Stablecoins Do Not Deserve Special Treatment

In the wake of the May 2022 stablecoin meltdown, paradoxically, the United States House of Representatives is looking to introduce a House bill on stablecoins which would be an enormous step backward. Instead of addressing the consumer protection issues raised by stablecoin products, this proposed bill would increase the risk of stablecoins by creating an unnecessary bespoke regime and regulatory carveout. The bill is led by Patrick McHenry (R-NC) and is likely written explicitly by the crypto lobbyists. This bill would expressly allow non-bank financial institutions to issue dollar-denominated stablecoins, which is a highly inadvisable outcome. To understand the policy issuers at play here, we first need to discuss stablecoins.

Stablecoins are effectively dollar derivative financial products used for offshore payments to entities involved in the crypto asset ecosystem outside the traditional financial system. Stablecoins exist for two primary reasons:

  1. The proliferation of offshore crypto exchanges, whose businesses are in direct conflict with US Securities law and are thus set up in Caribbean tax shelters to avoid regulators and require a settlement network outside of the remit of US law and the AML/CFT framework.

  2. To avoid capital gains tax when converting between positions on speculative crypto assets. Instead of withdrawing to dollars—which is a taxable event—allowing crypto speculators to hold their winnings in stablecoins stored with the house, much like casino tokens.

Stablecoins are somewhat structurally similar to money market mutual funds (MMMF). Investors in stablecoins purchase “shares” in a managed fund of theoretically highly liquid assets (called reserves) with the expectation that the shares will always be valued at one dollar. In reality, the actual value of each “share” in the stablecoin fluctuates depending on the underlying assets that the fund holds. Moreover, when customers go to redeem their shares for real money may not be sufficient funds to cover withdrawals, thus “breaking the buck.” However, unlike MMMFs, the shares in the stablecoin fund are generally not interest bearing, are tradeable on crypto exchanges, and used as a medium of exchange for payments as a theoretical substitute for actual dollars.

Thus stablecoins are not “simple e-money”; they depend on a complex chain of intermediaries and risks from many different counterparties, including the issuer of the stablecoin, the custodian of the stablecoin reserves, and the banking partners of the stablecoin issuer, and the issuers of the reserve portfolio components. For an ordinary fund like Vanguard VMRXX, anyone can go on their website to inspect the entire daily portfolio and get the CUSIPs for every component of the product. Unfortunately for stablecoins, no such transparency exists; these products are giant financial black boxes of unknown assets where customers have almost no insight into what they are buying or what is backing them.

The most popular stablecoin issuer, Tether, and their product USDT is infamously an 80 billion dollar black box, making them theoretically one of the largest managed funds in the world. However, nobody knows what comprises their counterparties or reserves or which country the assets are held. The company’s US subsidiary has been banned from doing business in the state of New York after an investigation into the fund, which led the NYAG to issue a very not subtle remark:

Tether’s claims that its virtual currency was fully backed by US dollars at all times was a lie. These companies obscured the true risk investors faced and were operated by unlicensed and unregulated individuals and entities dealing in the darkest corners of the financial system.

Similarly, in the United States, the company Circle issues a product known as USDC. Again, theoretically, this product is backed by a mixture of cash and short-duration US treasuries, but the company has not offered the same level of daily transparency reports equivalent to money market funds. We have far less insight into the fund’s total value and relationship to the underlying reserves. The working model for many of these stablecoins appears to be “trust, don’t verify; we have not had a run yet.” Matt Taibbi’s detailed analysis of the Circle reserve situation raises legitimate concerns about consumer protections.

Last year the President’s Working Group on Financial Markets, FDIC, and OCC released a report clearly outlining the need for regulation on stablecoins. The observation is clear: a growing number of Americans are now exposed to these products, yet the industry increasingly wants to obscure the risk involved in the product for their profit-seeking intents. This situation is not all that dissimilar from similar surrogate money schemes that arose in the Wildcat Banking Era in the Americas in the 1800s, where private money issuers would shuffle reserves of gold between institutions whenever audited, to create the illusion of solvency, and to issue massive amounts of unbacked bank notes. In light of all this, the working group’s conclusion was to require that only insured depository institutions, such as banks, be allowed to issue stablecoins.

Now with McHenry’s bill and the unexplainable support of some Democrats in the House Financial Services Committee, we appear to be revisiting the analysis of the President’s Working Group paper in favor of a far more complicated and risky policy solutions to rein stablecoins in. The question that policymakers have to act on is a pure matter of consumer protection, given that many consumers now treat stablecoins like a form of pseudo-bank deposit but with zero protections customarily offered by banks. In the event of a stablecoin collapse, all customers would be treated as our general unsecured creditors in an event not unlike the bank runs that occurred during the Great Depression. That is not an era we want to revisit.

As part of this discussion, we should first be asking why stablecoins should even exist in the first place. These products form the backbone of the crypto shadow banking world, allowing crypto exchanges to sustain their offshore casinos. To the extent that Americans are using these services, they are using them to gamble and avoid taxes. While at the same time, the flow of stablecoin between these offshore entities is an enormous hub for illicit financing used by Russia, North Korea, and other entities not aligned with the eco-political interest of the United States to avoid sanctions. Reuters reports that Binance served as a conduit for laundering at least $2.35 billion in illicit funds. It does not appear to be in the interests of the United States to create a bespoke regulatory regime simply to allow products that overwhelmingly undermine American foreign policy interests and the dollar hegemony, which forms the basis for the rules-based international system on which we all depend.

Even if stablecoins were regulated as banks, they would require deposit insurance which utlimately depends on the mutualization of risk across all American taxpayers. Why should the American taxpayers backstop a digital bearer instrument that is by foreign actors who don’t contribute to the insurance of said instrument? Even more so if the instrument is primarily itself a vehicle for tax avoidance in the first place. Stablecoins represent a drastic expansion of exactly the same shadow financial system that led to the Panama Papers leaks and would escalate these conditions tenfold.

In the second part of the discussion, we should consider the systemic risks of allowing stablecoins, backed by black box reserves, to grow to become a more significant part of the economy. If left unchecked, the systemic consequences would pressure national authorities to bail out stablecoins if any underlying funds collapsed. These events seem highly likely given their structural similarities to MMMFs. Remember that in September 2008, a money market fund with exposure to Lehman Brothers broke the buck, and the event cascaded into other money market mutual funds, causing panic and eventual government bailout. Moreover, subsequently, again, a similar event happened in March 2020 during the coronavirus-induced market downturn and required Federal Reserve intervention. Stablecoins present an even greater risk profile than money market funds, and we have now seen a decade of repeated government bailouts of similar products. We should work under the assumption of moral hazard created by the high probability of a government bailout of a failing token if widespread consumer use is allowed.

The third part of the discussion is that the networks that stablecoins run on are entirely based on the offerings of illegal securities. For instance every “rail” that the Circle USDC stablecoin runs on, itself depends on the purchase of illegal securities offerings (from initial coin offerings) for the functioning of the USDC stablecoin.

  1. Avalanche - Initial Coin Offering in 2020 which was an unregistered security.
  2. Tron - Initial Coin Offering in 2017 which was an unregistered security.
  3. Algorand - Initial Coin Offering in 2019 which was an unregistered security.
  4. Solana - Initial Coin Offering in 2020 which was an unregistered security.
  5. Ethereum - Initial Coin Offering in 2014 which was an unregistered security.
  6. Polygon - Initial Coin Offering in 2019 which was an unregistered security.

Entrenching stablecoins into law, on top of platforms which are in violation of the law, presents a legal paradox. And would fundamentally limit SEC enforcement action in the future. Under this law, to make an illegal security offering legal, one need only launch a “payment stablecoin” on top to exempt it from security classification. This is a strange loophole, that will be exploited by the industry.

The McHenry stablecoin bill is an enormous step backward on regulation that Democrats should not advance. Stablecoins should be issued strictly by banks, or centralized companies should be banned from issuing stablecoins entirely. As a society we should also be asking the fundamental question: Why are we regressing back to fascination with private money issuance instead of improving public money infrastructure. The history of the United States tells us that private forms of money do not last long and do not end well for the public.

There is nothing that stablecoins could ever do that non-blockchain-based payments solution (e.g. UPI, FedNow, SEPA) do not better, other than regulation and tax avoidance. Creating a bespoke regime for stablecoins only serves to expose consumers to undue risk for seemingly no reason. Maxine Waters and other Democrats on the House Finance Committee should look beyond the decentralization hype and consult leading financial stability experts and technologists before advancing ill-advised stablecoin laws. If these products must exist, they must be regulated as banks.