Stablecoins – Presidents Working Group (PWG) report

Two weeks back, the Presidents Working Group on Financial Markets (PWG) released a report on Stablecoins. The PWG includes the Treasury, Federal Reserve, SEC and CFTC is tasked with ensuring stability and strength of the U.S. financial system. The PWG was asked by the Treasury Secretary in July 2021 to assess risks of Stablecoins; identify gaps in oversight that could weaken the financial system and recommend measures to close those gaps.

What are stablecoins? Simply put stablecoins are a class of cryptocurrencies that are designed to maintain a stable value. Stablecoins maintain their stable value by having a collateral of reserve assets which could be a fiat currency like USD or precious metal like gold but can also be backed up by cryptocurrencies themselves. Another type of stablecoins is non-collateralized and maintains price stability through algorithmic supply expansion and contraction of the stablecoins.

Why are stablecoins popular? Stablecoins address the primary concern of excessive volatility that investors have over cryptocurrencies like Bitcoin while still retaining the attractive features of cryptocurrencies i.e. being fast and cheap to transfer across internet platforms and countries and being open to anyone on the internet without need for a bank account. Stablecoins are integral to DeFi (Decentralized Finance) since they are used for trading, lending and borrowing activity across platforms in DeFi. Stablecoins are also now being used to earn yield in many digital asset trading platforms and as collateral for USD loans.

What are the popular stablecoins? The PWG report notes that the total market capitalization of stablecoins is now over $127 billon and has seen a 500% increase over last 12 months. There are more than 200 stablecoins in circulation with new ones being issued every few months. Some stablecoins have even sought regulatory approval and recently, the New York State Department of Financial Services has approved two stablecoins backed by the US dollar, the Gemini Dollar (GUSD) and the Paxos Standard (PAX) backed by the precious metal, palladium. Even though there are lot of stablecoins in circulation, the market is dominated by three large US dollar pegged stablcoins as shown below with USD Tether, (USDT) being the most popular followed by USD Coin (USDC) which is the stablecoin issued by Coinbase and then Binance USD (BUSD) which is issued by the Binance. All three of these stablecoins are centralized in the sense that they are issued by a single digital platform (Tether, Coinbase, Binance respectively) while Dai on the other hand is an example of stablecoin that is decentralized and is crypto-backed.

What are the risks of stablecoins? The PWG report accurately breaks out all of the activities of stablecoin issuers into three broad areas; (A) creation and redemption of stablecoins (B) transfer between platforms and (C) storage of stablecoin. As noted in the report, gaps in the above activities could result in the following;

(1) use of reserve assets that fall in value or become illiquid

(2) failure to safeguard reserve assets

(3) lack of clarity about redemption to users

(4) operational risks of cybersecurity and collecting, storing and protecting data.

The above gaps could result in loss of value or liquidity or both for stablecoin users which could get exacerbated and result in stablcoin ‘run’. Secondly, broad usage of stablecoins as a means of payment also raises risks to financial system and caused macroprudential concerns since banks could lose retail deposits to stablecoins and this could result in increased borrowing costs and less credit circulation. Lastly, given dominance of few stablecoin issuers, failure of one of them could result in systemic risk and also create opportunities for abuse of power.

What does the Presidents Working Group recommend for stablecoins? Today there is no uniform set of regulatory standards for stablecoin issuers in US and given the inter-connection of digital asset platforms and custodial wallet providers with stablecoin issuers there is a need to develop a consistent regulatory oversight over all parties. Against that background, the report recommends three key measures to ensure market integrity, investor protection and prevent anti-money laundering. These 3 key recommendations are ;

1. All stablecoin issuers should be insured depository institutions and meet appropriate risk management standards. Supervisors should have authority to implement standards to promote interoperability among stablecoins.
2. All custodial wallet providers should be subject to appropriate federal oversight. Federal supervisors of stablecoin issuers should require that any entity that performs activities that are critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards
3. To prevent market concentration, all stablecoin issuers and custodial wallet providers should have restrictions to limit affiliation with commercial entities.

 In the interim, the PWG report also recommends that activity related to digital assets that falls under the jurisdiction of the SEC and CFTC should be subject to enforcement, rulemaking and oversight by them to address above concerns.

This short but impactful report shows how the current Treasury is responding to new technological advances and to the changing demand for financial services by taking the first step to put in place prudential safeguards for responsible financial innovation.