The exploding stablecoin market has increased the urgency of providing a regulatory framework for banks to participate in this fast-growing asset class.
As regulators set a path for banks to become more involved in the fast-growing asset class, further clarity will unfold in 2022, likely led by federal agencies since congressional action may lag. Currently, stablecoin issuers, which mint a blockchain-driven cryptocurrency tied to the U.S. dollar on a one-to-one basis often used to buy other cryptocurrencies, rely on a select number of federally chartered banks or state-level charters to operate in the space. Banks already servicing stablecoin companies, such as Silvergate Bank, have reported massive asset growth — and skyrocketing share prices — over the last year, and some of the nation's largest banks including JPMorgan Chase & Co. are exploring their own cryptocurrency technologies to facilitate payments.
In November, the Office of the Comptroller of the Currency reiterated an interpretive letter issued in October 2020 that allows banks to hold dollar deposits to back stablecoins under certain circumstances, but the OCC added that banks must obtain approval from their supervisory office and demonstrate the ability to hold these deposits in a safe and sound manner. On the same day, the OCC, along with the Federal Reserve and Federal Deposit Insurance Corp., announced that they will formulate more policies through 2022 regarding banks' activities involving cryptocurrency, including the issuance and distribution of stablecoins. And FDIC Chairman Jelena McWilliams said this week that the regulator is considering how to provide deposit insurance for stablecoin accounts.
The three agencies joined the President's Working Group on Financial Markets to outline guidance on applying stablecoins as a means of payments and store of value in a Nov. 1 report. They called for Congress to pass legislation that creates a supervisory infrastructure for stablecoin issuers that requires the largely private companies to become insured depository institutions, an expensive, time-intensive regulatory process. But congressional action appears unlikely in the near-term.
"The simple reality is Congress at the moment is struggling to even keep the lights on, let alone legislate on an innovative and constantly moving subject like blockchain," said Isaac Boltansky, director of policy research at BTIG. A comprehensive legal framework may not be written into law during this Congress and even the next one, Boltansky said in an interview.
Regulatory developments over the last month suggest officials are concerned the stablecoin market has grown so much that the patchwork regulatory system could prove insufficient to protect markets from systemic risk should a stablecoin issuer collapse. If a stablecoin issuer's reserves backing the cryptocurrency proved insufficient, consumers could face a liquidity crunch, unable to retrieve their funds.
"Funding risks were an emerging concern at entities issuing stablecoins, because they appeared to have structural maturity and liquidity transformation vulnerabilities similar to those for money funds but with considerably less transparency and an underdeveloped regulatory framework," according to the latest available minutes, released Nov. 24, from the Federal Open Market Committee, a joint meeting of top regulators.
Despite different technology and terminologies, cryptocurrency is a medium to exchange and store value, and it fits in the historical lexicon of money. Banks are primarily focused on stablecoins right now because the path seems to be shorter to a potentially acceptable regulatory approach when compared with other cryptocurrencies, David Sandler, co-head of financial services investment banking at Piper Sandler, said in an interview.
"Given the economic similarities between payment stablecoins and bank deposits, I have no objection to the idea of banks issuing both instruments," said Christopher Waller, a member of the Federal Reserve Board of Governors, at a conference Nov. 17. But stablecoin issuance should not be conducted by only banks, and innovators outside of the banking sector should be permitted to compete on a clear and level playing field, Waller said.
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What to expect next
The working group paper suggested federal agencies, as well as the Financial Stability Oversight Council, would police the stablecoin marketplace, if the Congress does not act in a timely manner. Analysts said congressional action appears unlikely in the near-term as Washington wrestles over other contentious matters.
The report could set a path to regulate stablecoin issuers and activities under the Dodd-Frank Act's Title VIII of payment, clearing, and settlement supervision, because the application of stablecoins is essentially forming a new infrastructure to process payments, said John Popeo, partner at bank consultancy The Gallatin Group. Under the Title VIII regime, payments moved via stablecoins or the stablecoin issuers themselves could be designated as systemically important institutions and thus subject to the standards of operation set by the Fed, the U.S. Commodity Futures Trading Commission, the Securities and Exchange Commission and the FDIC.
Boltansky echoed that activities-based systemically important designation under Title VIII appears to be the likeliest option. It provides the FSOC with the clearest and relatively quickest avenue for action, he wrote in a research note.
"Ultimately I'm encouraged because I think part of what you're seeing reflected in the PWG report is an understanding that this is a new architecture for money. And this is a new financial market architecture, and the answer is not just slam it into the old one," Jeremy Allaire, CEO at stablecoin issuer Circle Internet Financial Ltd. said in a webinar hosted by the Brookings Institution Nov. 3. Circle in August filed with the SEC to be a full-reserve national commercial bank.
Banks' interest picking up
Universal banks such as JPMorgan and Citigroup Inc. have experimented with designing their own cryptocurrency to facilitate payments. Smaller banks have also started to evaluate the costs and economic benefits of servicing cryptocurrency, or deploying blockchain technology in their infrastructure.
Silvergate Bank, one of the most active banks in the crypto space, is mulling its options following the working group's report. One strategy could be to launch its own branded stablecoin, according to a Nov. 17 report by Wedbush Securities, citing the bank's top executives in a recent investor meeting.
Banks have been in active talks to deploy blockchain-enabled payments infrastructure after seeing the success of pioneers such as Signature Bank, said Ron Totaro, CEO of fintech firm Tassat Group LLC. Tassat holds the intellectual properties of what powers Signature Bank's blockchain payment platform, Signet.
Tassat helps banks create one cryptographic token for each dollar — similar to the stablecoin concept — and transfers these tokenized U.S. dollars in a blockchain network in real time. Early adopters believe this mechanism is faster and transparent, resolving the long-time headache of slowness in the U.S. payment system.
Tassat's payments technology has been reviewed by the New York Department of Financial Services, the OCC, the Fed and the FDIC, Totaro said. Regulators often examine whether the digital tokens are one-to-one redeemable to U.S. dollars held in the banks' demand deposit accounts.
Banks and regulators are concerned about the high volatility and high risks of cryptocurrency, making stablecoin "a valuable piece of this puzzle," said Richard Baier, president and CEO of the Nebraska Bankers Association. Nebraska's legislature this year passed a bill that would allow banks to trade cryptocurrencies.
Several states are leading the regulation of cryptocurrency arrangements, creating the patchwork system that enables current operations. The New York Department of Financial Services in 2015 wrote virtual currency regulation into the state banking law and now supervises 26 nonbank entities' cryptocurrency-related operations. The Wyoming Division of Banking in 2019 created a charter of "special purpose depository institutions" for nonbank entities who administer digital assets and now oversees four companies under this charter.
In October 2021, the Nebraska Financial Innovation Act took effect. The act allows digital asset depository institutions to obtain charters. State-chartered financial institutions can also apply to conduct digital asset related activities within a segregated division.
Although the nonbank issuers' efforts to fit in banking appear to be cumbersome amid all the uncertainties, it could pay off in the long term. "We continue to believe that market participants embracing either bank partners or bank-like regulatory regimes will be best positioned," Boltansky wrote in the report.