January 21, 2022

Volume XII, Number 21

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The Future of Stable (bank) Coins?: President’s Working Group on Financial Markets Urges Legislation Limiting Stablecoins to Insured Banks

On 1 November 2021, the President’s Working Group on Financial Markets (PWG), in conjunction with the Federal Deposit Insurance Corporation and the Comptroller of the Currency, issued a long-awaited joint “Report on Stablecoins” (Report). Per the press release (and a speech by Undersecretary of Treasury Nellie Liang), the Report is intended to “identify regulatory gaps related to “payment stablecoins” (defined as stablecoins that are designed to maintain a stable value and “therefore have potential to be used as widespread means of payment”), and to present recommendations for addressing those gaps.”

Risks Identified

The Report identifies several “key risks” presented by payment stablecoins and “sablecoin arrangements” (referring to the network of service providers necessary to the issuance, settlement, and maintenance of stablecoins and their reserves), including: run risk; payment risk; systemic risk; concentrated market power; and risks to bank-based credit, among others.

The PWG is concerned about the risk of a “run” on a stablecoin’s reserve assets, resulting in unstable value of the specific stablecoin, and, potentially, contagion to other stablecoins as well as possible disruption to funding markets. Mass and successive redemption of reserve assets could arise because holders lose trust in the stablecoins for various reasons: illiquid, mispriced, or overly risk assets; insufficient clarity on redemption rights; and operational errors.

Additionally, the Report discusses traditional risks faced by payment instruments (credit risk, liquidity risk, operational risk, ineffective governance, and settlement) as well as “novel operational risks.” In particular, the PWG points to operational risks from network congestion, liquidity risks if settlement of stablecoins and redemption of underlying assets do not operate on the same timelines; and the challenges of coordinating decentralized networks.

Moreover, the Report notes the possibility of systemic risk of payment stablecoins gain significant network effect and risk to consumer data and privacy if nonbank commercial entities can issue stablecoins or custodial digital wallets. The latter concern stems from growing criticisms of embedded finance and the role of “BigTech” in the financial system against the general (but not comprehensive) division of commerce and banking.

Proposed Policies

First and foremost, the report authors call for federal legislation to, among other things:

  1. Limit payment stablecoin issuance to “insured depository institutions, which are subject to appropriate supervision and regulation, at the depository institution and the holding company level” (meaning banks and bank holding companies subject to the Bank Holding Company Act);

  2. Require custodial digital wallet providers in a stablecoin arrangement to be regulated by the appropriate federal banking regulator based on the stablecoin issuer;

  3. Prohibit custodial wallet providers from lending stablecoins as well as require them to meet liquidity, capital, and risk management requirements; and

  4. Prohibit custodial digital wallet providers from affiliating with commercial entities or at least restrict use of consumers’ transaction data.

Absent federal legislation, the Report urges the Financial Stability Oversight Council (FSOC) to “designation of certain activities conducted within stablecoin arrangements as, or as likely to become, systemically important payment, clearing, and settlement activities.”

Implications

The Report is the clearest explanation of the Biden Administration’s views on the risks “payment stablecoins” represent and the regulatory framework they hope is implemented. However, the Report does not implement any policy changes and does not necessarily reflect how Congress will approach these issues.

It is unlikely that the legislation proposed in the Report will be implemented in the near term given the upcoming midterm election, growing polarization on digital asset federal policy, and the crowded Congressional agenda, among other issues. Regardless of any legislation, it is likely that the federal banking regulators will closely scrutinize any banks’ stablecoin-related services, including for third party risk management, as well as proposed services by de novo institutions. Also, it is unclear whether and when FSOC will act as recommended, but if it does, the process is likely to be lengthy. However, such a process would present meaningful regulatory risk for stablecoin issuers and payment arrangements.

Conclusion

The Report demonstrates the seriousness with which the Biden Administration and federal banking regulators approach stablecoin arrangements. It also shows the bank-centric (particularly large bank) focus on stablecoin policy that the Administration is pursuing. However, the legislative and regulatory debate and development is just underway, but is moving.

Copyright 2022 K & L GatesNational Law Review, Volume XI, Number 307
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About this Author

Judith E. Rinearson, KL Gates, federal consumer protection lawyer, anti money laundering attorney
Partner

Judith Rinearson is a partner in the firm’s New York and London offices. Ms. Rinearson concentrates her practice in prepaid and emerging payment systems, electronic payments, crypto/virtual currencies, reward programs, ACH and check processing. She has more than 25 years of experience in the financial services industry, including 18 years at American Express’s General Counsel’s Office. Her expertise focuses particularly in the areas of emerging payments and compliance with state and federal consumer protection laws, anti-money laundering laws, state money transmitter...

212-536-3928
Associate

Jeremy McLaughlin is an associate in the firm’s San Francisco office and a member of the Consumer Financial Service group. His practice focuses principally on regulatory compliance and government enforcement for Fintech and consumer financial products and services, with particular attention on emerging payments and compliance with state and federal consumer protection laws, state money transmitter licensing laws, and international remittances, as well as advising on privacy, data security, and PCI compliance. He represents and advises financial technology companies,...

415-882-8230
Daniel Cohen, KL Gates Law Firm, Washington DC, Finance Law Attorney
Associate

Dan Nuñez Cohen is an associate in the firm's Washington, D.C. office. Dan advises and advocates for clients at the intersection of federal legislative and regulatory policy and compliance, focusing on financial services issues affecting depository institutions, trust companies, money services businesses including digital asset exchanges, wallet providers, and token issuers; and the cannabis industry. He has experience assisting with bank charters and money transmitter licenses; counseling clients on compliance with federal banking and trust laws; and advocating for...

202-778-9020
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