By Marcelo Prates
Compiled by: Mars Finance, MK
Recently, Hilary Allen, a law professor at American University, explained in a podcast the risks that stablecoins may pose to the banking system and the general public. She pointed out that stablecoins have the potential to destabilize banks and may eventually require government rescue. At the same time, the U.S. Congress is pushing for federal regulation of stablecoins. Although bills on stablecoins are difficult to pass in a presidential election year, Allen is still worried that these bills may prompt public support for stablecoins. She made it clear that stablecoins "lack important uses and should be banned."
Marcelo Prates is a speaker at Consensus 2024 and a senior expert on financial policy and regulation. He has written numerous articles on currency, payments, and digital assets. In response to Allen's concerns, he believes that such concerns may only apply to those who oppose competition and do not welcome regulatory transparency. He countered that what Allen described was an over-exaggerated and unhelpful trend. In fact, this represents an advanced version of one of the most revolutionary innovations in the financial field in the past 25 years: electronic money issued by non-bank institutions.
Since the early 2000s, the EU has recognized the need to promote faster and cheaper digital payments. Based on this, EU lawmakers have developed a regulatory framework for e-money that allows startups to take advantage of so-called fintechs to provide payment tools in a regulated and secure manner.
The logic behind this is clear: due to the multiple services provided by banks and their complex structure, they face high risks and strict regulatory requirements, making digital payments through bank accounts is usually not only cumbersome but also costly. The solution is to establish an independent licensing and regulatory mechanism for non-bank institutions, focusing on one service: converting cash deposited by customers into electronic money that can be used for digital payments through prepaid cards or electronic devices.
In practice, these e-money issuers operate similarly to banks, but with a more specialized focus. They are required by law to safeguard customers’ cash and ensure that e-money balances are always convertible back to cash of equivalent value, thus avoiding devaluation. Because these institutions are licensed and regulated, customers can rest assured that their funds are safe in most cases, barring serious regulatory failures.
Therefore, most existing stablecoins - that is, those based on sovereign currencies such as the US dollar - actually have some of the characteristics of electronic currencies: what makes them special is that they are issued through blockchain technology, are not restricted by national payment systems, and can circulate globally.
Stablecoins are not a dangerous financial product, but rather a veritable “electronic money 2.0” that has the potential to further fulfill the original promise of electronic money: to increase competition in the financial sector, reduce costs for consumers, and promote financial inclusion. But in order to deliver on these promises, stablecoins do need to be properly regulated at the federal level. In the absence of federal legal regulation, U.S. stablecoin issuers will continue to be subject to state money transmission laws, which are not uniformly designed and implemented in terms of segregation of customer funds and the integrity of reserve assets.
Taking into account the EU’s decades of experience in the field of electronic money, as well as advanced improvements in other countries, effective stablecoin regulation should be built on three pillars: granting non-bank licenses, direct access to central bank accounts, and bankruptcy protection for backing assets.
First, restricting the issuance of stablecoins to banks is itself a contradiction. The essence of banking is holding public deposits that are not always 100% backed, traditionally known as “fractional reserve banking.” As a result, banks can make loans without using their own capital.
On the other hand, for stablecoin issuers, the goal is to ensure that each stablecoin is fully backed by liquid assets. Their main responsibilities are to receive cash, provide equivalent in the form of stablecoins, safely keep the cash received, and return the cash when users redeem stablecoins. Lending is not part of their business.
Stablecoin issuers are very similar to electronic money issuers, both of which aim to compete with banks in the payment field, especially in cross-border payments. They should not replace banks, let alone evolve into banks.
That is why stablecoin issuers should obtain a specific non-bank license, like e-money issuers in the EU, UK and Brazil, which is simpler and has requirements (including capital requirements) that match their limited activities and lower risks. They do not need a banking license and should not be required to hold one.
Second, to reinforce their lower risk profile, stablecoin issuers should be able to have central bank accounts to hold their backing assets. Keeping customers’ cash in bank accounts or investing in short-term securities is usually a safe option, but both options can carry greater risks during times of stress.
For example, Circle, a US stablecoin issuer, faced difficulties due to the collapse of Silicon Valley Bank (SVB), and its $3.3 billion cash reserves (almost 10% of total reserves) deposited with SVB were once unavailable. Affected by the rise in interest rates in 2022, many banks holding US Treasury bonds suffered losses, and the price of Treasury bonds in the market fell, causing some banks to be short of liquidity and difficult to respond to withdrawal requests.
To prevent problems in the banking system or Treasury markets from affecting stablecoins, issuers should be required to deposit their backing reserves directly with the Federal Reserve. This measure would effectively eliminate credit risk in the U.S. stablecoin market and enable real-time supervision of stablecoin backing—without deposit insurance and without bailout risk, similar to the case of electronic money and in contrast to bank deposits.
Note that it is not unprecedented for non-bank institutions to have central bank accounts. E-money issuers in countries such as the UK, Switzerland and Brazil can protect users' funds directly through the central bank.
Third, customer funds should be managed separately from the issuer’s funds in accordance with the law and should not be subject to any bankruptcy proceedings if the stablecoin issuer fails (e.g. due to operational risks such as fraud). With this additional layer of protection, stablecoin users can quickly regain access to their funds during liquidation, as general creditors of a bankrupt issuer have no right to seize customer funds. Again, this is considered best practice for e-money issuers.
In the public debate on stablecoin regulation, these innovative approaches may impress the audience. However, for those who pay attention to details, the balanced arguments based on successful cases and experiences around the world should be more persuasive.
Based on the EU's decades of experience in the field of electronic money and advanced reforms in other countries, effective stablecoin regulation should be based on three pillars: granting non-bank licenses, direct access to central bank accounts, and bankruptcy protection for backing assets.
First, it is a contradiction to limit the authority to issue stablecoins to banks themselves. The essence of banking is to keep public deposits, which are not always 100% backed by funds, traditionally known as "fractional reserve banking." Therefore, banks are able to provide loans without using their own capital.
As for stablecoin issuers, their main task is to ensure that each stablecoin is backed by sufficient liquid assets. Their core responsibilities include receiving cash, providing an equivalent amount of currency in the form of stablecoins, safely keeping the collected cash, and returning the cash when the user demands it. This has nothing to do with the loan business.
Stablecoin issuers are similar in nature to electronic money issuers in that they aim to compete with banks, especially in the cross-border payment space. They aim to supplement rather than replace banking functions, and should not evolve into banks.
This is why stablecoin issuers should obtain a specific non-bank license, similar to the licenses obtained by electronic money issuers in the EU, the UK and Brazil, which are relatively simple and have requirements (including capital requirements) that are appropriate to their limited business activities and lower risks. They do not need a banking license and should not be required to hold one.
Second, to strengthen their low-risk status, stablecoin issuers should be able to have central bank accounts to hold their backing assets. Keeping customer funds in bank accounts or investing in short-term securities is often seen as a safe option, but both options can carry greater risks during periods of economic stress.
For example, Circle, a US stablecoin issuer, faced difficulties due to the collapse of Silicon Valley Bank, and its $3.3 billion cash reserves in the bank (accounting for nearly 10% of its total reserves) were once unavailable. Affected by the rise in interest rates in 2022, many banks holding US Treasury bonds suffered heavy losses, and the decline in Treasury prices led to a shortage of liquidity and difficulty in meeting withdrawal demands.
To prevent fluctuations in the banking system or Treasury market from affecting stablecoins, issuers should be required to deposit their backing assets directly with the Federal Reserve. This measure would effectively eliminate credit risk in the U.S. stablecoin market and enable real-time supervision of stablecoin backing—without deposit insurance or bailout risk, similar to the case of electronic money and unlike bank deposits.
It is worth noting that it is not unprecedented for non-bank institutions to have central bank accounts. In countries such as the United Kingdom, Switzerland and Brazil, electronic money issuers can directly protect users' funds through the central bank.
Third, customer funds should be managed separately from the issuer's funds in accordance with the law, and should not be subject to any bankruptcy proceedings if the stablecoin issuer fails due to operational risks (such as fraud). This additional layer of protection ensures that stablecoin users can quickly regain their funds during the liquidation process, and general creditors of the bankrupt issuer have no right to seize customer funds. This practice is regarded as a best practice for e-money issuers.
In the public debate on stablecoin regulation, these innovative measures may impress the audience. However, for those audiences who pay attention to details, balanced arguments based on global success stories and experiences should be more persuasive.
