The Stablecoin Problem

The below article is a guest post by Amias Gerety, partner at QED Investors.

A wave of crypto-enforcement cases involving successful crypto companies in the U.S. (not just obvious scams) was the opening salvo from U.S. regulators trying to come to grips with the explosive growth of the crypto and DeFi ecosystem.  These enforcement actions have now been paired with a stablecoin report recommending that Congress take action to require stablecoin issuers to be insured depository institutions (banks) and forthcoming actions from the bank regulators to defend the regulatory perimeter.

I was the first-ever staffer to support the Financial Stability Oversight Council – a justice league of regulators. I believe that the most important regulatory failure leading up to the great financial crisis was a failure to require that large new markets operate within established standards for disclosure, safety and soundness. It is safe to say that the financial crisis was defined by a run on the shadow banking system. Moreover, many stablecoins – particularly algorithmic stablecoins or those backed by commercial paper – fit the classic definitions of shadow banking.

But by recommending new legislation, the stablecoin report actually increases uncertainty in the U.S. regulatory regime.

First, given other priorities and heading into an election year, the chances of Congress passing a new legislative regime into law are near zero. Second, even if legislation were to succeed, what would it say? The report is not clear. But it appears that U.S. regulators are making the exact same errors as the DeFi boosters – namely, prioritizing technology over substance and overcomplicating a muddled conversation.

The U.S. government should move urgently to clarify the regulatory approach to stablecoins, but the tools to do so will mostly not require new legislation.

There’s an old truism that “financial services is a highly regulated industry.” This is also true.

At its core, we regulate financial services because financial services are the business of taking people’s money in exchange for promises, rather than in exchange for goods and services.

Stablecoins offer the simplest version of this promise – a promise of safekeeping. And while much of the discussion of stablecoins, and much of their function, has focused on their use as a new payment system, it is the ability to fulfill this safekeeping promise that enables all the other functionality they can offer.

Overlooked by the stablecoin report’s recommendation of new legislation is the fact that this promise is already regulated in the United States. It’s already clear that only banks and trusts have the ability to make this promise legally to U.S. consumers, and money market funds are another fully regulated way to make a version of this promise. In fact, many stablecoin issuers are already complying with this framework, either by partnering with banks and trusts or by getting licensed themselves.

Though the language and the history of financial regulation is complex, there are only five fundamental promises you can make with money:

• Holding money with a promise to keep it safe – these transactions are almost always regulated as a bank deposit or a trust account.
• Taking money with a promise to use for some profit-making exercise – this is defined in U.S. law as selling a security.
• Taking the money and promising to pay it back with interest – this is called borrowing, which at truly 1-1 scale can be unregulated, but at large scale ends up being another form of security.
• Taking the money and promising to make a larger payment if something bad happens – this is regulated as insurance.
• Finally, there are derivatives, which sometimes can involve only the exchange of promises, and are after Dodd-Frank fully regulated as well.

That’s it. In fact, looking at the framework of financial services as a series of regulated promises, we could rapidly bring clarity to the regulatory perimeter and the DeFi ecosystem.

Of course, the crypto world is full of arguments that many tokens should not be regulated because they have utility. But there’s very little in the world of crypto that looks like handing someone a bushel of corn.

Successive generations have experimented with new technology and new language to apply to these promises, but the current iteration of DeFi has shown very little that has made new kinds of promises.

Arguably, the U.S. government should be much more aggressive in enforcing banking law, and so very few crypto projects are themselves regulated as banks or trusts. Partly, this is because one quirk of U.S. law is that banking regulators do not have direct authority to bring enforcement actions against unregulated banking, even as they do have authority to bring enforcement actions against regulated banks. Therefore, one of the most important steps on stablecoins would be to work with the Department of Justice on enforcement against entities that are not working within the regulated system of banks and trusts. Unfortunately, the stablecoin report has only a single passing reference to the DOJ.

The comparison between banking law and securities law here is instructive. U.S. securities law operates with a particularly well-enforced regulatory perimeter, where the SEC has plenary authority to enforce the laws it oversees. Any person can issue a security. And in securities law, there are already clear exemptions and frameworks for people who operate only a small scale.

Stablecoins may also end up participating in a long-running debate among the financial regulatory community around money market funds. There is a long history of financial regulators worrying about the difference between money market funds as securities and as bank deposits. For the purposes of this analysis, the point is that both are regulated activities.

While the industry has traditionally decried “regulation” by enforcement, this is in fact the most direct way to bring clarity to a rapidly growing part of the financial services industry.

While interesting and clever software programming and a powerful movement of global consumer participation have enabled the decentralization of financial transactions (what a decade ago, we would have called peer-to-peer), the conflict with U.S. regulators largely stems from the desire to have a truly permissionless financial system, free from government oversight.

But mass civil disobedience on financial regulation is not itself an innovation. Creating a set of products with the goal of circumventing regulation to benefit from a lower-cost structure is an age-old strategy.

We can salute the clever programming and the consumer excitement for decentralization as a concept, without dropping our commitment to financial regulation.

For the many in the crypto ecosystem who want to play by the rules and just seek clarity, we can simplify the world with the application of only two principles.

• Principle #1: I have an affirmative obligation to follow the law.
• Principle #2: One of these frameworks, which is already described in the law, must apply.

None of this says that financial regulation in the U.S. is simple, nor that innovation can’t deliver benefits. But in order to provide clarity, we should start with a clear intent to enforce the laws that stand today.

Moreover, excitement about Web3/crypto/DeFi should not dim our hope for future innovations of “Web4” or “Web5.” We don’t know what future tech waves will bring. Then, if there is legislative movement, we should be trying to remove references to technological standards, rather than enshrining new regulatory regimes around the technology of the current moment.

Also see: Ex-Treasury Official: Crypto Fits Under Existing Financial Regulations; Deal With It