A Simple Proposal for Regulating Stablecoins

There is nothing inherently problematic about a federal regulatory framework for stablecoins, and a properly structured one would likely spur further innovation to the U.S. payments system, benefiting millions of people. However, the Biden administration is promoting a misguided approach that will discourage innovation and keep beneficial payments innovations—and the companies that create them—out of the United States. This briefing paper proposes a better regulatory framework for the most common types of stablecoins: straightforward rules based on preventing fraud and promoting transparency.

Stablecoins are special cryptocurrencies designed to maintain a stable value rather than be subject to the volatile price movements seen with other digital currencies, such as Bitcoin and Ethereum. The general idea behind stablecoins is that their stable value will help promote their use as a widespread medium of exchange, but they have not yet achieved that status. The most common use for stablecoins is transferring money between crypto exchanges. Currently, the market capitalization of all stablecoins is $130 billion.⁴

Although the details can differ widely, all stablecoins aim to achieve price stability by tying their value to some other asset. Some of the most popular stablecoins tie their price to national fiat currencies, such as the U.S. dollar, but some anchor their price to precious metals, short-term corporate debt, or even other cryptocurrencies. Most stablecoins try to achieve price stability by using cash and short-term securities as collateral, but others hold no assets in reserve.⁵ The proposal in this briefing paper recommends a regulatory framework only for stablecoins that collateralize with cash and short-term securities.

One of the oldest stablecoins is Tether, which is fully backed by reserves that, according to its website, include “traditional currency and cash equivalents and, from time to time … other assets and receivables from loans made by Tether to third parties.”⁶ Tether is also the largest stablecoin, with a market value of $68 billion.⁷ Another popular stablecoin is USD Coin (USDC), which has more than $32.5 billion in circulation and claims to be “fully backed by cash and equivalents and short-duration U.S. Treasuries, so that it is always redeemable 1:1 for U.S. dollars.”⁸ The biggest financial risk from stablecoins is whether the issuing entity has the reserves that it claims to have.⁹

Multiple countries increased their regulatory scrutiny of stablecoins when Facebook, with its network of several billion people, announced its Libra stablecoin project (it is now referred to as Diem). Several members of Congress, for instance, expressed concerns that digital currencies might undermine the dollar and potentially have an “unprecedented impact on the global financial system.”¹⁰ Naturally, these types of concerns ignore that monetary competition—even just the credible threat of such competition—can help expose weaknesses and inefficiencies in existing monetary systems.

Rather than acknowledge these possible benefits, the Biden administration’s new report endorses several ideas that proponents of strict stablecoin regulations have been promoting for years. The report’s main recommendation—that only federally insured depository institutions be allowed to issue stablecoins—is profoundly anti-competitive and in direct conflict with the administration’s stated goal of guarding against an “excessive concentration of economic power.”¹¹ Recommending that the FSOC review whether stablecoins threaten financial stability is both misguided and, at best, delays providing a clear regulatory framework.¹²

These and other ideas promoted by advocates for strict stablecoin regulations are ill-advised. Some proposals fail to provide the much-needed clarity that the cryptocurrency industry needs, and others are based on a fundamentally flawed concept of stablecoins. Some share both of these weaknesses.

For example, regulating stablecoins like bank accounts is not a good solution because unlike bank deposits, stablecoins serve a niche payment function for transferring funds between crypto exchanges without having to transfer back and forth into a national fiat currency. The stability of a stablecoin’s value is tied to other assets, and stablecoin holders know that they can only convert into a national fiat currency by selling their coins. Moreover, there is no readily apparent justification for forcing federal taxpayers to back firms that issue stablecoins.

Some have suggested regulating stablecoins like money market mutual funds, but that solution is no better. Unlike money market mutual funds, stablecoins are not investments and are designed to maintain a stable value without offering the traditional principal-interest component of a capital market investment.

Former Commodity Futures Trading Commission (CFTC) chairman Timothy Massad has suggested that the FSOC require the Federal Reserve to regulate stablecoins as a systemically important payment activity.¹³ But such an approach merely assumes that these coins pose systemic risks to financial stability—an assumption that is not warranted.¹⁴

Similarly, all the proposals that the administration has endorsed appear to be driven by the desire to prevent stablecoin use from growing and to isolate the banking industry from competition. The proposals go much farther than needed, thus threatening to inhibit beneficial innovations in the payments system.

The greatest risk for most stablecoin holders is whether the issuing entity has the reserves that it claims to have. A lack of transparency about the reserves that are used to stabilize the coin’s value prevents a holder from evaluating the issuer’s claims about stability and does little to protect holders from fraudulent misconduct.

A good regulatory framework addresses this issue by providing basic collateral requirements and requiring a baseline for transparency. While state laws generally provide protection against deceptive or unfair practices (and the state of New York did sue Tether for deceptive trading practices), dealing with up to 50 separate state laws is cumbersome and costly for both issuers and holders.¹⁵ Therefore, it makes sense to have a streamlined federal regulatory framework for stablecoin issuers.¹⁶

This briefing paper suggests creating such a proper federal framework by requiring a stablecoin issuer to be regulated as a newly created “limited purpose investment company.” A limited purpose investment company would be subject to basic reserve requirements and mandatory disclosure of relevant information about reserve holdings. This framework would be designed to regulate the reserves that stablecoin issuers claim to hold and, therefore, the actions that issuers undertake to maintain a stable coin value.

Congress could create such a framework, for example, by amending the Investment Company Act,¹⁷ which would give the Securities and Exchange Commission (SEC) unambiguous regulatory authority over most stablecoin issuers, that is, those that collateralize with cash and securities.¹⁸ First, Congress would need to add a new § 80a‑3(a)(2) (renumbering the current § 80a‑3(a)(2) to § 80a‑3(a)(3)) to the Investment Company Act, defining a limited purpose investment company as follows:

Second, Congress would add the following language to create § 80a–65:

The Biden administration has missed an opportunity to provide the much-needed clarity that the blockchain industry has been seeking for close to a decade. Its new report claims that stablecoins pose a wide variety of risks to users and broader markets, and argues that both the SEC and CFTC have broad enforcement, oversight, and rule­making authorities that might address these risks. Yet, rather than provide concrete proposals that address actual risks, the administration calls on Congress to pass legislation that might mitigate a variety of potential risks. Perhaps worse, the report recommends legislation that would insulate traditional banks from competition and also force taxpayers to stand behind stablecoin issuers.

Just as in other areas of the economy, excessive government regulation prevents financial firms from best serving the needs of their customers and, therefore, society. Federal officials have no special knowledge regarding the best way to serve financial-market participants. Financial companies do not require rules and regulations that replace the judgment of owners, employees, and investors with those of government bureaucrats. The administration’s new proposals for regulating stablecoins will stifle innovation and shift risk from financial market participants to taxpayers who are not otherwise exposed to stablecoin risk. This briefing paper offers a superior alternative, one that will foster innovation while adequately addressing the main risks that stablecoin users face. Unlike the administration’s proposal, this plan is entirely compatible with a free-enterprise system based on limited government principles.