LianGuairadigm Stablecoins should not be regulated as banks and money market funds

Author: Brendan Malone, LianGuairadigm; Translator: LianGuai0xxz

1. Abstract

Stablecoins offer an opportunity to upgrade and meaningfully expand digital-age payment systems. However, despite ongoing technological advancements worldwide and the continuous demand from customers in today’s digital economy, recent regulatory actions and certain aspects of current legislative proposals are forcing cryptographic payment tools into existing banking and securities frameworks, which would be a step backward.

Instead, if legislative work in this area continues to progress, they should focus on three key goals:

To address the risks faced by users of stablecoins pegged to the US dollar, legislation may require centralized issuers of stablecoins pegged to the US dollar to meet appropriate risk management standards. For fiat-backed stablecoins, the issuer of such stablecoins claims to guarantee redemption at face value, which may include holding reserve assets, proving they are 1:1 matched with outstanding stablecoin balances, composed of central bank liabilities or short-term government bonds, segregated from the issuer’s own assets, not subject to creditor proceedings, and subject to evaluation or audit. Importantly, these issuers do not need to be banks and do not need to be subject to comprehensive banking-like regulation.

To promote growth and competitiveness, legislation can prioritize orderly and effective competition between stablecoins and related services and existing banks. This includes setting clear fences to ensure that the regulatory framework for stablecoins and traditional payment infrastructure regulations have objective, risk-based, and publicly disclosed eligibility, allowing banks and regulated non-bank entities to obtain licenses fairly and openly at the state and federal levels. Access for end users, whether businesses or individuals, should also be open.

To encourage responsible stablecoin innovation, legislation can provide a broad range of payment and related services to consumers and businesses while meeting baseline security requirements. Regulation should not dictate that all stablecoins must be pegged to the US dollar, should not broadly prohibit algorithmic stablecoins or stablecoins with overcollateralized on-chain assets, but should explicitly allow for experimentation and innovation within additional rules that are commensurate with basic consumer protection and the level of stability, complexity, and scale.

2. Background

Although recent proposals in the US Congress allow stablecoins to be issued outside of banks, policy discussions surrounding appropriate regulations often focus on traditional safety and soundness principles of bank regulation, such as capital requirements or risk management frameworks associated with securities, such as money market funds (MMFs).

However, given the unique risks of stablecoins and the current use cases, traditional banking and securities frameworks are a poor model for regulating stablecoins. If policymakers want to seize the opportunity to develop regulations that are suitable for the current situation, they should achieve this goal by promoting openness and competition more than the current banking or securities frameworks.

Specifically, although it is crucial to address prudential and market risks, we believe that the regulatory framework must also allow stablecoin payments to play a role and thrive. Regulatory guardrails can help maintain people’s confidence in stablecoins as a form of currency and ensure that the power to determine our monetary system does not fall into the hands of a few market participants.

3. What is a stablecoin?

A stablecoin is a digital dollar issued on a public, permissionless blockchain. Due to the specific features of blockchain, they can significantly improve the digital payment ecosystem.

Reliable, shared infrastructure. Public chains are data and network infrastructure with more open access and longer normal operating times, requiring minimal initial capital expenditure for payments and tokenization.

Programmability. Thanks to smart contracts, most public chains are programmable, allowing for transparent execution of complex code based on conditions set by users and customization according to their preferences.

Composability. Applications and protocols built on public chains can be combined and interoperable to create new functionalities.

These features make it possible to design electronic payment systems, significantly reducing the reliance on intermediaries in bank balance sheets and creating new pathways for efficient payment flows. Stablecoins that maintain stability using different mechanisms (e.g., on-chain collateralization) rely less on the banking system and intermediaries in balance sheets.

At the same time, trust and confidence are fundamental characteristics of money. Establishing regulatory infrastructure that ensures trust and confidence in stablecoins can help them thrive. However, if stablecoins are forced into regulatory frameworks that are not suitable for banks or money market funds, they will eventually resemble banks or money market funds, and as a result, they will be as inefficient as existing financial services.

4. From a risk perspective, stablecoins are not bank deposits

Banks play a central role in the financial system and the broader economy: their balance sheets hold the savings of households and businesses nationwide. In addition to absorbing deposits, they provide loans to individuals, businesses, government entities, and a range of other clients. If businesses could only rely on self-funding or individuals could only purchase homes or cars with cash on hand, commercial activities would be greatly restricted.

Banking activities can also be high-risk. Banks absorb deposits from customers who can withdraw them at any time, lend or invest in often long-term assets such as bonds (a process known as maturity transformation), and are susceptible to losses due to poor judgment. If all customers of a bank attempt to withdraw their deposits immediately, the bank may not have sufficient assets on hand. This can lead to panic, bank runs, and fire sales. If a bank manages poorly and incurs losses due to bad loans or poor investment choices, it can also impact its ability to repay customers when they try to withdraw their deposits. Even the perception of these risks can be risky.

Stablecoins, in essence, do not bring about the same risks. The issuers of stablecoins pegged to the US dollar, according to their terms, can redeem them on demand at face value and may hold asset reserves to support their redemption commitments. These reserve assets may be one-to-one matched with the stablecoins in circulation, consisting of liabilities from central banks or short-term government bonds, isolated from the issuer’s own assets, unaffected by creditor procedures, and subject to evaluation or audit. Specific safeguards may be required under federal regulations implemented by new legislation. If so, unlike bank deposits, there is no maturity mismatch between short-term liabilities (stablecoin holders can redeem at face value anytime) and long-term or risky assets.

More generally, even for stablecoins not pegged to the US dollar or not committed to redeeming at face value, the issuer essentially does not engage in maturity transformation like banks. Safeguards can also be taken here to ensure consumer protection and maintain financial stability. These safeguards may include required disclosures, third-party audits, and even baseline consumer protection rules for centralized service providers that choose to offer or promote such stablecoins.

Essentially, a risk management framework applicable to stablecoins should aim to manage the unique risks associated with stablecoins, which are different from those in traditional banking.

5. Stablecoins differ from MMFs in practice

Some regulatory bodies, including the SEC, have argued that certain stablecoins are similar to money market funds (MMFs), especially when they hold various assets such as government securities, cash, and other investments as reserves to support their stable value, and should therefore be regulated as MMFs. We believe this is not an appropriate form of regulation as it is inconsistent with the actual market use of stablecoins.

MMFs are open-end management investment companies regulated under securities laws. They invest in high-quality short-term debt instruments such as commercial paper, US Treasury securities, and repurchase agreements. They pay dividends reflecting current short-term rates, are redeemable on demand, and, under SEC rules, are required to maintain stable net asset values (or “NAV”) typically at $1.00 per share. Like other mutual funds, they are registered with the SEC and regulated under the Investment Company Act of 1940. MMF shares are purchased and traded on public exchanges through securities intermediaries such as brokers or banks.

Over the years, various types of money market funds have been launched to meet the different investment objectives and risk tolerances of investors. As classified by the US Securities and Exchange Commission nearly a decade ago, most investors invest in prime money market funds, which typically hold various short-term debts issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper. In contrast, government money market funds primarily hold US government securities, including US Treasury bonds, as well as repurchase agreements backed by government securities. Government money market funds generally offer higher principal safety compared to prime funds, but historically have lower yields.

The combination of stability, liquidity, and short-term yields provided by money market funds is similar to stablecoins pegged to the US dollar. However, it is important to note that stablecoins serve a different purpose in practice compared to money market funds. If stablecoins were to be regulated as money market funds, most stablecoins would lose their utility.

In practice, stablecoins are primarily used as a means of payment in cryptocurrency transactions, rather than as investment options or cash management tools. For the largest stablecoins pegged to the US dollar, holders do not earn any returns based on reserves. Instead, stablecoins are used as equivalents to cash itself. Holders of stablecoins pegged to the US dollar typically do not seek to redeem the value of their stablecoins from the issuer and then use the proceeds for cryptocurrency transactions. They simply use the stablecoins themselves as a means of payment in US dollars for cryptocurrency transactions. It would be impossible or impractical for stablecoins to be regulated as money market funds and require holders to sell them through brokers or banks.

We believe that it is wrong to force stablecoins into the regulatory framework of money market funds, especially when there is an opportunity for legislation to create a framework that is more suitable for the risks associated with stablecoins and their surrounding market behavior. In fact, the Supreme Court has refused to expand the SEC’s jurisdiction to such instruments, when comprehensive legal frameworks are already in place for managing arrangements such as bank deposits or pension plans.

In other words, just as money market funds are subject to different regulations than other investment companies due to their different structures and purposes, stablecoins should also be regulated in a manner consistent with their unique structure and purpose.

6. Conclusion

We believe that over-regulating stablecoins under the existing banking and securities law framework would also overlook key principles of payment systems, especially those related to fairness and open access. The uniqueness of payment systems lies in the dynamic nature of network effects, where the benefits users derive from the system increase with the number of other users on the system. Coupled with entry barriers, including excessive and stringent bank-like regulation on stablecoin issuers, these factors often limit competition and concentrate market power in a few dominant players. If left unchecked, this could result in lower levels of customer service, price increases, or inadequate risk management systems.

This concentration of power would also be a curse on the freedom and decentralization of cryptocurrencies. Stablecoin issuers or service providers with concentrated market power may make governance decisions for public chains and have discretionary influence over the competitive balance among other participants. They could choose to disadvantage certain participants (and their customers) by restricting or otherwise limiting access to their services, and favorably reward other favored cryptocurrency service providers, thereby enhancing their market power.

For these reasons, we urge Congress to take immediate action to enact legislation to address the risks posed by stablecoins while still allowing stablecoin payments to function and continue to innovate. Legislation of this kind, guided by these principles, would address key issues while still allowing for the operability of stablecoins:

  • Protecting stablecoin users by establishing reasonable risk management requirements for centralized providers;

  • Ensuring viable pathways for competition by non-bank issuers at both the federal and state levels;

  • Allowing for various forms of stablecoins as long as they meet consumer protection benchmarks and appropriately manage risks, thus fostering innovation.

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