It’s Time to Regulate Stablecoins as Deposits and Require Their Providers to Be FDIC-Insured Banks

In November 2021, the President’s Working Group on Financial Markets (PWG) issued a report analyzing the rapid expansion and growing risks of stablecoins. Stablecoins are digital assets that promise to maintain parity with a designated fiat currency (typically the US dollar) based on their investment reserves or a cross-trading arrangement with another cryptocurrency. PWG’s report pointed out that stablecoins pose a wide range of potential dangers, including inflicting large losses on investors, destabilizing financial markets and the payments system, supporting money laundering, tax evasion, and other forms of illicit finance, and promoting dangerous concentrations of economic and financial power.

PWG’s report called on Congress to pass legislation that would (1) require issuers of payment stablecoins to be FDIC-insured banks, and (2) ‘ensure that payment stablecoins are subject to appropriate federal prudential oversight on a consistent and comprehensive basis.’ PWG also recommended that federal agencies and the Financial Stability Oversight Council should use their ‘existing authorities’ to ‘address risks associated with payment stablecoin arrangements . . . to the extent possible’ (pp 16, 18).

At present, stablecoins are mainly used as a medium of payment for trades in cryptocurrencies and as collateral for derivatives and lending transactions involving cryptocurrencies. However, technology companies are exploring a much broader range of potential uses for stablecoins, including their use as digital currencies for purchases and sales of goods and services and other transfers of funds.

Issuers and distributors of stablecoins are quickly becoming a new category of systemically important ‘shadow banks’. Shadow banks offer functional substitutes for deposits (‘shadow deposits’) and provide lending, trading, and other financial services that mimic the activities of banks. However, shadow banks are not required to comply with federal banking laws that protect consumers and establish essential safeguards for the safety, soundness, and stability of our banking system. The systemic significance of stablecoin providers would increase exponentially if stablecoins become a widely-accepted medium of payment for consumer and commercial transactions. Under those circumstances, stablecoins would become a leading form of ‘private money’ comparable to money market funds, which do not have explicit government backing but rely on a widely-shared expectation of government support during future economic downturns and financial crises.

Federal agencies have not yet issued rules governing the creation and distribution of stablecoins. PWG’s report calls on federal agencies and Congress to take immediate steps to establish a federal oversight regime that could respond effectively to the dangers created by stablecoins. My recent article strongly supports three regulatory approaches discussed in PWG’s report.

First, the Securities and Exchange Commission (SEC) should use its available powers to regulate stablecoins as ‘securities’ in order to protect investors and securities markets. However, the scope of the SEC’s authority to regulate stablecoins is not entirely clear. In addition, federal securities laws do not provide adequate safeguards to control the systemic dangers that stablecoins pose to financial stability and the payments system.

Second, the Department of Justice (DOJ) should designate stablecoins as ‘deposits’ and bring enforcement actions to prevent stablecoin providers from unlawfully receiving ‘deposits’ in violation of Section 21(a) of the Glass-Steagall Act, 12 USC § 378(a). Section 21(a) offers a promising avenue for regulatory action, but its provisions contain uncertainties and gaps and do not provide a complete remedy for the hazards created by stablecoins. The most significant gap in Section 21(a) allows state (and possibly federal) banking authorities to charter special-purpose depository institutions that could issue and distribute stablecoins without obtaining deposit insurance from the FDIC.

Third, Congress should adopt legislation mandating that all issuers and distributors of stablecoins must be FDIC-insured banks. That requirement would compel stablecoin providers and their parent companies to comply with federal laws that protect the safety, soundness, and stability of our banking system and obligate banks to operate in a manner consistent with the public interest. Requiring stablecoin providers to be FDIC-insured banks would also maintain our longstanding policy of separating banking and commerce, embodied in the Bank Holding Company Act (BHC Act). Upholding that policy would prevent Big Tech firms from using stablecoin ventures as cornerstones for building shadow banking empires.

The entry of Big Tech firms into the banking business would create a wide range of potential threats, including unfair competition, market dominance, predatory lending, abusive sharing of customer data, other violations of customer privacy rights, and the risk of causing systemic contagion across our economy’s financial and nonfinancial sectors during future financial crises and economic downturns. The PWG Report (p 14) correctly determined that ‘the combination of a stablecoin issuer or [digital] wallet provider and a commercial firm could lead to an excessive concentration of economic power’, which could ‘restrict access’ to credit and other financial services and have ‘detrimental effects on competition’.

Our nation stands at a crossroads. We can choose to defend the BHC Act’s policy of separating banking and commerce, thereby preserving (1) a financial sector that is not compromised by toxic conflicts of interest and (2) an economy and society that are not dominated and exploited by the overwhelming market power and political influence exercised by giant banking-and-commercial conglomerates. Or we can allow Big Tech firms to enter the banking business and leverage their stablecoin ventures to create massive shadow banking kingdoms. In that event, Big Tech firms might well gain dominance over our banking industry and perpetrate the very evils that Congress intended to prevent by enacting the BHC Act.

PWG’s report provides a welcome blueprint for urgently-needed actions by regulatory agencies and Congress. The SEC should use its existing powers to regulate stablecoins as ‘securities’ in order to protect investors and securities markets. DOJ should designate stablecoins as ‘deposits’ and bring enforcement actions to prevent stablecoin providers from violating Section 21(a) of the Glass-Steagall Act. To overcome uncertainties and gaps in the authorities available to the SEC and DOJ, Congress should pass legislation requiring all issuers and distributors of stablecoins to be FDIC-insured banks. The foregoing measures would enable us to counteract the grave dangers that stablecoins currently pose to our society, financial system, and economy.

[Author’s update: The present post summarizes an article I completed in January 2022. As Rosa Lastra and I explain in a recent op-ed, subsequent events have strengthened the case for requiring all stablecoin providers to be FDIC-insured banks. The combined values of cryptocurrencies fell by more than half (from $3 trillion to $1.3 trillion) between November 2021 and May 2022. Terra, an algorithmic stablecoin, and its associated Luna cryptocurrency collapsed during the second week of May, resulting in over $40 billion of investor losses. Tether, the largest asset-backed stablecoin, declined to a per-coin value of 95 cents during the same week and struggled to regain parity with the U.S. dollar.

Between April 29 and May 20, the total value of Tether coins fell from $83 billion to $77 billion and the combined values of Tether and fourteen other leading stablecoins dropped from $181 billion to $155 billion. Terra’s collapse and Tether’s wobbles provide clear warnings about the significant risks that stablecoins pose to our financial system and our economy. The collapse of a major stablecoin like Tether could potentially unleash a systemic financial panic and impose widespread losses on investors, consumers, businesses, and financial institutions.]

The foregoing summary has been cross-posted by permission from The FinReg Blog, published by the Global Financial Markets Center at Duke University’s School of Law.

Arthur E. Wilmarth, Jr. is a Professor Emeritus of Law at George Washington University Law School.