The growth of cryptocurrencies and other digital assets over the past few years has occurred primarily outside the auspices of traditional banking organizations. While several conditions have led to digital assets’ relatively low adoption rate by financial institutions, significant factors include the lack of clear regulation and legal frameworks surrounding the assets, as well as their generally speculative nature. However, one type of digital asset is clearly outpacing the others in its influence in regulated financial institutions—the stablecoin.
What is a stablecoin?
Broadly, a stablecoin is a digital asset on a blockchain designed to maintain a stable value relative to the asset(s) backing it.1 For example, for every token, i.e., a stablecoin unit, in circulation, the issuer asserts there is $1 backing the token in regulated financial institutions. Because each token in circulation is redeemable on demand from the issuer for $1, the secondary market price of the token tends to remain stable around $1 per token.
Why are stablecoins used instead of dollars?
Several use cases for stablecoins exist in the digital assets ecosystem. However, most of the use cases center around providing better liquidity, payment efficiency, and price discovery.
Perhaps the current highest volume use case for stablecoins is their use as a proxy for fiat currency in cryptocurrency trading markets. Cryptocurrency exchanges have the ability to settle cryptocurrency trades between counterparties in near real-time execution. Conversely, fiat currency transactions through traditional payment systems can take one or more days to clear, e.g., through Automated Clearing House (ACH) or wire. And while other widespread real-time payment options such as FedNow are in the works, most are not yet operational. The mismatch in timing when using traditional payment methods slows the ultimate settlement of cryptocurrency trades that also involve fiat currency. Since stablecoins use the same infrastructure as cryptocurrencies, i.e., the public blockchain, the expedited timing of trade settlement can be achieved. (While this example relates to cryptocurrency trading, the same concept can apply to other types of digital asset payments and value transfer as well.)
Further, proponents contend the use of stablecoins pegged to a fiat currency such as the U.S. dollar facilitates conditions necessary for efficient price discovery, including increased liquidity, decreased volatility, and higher market risk transparency in cryptocurrency markets.
Why should financial institutions understand stablecoin?
- The stablecoin market is sizeable and growing.
As with many new technologies, opportunities abound—but so do risks. To date, development of the most widely used stablecoins has primarily taken place outside the confines of regulated financial institutions. The market capitalization of U.S. dollar-pegged stablecoins now exceeds $100 billion2 and is growing.
Whether or not a financial institution holds these assets itself, stablecoins and other digital assets, e.g., cryptocurrencies and nonfungible tokens (NFT), are becoming more common on the financial statements of retail customers and commercial enterprises. A basic understanding of these assets and their risks is increasingly needed to assess customers’ financial condition.
- Stablecoins have enabled activities that mirror and often compete with financial institutions’ products and services.
While much of the capital supporting the stablecoin infrastructure is held as deposits in regulated financial institutions, the stablecoin transaction volume and other capital markets activity occurs largely outside the traditional financial system.
A few traditional community banking products and services that have competing digital assets offerings include, but are not limited to:
- Yield-bearing deposit accounts – Customers can earn interest on their stablecoin and cryptocurrency deposits.3
- Reward credit cards – Instead of points for travel, cash back, etc., customers can earn cryptocurrency rewards for using their credit card.
- Collateralized lending – Borrowers can post stablecoin holdings as collateral for U.S. dollar and/or cryptocurrency denominated loans.
- Payments – Business and retail customers can make and accept payments using stablecoin infrastructure that often provides expedited access to funds for the customer and efficient settlement terms for the intermediary.
In addition, stablecoins have fueled an ever-expanding cryptocurrency spot/derivatives trading, margin lending, and investing ecosystem.
The current settlement speed of the public blockchain infrastructure on which most stablecoins are built surpasses that of most traditional ACH and wire transfer payment methods. However, public blockchains do not yet rival the transactional throughput volume and proven stability of established payment and credit card networks. This point is changing rapidly with advances in this regard being measured in months, not years.
- Regulators are paying close attention.
Understandably, the risks posed by underregulated financial markets are a key focus for regulatory authorities. Regulators have acknowledged the financial innovation and opportunities stablecoin technologies create and are working to build policy within existing regulatory regimes.
Facts and circumstances surrounding any particular stablecoin determine which regulatory body has authority. For example, stablecoins backed by securities, rather than cash deposits, may be deemed securities themselves and, therefore, under the purview of the SEC. Organizations deemed money service businesses (MSB) must register with the Financial Crimes Enforcement Network (FinCEN). Money transmitters under various state laws must comply with the requirements of each state in which they operate. The myriad state requirements and general regulatory uncertainty have encouraged some stablecoin issuers to seek bank and bank-like charters to help ensure their activities are compliant and take advantage of more fluid interstate commerce.
The regulatory landscape regarding stablecoins also includes discussions of central bank digital currencies (CBDC). A CBDC is fiat currency issued directly by a central bank to a digital wallet. The Federal Reserve is currently researching the notion of a U.S. dollar CBDC but has made no public statement as to the likelihood of adoption. More than a dozen other countries are in various stages of CBDC research and development. China and Sweden are among the nations currently piloting CBDCs.
Since stablecoins can be accessed on public blockchains across the globe, international efforts are underway to ensure standards and risk mitigation efforts are consistently applied. For example, in October 20204, the Financial Stability Board (FSB) published a list of high-level recommendations for regulation, supervision, and oversight of global stablecoin arrangements. A progress report related to these recommendations was published in October 2021.5 Further, G7 finance ministers and central bank governors recently released a statement on CBDCs and digital payments pledging continued cooperation to ensure stablecoin innovations meet shared policy objectives.6
In the U.S., the President’s Working Group on Financial Markets (PWG) recently issued a report7 discussing the potential benefits and risks of stablecoins, the current U.S. regulatory framework, and the development of recommendations for addressing any regulatory gaps. U.S. prudential regulators have also signaled their intent to issue further clarifying guidance related to stablecoins and digital assets over the next year.
Regardless of the ultimate form stablecoins take or the legal/regulatory regimes they operate under, financial institutions should consider stablecoins’ rising effects on the business of banking and their customers’ needs and expectations. Financial institutions are uniquely positioned to become (or partner with) financial innovators to usher in the use of this new technology, all while working with regulators to ensure the safety and soundness of our financial system.
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1 Stablecoins can take several forms, including those backed by nonfiat assets or uncollateralized algorithmic stablecoins, which stabilize value by systematically adjusting supply based on varying demand. For purposes of this discussion and example, we focus on redeemable stablecoins fully backed by fiat currency. ↩
2 Source: www.coinmarketcap.com. Includes fully and partially asset-backed stablecoins, as well as algorithmic stablecoins. ↩
3 Recently, certain states have filed cease and desist orders against nonbank companies offering interest-bearing deposit cryptocurrency and stablecoin deposit accounts—particularly when the deposits fund the nonbank companies’ lending activities. These states claim the practice violates securities laws and regulations. ↩
4 Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements: Final Report and High-Level Recommendations ↩
5 Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements: Progress Report on the implementation of the FSB High-Level Recommendations ↩
6 G7 Finance Ministers and Central Bank Governors’ Statement on Central Bank Digital Currencies (CBDCs) and Digital Payments – 13 October 2021 ↩
7 President’s Working Group’s Report on Stablecoins ↩