Donovan Choy / Joakim Book
American regulators are inching closer to the world of crypto. In a recent report released by the US Treasury, regulators have voiced their clearest intentions yet to bring stablecoin issuers under the existing regulatory regime of traditional banking.
Stablecoins are cryptocurrencies intended to mirror the value of a real-world currency, often a fiat currency like the US dollar or British pound. They vary in how they achieve this, but the largest ones – Coinbase’s USDC, Tether’s USDT and Binance’s BUSD – achieve trading parity by (so far) credible promises to assets held in reserve so as to back the issued liabilities.
Stablecoins have use because the volatility of other cryptocurrencies’ prices render them less than ideal for trade or holding digital assets. Thanks to the stable-value, intermediated digital currencies provided by companies like Tether, Binance and Coinbase, users have access to a settlement asset that easily transits between crypto and fiat, allowing them to bypass the friction of transferring money between crypto exchanges and banks over old-school monetary rails.
The report’s proposal mirrors the STABLE Act that was announced last December, which would place stablecoin-issuers under the same set of rules that govern banks. Importantly, issuers of stablecoin thus are treated akin to banks that offer savings accounts for customers, a privilege that comes with similar kinds of regulatory requirements such as obtaining a banking license, Federal Deposit Insurance Corporation (FDIC) insurance, and perhaps even a master account at the Fed.
It shouldn’t be a surprise that financial regulators are coming for crypto. As of November 2021, crypto’s decentralized finance (DeFi) industry is a $80 billion industry. One estimate projects this to grow tenfold by 2022. Stablecoins are what connects this fast-growing space to the world of fiat. Consumers and users in the world of crypto rely on stablecoins to transact inside and outside their spheres. Due to the globally decentralized (and oftentimes anonymous) nature of DeFi, it makes plenty of logistical sense for regulators to swoop in on the entities that present a centralized organizational target. If you can’t restrain the transactions, or successfully regulate the users, at least you can target the major choke points.
In theory, these centralized stablecoins are fiat-collateralized and backed by reserve assets. In practice however, it is not always clear how robust these backings are, provoking regulatory concerns of potential bank runs.
The Unintended Consequences of Stablecoin Regulation
Should the crypto world be worried by what seems like impending regulation of stablecoins?
The first thing to note is that the proposals to regulate stablecoin issuers like banks are completely preemptive and not based on any plausible consumer harm that is already happening. The US Treasury report repeatedly emphasizes the “urgency” for protecting consumers from abuse and bank runs, even though these harms are purely hypothetical concerns – at least so far. Thus, this regulatory move has all the hallmarks of a political power grab.
This precautionary approach may come with the best of intentions, but it would also have the impact of curbing capital flows into DeFi, and distorting the price signals and profit incentives that are essential to spurring innovation in a nascent industry.
Second, regulating the established stablecoins would entrench their position in the market. Onerous capital reserves or anti-money-laundering requirements would be easily met by these incumbents while posing a drastically higher barrier of entry for smaller competitors and future entrants onto the stablecoin scene.
This is no surprise, and the big boys are well aware of the competitive advantage the regulation would confer on them. Both Tether and Circle have themselves given approving feedback to the report’s proposal, with the chairman of the latter claiming to be “fully supportive of the call for Congress to act and establish federal banking supervision for stablecoin issuance.” When the key targets of regulation themselves are willingly trodding into the lion’s den, it doesn’t take a cynic to point out that the wheels of crony capitalism are well-oiled and already in motion.
Regulating stablecoins as banks would automatically increase their competitive advantage as the go-to stablecoins across a wide range of niche crypto markets such as centralized crypto exchanges or wealth management companies like BlockFi and Celsius (that offer consumers attractive interest rates of 8% or more for deposited stablecoins). For reasons of regulatory compliance, these companies (facing regulatory scrutiny themselves) would have a larger incentive to privilege regulated stablecoins as part of their product offerings, again at the expense of smaller competitors or innovators. If not a political power grab, then a solidifying of today’s market structure rather than tomorrow’s.
The stablecoin market today consists of at least 53 active stablecoins in a variety of pegs to USD, GBP, commodities, and/or baskets of currencies. The sheer novelty of DeFi is a good reason to keep a competitive state of affairs in the stablecoin market as more consumers enter crypto.
Third, cryptos’ strong ethos of maintaining decentralization would likely react to these regulations by speeding up innovation and market demand for decentralized stablecoins that are out of reach from regulators. That is perhaps a good thing, albeit an unintended consequence. There are many such forms of decentralized stablecoins, from TerraUSD (UST) and Liquity USD (LUSD) to Olympus (OHM), but the most popular example is MakerDAO’s DAI, which relies on price incentives to equilibrate its coin towards a $1 valuation.
When the market value of DAI rises above 1 USD, a profit opportunity is presented for users to mint higher-than-average value DAI, increasing its supply and thereby putting downward pressure on the price of DAI. Similarly, when DAI dips below 1 USD, owners of DAI can do the opposite: pay down their DAI debt for Ether at a better rate and apply upward pressure on its price.
These mechanisms provide users with a stablecoin that enables them to navigate the world of DeFi free from regulatory scrutiny because unlike USDT or USDC, it is not collateralized by active reserve management in fiat or corporate bonds (thereby putting these entities within reach of regulators), but by crypto assets on smart contracts. As distrust over centralized stablecoins increases because of the looming pressure from regulators, crypto users will likely find these options more and more desirable..
On face value, stablecoins behave somewhat like banks, so it seems reasonable to extend the regulatory regime of traditional banks onto them. But this simple train of thought makes a crucial misstep. Stablecoins emerged within an alternative financial ecosystem in the aftermath of the Great Financial Crisis by entrepreneurs who sought to avoid the over-regulated traditional banking system. They may parallel savings deposits as a store-of-value, but unlike savings accounts, their key purpose was not a final parking destination for capital, but to “bridge” capital into DeFi.
Proponents of the stablecoin regulation would do well to keep in mind this critical detail. All the risks that accompany the danger of overregulation like rent-seeking and regulatory capture is magnified in the event of regulatory failure.