The Stablecoin TRUST Act is a good start but falls short in key areas

Depending on who you ask, private stablecoins are a new technology that will change the way we do business or a passing crypto-crazed fad. The dichotomy is on full display in the federal government. 

Some in Congress want to outlaw stablecoins, while others embrace them. The newest congressional embrace, the Stablecoin TRUST Act, addresses the administration’s concerns regarding the growth of private stablecoins by standardizing stablecoins’ legal and regulatory treatment, but not in the bank-centric way the administration envisioned. The act provides regulatory certainty that will boost the public’s willingness to accept private stablecoins as payment but proposes a legal framework that has yet to be publicly embraced by the administration or the cryptocurrency industry.  

Private stablecoins are digital instruments that can be purchased and traded over the internet and used as a means of payment. They are designed to trade at stable values relative to a reference currency like the dollar, or a commodity, like gold. However, unlike bank deposits which are also digital money, private dollar-linked stablecoins are not federally insured nor universally accepted as payment. Moreover, there is no guarantee that stablecoins will maintain their value relative to the dollar, and no assurance that they can be readily redeemed for dollars. Much of this uncertainty would be resolved by the passage of the Stablecoin TRUST Act.

There are two types of private stablecoins: reserve asset stablecoins and algorithmic stablecoins. In a dollar-linked reserve asset stablecoin, the dollar proceeds from a newly-issued stablecoin are converted into an equivalent value of high-quality, short-term, liquid dollar-denominated assets held by the stablecoin sponsor. Should the stablecoin trade below $1, the sponsor can liquidate reserve assets and purchase outstanding stablecoins from cryptocurrency exchanges to push the market price towards $1. Should the stablecoin trade above $1, the stablecoin sponsor can issue additional coins to push down the stablecoin price.

There are also dollar-linked stablecoins that hold cryptocurrencies as reserve assets. These stablecoins need to maintain cryptocurrency reserves with a market value in excess of the dollar value of the stablecoins sold. Over-collateralization is necessary because the dollar value of cryptocurrencies like Bitcoin fluctuates daily, sometimes by large amounts. At present, there is no regulation or authority that ensures that reserve-asset private stablecoins maintain adequate reserves.   

Algorithmic stablecoins maintain parity with the dollar using arbitrage trading strategies that involve other cryptocurrencies. Algorithmic stablecoins typically are organized as decentralized autonomous organizations (DAOs) which are comprised of open-source computer code that executes arbitrage trades designed to maintain dollar parity using actively traded cryptocurrencies.

Private stablecoins resemble a number of existing financial instruments, and this similarity creates ambiguity regarding their regulatory treatment. Currently, cryptocurrencies like Bitcoin are treated as commodities subject to Commodities Futures Trading Commission regulations. Depending on their features, private stablecoins can be securities subject to Securities and Exchange Commission regulations or be governed by State regulations that apply to money transfer agents. Algorithmic private stable coins do not fit neatly into any regulatory framework because they are virtual organizations without management, physical assets, financial statements, or even a business address.

The Stablecoin TRUST Act standardizes the definition of “payment stablecoin.” A payment stablecoin must: maintain a stable value relative to a fiat currency or currencies; convert directly into fiat currency by the issuer; be issued by a central entity; not pay interest; be widely used as a medium of exchange and be recorded on a public distributed ledger. The act also clarifies that payment stablecoins are not securities or investment funds and are not subject to SEC regulations.  

This definition excludes many private stablecoins trading today. Algorithmic stablecoins, DAO stablecoins (no central issuer), commodity-linked stablecoins, stablecoins designed for specialized transactions and not general use, and coins not readily redeemable by the issuer are not covered by the act.

Under the act, a payment stablecoin can be issued by different legal entities, each of which is supervised by a state or federal regulator. The act requires no single regulator or regulatory framework other than the common requirements a payment stablecoin must satisfy. Potential issuers include entities holding a National Limited Payment Stablecoin Issuer license, a license or authorization to engage in a state-regulated money transmitting business or a federally insured depository institution. Regardless of the licensing authority, all payment stablecoin issuers must publicly disclose their reserve assets on a monthly basis and have these disclosures certified by a registered public accounting firm on a quarterly basis.

The National Limited Stablecoin Issuer license is a new limited-purpose national bank charter administered by the Office of the Comptroller of the Currency (OCC). Licensees will be subject to capital, liquidity and other requirements set by the OCC and have access to the Federal Reserve bank payments system. Issuers must fully collateralize their stablecoins with high-quality liquid assets and cannot make loans or offer any extensions of credit other than those needed to manage reserve assets, issue, redeem or make a market in their stablecoin.

Unlike the President’s Working Group recommendations, payment stablecoin issuers could, but need not, be regulated as banks. Moreover, there is no requirement that payment stablecoins have federal deposit insurance or face uniform capital, liquidity, risk management or other operating requirements. Private stablecoins that pay interest could still be regulated as securities by the SEC and the act does nothing to clarify the legal and regulatory framework that applies to algorithmic, DAO or commodity-linked stablecoins.

The Stablecoin TRUST Act is a positive step toward legitimizing fiat currency-linked private stablecoins. To its credit, the act recognizes the value of regulatory competition by creating alternative paths to becoming a licensed payment stablecoin issuer. However, the plurality of options may be an anathema given the administration’s preference for a strict bank-centric regulatory framework. Moreover, the legislation’s failure to provide a framework for many popular forms of stablecoins currently trading may lessen its appeal to the crypto industry.

Paul H. Kupiec is a senior fellow specializing in banking and financial industry issues at the American Enterprise Institute.