Stablecoin Regulation

A detailed guide about regulating stablecoins.

Many governments have been trying to regulate cryptocurrencies for a while now to protect financial markets. Major cryptocurrencies such as Bitcoin were initially the target, but regulatory agencies are also looking into regulating stablecoins. This has caused mixed reactions in the crypto industry as some feel that regulation will do more harm than good. To help you see the bigger picture, we have created a detailed guide about regulating stablecoins. Read on to learn.

What Are Stablecoins?

Stablecoins are cryptocurrencies backed by assets such as fiat currencies, cryptocurrencies, and precious metals. They are designed to provide a stable value in the crypto market. Most are usually pegged to fiat currencies such as the U.S. dollar, meaning they maintain the same value. Therefore, you can easily interchange between stablecoins and fiat currency without losing any value. So, if you want a volatile-free cryptocurrency for performing daily online transactions, then stablecoins are what you need.

These digital currencies also allow you to enjoy the benefits of both fiat currency and crypto because they offer secure and fast transactions while ensuring anonymity.

Are Stablecoins Regulated?

There currently aren’t major regulations specifically targeting stablecoins. But stablecoins have attracted plenty of scrutiny from regulatory agencies such as the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC). Therefore, there will likely be clear regulations by the end of 2022. However, most digital asset trading platforms are regulated.

Since stablecoins allow crypto traders and investors to transact easily, regulating them would help capture a huge percentage of transactions in the industry. This would help regulate the crypto industry without directly regulating every digital asset.

Why Do Stablecoins Need to Be Regulated?

You are probably wondering why stablecoins should be regulated if they make transactions more secure and faster. Well, there are a few reasons why governments feel regulating stablecoins is necessary for the benefit of the broader financial system.

Cryptocurrencies are mostly used anonymously, which governments are afraid might encourage illegal activities and break federal securities laws. Therefore, the regulation would reduce criminal activity in the stablecoin space.

Also, stablecoins need enough backing reserves to maintain stability. If the stablecoin issuer has inadequate reserve assets, that might easily mess up the stablecoin’s stability. That’s why stablecoin issuers are needed to prove they have enough backed assets. However, not all of them do so. This can be pretty misleading because crypto investors use stablecoins because they believe they’re a safe way to store value without worrying about price fluctuations. Therefore, having regulations would ensure stablecoin issuers have the required backing reserves and don’t put their clients’ investments at risk.

The State of Stablecoin Regulations in the UK

The Bank of England (BoE) recently asked policymakers to add more regulatory laws to help capture transactions from the crypto industry. The BoE was worried since even huge financial institutions such as investment firms and banks were considering jumping into the crypto market, which might affect the country’s financial stability.

Also, crypto companies in the UK are being forced to register with the Financial Conduct Authority (FCA). However, many digital asset trading platforms are failing to meet FCA’s anti money laundering requirements meaning they’ll have to shut down their operations in the UK.

Therefore, the UK government is still planning on how to regulate stablecoins and the entire cryptocurrency industry. So, although the government has started taking some measures to regulate the industry, clear regulations are yet to be released.

The State of Stablecoin Regulation in the US

The U.S. federal government has been more active in trying to regulate stablecoins. One of the most recent efforts to do so was releasing a report on stablecoins on November 1, 2021. This detailed report was released by the President’s Working Group (PWG), Office of the Comptroller of the Currency (OCC), and Financial Deposit Insurance Corporation (FDIC).

This section will discuss what this report is about and what the involved agencies suggested. Note that we will be collectively referring to them as “agencies”.

In the PWG report, these agencies stated that laws should be immediately created for regulating stablecoins to help prevent the damage they can cause to the financial system. This decision was mostly triggered by stablecoins’ growth from $29.06 billion to $152.12 billion starting January 2021 to January 2022. A whopping 523%.

What Issues Does the PWG Report Address?

The agencies believe that regulating stablecoins would help ensure the following:

  • Financial stability

  • Consumer and investor protection from crypto scams

  • Using insurance to minimize losses from cyberattacks

  • Minimizing illegal activities such as money laundering

  • Financial innovation

What the PWG Report Recommends

The regulatory bodies made different recommendations to custodial wallet providers, stablecoins issuers, and any other institution that handles crucial activities to the functioning of the payment stablecoin arrangements.

If Congress implements the PWG report’s suggestions, here is what to expect:

  • Stablecoin issuers must be Insured Depository Institutions (IDI) subject to regulatory bodies such as the Federal Deposit Insurance Corporation (FDIC), Federal Reserve Board (FRB), and The Office of the Comptroller of the Currency (OCC).

  • Stablecoin issuers will be examined and supervised by the FRB (at the holding company level), and any affiliation with commercial entities will be limited.

  • Custodial wallet providers will be forced to meet the set capital, risk management, and liquidity requirements. They will also be restricted from lending their clients’ stablecoins.

Let’s now discuss these recommendations in more detail.

Recommendations to Stablecoin Issuers

The agencies suggested that Congress limit stablecoin issuance and redeeming and maintaining reserve assets to Insured Depository Institutions. The agencies believe that doing so will help eliminate the financial risks posed by stablecoins. An insured depository institution would also be better positioned to always maintain enough backing assets to provide the expected stability.

Recommendations to Wallet Providers

The agencies also suggested laws subjecting custodial wallet providers to federal oversight. According to the PWG report, this would help ensure wallet providers meet specific capital, liquidity, and risk management requirements. It would also prevent them from lending their customers’ digital assets.

The agencies mentioned that stablecoins also present the issue of concentration of economic power. To solve this, they recommended laws requiring custodial wallet providers to limit using their customers’ transaction data and affiliating with commercial, financial institutions.

Recommendations to Institutions Handling Crucial Activities to the Functioning of the Payment Stablecoin Arrangements

The agencies also suggested that Congress give a supervising body such as the FDIC, OCC, or FRB the power to demand any institution that handles crucial activities to the functioning of the agreement to meet the set risk management standards. They also recommended that the agencies have examination and enforcement authority to regulate any stablecoin activities these institutions perform.

Recommendations to the Financial Stability Oversight Council (FSOC)

The agencies also suggested that if Congress doesn’t provide the way forward, the FSOC should have the authority to do whatever in its power to curb the risks outlined in the PWG report. The FSOC can be expected to start taking direct regulatory action if the stablecoin supply continues growing dramatically or a stablecoin issuer or wallet provider rapidly increases activity. This would aim to prevent the financial risks that stablecoin growth would cause.

Those are the recommendations the different agencies made regarding regulating stablecoins. Therefore, the agencies will likely be responsible for implementing risk management measures for financial institutions engaging in important payment, clearing, and settlement (PCS) activities. This means that the agencies will set requirements for asset backing and stablecoin arrangement operations.

Pros and Cons of Regulating stablecoins

Although regulating stablecoins is great for bringing some order to the crypto industry, it also has disadvantages. Below are the major pros and cons of regulating stablecoins you should be aware of.

Advantages of Regulating Stablecoins

  • Regulating stablecoins helps reduce scams. Stablecoin regulation sets strict requirements that every stablecoin issuer must meet to start operating. Doing so might help kick out fake tokens from the market.

  • It would attract more investors to the industry. Many investors shy from investing in stablecoins because they aren’t really regulated. Therefore, they aren’t sure if a trading platform might easily disappear with their funds. So, having regulations would help make the stablecoin industry more legitimate and easier to invest in. This would attract more people to invest their digital assets, boosting the market’s liquidity.

  • Regulation would eliminate dishonesty. Stablecoins require backed assets to remain stable. However, some stablecoin issuers might use their backing assets for other purposes, risking the token’s stability. Therefore, the regulation would keep stablecoin issuers accountable, ensuring they always have the claimed backed reserve assets.

  • Regulating stablecoins would also reduce the losses when hacks occur. Regulated stablecoin issuers and lending platforms would be insured, ensuring they can easily compensate clients if their digital assets get stolen.

  • It would help reduce illegal transactions.

Disadvantages of Regulating Stablecoins

  • Some investors might withdraw their crypto assets. Most people use stablecoins because they offer some anonymity. Therefore, introducing more regulations would mean that the federal reserve and federal government would be accessing lots of information, eliminating the privacy people crave. This might cause some people to change their minds and turn to riskier assets, such as Bitcoin.

  • The high risk management standards would limit many stablecoin issuers and lending platforms from entering the market.

Conclusion

Stablecoin regulation has been a major discussion in financial markets for some time now and is bound to happen at some point. As you have seen, the regulation would bring different changes in the industry. Fortunately, the advantages outweigh the disadvantages. Therefore, it is clear that regulating stablecoins would improve the industry by far. However, over-regulation would also be problematic.

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