LianGuai Paradigm Stablecoins have their unique characteristics and should not be included in the regulatory frameworks of banks and securities.

LianGuai Paradigm Stablecoins should not be regulated by banks and securities as they have unique characteristics.

Author: Brendan Malone, LianGuairadigm

Translation: Luffy, Foresight News

Stablecoins present a rare opportunity to upgrade and expand the digital payment systems in the era of the internet. However, despite technological advancements and growing customer demands in the digital economy worldwide, recent regulatory actions and legislative proposals are forcing encrypted payment tools into existing banking and securities frameworks, which is a step backward.

If legislative work in this field is to continue moving forward, lawmakers should focus on three key objectives:

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• To address the risks faced by USD stablecoin users, legislation may require centralized issuers of USD stablecoins to meet appropriate risk management standards. For fiat-backed stablecoins that claim to guarantee redemption at face value, issuers must hold reserve assets to demonstrate their match with outstanding stablecoin balances. These reserve assets can consist of bank deposits and short-term government bonds, which should be segregated from the issuer’s own assets, immune to creditor proceedings, and subject to evaluation or audit. Importantly, these issuers do not have to be banks and do not need to be subject to similar banking regulations.
• To promote growth and competition, legislation can prioritize a fair and effective competition between stablecoins and existing banks, along with related services. This includes setting clear barriers to ensure that the regulatory framework for stablecoins, as well as regulations for traditional payment infrastructure, have objective, risk-based, and publicly disclosed licensing qualifications, allowing both banks and regulated non-bank entities to obtain licenses fairly at the state and federal levels. Access for end users, whether businesses or individuals, should also be liberalized.
• To encourage responsible stablecoin innovation, legislation can provide consumers and businesses with a wide range of payment and related services. Regulations should not dictate that all stablecoins must be pegged to the US dollar or prohibit algorithmic stablecoins and on-chain over-collateralized stablecoins. Instead, experimentation and innovation should be allowed within additional rules that ensure consumer protection and proportionate risk levels.

Background

Although recent proposals in the US Congress allow entities other than banks to issue stablecoins, policy discussions surrounding appropriate barriers often focus primarily on the traditional safety and soundness principles of bank regulation, such as capital requirements or securities-related risk management frameworks.

Given the unique risks of stablecoins and the current use cases, traditional banking and securities frameworks are flawed for regulating stablecoins. Policymakers should develop a new framework that promotes openness and competition more than the current banking or securities frameworks.

Specifically, while ensuring the resolution of prudential risks and market risks is crucial, we believe that the regulatory framework must allow payment stablecoins to function and thrive. Regulatory barriers can help maintain confidence in stablecoins as a form of currency and ensure that the power of our monetary system does not fall into the hands of a few market participants.

What is Stablecoin?

Stablecoins are digital dollars issued on a public, permissionless blockchain. Due to the characteristics of blockchain, they can significantly improve the digital payment ecosystem.

• Reliable, shared infrastructure. Public blockchains are data and network infrastructure with more open access and longer normal operation time, requiring very limited upfront capital expenditure for payments and tokenization.
• Programmability. Thanks to smart contracts, most public blockchains are programmable and can transparently execute complex code based on arbitrary conditions set by users.
• Composability. Applications and protocols built on public blockchains can be combined to create new functionalities.

These features make it possible to design a new generation of electronic payment systems that can significantly reduce the intermediation of bank balance sheets and create new paths for the efficient flow of payments. Stablecoins rely less on the banking system and intermediation in balance sheets by using different mechanisms to maintain stability.

At the same time, trust and confidence are fundamental characteristics of money. Regulatory infrastructure that maintains trust and confidence in stablecoins can help their flourishing. However, if stablecoins are shoehorned into regulatory frameworks that are not suitable for banks or money market funds, they will eventually look like banks or money market funds and be as inefficient as existing financial services.

From a risk perspective, stablecoins are not bank deposits

Banks play a core role in the financial system and the wider economy. They hold the savings of countless households and businesses on their balance sheets. In addition to accepting deposits, they also provide loans to individuals, businesses, government entities, and a range of other clients. If businesses can only rely on self-financing or individuals can only purchase houses or cars with cash on hand, commercial activities will be severely constrained.

Banking activities can also be high risk. Banks take in customer deposits (which customers can withdraw at any time) and make loans or invest in bonds or other long-term assets (engaging in so-called maturity transformation). In this process, banks may suffer losses due to misjudgment. If all customers of a bank collectively withdraw their deposits and the bank may not have enough assets on hand, it can lead to panic, bank runs, and fire sales. If a bank mismanages its operations and suffers losses due to bad loans or investments, it can also affect its ability to repay customer deposits.

Stablecoins inherently face different risks from banks. The issuer of a stablecoin tied to the US dollar (which can be redeemed on demand according to its terms) may hold reserve assets to meet customer redemptions. These reserve assets may be matched to the stablecoin issued and consist of central bank liabilities or short-term government bonds that are segregated from the issuer’s own assets, not subject to claims of creditors, and subject to evaluation or auditing. Specific safeguards may be required under federal regulations implemented by newly enacted legislation. If so, unlike bank deposits, there is no maturity mismatch between short-term liabilities (stablecoin holders can redeem at face value at any time) and long-term or risky assets.

More generally, even for stablecoins that are not pegged to the US dollar or do not promise redemption at face value, the issuer fundamentally does not engage in maturity transformation like a bank. Safeguards can be put in place to ensure consumer protection and maintain financial stability. These safeguards may include information disclosure, third-party audits, and even basic consumer protection rules for centralized service providers offering or promoting such stablecoins.

Essentially, the risk management framework applicable to stablecoins should aim to manage the unique risks associated with stablecoins, which are different from those in traditional banking.

Stablecoins differ from MMFs in practice

Regulatory bodies, including the SEC, have stated that certain stablecoins resemble money market funds (MMFs), especially when they hold various assets such as government securities and cash as reserves to maintain their value stability. Therefore, these stablecoins should be regulated as money market funds (MMFs). We believe this is an inappropriate regulatory approach because the actual market use of MMFs differs from stablecoins.

MMFs are open-ended investment companies regulated under securities laws. They invest in high-quality short-term debt instruments such as commercial paper, treasury bills, and repurchase agreements. The interest they pay reflects prevailing short-term rates, they are redeemable on demand, and they are required to maintain a stable net asset value per share under SEC Rule MMF, typically at $1.00 per share. Like other mutual funds, they register with the SEC and are regulated under the Investment Company Act of 1940. MMFs are publicly traded investments purchased and traded through securities intermediaries such as qualified brokers or banks.

Over the years, various types of money market funds have been introduced in the market to meet the different needs of investors with different investment objectives and risk tolerances. As classified by the US Securities and Exchange Commission nearly a decade ago, most investors invest in prime money market funds, which typically hold various short-term debt issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper. In contrast, government money market funds primarily hold debt issued by the US government, including the US Treasury, as well as repurchase agreements secured by government securities. Government money market funds generally offer higher principal safety but lower yields compared to prime funds.

The combination of principal stability, liquidity, and short-term yield offered by money market funds bears some similarities to US dollar stablecoins. However, it is important to note that stablecoins serve different purposes in practice compared to money market funds, and if stablecoins were regulated as money market funds, most stablecoins would lose their utility.

In practice, stablecoins are primarily used as a means of payment in cryptocurrency transactions, rather than as investment choices or cash management tools. Holders of USD stablecoins do not receive any return on their reserves. Instead, stablecoins are used as cash equivalents. USD stablecoin holders typically do not seek to redeem the value of their stablecoins from the issuer and then use the proceeds for cryptocurrency transactions. They only need to transfer the stablecoin itself as the USD payment part in cryptocurrency transactions. It would be impossible or impractical if stablecoins were regulated as money market funds (MMFs) and required holders to sell them through brokers or banks.

We believe that it is wrong to force stablecoins into the MMF regulatory framework, especially when there is an opportunity to create a more suitable framework through legislation. In fact, the Supreme Court has refused to expand the SEC’s jurisdiction to such instruments.

In other words, just as money market funds are subject to different regulations from other investment companies due to their different structures and purposes, stablecoins should also be subject to regulations consistent with their unique structures and purposes.

Conclusion

We believe that limiting stablecoins to existing banking and securities law frameworks would overlook key principles of payment systems, especially those related to fairness and open access. The uniqueness of payment systems lies in the dynamic network effects, where the benefits users derive from the system increase with the number of system users. Coupled with barriers to entry, including overly burdensome and strict bank-like regulations on stablecoin issuers, these factors often limit competition and concentrate market power in a few dominant players. If left unchecked, this can lead to a decline in customer service levels, price increases, or insufficient investment in risk management systems.

This concentration of power would also be a curse on the freedom of choice and decentralization of cryptocurrencies. Stablecoin issuers or service providers with centralized market power may make governance decisions for public blockchains and also influence the balance of competition among other participants. They can choose to disadvantage certain participants (and their customers) by limiting access, while rewarding favored cryptocurrency service providers with preferential treatment, thereby enhancing their own market power.

For these reasons, we urge Congress to take immediate action to enact legislation that addresses the risks posed by stablecoins, while still allowing stablecoins to function and continue to innovate. Legislation of this kind, based on these principles, would address critical issues while still allowing the operability of stablecoins:

1. Protect stablecoin users by setting reasonable risk management requirements for centralized service providers;
2. Ensure that non-bank issuers at the federal and state levels have viable avenues to fairly participate in competition;
3. Stablecoins can adopt various models as long as they meet consumer protection benchmarks and appropriately manage risks, thereby promoting innovation.

Acknowledgement: Special thanks to Jess Cheng for her assistance with this article.

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