We asked if “stablecoins are in the crosshairs for federal regulation” after the release of President Biden’s Working Group on Financial Markets report last month. And discussions over the last two weeks are painting a clearer picture of the legislative priorities within Washington, as stablecoins took center stage during hearings held by the House Financial Services Committee and the Senate Banking Committee.
Top industry executives offered testimony at both hearings to give members of Congress a better understanding of digital assets and stablecoins. However, it was readily apparent that most members involved in the hearings not only had an understanding of digital assets but had already formed polarized opinions as to their usefulness, risk to consumers and the extent of regulation warranted. As 2022 is likely to see continued scrutiny and the potential for regulation, there are ways that stablecoin issuers can address Congressional concerns while awaiting further guidance and legislation.
1. Choose a Regulatory Regime Based on Your Business Model
Many stablecoin issuers register as a money services business (MSB) under FinCEN and for a money transmitter license (MTL) within their appropriate state(s). The severity of the reporting requirements and oversight associated with these registrations and licenses vary; however, they include basic components to instill trust within the marketplace, such as:
- Development of an effective AML program,
- Filing of appropriate FinCEN forms associated with suspicious activities and cash transactions,
- Filing of appropriate BSA forms,
- Obtaining a surety bond and
- Adhering to financial statement reporting requirements.
Although we may be a year or more away from a final regulatory framework, we believe it will ultimately include, at a minimum, some of the same basic tenants of the MSB and MTL regimes.
2. Establish Standards for Permissible Reserve Assets and Reserve Segregation
Reserve assets backing stablecoins could include fiat currencies, traditional financial assets, commodities, or other digital assets and algorithms. The goals of the stablecoin will inform its selection of reserve assets. For example, if a stablecoin is using a reference currency of the U.S. dollar, then the reserve asset should be denominated in the U.S. dollar and be high quality, liquid assets that would remain liquid and not incur significant losses in a run.
One way to establish segregation of the reserves, or collateral, and safely hold them is to establish a specific escrow or trust arrangement with a regulated financial institution. The collateral can be deposited into the escrow or trust account designated for the benefit of the coin holders. The escrow agent or trustee would be bound by the contract to deliver, or return, the collateral to a coin holder in accordance with strict instructions. The depositary has a fiduciary duty to the escrow parties to comply strictly to the terms of the agreement, and negligence in the dispensing of their duties could result in liability for losses. This type of arrangement also protects coin holders in the event of insolvency or bankruptcy by the stablecoin issuer.
3. Enhance Transparency About Your Reserves
Both Congressional hearings resulted in a recommendation that issuers pursue regular reporting, including independent third-party audit or attestation, of stablecoin reserves. While there is currently not a standard reporting framework, sophisticated public accounting firms are performing regular attestations of stablecoin reserves. These reports provide transparency to the marketplace and instill confidence that the stablecoin has sufficient assets backing the outstanding coins. These reports also enable an issuer to disclose terms and policies as outlined below.
4. Ensure Appropriate Disclosure of All Terms and Policies
Determining what disclosures are appropriate may vary based on the simplicity or complexity of the stablecoin. However, there are a few that most coin holders are likely to find relevant and that regulators would be anxious to understand. The first is regarding the internal controls and processes surrounding the minting and burning of tokens, which help ensure outstanding coins do not exceed their collateral backing. These processes should have clarity and predictability in how claims arise and obligations are discharged between parties in the transaction chain.
Other relevant disclosures include the legal nature of the issuer’s commitment to stablecoin holders in relation to the underlying assets on reserve. What are the issuer’s obligations as to safekeeping and management of those assets? What are the terms of redemption for holders of the stablecoins? Issuers might consider leveraging commercial law guidance for securities transfers and virtual currency businesses where specific rules are outlined. This could provide assurance to market participants that their coin is underpinned by clear legal terms that define and govern with certainty the individual components of the stablecoin arrangement.
One thing is clear from the recent hearings — stablecoins are most certainly in the crosshairs for federal regulation. Now is the time for issuers to evaluate their standards and take any necessary steps to build a robust framework that instills confidence for their customers.
Contact Cynthia Pedersen at firstname.lastname@example.org, Christian Hinder at email@example.com or a member of your service team to discuss this topic further
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.