Regulating the Unregulated
Exploring what it means to regulate stablecoins and how this may impact the money markets and the banking system.
Although the broader cryptocurrency market has been relatively stagnant at $2 trillion for over a year, stablecoins adoption has grown at roughly 5x over the same period, reinforcing the notion that stablecoins are the cash of crypto. The growing interest and adoption in stablecoins have sparked conversations at both the institutional- and governmental-level on possible ways to regulate stablecoins.
What if We Regulate Them Like Banks?
If stablecoins are regulated to the same degree as banks, it could structurally change the money market landscape and the banking system:
1) Significantly increase demand for high quality liquid assets (“HQLA”), leading to shortages in safe and liquid assets.
2) Encourage a rotation from bank deposits and money market funds (“MMFs”) towards stablecoins, removing the traditional financial system and leading to less credit and liquidity provided to the broader economy.
Before we dive into how the rest of money markets and the banking system might evolve to complement stablecoins as cash alternative, let’s first take a look at the differences between stablecoins and deposits and MMFs.
How are Stablecoins Different from Deposits and MMFs?
The principal idea behind stablecoins is that they are supposed to function as another form of currency. This means they must intrinsically provide a store of value, be a medium of exchange, and be valued at par. These 3 features are what allows money to effectively exchange hands throughout the financial system.
While there are similarities between stablecoins and deposits, stablecoins do not fit the definition of currency. Most notably, it is currently unclear whether stablecoins can be redeemed at par — a key feature that dictates the effectiveness of stablecoins being a medium of exchange, as we have yet to see a true run on stablecoins.
Let’s explore the 2 factors why the economic par value of stablecoins can be brought into question:
#1 Stablecoins more resemble private banknotes of the 19th century:
There are currently hundreds of types of stablecoin issuers and stablecoins, all backed by different types of collateral. This arrangement is reminiscence of the 19th century banknotes where banks could offer their own private notes as long as they collateralized the notes with state bonds. This production of private bank money gave way to the markets valuing various types of private banknotes differently. The market could value a note from a certain state at a discount to a note from a different state. Effectively, the market was assigning a credit risk on each private banknotes, resulting in certain notes trading at a discount to par. As a result, banknotes were an inefficient form of payment, and in times of stress, the private banks were prone to runs. Ultimately, the National Bank Act in 1863 was introduced which allowed for the establishment of national banks issuing national banknotes backed by US Treasuries. Since then, national banknotes are now a uniform currency, all valued at par. On the other hand, stablecoins trade at different values with different collateralization, and are reminisce of private banknotes.
#2 Stablecoins are not always backed by stable assets:
Due to lack of regulations, stablecoin issuers back their stablecoins with a substantial amount of non-HQLA. The largest stablecoin issuer has close to 50% of their reserves in non-HQLA, posing substantial risk to redemption in times of stress. Exposure to riskier assets as a source of liquidity certainly poses a run risk, as evident in the market of prime MMFs in 2008 and 2020. On the contrary, regulations concerning deposits require banks to maintain a minimum level of HQLA to not only meet intraday liquidity needs but also sudden liquidity events. However, stablecoin reserves can often be made up with large portions of non-HQLA.
In short, although stablecoins provide substantial benefits from a payments perspective (i.e. settlement time, cross-border efficiencies), the uncertainty of par redemption differentiates them from deposits as a form of currency.
Regulating Stablecoins like Banks Means Issuers are Treated as Insured Depository Institutions
Beyond the run risks, stablecoins are exposed to other risks like systems risks, custodial risks, money laundering risks, etc. Regulating stablecoin issuers like banks would minimize run risks, but also payment systems risks and concerns about concentration of economic power in the event an issuer becomes a dominant payment service provider. Run risks can be mitigated through capital, liquidity, and other prudential requirements as well as access to the Fed as a lender-of-last-resort. Payment system risks can be reduced through various risk management practices. And concern of concentration of power would be addressed by prohibiting issuers from conducting certain activities.
If stablecoin issuers are regulated as insured depository institutions (“IDIs”), they will be subject to federal supervision and regulation at both the company and holding company level. They will need to comply with capital and liquidity requirements. Presumably, stablecoin deposits would be covered by the FDIC deposit insurance, subject to legal limits, and maintain access to emergency liquidity and Fed services. All these measures would increase market confidence in stablecoins as a means of payment and store of value in times of stress; thereby, minimizing the run risks of stablecoins.
However, Regulated Stablecoins Could Materially Impact the Money Market Landscape and the Banking System
Mandating stablecoin issuers to hold HQLA in reserves could significantly increase the demand for safe and liquid assets. As of December 2021, Tether (USDT) and Circle (USDC) held in total $78 billion of Treasury bills. Although this may only represent 2% of the Treasury bill market, demand and adoption of stablecoins have been increasing at a rapid pace (increasing to $180 billion in total stablecoin market capitalization from only $38 billion last year) and further adoption could intensify the supply-demand imbalance in the money markets. If stablecoin issuers are regulated like banks, this could lead to a potential shortage of Treasury bills and other HQLA.
Regulating stablecoin issuers could encourage a rotation out from deposits and MMFs into stablecoins, which would disrupt the funding markets and the broader economy. A rotation from corporates and institutions would not be a stretch, considering that stablecoins are an effective form of payment, particularly cross-border payments, and the ease of use might be appealing to multinational corporates.
Furthermore, stablecoins offer a large upside to corporate treasury management as they provide the ability to earn interest at a much higher rate than deposits and MMFs. As an illustration, stablecoins can earn 2.0–3.0% yields on DeFi protocols (AAVE, Compound) while the average net yields on bank deposits and MMFs are 0.06% and 0.1%, respectively.
A substantial rotation into stablecoins would likely take away funding from traditional banks and the credit they provide to the rest of the economy. Banks would have less funding and they would not be able to finance as many loans which reduces the availability of credit in the banking system. This would lead to an increased in borrowing cost. As noted in the President Working Group report, “if insured depository institutions lose retail deposits to stablecoins, and the reserve assets that back stablecoins do not support credit creation, the aggregate growth of stablecoins could increase borrowing costs and impact credit availability in the real economy.” Although the report focuses on retail rotation, regulating stablecoins as IDIs would bolster market confidence and likely entice similar moves from corporations and institutions.
Compound Capital Partners is an open-ended fund, providing access to the digital asset class through its dual approach in stablecoin and delta-neutral yield farming.
Twitter: https://twitter.com/investcompound
Website: https://www.compound.capital/
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