Original author: Brendan Malone, Paradigm

Original translation: Luffy, Foresight News

Stablecoins present a rare opportunity to upgrade and expand the digital-age payment systems. However, despite ongoing technological advancements worldwide and growing customer demands in the digital economy, recent regulatory actions and legislative proposals are forcing crypto payment tools into existing banking and securities frameworks, which is a step backward.

If legislation is to continue progressing in this field, lawmakers should focus on three key objectives:

• To address the risks faced by USD stablecoin users, legislation may require centralized issuers of USD stablecoins to meet appropriate risk management standards. For fiat-backed stablecoins, where the issuer claims to guarantee redemption at face value, the issuer must hold reserve assets, proving they match the outstanding stablecoin balance. Reserve assets can consist of bank deposits and short-term government bonds, which should be segregated from the issuer's own assets, immune to creditor procedures, and subject to assessment or audits. Importantly, these issuers need not be banks nor require bank-like regulation.

• To foster growth and competition, legislation can prioritize orderly and effective competition between stablecoins and existing banks, along with clear safeguards. This involves ensuring that the regulatory framework for stablecoins and regulations on traditional payment infrastructure have objective, risk-based, and publicly disclosed licensing requirements, thus enabling both banks and regulated non-bank entities to fairly obtain licenses at state and federal levels. Access for end users, whether businesses or individuals, should also be opened.

• To encourage responsible stablecoin innovation, legislation can provide broad payment and related services for consumers and businesses. Regulation should not stipulate that all stablecoins must be pegged to the US dollar or outright ban algorithmic stablecoins and on-chain over-collateralized stablecoins, but rather allow for experimentation and innovation within additional rules that match consumer protection and risk levels.

Background

While recent US congressional proposals on stablecoins permit issuers outside of banks, policy discussions surrounding appropriate safeguards often focus on traditional bank regulatory security and soundness principles, such as capital requirements or securities-related risk management frameworks.

Considering the unique risks of stablecoins and current-use cases, traditional banking and securities frameworks are flawed for stablecoin regulation. Policymakers should develop a new framework that promotes openness and competition more than the current banking or securities frameworks.

Specifically, while ensuring prudent and market risk mitigation is crucial, we believe that regulatory frameworks must allow for the role and vibrant growth of payment stablecoins. Regulatory safeguards can help maintain people's confidence in stablecoins as a form of currency and ensure that the power of our monetary system does not fall into the hands of a few market participants.

What are Stablecoins?

Stablecoins are digital dollars issued on a public, permissionless blockchain. Due to the characteristics of blockchain, they can significantly improve the digital payment ecosystem.

• Reliable, shared infrastructure. Public blockchains are data and network infrastructures with more open access and longer normal operation times, making the initial capital expenditure required for payments and tokenization very limited.

• Programmability. Thanks to smart contracts, most public blockchains are programmable and can transparently execute complex code based on arbitrary conditions set by users.

• Composability. Applications and protocols built on public blockchains can be combined to create new functionalities.

These features make it possible to design a new generation of electronic payment systems that can significantly reduce the intermediation of bank balance sheets and create new paths for the efficient flow of payments. Stablecoins require less reliance on the banking system and intermediaries in balance sheets, using different mechanisms to maintain stability.

At the same time, trust and confidence are fundamental characteristics of currency. Regulatory infrastructures that maintain 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 they will be as inefficient as existing financial services.

From a risk perspective, stablecoins are not bank deposits

Banks play a central role in the financial system and the broader economy. They hold the savings of countless households and businesses on their books. In addition to taking deposits, they also provide loans to individuals, businesses, government entities, and a range of other clients. If businesses could only rely on self-financing or individuals could only purchase homes or cars with cash on hand, commercial activities would be severely restricted.

Banking activities can also involve high risks. Banks take in customer deposits (which can be withdrawn at any time) and make loans or invest in bonds or other long-term assets (referred to as maturity transformation). In this process, banks can suffer losses due to misjudgment. If all of a bank's customers collectively withdraw their deposits and the bank does not have sufficient assets on hand, it can lead to panic, bank runs, and fire sales. If a bank manages poorly and incurs losses due to non-performing loans or bad investments, it can also affect its ability to repay customer deposits.

Stablecoins inherently face different risks from banks. The issuer of a US dollar stablecoin (which can be redeemed on demand at face value according to its terms) may hold reserves to address customer redemptions. These reserves may be matched to the stablecoins issued and consist of central bank liabilities or short-term government bonds that are segregated from the issuer's own assets, are not subject to creditor proceedings, and are subject to assessment or auditing. Specific safeguards may be required under federal regulations implementing newly enacted legislation. If so, unlike bank deposits, there is no term mismatch between short-term liabilities (which stablecoin holders can redeem at face value at any time) and long-term or risky assets.

More generally, even for stablecoins that are not pegged to the US dollar or do not promise redemption at face value, issuers do not inherently engage in maturity transformation like banks. Here, safeguards can be put in place to ensure consumer protection and maintain financial stability. These safeguards may include information disclosure, third-party audits, and even basic consumer protection rules for centralized service providers offering or promoting such stablecoins.

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

Differences between Stablecoins and MMFs in Practice

Regulatory bodies, including the SEC, have stated that certain stablecoins are similar to money market funds (MMFs), especially when they hold various assets such as government securities and cash as reserves to maintain their value stability. Therefore, these stablecoins should be regulated as money market funds (MMFs). We believe this is an inappropriate regulatory approach because the actual market use of MMFs is different from that of stablecoins.

MMFs are open-ended investment companies regulated under securities laws. They invest in high-quality short-term debt instruments such as commercial paper, treasury bills, and repurchase agreements. The interest they pay reflects prevailing short-term rates, and they are redeemable on demand and subject to SEC rules requiring a stable net asset value per share of typically $1.00. Like other mutual funds, they are registered with the SEC and regulated under the Investment Company Act of 1940. MMFs are bought and sold by public dealers (e.g., brokers or banks) through which they are traded on exchanges.

Over the years, various types of money market funds have been introduced in the market to meet the different needs of investors with different investment goals and risk tolerances. As classified by the U.S. Securities and Exchange Commission a decade ago, most investors invested 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 invest in U.S. government debt, including debt issued by the U.S. Treasury, and repurchase agreements collateralized by government securities. Government money market funds generally offer higher principal security but lower yields compared to prime funds.

The combination of principal stability, liquidity, and short-term yield offered by money market funds has some similarities to USD stablecoins. However, it is important to note that the use of stablecoins in practice is fundamentally different from that of money market funds, and 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 crypto transactions rather than as investment choices or cash management tools. Holders of USD stablecoins do not earn any return on their reserves. Instead, stablecoins are used as cash equivalents. USD stablecoin holders typically do not seek to redeem the value of their stablecoins from issuers and then use the proceeds for crypto trading. They simply transfer the stablecoins themselves as USD payment portions in crypto transactions. It would be impossible or impractical to require stablecoin holders to sell their holdings through brokers or banks if stablecoins were to be regulated as money market funds (MMFs).

We believe that it is wrong to force stablecoins to be included in the MMF regulatory framework, especially when there is an opportunity to create a more suitable framework through legislation. In fact, the Supreme Court has rejected expanding the SEC's jurisdiction to such tools.

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 subject to regulations that are consistent with their unique structure and purpose.

Conclusion

We believe that confining stablecoins within the existing banking and securities law frameworks would overlook crucial principles of the payment system, particularly the principles of fairness and open access. The unique nature of the payment system lies in the dynamic network effects, where the benefits users derive from the system increase with the number of system users. The presence of entry barriers, including excessive and stringent bank-style regulations imposed on stablecoin issuers, often restricts competition and concentrates market power in the hands of a few dominant players. Left unchecked, this could lead to a decline in customer service levels, price increases, or inadequate risk management system investments.

This concentration of power would also be a curse on the freedom of choice and decentralization of cryptocurrencies. Stablecoin issuers or service providers with centralized market power could make governance decisions for public blockchains and also influence the competitive balance among other participants. They could choose to disadvantage certain participants (and their customers) by restricting access, while giving preferential treatment to favored providers of cryptographic services, thus enhancing their own market power.

For these reasons, we urge Congress to take immediate action and enact legislation to address the risks posed by stablecoins, while still allowing them to play a role in payments and continue to innovate. Based on these principles, such legislation would address key issues while still allowing for the operability of stablecoins:

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

• Ensure fair participation in competition by federal and state-level non-bank issuers;

• Allow for various models of stablecoins, as long as they meet consumer protection standards and manage risks appropriately, thereby promoting innovation.

Acknowledgment: Special thanks to Jess Cheng for her assistance with this article.