The Stablecoin TRUST Act

Stablecoin regulation is one of my perennial favourite topics. Yes I know – I need to get out more but getting this stuff right does truly matter. I have gone down this particular rabbit hole more than a couple of times already. This has partly been about the question of how much we can rely on existing disclosure regarding reserves (here and here for example ) but the bigger issue (I think) is to determine what is the right regulatory model that ensures a level playing field with existing participants in the provision of payment services while still allowing scope for innovation and competition.

JP Koning has been a reliable source of comment and insight on the questions posed above (see here and here for example). Dan Awrey also wrote an interesting paper on the topic (covered here) which argues that the a state based regulatory model (such as the money transmitter licensing regime) is not the answer. There is another strand of commentary that focuses on the lessons to be learned from the Free Banking Era of the 19th century, most notably Gorton and Zhang’s paper titled “Taming Wildcat Stablecoins” which I covered here.

Although not always stated explicitly, the focus of regulatory interest has largely been confined to “payment stablecoins” and that particular variation is the focus of this post. At the risk of over-simplifying, the trend of stablecoin regulation appears to have been leaning towards some kind of banking regulation model. This was the model favoured in the “Report on Stablecoins” published in November 2021 by the President’s Working Group on Financial Markets (PWG). I flagged at the time (here and here) that the Report did not appear to have a considered the option of allowing stablecoin issuers to structure themselves as 100% reserve banks (aka “narrow banks”).

Against that background, it has been interesting to see that United States Senator Toomey (a member of the Senate Banking Committee) has introduced a discussion draft for a bill to provide a regulatory framework for payment stablecoins that does envisage a 100% reserve model for regulation. Before diving into some of the detail, it has to be said that the bill does pass the first test in that it has a good acronym (Stablecoin TRUST Act where TRUST is short for “Transparency of Reserves and Uniform Safe Transactions”.

There is not a lot of detail that I can find so let me just list some questions:

  • The reserve requirements must be 100% High Quality Liquid Assets (HQLA) which by definition are low return so that will put pressure on the issuer’s business model which relies on this income to cover expenses. I am not familiar with the details of the US system but assume the HQLA definition adopted in the Act is the same as that applied to the Liquidity Coverage Ratio (LCR) for depositary institutions.
  • Capital requirements are very low (at most 6 months operating expenses) based I assume on the premise that HQLA have no risk – the obvious question here is how does this compare to the operational risk capital that a regulated depositary institution would be required to hold for the same kind of payment services business activity
  • Stablecoin payment issuers do not appear to be required to meet a Leverage Ratio requirement such as that applied to depositary institutions. That might be ok (given the low risk of HQLA) subject to the other questions about capital posed above being addressed and not watered down in the interests of making the payment stablecoin business model profitable.
  • However, in the interest of a level playing field, I assume that depositary institutions that wanted to set up a payment stablecoin subsidiary would not be disadvantaged by the Leverage Ratio being applied on a consolidated basis?

None of the questions posed above should be construed to suggest that I am anti stablecoins or financial innovation. A business model that may be found to rely on a regulatory arbitrage is however an obvious concern and I can’t find anything that addresses the questions I have posed. I am perfectly happy to stand corrected but it would have been useful to see this bill supported by an analysis that compared the proposed liquidity and capital requirements to the existing requirements applied to:

  • Prime money market funds
  • Payment service providers
  • Deposit taking institutions

Let me know what I am missing

Tony – From the Outside

Note – this post was revised on 14 April 2022

  1. The question posed about haircuts applied to HQLA for the purposes of calculating the Liquidity Coverage Ratio requirement for banks was removed after a fact check. In my defence I did flag that the question needed to be fact checked. Based on the Australian version of the LCR, it seems that the haircuts are only applied to lower quality forms of liquid assets. The question of haircuts remains relevant for stablecoins like Tether that have higher risk assets in their reserve pool but should not be an issue for payment stablecoins so long as the reserves requirement prescribed by the Stablecoin TRUST Act continues to be based on HQLA criteria.
  2. While updating the post, I also introduced a question about whether the leverage ratio requirement on depositary institutions might create an un-level playing field since it does not appear to be required of payment stablecoin issuers

What stablecoins might become

Bennett Tomlin offers a useful summary here of what is currently playing out in the USA on the regulation of stablecoins. His conclusion is that the future of stablecoins lies in some form of bank like regulation.

It is difficult to say exactly how all of this will play out. My intuition is that a new type of banking charter will be created that will allow stablecoin issuers to access Fed master accounts and there will be an expectation that stablecoins will hold their reserves there. It also seems reasonably likely that the Treasury gets its way and stablecoin issuers will need to register with the Treasury. I expect that securities regulations may be part of the cudgel that will be used to help ensure that the only stablecoins are the “approved” stablecoins.

The end result of this will likely be that any stablecoin issuer that wants to continue operating would need to become a bank and is going to have significantly less flexibility with what they can do with their reserves. Those that choose not to register or are not approved are likely to have difficulty accessing the U.S. banking system. They may have trouble servicing redemptions, and may perhaps even find themselves aggressively pursued by regulators.

https://www.coindesk.com/policy/2021/10/20/what-stablecoins-might-become/

Who knows if the end game is a bank charter but the regulatory solution will undoubtedly shape what stablecoins become. The best solution (I think) will recognise that there is in fact a variety of types of stablecoins offering their users different kinds of promises.

If the answer proposed is a bank charter then it will be interesting to see how bank liquidity requirements might apply to a 100% reserved stablecoin arrangement. The kinds of haircuts that bank liquidity rules apply to liquid assets (other than funds held at a central bank) seem to be completely missing in the approaches currently applied in fiat backed stablecoin arrangements.

Tony – From the Outside

Stablecoin backing

… is a hot topic full of claims, counter claims and clarifications. Tether’s USDT token has been getting the bulk of the attention to date but questions are now being asked about Circle’s USDC token (a cryptographic stored value token or stablecoin that allows users to trade crypto assets).

My understanding is that USDC is one of the better (in relative terms) stable coins regarding backing and disclosure but this analysis from Amy Castor argues that is still not especially good and may be getting worse. The Financial Times makes a similar argument.

The broad problem they outline

  • Stablecoins generally start out with a promise that each coin is backed 1:1 with fiat currency (typically USD) or fully reserved
  • Ideally those fiat currency reserves are held on deposit in a bank on a custodial basis
  • Over time that simple promise becomes more nuanced with qualifications that dilute the fiat currency component and introduce concepts like “approved investments”
  • The location of the deposit may also become ambiguous
  • Not always clear if the backing itself has evolved or the disclosure evolves in response to questioning

USDT has been the most high profile example of asset backing being understood to be USD cash but evolving into something USD based but not always 100% cash or necessarily liquid. The two sources cited above suggest that USDC backing may also be less than 100% USD.

Amy Castor points to the change in USDC disclosure between February and March 2021 as evidence of an apparent change in (or clarification of?) the composition of the reserve backing.

Source: Amy Castor, “What’s backing Circle’s 25B USDC? We may never know”

As always I may be missing something, and maybe this is just my traditional banking bias, but Amy poses what seem to me to be pretty reasonable questions like “what are those approved investments? Who approves them? What percentage of assets are in that category?” that Circle is yet to answer.

Tony – From The Outside

Tether offers a bit more detail on the composition of its reserves

… but Jemima Kelly at FT Alphaville remains a sceptic. I think the FT headline is a bit harsh (“Tether says its reserves are  backed by cash to the tune of . . .  2.9%”). Real banks don’t hold a lot of “cash” either but the securities they hold in their liquid asset portfolios will tend to be a lot better quality than the securities that Tether disclosed.

The role of real banks in the financial system may well be shrinking but the lesson I take from this FT opinion piece is that understanding the difference between these financial innovations and real banks remains a useful insight as we navigate the evolving new financial system.

Let me know what I am missing …

Tony – From the Outside

Adair Turner makes the case for “Monetary Finance”

This link takes you to an interesting post by Adair Turner on the limits of “monetary policy” (both conventional and the unconventional negative interest rate variety) and the potential use of “monetary finance”. Turner defines Monetary Finance as running a fiscal deficit (or higher deficit than would otherwise be the case) which is not financed by the issue of interest-bearing debt, but instead financed by an increase in the monetary base (i.e. by increasing the irredeemable non-interest bearing liabilities of the government/central bank.

I am probably over simplifying but, crudely stated, I think this is colloquially referred to as printing money and conventionally deemed to be a bad thing. So it is especially interesting seeing someone who was at the heart of the central banking world making the case. The post strikes a balance between the extremes of :

– there are no limits to what governments want to finance; and

– printing money = hyperinflation = the road to ruin.

I recommend you read his post in full but this extract gives you a flavour of the key message (or at least the one that I took away).

“So, on close inspection, all apparent technical objections to monetary finance dissolve. There is no doubt that monetary finance is technically feasible and that wise fiscal and monetary authorities could choose just the “right” amount.

The crucial issue is whether politicians can be trusted to be wise. Most central bankers are skeptical, and fear that monetary finance, once openly allowed, would become excessive. Indeed, for many, the knowledge that it is possible is a dangerous forbidden fruit which must remain taboo.

They may be right: the best policy may be to provide monetary finance while denying the fact. Governments can run large fiscal deficits. Central banks can make these fundable at close to zero rates. And these operations might be reversed if future rates of economic growth and inflation are higher than currently anticipated. If not, they will become permanent. But nobody needs to acknowledge that possibility in advance.”

I don’t agree with everything he writes but Turner is to my mind one of the more thoughtful commentators on banking, economics and finance. His resume includes being the head of the UK Financial Services Authority during the GFC. A book he wrote in 2015 titled “Between Debt and the Devil: Money, Credit and Fixing Global Finance” is also on my recommended reading list.

Tony (From the Outside)