Regulate stablecoins. Please! | Financial Times

The author is a former chairman of the US Federal Deposit Insurance Corporation and currently serves on the board of Paxos, a blockchain company and regulated stablecoin issuer. The views are her own.

Everything old is new again and there is nothing new about a financial company telling investors that something is safe when it is not.

Such was the case with last month's all-too-predictable meltdown of Terra, a so-called stablecoin cryptocurrency whose issuers had promised would maintain a value pegged to the U.S. dollar but backed up that promise with little more than an algorithmic wing and a prayer.

One might think that preventing such disasters would be the responsibility of a U.S. regulator. Unfortunately, the alphabet soup of U.S. Treasury authorities makes it unclear who has authority. It is time for regulators to get creative and use their current powers to act. The Securities and Exchange Commission has a regulatory model tailored to stablecoin issuers: government money market funds. Both stablecoins and sovereign money market funds promise investors liquidity and stable value – a dollar in, a dollar out. Both rely on the security of the reserves behind them for their stability.

Government money market funds have proven safe and resilient in times of stress because they are required to invest their reserves in cash and highly liquid federal-backed securities. They are subject to strict rules regarding investor disclosure and transparency. Subjecting stablecoin issuers to these rules would make this market safer for investors.

Such a move would require the SEC to determine that stablecoins are securities. This would be an untested interpretation. The traditional legal test for a security involves an investor's expectation of profit, and most stablecoins do not provide a return. At a minimum, the SEC could pursue a voluntary regulatory regime to give responsible stablecoin issuers a credible regulatory framework for their operations and help investors distinguish them from riskier offerings.

An alternative would be banking regulation. This was the proposal of a group of leading US financial regulators. However, forcing the stablecoin business into banks would require legislation, and the idea has found little traction in Congress. Banking regulators could approve stablecoin issuers' voluntary applications for banking licenses, but this has drawbacks.

For one, it would give stablecoin issuers access to safety net programs, including deposit insurance and the ability to borrow from Federal Reserve banks. So it would provide stability to stablecoins, but at the expense of the government. Furthermore, moving this business into banks would exacerbate the risk of excessive money creation – which is already embedded in the proliferation of cryptocurrencies. Banks “create money” by lending out most of their deposits, which borrowers in turn invest with other banks that lend them out, and so on. The last thing we need is more money creation.

These concerns could be partially addressed if banking regulators would supervise stablecoin issuers as escrow banks, a model pioneered by the New York State Department of Financial Services' regulation in regulating three stablecoin issuers. (Disclosure: I am on the board of Paxos, one of these trusts.) For the issuers it regulates, the NYDFS has just published guidance limiting stablecoin reserves to bank deposits and short-term U.S. Treasury securities, with credible third-party verification.

Trust banks are subject to robust capital and liquidity requirements, but do not accept deposits and therefore do not benefit from deposit insurance. Still, banking regulation is ill-equipped to deal with the problems of investor protection, transparency, manipulation and fraud that plague the crypto world. This is the specialty of market regulators like the SEC, not banking regulators who specialize in credit risk.

Other partial solutions include the Commodity Futures Trading Commission making greater use of its broad enforcement authority to combat fraud and manipulation. Or the Financial Stability Oversight Council, a group of US regulators responsible for financial stability, could designate stablecoins as potentially systemically important and give the US Federal Reserve the authority to impose some supervisory standards on them.

None of these steps would preclude legislation. If regulators move forward, it could actually spur Congress to act. One thing Congress should not do is create a new crypto asset regulator. We already have too many. One or more need only clear authority from Congress to act. Until then, people will be hurt - pensioners, ordinary investors and young people. It's time to do something.