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The crypto market has been quite excited since PayPal announced its launch of its U.S. dollar-denominated stablecoin (PYUSD), which, as the company indicated in its press release, “is fully backed by U.S. dollar deposits, short-term U.S. treasuries and similar cash equivalents, and can be redeemed 1:1 for U.S. dollars. ” However, with a supervisory letter issued on the day immediately following PayPal’s announcement, the Federal Reserve seems to have been on the cautious side when it comes to the use of stablecoins in a conventional finance setting.

In its letter titled “Supervisory Nonobjection Process for State Member Banks Seeking to Engage in Certain Activities Involving Dollar Tokens ,” the Board of Governors of the Federal Reserve System (the “Board”) laid out the “nonobjection process” for a state member bank (i.e., the banks that are state-chartered and are members of the Federal Reserve System) seeking to engage in “dollar token activities,” which include the “issuance, holding, or transacting in dollar tokens to facilitate payments.” The state member bank is required to first submit the activity that it intends to engage in to the lead supervisory point of contact at the Board for review (even if the contemplated activity is solely related to the bank’s testing as to the viability or reliability of incorporating such dollar token activities). After receiving the state member bank’s submission, the Board will assess the bank’s risk management measures against the following risks to determine whether the Board should issue a written notification of supervisory nonobjection for the bank’s proposed activity:

  1. Operational risks (including the risks associated with “the governance and oversight of the network” and the risks such as involved parties’ responsibilities and transaction validation process).

  2. Cybersecurity risks (including the risks associated with “the network on which the dollar token is transacted, the use of smart contracts, and any use of open source code”).

  3. Liquidity risks (including the risk that “substantial redemptions in a short period of time that would trigger rapid outflows of deposits”).

  4. Illicit finance risks (such as the risk that would result in a state member bank’s violation of anti-money laundering or sanction compliance obligations).

  5. Consumer compliance risks (such as the potential violations of applicable consumer protection law).

  6. Risks of fraud and scams among crypto-asset sector participants.

  7. Legal uncertainties related to custody practices, redemptions, and ownership rights.

  8. Susceptibility of stablecoins to run risk, creating potential deposit outflows for banking organizations that hold stablecoin reserves.

  9. Contagion risk within the crypto-asset sector resulting from interconnections among certain crypto-asset participants, including through opaque lending, investing, funding, service, and operational arrangements.

  10. Other risks as identified in the Joint Statement issued by the Board the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency on January 3, 2023.

While the Board has generally identified the key risks to be addressed in connection with its review of a state member bank’s proposed activities involving dollar tokens, a few categories of risks underlying the adoption of stablecoin (e.g. PYUSD) might require the bank to come up with some creative risk-mitigating measures given the nature and the potential use of stablecoins in conventional finance settings. For instance, a stablecoin’s liquidity risks, as shown in the USDC’s temporary loss of peg to US dollars due to Circle’s SVB disclosure back in April, has been proven to be outside the control of relevant parties involved in SVB’s closing down. Major crypto exchanges (such as Coinbase and Binance ) had temporarily ceased converting USDC while it fell below 87 cents (as opposed to $1 that it was supposed to be trading at). Although USDC is now back on its feet, such de-pegging and temporary pause of conversion suggested a possible scenario that a stablecoin’s liquidity could be seriously affected as a result of its (loss of) ties to the underlying fiat currency (even when the root cause is in fact (remotely) pertinent to the stablecoin itself).

Another example of the concerned liquidity risk is that centralized stablecoins (such as PayPal’s PYUSD) is usually designed in a way that allows the issuer/owner to pause transfers, freeze addresses (to prevent the facilitation of transactions) and/or adjust total supply at will . Such centralized nature could either remediate or exacerbate a liquidity event and would require faith of the consumers and conventional banks handling the flow of stablecoins. Accordingly, a state member bank’s development of mitigating measures for the liquidity risks might need to go beyond its establishment of adequate fiat reserves for stablecoins and consider other factors, such as the origination of stablecoins (e.g., whether such stablecoin is the loan proceed from a DeFi lending protocol or is pledged as collateral), the role of the bank (e.g., facilitating conversion of stablecoins or using stablecoins as a mean of payment) and the type of stablecoins (e.g., whether a stablecoin is pegged to (a basket of) fiat currencies or is algorithm-based).

Separately, a state member bank might also find the murky legal status surrounding stablecoins a challenge to its contemplated adoption. For instance, New York State Department of Financial Services has issued a guidance on June 8, 2022 addressing the issuance of USD-backed stablecoins, in which the department sets forth extensive requirements on a stablecoin’s backing and redeemability (e.g., stablecoin issuers are required to facilitate redemption within a T+2 timeframe), reserves (e.g., reserve for stablecoins should only consist of U.S. Treasury bills, adequately and fully collateralized reverse repurchase agreements, certain government money-market funds, and deposit account at a U.S. state or federally chartered depository institutions) and other control measures.

While such requirements are imposed on stablecoin issuers, not every state has had the same guidance in place, and a bank will need to verify whether a stablecoin issuer has been compliant with applicable state regulatory guidance in the states where the stablecoin might flow to/through or whether conflicting guidance exist in the target states. Such uncertainty (as well as other legal uncertainties relating to custody requirements and pertinent rights and obligations) might be addressed in the proposed Lummis-Gillibrand crypto bill, but before the bill is adopted into law, a bank might still need to customize its risk mitigating measures and have an overall examination of its existing control and risk-mitigation framework to address the risks underlying its adoption or handling of stablecoins.

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By Chih-Hsun (Tim) Lin

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