A $100 billion "financial nuclear bomb" - Stablecoins have caused U.S. regulators to frown

Crypto Lode of $100 Billion Stirs US Worry Over Hidden Danger

By Joe Light

Compiled by: Chen Zou

Regulators worry that investors and even the financial system are exposed to hidden risks from a fast-growing segment of the cryptocurrency market called stablecoins, which are designed to be immune to volatility.

So-called stablecoins are a form of cryptocurrency that has a fixed price, usually one dollar, and is backed by a reserve of real currency.

At the end of May, the total market value of stablecoins exceeded $100 billion, including the stablecoins USDT and USDC provided by cryptocurrency companies Tether and Centre.

In recent weeks, stablecoins have attracted the attention of U.S. lawmakers and officials from the Federal Reserve and the government, who have expressed consternation publicly and privately that some consumers are not protected if one of the companies is not backed by the currency reserves they claim. They also say the growing size of stablecoins has created a situation where large amounts of dollar-equivalent coins are traded without entering the U.S. banking system, providing fertile ground for illicit finance.

“They are a huge threat to both their users and the broader financial system,” Lev Menand, an academic fellow at Columbia Law School, told a Senate banking subcommittee last week.

In recent weeks, government officials have told representatives of stablecoin issuers that consumers don’t understand that funds in stablecoins are not protected by the Federal Deposit Insurance Corporation and that they risk losing money in stablecoins in some cases, according to a person familiar with the matter. Officials are also concerned that criminals can use stablecoins to move money without having to enter the banking system, meaning they can bypass the government’s financial regulatory system, the person said.

Speaking at a Senate Banking Subcommittee hearing last week, Massachusetts Democratic Senator Elizabeth Warren likened stablecoins to the "wildcat notes" issued by undercapitalized banks in the 19th century. These notes later caused many holders to suffer huge losses. If the Fed issues its own digital currency, consumers can get the benefits of stablecoins without taking on huge risks, Warren said.

The United States and other countries are already considering launching their own digital currencies. These tokens, known as central bank digital currencies (CBDCs), would be direct competitors to stablecoins. Later this year, the Federal Reserve Bank of Boston plans to release research and open-source code demonstrating the technology that could be used to support a digital dollar. Federal Reserve Chairman Jerome Powell said lawmakers may need to weigh in on the project, a process that could take years.

Last month, in a statement on the Fed’s progress in studying CBDCs, Powell said that stablecoins could pose risks to the financial system. “As the use of stablecoins increases, we must also conduct appropriate regulation and establish a corresponding supervisory framework.”

A few days after Powell’s statement, Federal Reserve Governor Lael Brainard warned in a speech that the expanded use of stablecoins could fragment the financial system and potentially raise costs for American households and businesses.

Brainard and other Fed officials have warned that if privately issued stablecoins become widely used but consumers subsequently lose confidence in them, it could lead to threats to financial stability and even a "bank run" panic.

As cryptocurrency trading has exploded, so has the use of stablecoins. Investors now primarily use stablecoins as a tool to park their funds on cryptocurrency exchanges without having to transfer cash back to their bank accounts. By far the largest stablecoin provider is Hong Kong-incorporated Tether, which has a market cap of $62.6 billion. The U.S. dollar coin, or USDC, has a market cap of $23.8 billion and was created by Centre Consortium, a collaboration between cryptocurrency payments company Circle Internet Financial Inc. and U.S. cryptocurrency exchange Coinbase Global Inc.

Early stablecoin controversy centered around Tether International Ltd., which initially said its coin was fully backed by cash reserves. In February, New York’s attorney general said the company didn’t actually have as much cash as it said for years and banned Tether from trading with New York residents. Now, the company says Tether’s coins are backed not only by cash but also by assets including commercial paper, corporate bonds and precious metals. Centre Consortium, on the other hand, says each USDC is backed by one dollar held in a bank account.

“Tether is a champion of transparency and regulation,” Tether Chief Legal Officer Stuart Hoegner said in a statement, noting that the company is registered with the Treasury Department as a money services business. Tether currently does not accept U.S. customers and is seeking an audit of Tether’s reserves over the past several years. “We will continue to explore appropriate regulatory pathways around the world.”

It is unclear what regulators can do to slow the rapid growth of stablecoins, other than continuing to study CBDCs and increasing what stablecoin companies must disclose to consumers. In a May column, Timothy Massad, former chairman of the Commodity Futures Trading Commission, said that the Securities and Exchange Commission (SEC) could regulate stablecoins in a similar way to money market funds, which are not FDIC insured (the Federal Deposit Insurance Corporation (FDIC) is an independent government agency established in 1933 to respond to the widespread failure of U.S. banks in the 1920s and 1930s, which led to the Great Depression. The devastating impact of the financial crisis prompted the government to develop a strategy to prevent future economic collapses.), and faced tremendous pressure during the 2008 financial crisis.

A bill introduced in Congress last year would require stablecoin issuers to have a banking charter and approval from the Federal Reserve and other agencies, though it is unlikely to become law.

The most direct way some stablecoins could come under attack is from law enforcers, such as New York’s attorney general, who could hold issuers accountable for deceiving consumers, said Josh Lipsky, director of the Atlantic Council’s Center for Geoeconomics. Stablecoin issuers could eventually work with international government projects to issue their own digital currencies, but the U.S. and other countries would have to develop regulations to ensure consumers aren’t harmed, Lipsky said.

“Stablecoins are marketed in a way that users are getting a dollar, but it’s important to understand that stablecoins are not always that stable,” Lipsky said.