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US government considers deposit protection for stablecoins

by Tim

A US government working group has written a report on stablecoins. The report shows how seriously the US takes stablecoins – and how much the perspective on crypto in the United States has changed in the meantime.

Stablecoins are becoming increasingly important, but for the US they are a double-edged sword: on the one hand, they cement the dominance of the dollar. While central banks in the rest of the world rack their brains over how to build a digital currency, private companies do it for the US. For the dollar, this is a big advantage.

On the other hand, stablecoins allow private companies to do without a licence what banks or even central banks normally do. Stablecoins undermine the regulatory grip of the US government. They even make it possible, as with Tether, for companies that are not based in the US but in regulatory nowhere to become dollar issuers.

In this way, stablecoins simultaneously strengthen and weaken US financial sovereignty.

For the government, this is a neat challenge. How can it get a better handle on stablecoins to prevent potential disasters – but how, without wiping out their potential?

These were the questions addressed by a “President’s Working Group on Financial Markets” supported by several institutions, such as the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). The report of the working group has now been published.

The document could be seen as a kind of turning point. For the first time, it expresses very clear concerns that crypto is becoming a danger to the stability of the financial system – but also the will to integrate privately issued stablecoins into it.

It can happen very quickly …

First of all, the working group takes stock as honestly as possible, not afraid to name the positive things about stablecoins.

In October, it notes, the largest stablecoins had a combined market capitalisation of $127 billion. That amount has increased by 500 per cent over the past year, she says. Counting on CoinGecko today, I’m already at $140 milllion, an increase of just over 10 per cent a month. Stablecoins continue to grow, but not as rapidly.

In the US, the report explains, stablecoins are mainly used to operate in crypto markets: They are used to trade, borrow and lose digital assets. Supporters of stablecoins are also convinced that they will be used as a general means of payment in the future.

The working group agrees – though not without reservations: “If well designed and appropriately regulated, stablecoins can allow faster, more efficient and inclusive payments.” This transition to stablecoins, the authors believe, “could happen rapidly if network effects and synergies with existing user groups or platforms take hold.”

The working group is preparing for such a scenario.

Preventing one Coins from dominating them all

The report acknowledges the tremendous growth of stablecoins in recent years and recognises in them – both individually and collectively – the potential to continue to grow so rapidly. Therein lie certain opportunities. Above all, however, the report addresses the concerns.

The group is particularly concerned that a single stablecoin is becoming too large and dominant. For example, because it scales rapidly thanks to an existing user base. This is not the last time the report alludes to Facebook’s Dien plans.

If a stablecoin becomes too overpowering, it can become a threat. Not just for the stablecoin, not just for consumers, but “for the financial system and the real economy”. If such an over-powerful stablecoin combines with a commercial company – huhu, Tether / Bitfinex (USDT), huhu Center / Circle / Coinbase (USDC) – then this can lead to an “excessive concentration of economic power”. If it also involves high costs and a lot of friction to switch from one stablecoin to another as a user, this can limit competition.

Such concerns are understandable, especially if you are in favour of decentralisation like we are. No one wants a stablecoin market dominated by one player – whether an unregulated one like Tether, a regulated one like Center, or a decentralised one like Dai (DAI). No one wants an ecosystem that revolves around a thick centre.

However, the question should be allowed whether this is not exactly the situation in traditional finance. Don’t VISA, Mastercard and PayPal have far too much power? And doesn’t government regulation strengthen that very centralisation by raising regulatory hurdles and thus reducing competition?

The spectre of DeFi is haunting

But even without too much centralisation, the working group sees a wide range of risks in stablecoins. Some of the risks arise primarily from the financial activities surrounding stablecoins.

According to the working group, stablecoins facilitate speculative trading. Investors can lose money when they trade with complex derivatives and levers; fraud, insider trading, front-running and manipulation can hardly be prevented. This is not only relevant for consumer protection. Rather, the working group fears that these activities, if they involve significant sums, “can also create risks for the broader financial system. “

These risks extend to traditional exchanges and financial services providers. However, they are most prevalent in Decentralised Finance (DeFi). This issue, which is closely intertwined with stablecoins, seems to frighten and confuse the working group.

DeFi, the working group says, means “a variety of financial products, services, activities and arrangements enabled by smart contracts …” DeFi could “reduce the use of traditional financial intermediaries and centralised institutions to perform certain functions”. The actual degree of decentralisation, however, varies significantly.

Stablecoins play a central role in DeFi. Without them, it would not be possible to trade cryptocurrencies and tokens for fiat money or to borrow dollars and lend them. In essence, stablecoins made DeFi really possible in the first place, and that could be their central role.

There are risks in DeFi, however. They can be abused for fraud, money laundering, terrorist financing or unregulated trading in risky, multi-leveraged financial products, as well as manipulation of markets. DeFi removes from the grasp of regulators all the toxic, incendiary geniuses of finance that are involved in every financial crisis. Supervisors can ban or mitigate leveraged short selling in many cases – but not when it is run on a DeFi platform.

This fear of losing control is palpable. Stablecoins are becoming a catalyst for the replacement of traditional financial institutions with decentralised organisations. This means that the established methods of controlling the financial markets are running into the void.

The danger of an infectious bank run

But even the rather innocent use of stablecoins as a means of payment poses dangers for the working group.

The main concern here is the stability of stablecoins. If they are used on a broad basis for payment, they take on systemic importance. In order to do justice to this, they must be stable.

As a means of payment, stablecoins are subject to the same risks as traditional payment systems: credit risks, liquidity risks, operational risks, governance risks, settlement risks. However, these can manifest themselves differently with stablecoins, for example if they are arranged in a decentralised manner like DAI. Then “no single organisation can be held accountable for risks and damages”. The usual methods to reduce risks do not work, because where the central point should be, where the government usually starts, there is nothing but a gap.

Furthermore, in order to remain stable, stablecoins need to gain and maintain the trust of users. Users must trust that the stablecoin is backed and that they will be able to redeem their stablecoins for fiat money.

If a stablecoin loses this trust, a run is imminent. And, worse, “runs can spread infectiously from one stablecoin to another, possibly to other types of financial institutions with a similar risk profile. As a result, risks to the broader financial system can grow rapidly along with it … a run that occurs in a tight market can have the potential to amplify the shock to the economy and the financial system. “

It’s no longer just about consumer protection and money laundering

Let’s briefly summarise what risks the working group sees in stablecoins. As we will see in a moment, the narrative has shifted significantly compared to previous years.

As ever, the government is worried about consumer protection being sanded down and criminal elements laundering money and funding terror. So far, everything remains the same. What is new, however, is that consumer protection and money laundering are no longer central.

At almost every point in the report, with every risk and – we will see this in a moment – with every recommendation, another concern resonates, more or less explicitly. She is concerned about the big picture: that stablecoins threaten the integrity of the financial system.

This passage is too important not to repeat: The President’s Working Group worries that an uncontrolled proliferation of stablecoins threatens the stability of the world’s largest and most powerful monetary system – the dollar. So that’s where we’re at.

Not all stablecoins are created equal

Freely, not all stablecoins are the same. This has already been mentioned. The working group is quite capable of distinguishing between unregulated, foreign stablecoins (USDT) and regulated, domestic ones (USDC), between centralised stablecoins and decentralised ones (DAI), and between independent stablecoins and those that are related to other companies (Dien).

These axes of “arrangements”, as the report so nicely puts it, naturally have an impact on the risks. Some hold all – or pretty much all – reserves in insured bank accounts in dollars or US government bonds. That would be the USDC. The others, however, the tethers, hold riskier assets, such as commercial paper, bonds or others. This of course increases the risk.

Similarly, the rights to exchange a stablecoin for dollars vary. Both in who may initiate this, as well as the limits from how much and up to how much is to be exchanged. Again, this probably alludes to Tether, which does not make it easy to exchange stablecoins for dollars.

The goal of regulation is to promote the least risky stablecoins and either force the risky ones to be safe or ban them from the market. In this sense, the paper is quite constructive: the regulator wants stablecoins to play an economic role. It wants this by all means – but under the conditions that it considers sensible.

It is no longer a question of yes or no, not of whether – but of “how”.

The cross with definitions

So, in order to safely integrate stablecoins into the economy, the working group urges Congress to pass a law as soon as possible that mandates adequate and strict oversight. It has to be fast, because stablecoins are growing rapidly, which is why the matter does not allow any further delay.

Failure is also not allowed. By doing so, the government would “risk stablecoins continuing to grow without adequate protections in place, for consumers, for the financial system and for the broader economy.” An adequate regulatory framework, on the other hand, would help stablecoins become a meaningful and useful payment option. The report does not doubt that this is the goal.

The actual regulation, however, is tricky. It already starts with who is responsible. The SEC? The CFTC? The CEA? Or the courts? This depends on what you define a stablecoin as. A security? A commodity? A derivative? In the long run, it would probably be helpful to achieve a definition here that makes it clear who is responsible.

But it is clear that measures need to be taken. For example, legislators should ensure that trading, lending or borrowing of stablecoins in the US is only possible under the laws and rules enforced by regulatory bodies such as the SEC and CFTC.

“A federal safety net for stablecoins “

But the report goes beyond simply calling for existing regulatory standards. It also suggests how lawmakers should make stablecoins safer. It is supposed to set “smart regulatory standards”, which include – potentially – access to an adequate federal safety net. Properly understood: The working group is thinking about some kind of deposit insurance for stablecoins. It is quite willing to support stablecoin issuers that play by its rules.

Only banks and bank-like institutions should be allowed to issue Stablecoins. These institutions should be able to insure balances, meet regulatory requirements and also “have access to emergency liquidity through the Federal Reserve.” Once again, the working group brings into play a kind of deposit protection for stablecoins.

This is a relatively clear indication of the working group’s motivation: stablecoins may become big, really big, and possibly significant, really significant, for the entire economy. Stablecoins could be the technological future of the dollar, and perhaps that is inevitable. If that is the case – then, please, not against, but with the government; not on its own, but under the loving, supportive, but also strict hand of the state.

Other entities, i.e. those that are not banks or bank-like, should not be allowed to issue Stablcoins. Because it is almost too obvious that this idea stands in stark contrast to the concern expressed above that monopolies or cartels could form, the report proposes that the legislator form standards that strengthen the interoperability of stablecoins.

And that brings us to the final, concluding point, where presumably even policymakers can no longer ignore the beauty of cryptocurrencies. If you strictly regulate conventional finance, oligopolies form: a few corporations that have a lot of power and, thanks to the silo-like structures, are the only ones to profit from the network effects they form.

With crypto, on the other hand – whether a real cryptocurrency or a stablecoin – everything is transparent and also interoperable. If a stablecoin collects network effects, everyone can benefit from them, and if one stablecoin provider slips, users can quickly switch to another.

Stablecoins are the better dollars after all, and there are signs that the US government understands this too.

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