Could stablecoin regulation re-risk the banking system?

WASHINGTON —  As far as major market turmoil goes, banks escaped last week’s TerraUSD collapse largely unscathed. 

Terra and its corresponding crypto coin Luna plummeted last week, losing nearly all of their value and throwing the wider crypto market into a selloff. It was an existential moment for crypto proponents and a told-you-so one for its detractors, dredging up fundamental questions about how digital assets are regulated and by whom. 

“A stablecoin known as TerraUSD experienced a run and had declined in value,” Treasury Secretary  Yellen said during testimony before the Senate Banking, Housing and Urban Affairs Committee last Tuesday. “I think that simply illustrates that this is a rapidly growing product and that there are risks to financial stability and we need a framework that’s appropriate.”

Treasury Secretary Janet Yellen said that recent volatility in the cryptocurrency market highlights that “there are risks to financial stability [from stablecoins] and we need a framework that’s appropriate.”

Bloomberg News

Yet despite wider fears about financial stability and the recent entrance of large financial players into the crypto space, most of Terra’s collapse stayed confined to the digital assets world. 

That’s a win for financial regulators, according to experts. The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. have been cautious about how banks dip their toes into crypto-related activity. 

“I really commend the bank regulators for ensuring that banks have kept crypto off of their balance sheets,” said Todd Phillips, director of financial regulation and corporate governance at the Center for American Progress.  “The bank regulators deserve a lot of credit for preserving the safety of the financial system.” 

Banks, it seems, have successfully kept these kinds of volatile assets off their balance sheets, and the run on Terra isn’t running into a more traditional bank run that could deeply destabilize markets. 

“The good news coming out of the recent crypto market turmoil is that it hasn’t spilled into the financial sector and the banking system, and that absolutely strengthens the prudential regulatory agencies’ hand when it comes to looking very skeptically upon banks’ involvement in digital assets,” said Lee Reiners, executive director of Duke University’s Global Financial Markets Center. “In some ways, this is kind of like a policy success.” 

Still, the run on Terra is prompting policymakers to act with more urgency regarding the regulation of digital assets. Crypto companies have spent large sums trying to convince Washington that digital assets are a safe and growing place to put money, but last week’s turmoil could have shaken those efforts. 

The Biden administration, through a report from the President’s Working Group, has previously suggested that stablecoins — which underpin digital assets markets — be required to have a bank charter, a path that Yellen defended last week in front of Congress. 

But there are broader concerns about bringing the risk that stablecoins pose on bank balance sheets, contradicting what some say kept the financial system secure during Terra’s meltdown. 

Terra was also what is known as an “algorithmic” stablecoin, which means its value is determined by a financial algorithm rather than a reserve of assets, so a run on Terra is less risky to the overall financial system. If another stablecoin that is backed by assets were to experience a run, that could be a bigger problem. 

“Dodd-Frank was about de-risking the big banks, and now the President’s Working Group contemplates that we’re going to add more risks to these institutions,” Rep. Pat McHenry, R-N.C., said Thursday during Yellen’s House Financial Services Committee hearing

Reiners said adding stablecoin risk to bank balance sheets is a valid concern, especially after seeing the run on Terra. 

“There isn’t a uniform agreement about what to do on stablecoins,” he said. “There are well-known issues within crypto; why would we want to import those problems into the banking system? There’s no perfect solution here.” 

The hope, Reiners said, is that banklike regulation for stablecoins acts in a similar way in preventing runs as it does with banks — allowing oversight from bank regulators, deposit insurance and requiring that stablecoins be backed by relatively liquid assets.  

The other option would be to treat stablecoin issuers as the financial system does money market funds, with a disclosure-based regime. 

“The issue with the money market approach is that it hasn’t worked very well,” he said. “Twice in a 12-year period the Federal Reserve has had to backstop money market funds.” 

Phillips said that the market mayhem means that legislative proposals that create a separate charter for stablecoin issuers have a greater chance of making it into law.

Proposals that give traditional banks a freer hand to hold crypto assets on their balance sheets, meanwhile, will have a tougher time, he said. 

“I would be hard pressed to see Congress be really willing to put stablecoins on bank balance sheets now,” he said. “And if there are institutions that had hoped to bring crypto onto their balance sheets, I think they’re going to have to wait a long, long time before that happens, if it happens at all.” 

Bank regulation would have other benefits, said Thomas Vartanian, executive director of the Financial Technology & Cybersecurity Center. Bank regulators could require that stablecoin issuers have robust anti-money- laundering processes in place, which could mitigate risks posed by hackers and other security concerns. 

“All that would happen under the watchful eye of regulators, which is not happening now,” Vartanian said. “The question is what is the legitimate market need for this stuff that actually saves money, makes the system more secure and in turn can attract the confidence of customers? By driving it to the banks, it forces those questions to be asked and answered, because I think the regulators would require them to be asked and answered.” 

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