With Crypto Scams on the Rise, Legislators Debate Regulations

Cryptocurrency scams are on the rise, and will become even more prevalent in 2022 according to security firm Lookout. That prediction is supported by data from the U.S. Federal Trade Commission, which found that from October 200 to May 2021, consumers reported losing more than $80 million to cryptocurrency scams—an increase of nearly 12 times more than previous years.

Legislators have taken notice of this rising threat. On Tuesday, December 14, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing focused on the future of cryptocurrency regulations in the United States. The hearing was focused on stablecoins—which unlike popular cryptocurrencies Bitcoin, Ethereum, and Dogecoin—are designed to be less susceptible to dramatic price swings.

Proponents of stablecoins tout the currency’s ability to speed up transactions, reduce costs, and promote financial inclusion—while critics argue they will facilitate illicit activities, defraud average Americans, and cause financial volatility.

The witnesses all offered policy suggestions, although the title of the hearing—Stablecoins: How Do They Work, How Are They Used, and What Are Their Risks—indicates legislators are still grappling with the fundamentals of how new concepts and technologies like blockchain and decentralized finance interact with the traditional banking system and the broader U.S. economy.

How Stablecoins Work

Stablecoins operate through crypto exchanges and attempt to maintain stability by pegging their value to a fiat currency, such as the U.S. dollar. In theory, they hold their value through a dual set of promises: (1) The issuer agrees to buy and sell the coin back at par value; (2) the issuer then holds that amount in an asset reserve that has at least 100 percent of its aggregate par value.

According to the written testimony given by Jai Massari, Partner at Davis Polk & Wardwell, “a well-designed stablecoin would consist of cash and genuine cash equivalents, such as bank and deposits and short-term U.S. government securities,” to ensure the asset reserve maintains liquidity and can deliver on its obligation to sell the stablecoin at par value.

In essence, “a stablecoin dollar will supposedly be worth a real dollar,” said Senator Elizabeth Warren (D-MA), which would make [a] popular stablecoin, Tether, “one of the 50 largest banks in the country.” However, according to Tether’s own report, it only holds about 10 percent of its stablecoin assets in real dollars. This has raised fears of a liquidity crisis that would not only affect stablecoin investors and issuers but reverberate throughout the economy.

Unlike banks, which are in the business of maturity and liquidity transformations, stablecoins don’t rely on short-term deposits to make long-term loans. That type of risky behavior, well represented by the 2008 economic crisis, requires banks to be insured depository institutions. Many witnesses and Senators at the hearing were hesitant to prescribe a similar approach to the stablecoin market.

Senator Sinema (D-AZ) agreed, noting “we should not assume overlaying every law and regulation we have for other issuers or depository institutions is automatically the correct answer.”

The differences between how stablecoins are supposed to work and how they actually work, better elucidate their risks, rewards, and future regulatory considerations.

How Are They Used?

According to a report by the President’s Working Group (PWG) on Financial Markets, “stablecoins are predominantly used in the United States to facilitate trading, lending, and borrowing of other digital assets.” Although a stablecoin is theoretically of equal value to the U.S. dollar, it cannot be utilized in the same way. Currently, stablecoins are relegated to operating “on the margins of the banking system and the real economy,” according to stablecoin advocate Jai Massari, Partner at Davis Polk & Wardwell.

Two of the main benefits of stablecoin exchanges are increased speed and reduced cost. This has become a calling card for advocates. With $540 billion flowing to low- and middle-income countries in 2020 in the form of remittances, stablecoin offers promise. Person to person electronic transfers of money move quicker than dealing with a financial institution. Secondly, blockchain-based solutions claim their services offer a 40-to-80 percent cost reduction.

“The value proposition is a fundamentally lower cost transfer of value on the internet,” noted Daniel Disparte, Chief Strategy Officer and Head of Global Policy for Circle, the issuer of the United States Dollar Coin (“USDC”). “It is profoundly in the American national interest that we have options for how people can move money.”

Stablecoins make their assets available on several blockchains, like Ethereum and Coinbase, which offer a platform for users to trade various cryptocurrencies. Thus, “U.S. retail investors can neither purchase nor redeem the top two stablecoins directly from the issuer. Instead, they are reliant on exchanges,” said Alexis Goldstein, Director of Financial Policy at Open Markets Institute.

Rather than being used as instruments of payment for everyday goods, stablecoins are for now most typically viewed as a speculative investment on decentralized finance (“DeFi”) markets. These transactions take place through blockchain, and are recorded on a decentralized “ledger,” devoid of involvement from traditional banking institutions.

However, this is not entirely true. Stablecoins are neither decentralized nor independent from banking institutions. “Stablecoins are distinct from cryptocurrency in that there is a central entity that issues and is responsible for any given token,” remarked Senator Steve Daines (R-MT).

In the non-crypto world, when there is an issue with your money you simply call the bank. But, “a stablecoin in a truly decentralized fashion has nobody you can go to,” explained Professor Allen of American University Washington College of Law. Instead, under the current regime, “if the stablecoin has an issuer behind it that manages the reserve and there is a problem, you could go to that stablecoin issuer, but then that highlights that these things are not as decentralized.”

This also demonstrates the potential issues of any digital currency without a central control for remediation of problems. This is just one of the contradictions that lawmakers will have to contend with.

Stablecoins also claim to be independent of the existing banking system. This is also false. Because cryptocurrencies are not yet accepted in traditional retailers, anyone looking to utilize their crypto assets to purchase real-world goods must first convert them to their preferred currency. This directly undercuts one of the main arguments for stablecoins.

Due to the reliance on the existing banking system, stablecoins do not promote financial inclusion. To convert your stablecoin into a usable currency, one needs a traditional banking institution. According to the World Economic Forum’s White Paper on Stablecoins, “1.7 billion people are ‘unbanked’” Those looking to capitalize on stablecoin’s potential will need ties to a traditional banking institution to use their digital assets to purchase real commodities, internet services to access blockchain crypto exchanges, and capital to engage in speculative investments.

The most disadvantaged populations are unlikely to have these luxuries and thus are shut out of the cryptocurrency economy, just as they have been from traditional banking.

“They’re a mirror of the same system – with even less accountability and no rules at all,” remarked Senator Sherrod Brown in his opening statement.

While stablecoins are contained to DeFi and insulated from the broader economic system, advocates believe in its real-world applications. Outside of crypto-to-crypto trading, Massari believes “stablecoins payments though could have broader uses, complimenting existing payments such as cash, checks, credit and debit cards, and wire transfers.”

What Are Their Risks?

Stablecoins offer a litany of potential risks. Chief among these is the potential to create financial instability. In short, the value of a stablecoin is contingent upon the holder’s confidence in it. As the PWG report notes, “The mere prospect of a stablecoin not performing as expected could result in a “run” on that stablecoin – i.e., a self-reinforcing cycle of redemptions and fire sales of reserve assets.”

If stablecoin holders were to lose confidence in the currency from an event such as a hack or concern about the reserve asset, it could create “a run,” when a critical mass of people withdraw their money all at once, creating liquidity problems for the issuer. The risk magnifies with stablecoins. While issuers claim to hold 100 percent of the coin’s value in liquid reserves, a lack of regulatory oversight makes it impossible to verify that claim.

Since stablecoins are pegged to the U.S. dollar, such runs could have a ripple effect throughout the economy. In her written statement Professor Allen explains, “runs can cause financial stability problems in two ways: they can deprive the economy of capital intermediation services on which it relies, and they can ignite fire sales that drive down the prices of financial assets in a way that drags down other institutions and markets.”

However, “If stablecoin holders are only using them to speculate, they are not really going to expect stability so runs will be less likely,” Allen noted.

Yet another key aspect of stablecoins present risk. Ms. Massari claimed in her testimony that, “the reserve is meant to ensure that the issuer can always redeem outstanding stablecoins at their par value on demand,” thus enabling “the reserve to remain liquid even during stressed market conditions, minimizing the risk of loss if large number of stablecoin holders seek redemptions at once.”

This should, in theory, quell concerns. However, when probed by Senator Warren about whether there is any guarantee that the holder of a stablecoin would get their value back in such a scenario, Ms. Goldstein answered, “No, Senator. You are dependent on the exchange where you are trading.”

The growth of stablecoins and DeFi could negatively impact the Federal Reserve’s ability to control monetary policy. As we have seen throughout the pandemic, the Fed plays an important role in adjusting interest rates to reflect market conditions. But the adoption of currencies by private entities with no obligation to serve the public interest could hamper the central bank’s ability to adjust for inflation.

“If the central bank loses control over the monetary supply, they lose the control to put their hands on some of those levers,” said Senator Jack Reed (D-RI). That’s why, according to Professor Allen, “many central banks are contemplating adopting central bank digital currencies (“CBDCs”) to compete with privately-issued stablecoins.

One of the ingenuities of stablecoins – smart contracts – may also limit the ability to remediate issues that arise. That’s because, “distributed ledgers that crypto run on often have very complicated governance mechanisms, which make fixing problems caused by glitches and hacks extremely challenging,” explained Professor Allen, adding that, “fragilities also arise because the computer programs that operate on distributed ledgers—known as smart-contracts—execute automatically, even when the parties agree that forbearance is in their best interest.”

DeFi also offers the perfect medium for those engaging in illicit activities, which according to Goldstein is, “largely out of compliance with Know Your Customer (“KYC”), Anti-Money Laundering (“AML”), Countering the Financing of Terrorism (“CFT”), and sanctions checks.” In fact, an October report by FinCEN found that DeFi was a key instrument used to convert ransomware payments into other types of cryptocurrencies.

Goldstein testified that “smart contracts on DeFi exchanges typically do not compare the cryptocurrency addresses executing their code against the Specially Designated Nationals and Blocked Persons list (SDN list). This could open all actors in the crypto market to OFAC sanctions violations.

Proposed Solutions

The PWG report urges Congress to quickly enact legislation to deal with the risks outlined above. First, to protect against stablecoin runs, the report recommends that “stablecoin issuers be insured depository institutions, which are subject to appropriate supervision and regulation, at the depository institution and the holding company level.”

This proposal received significant pushback from witnesses, even those who shared the PWG’s concern over financial stability. Professor Allen warned that regulating stablecoins like banking products will lend them legitimacy and fuel the growth of DeFi. If stablecoins were to become more popularized, they would then be more closely connected to its asset reserve (held in U.S. dollars), “but if stablecoins remain modestly sized, then any fire sales will have limited impact on broader asset markets.”

Jai Massari agreed that insured-depository requirements would not fit the stablecoin model but for different reasons than Allen. Massari argues that “stablecoins can be structured and regulated to avoid the risks that require deposit insurance and the application of traditional banking oversight.” She reasoned that because stablecoins hold liquid assets, unlike banks, which use short-term deposits for long term loans, “an insured-depository requirement is unworkable.”

Despite Senator Toomey’s reservations that “requiring all stablecoin issuers to become banks would stifle innovation,” Dante Disparte—who represents USDC—noted in his testimony Circle’s intention to become a federally chartered commercial bank.

Senator Toomey laid out three options for stablecoin issuers: (1) operate under a conventional bank charter; (2) utilize a special-purpose banking charter designed for stablecoin providers; (3) register as a money transmitter under the existing state regime and as a money service business with FinCEN federally.

Regardless of the path they choose to pursue, the Republican Senator argued that stablecoin providers should disclose their backing asset, provide clear redemption policies, and be subject to audits. Ms. Massari supported “an optional federal charter for stablecoin issuers,” and agreed with Sen. Toomey that since stablecoins are non-interest bearing, “stablecoins are not necessarily securities and shouldn’t be automatically regulated as such.” Finally, Toomey called for the modernization of the Bank Secrecy Act to account for the rise of cryptocurrencies.

Allen offered several policy solutions for the Committee to consider. First, she recommended that the SEC and CFTC continue to oversee stablecoins to prevent issuers from misrepresenting their stability and compelling disclosures of the contents of the reserves backing any stablecoins. She did however warn against creating a new financial regulator, which could lead to “duplicative regulatory efforts and issues falling through regulatory gaps.”

Second, she tasks the Office of Financial Research (“OFR”) and the Financial Stability Oversight Council (“FSOC”) with monitoring the growth of stablecoins. In the event that stablecoins become a widely-used payment method, FSOC could designate it as a systemically important financial institution, making it subject to supervision by the Federal Reserve.

In efforts to prevent the rapid adoption of stablecoins, Allen believes “antitrust regulators should consider prohibiting a large tech firm from leveraging its network (as developed in a market where it has a monopoly or near-monopoly power) into a payments platform.” She fears that Meta/Facebook’s Diem would cause people to believe the currency does in fact have stable value and contribute to its growth and financial instability.

Finally, in order to keep DeFi from becoming integrated with the traditional financial system, Allen proposes legislation that would prevent banks—like JPMorgan which has already developed its own JPMCoin—from investing in DeFi or any other cryptocurrency. Allen fears that banks could use stablecoins to circumvent reserve and capital requirements by using their own stablecoins to make unlimited loans.

Next Steps

Stablecoins are complex financial instruments, currently operating without regulatory restrictions. While traditional cryptocurrencies tend to hog the headlines, it’s stablecoins that have gotten the attention of Capitol Hill. The hearing illuminated the partisan divides that dominate Washington, but stablecoins represent a financial innovation and pose a threat to the status quo of the financial system. While we may be far away from meaningful legislative or regulatory action, the stablecoin industry is now fully on the radar of policymakers at the highest levels.