customers to a bank account or investing in short-term securities are generally safe options, but both options can also carry greater risks.

Circle, a US stablecoin issuer, is in trouble due to the collapse of Silicon Valley Bank (SVB), and its $3.3 billion cash reserves (almost 10% of total reserves) deposited with SVB are temporarily unavailable. And several banks holding US Treasury bonds, including SVB, suffered losses after interest rates rose in 2022, and the decline in Treasury market prices has caused some of these banks to be short of liquidity and unable to withdraw.

In order to avoid problems in the banking system or Treasury market spreading to stablecoins, issuers should be required to deposit their backing reserves directly with the Federal Reserve. This rule will effectively eliminate credit risk in the US stablecoin market and enable real-time supervision of stablecoin support-no deposit insurance is required, and there is no risk of bailout, just like electronic money, as opposed to bank deposits.

Note that central bank accounts of non-bank institutions are not unprecedented. Electronic money issuers in countries such as the United Kingdom, Switzerland and Brazil can protect users' funds directly through the central bank.

Third, customers’ funds should be considered separate from the issuer’s funds under the law and should not be subject to any bankruptcy regime if the stablecoin issuer fails (for example, due to the emergence of operational risks such as fraud).

With this additional layer of protection, stablecoin users can quickly regain access to their funds during the liquidation process, as general creditors of the bankrupt issuer will not be able to seize customer funds. Again, this is considered best practice for e-money issuers.

In the public debate on stablecoin regulation, shocking practices may impress distracted audiences. However, for those paying attention, balanced arguments based on successful examples and experiences from around the world should prevail.