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Stablecoins have exploded 500% to exceed a $127B market cap over the past year, according to The President's Working Group (PWG) on Financial Markets. The report that was released on Nov. 1, 2021, in partnership with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), urged Congress to enact legislation to ensure that stablecoins are subject to a regulatory framework.

The problem with stablecoins, as the PWG outlined, is that much like traditional banks, stablecoins face credit risk, liquidity risk, operational risk and settlement risk. Why so much risk associated with this type of digital asset? Let’s provide a quick refresher:

What is a Stablecoin?

The purpose of stablecoins is to provide price “stability” as people transact across coins or between fiat and digital currencies. As a type of cryptocurrency that relies on a more stable asset as a basis for its value, stablecoins are linked to a fiat currency, such as the U.S. dollar, but they can also have value linked to precious metals or other cryptocurrencies.

From Tether (USDT), the largest stablecoin, to USD Coin (USDC), a stablecoin pegged to the U.S. dollar (and many others circulating globally), Stablecoins are essentially a bridge between cryptocurrencies that do not appear as a traded pair. However, there is no guarantee that the issuers have on hand the assets the coin is pegged to. Tether Holdings’ story is the prime example: The company once claimed to have $69 billion in real currency to support that amount of its coin in circulation. Yet no one who went looking for the money was able to find any evidence of it. After being sued by the state of New York, the company revealed it had been loaning money from its reserves to prop up an affiliated cryptocurrency exchange that was hundreds of millions of dollars in the hole.

House of Cards: Congressional Hearings Aim to Find Solutions for Stablecoins

Per the urging of the PWG to establish some regulatory clarity around stablecoins, Congress completed several hearings on the future of these digital assets. The hearings, which took place on Feb. 8 and then on Feb. 15, demonstrated not only the increasing interest in Congress in passing legislation to establish a regulatory framework for digital assets but also the lack of agreement on the right approach.

The lack of agreement is not surprising given the current political environment that exists in the US. However, the House and the Senate at least gave it a solid try (emphasis on try).

Under Secretary of the Treasury for Domestic Finance Nellie Liang appeared before the House Financial Services Committee on February 8 and the Senate Banking, Housing, and Urban Affairs Committee on February 15. During the House Financial Services Committee hearing, committee members express support for the report’s recommendation for new legislation to regulate stablecoins. However, there were a number of members, both Democrats and Republicans, concerned about the Report’s recommendation to only allow stablecoins to be issued through insured depository institutions (IDIs), saying that IDIs would needlessly burden stablecoin issuers, particularly those that provide coins backed by stable reserves, such as cash. The regulation of stablecoins, like regulating DeFi, needs to consider a different role and ecosystem than the traditional financial world for which IDI regulations have evolved. Although concerns and risks may be similar, the way to implement stablecoin regulations in order to mitigate these risks may manifest itself differently.

With that said, Under Secretary Liang highlighted the flexibility within the existing IDI regulatory framework that would actually reduce regulatory burdens of a stablecoin backed by reliable reserves such as cash or cash equivalents verses others backed by more volatile assets. She added that the IDI framework could address the payment and prudential risks associated with stablecoins.

During the Senate Banking Committee’s hearing with Under Secretary Liang, Democratic senators were more concerned about the risks of stablecoins and digital assets more generally, particularly the risks of runs on stablecoins and the use of stablecoins in illicit transactions. Elizabeth Warren (D-MA) urged Under Secretary Liang to direct the Financial Stability Oversight Council (“FSOC”) to regulate stablecoins in advance of congressional action on the issue, since, according to Senator Warren, the FSOC has the authority to regulate emerging risks to the financial system before they become systemic. Under Secretary Liang noted that the FSOC was still analyzing stablecoins’ potential threat to the financial system. Republican senators on the Banking Committee, much like Republicans on the House Financial Services Committee, were concerned about the PWG recommendations to regulate stablecoin issuers as IDIs.

A Nothingburger or Somethingburger?

Hearings like the ones that took place often times “kick the can” down the road, which is exactly what’s going on in this situation. While congress flexes their muscles and spews their partisan jabs, the world, along with the entire U.S. financial sector wait for critical regulatory guidance on stablecoins. And, while the U.S. continues to kick the stablecoin can further down the road, other countries, including China, are establishing themselves as leaders in the digital economy – taking the lead on CBDCs, on digital assets in general, and more.

Until the U.S. is able to fully develop and deploy its own CBDC, stablecoins are what people will continue to use more and more – growing the market exponentially. In this current scenario, regulation on stablecoins is needed, and needed now. However, we can’t lose sight of the benefits of stablecoins if and when they’re legislated and regulated sensibly with the understanding of the key role they play within the digital economy and decentralized finance, as well as their important role in continuing U.S. leadership in international financial markets. In other words, the world is waiting for U.S. leadership and foresight, which is exactly the opposite of what we’ve seen during the recent hearings.

If unregulated stablecoins are, in fact, one big house of cards, don’t we want to stop an unfortunate collapse before it becomes a catastrophic one?