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Stablecoins: Systemically Important, Soon to Be Regulated

Nov. 19, 2021, 9:45 AM

The President’s Working Group on Financial Markets issued a report (the “report”) on the future of stablecoins which included, among other things, a suggestion that certain activities conducted within a “stablecoin” arrangement may constitute “systemically important payment, clearing, and settlement activities.” This seemingly generic language suggests an application of a regulatory framework that may alter the digital asset landscape and usher in substantial changes to the taxation of digital assets.

What Is a ‘Stablecoin?’

First, right off the bat, it is worth noting that most well-known cryptocurrencies are not stablecoins. If you’ve heard about huge gains and losses in a digital asset, it is, almost definitionally, not a “stable” coin. A “stablecoin” can be thought of as a digital asset that is at least intended to be non-speculative in and of itself—its price is keyed to a reference asset, cryptocurrency, or fiat currency.

One example might be a stablecoin tied to gold—let’s call it GOLDCOIN.

One GOLDCOIN would be worth one ounce of gold, and when the price of an ounce of gold goes up, so does the GOLDCOIN. Suppose there is a cryptocurrency-wide crash in valuation—in that case, the presumption is that the GOLDCOIN would not be subject to the crash because it is a digital representation of an investment in another asset. Even if there was some effect on GOLDCOIN owing to, say, a market-wide skepticism of digital assets, the floor price for GOLDCOIN would be close to the value of an ounce of gold owing to the effects of arbitrage. The idea is a stablecoin will be more stable—at least as against other digital assets.

Why Do We Need Stablecoins and Other Cryptocurrencies?

One problem stablecoins solve, at least in theory, is that they provide a means to move value into digital assets without having to speculate. If you think of digital assets like Bitcoin and Ethereum as having a duality, and existing on a spectrum between investment and currency, a stablecoin is placed more toward currency. They can be used as a launching-off point or cash trove to make investments in more speculative digital assets.

What Did the Working Group Say About Stablecoins?

First, the working group report outlined the need for congressional action in the stablecoin space:

  • To address risks on the equivalent to bank runs on stablecoins through supervision and regulation; and
  • To address concerns about risks in the payment system by creating a system of oversight for digital asset wallet providers.

The likelihood of Congress taking up this call to action in the near term seems low.

In the absence of congressional action, the working group recommended that the Financial Stability Oversight Council of the Treasury Department (the “council”) declare activities within a stablecoin arrangement as systemically important payment, clearing, and settlement activities. This is a reference to the Core Principles for Systemically Important Payment Systems (CPSIPS) of the Federal Reserve. Declaring stablecoin activities systemically important payment systems puts them under the purview of the Federal Reserve by way of the Dodd-Frank Act.

What Would Being Declared ‘Systemically Important’ Mean?

Broadly, systemically important stablecoin activities would be subject to risk management policies, margin and collateral requirements, timing restraints, capital and financial resource requirements, and other digital asset-specific requirements suggested by the peculiarities of transacting in the digital space.

In so doing, the council would essentially be declaring stablecoin issuers as “systemically important financial institutions” (“SIFIs”) under Dodd-Frank—think of this as institutions that are “too big to fail.” They are subject to scrutiny of the extent of the leverage, exposure, interconnectedness with other SIFIs, importance as a source of credit for underserved communities, ownership, and any other risk-related factors deemed appropriate.

In sum, if stablecoins are of a sufficient size—as of yet undefined—and are sufficiently interconnected—also as of yet undefined—they would be subject to rules and oversight as though they were banks, with additional requirements owing to their unique nature as digital assets.

Looking Abroad for Next Steps

In September of 2020, the European Commission published a proposed regulation on markets in crypto-assets (“MiCA”). Contained in MiCA is a definition of a “significant stablecoin” which is similarly defined to SIFIs under Dodd-Frank: size, value, number of transactions, issuer’s reserve of assets, and instruments interconnectedness in the financial system.

MiCA has specific requirements for issuers of significant stablecoins. In addition to the kinds of oversight proposed by the report, MiCA requires that stablecoins hold funds amounting to at least 3% of reserve assets, establish liquidity management policies that will continue to operate even where liquidity is stressed, and establish fair, reasonable, and non-discriminatory terms with several crypto-asset service providers. Issuers of stablecoins subject to regulation in the United States can likely expect similar terms.

Proponents and purveyors of digital assets need a seat at the table. The working group needs to be populated with at least as many coders as finance folks—and a good deal number of folks wearing multiple hats. As per the report, stablecoins are a $127 billion industry as of October 2021. They are, already, too big to fail.

Current and potential issuers of stablecoins will want to create or establish clear and concise policies and procedures from the initial offering to address the kinds of risk management issues the report is concerned with. These safeguards will need to be set, first, “in the code.” For instance, smart contracts, such as those on the Ethereum blockchain, can manage collateral and ensure a dipping of reserve assets below the 3% mark is functionally impossible. These kinds of code-based safeguards are key but will not be sufficient.

A place for regulators and insurers will nonetheless exist, as the report notes a “self-reinforcing cycle of redemptions and fire sales of reserve assets” could threaten the stability of a so-called “stable” coin. Digital asset proponents are pushing back against the idea of regulation, but the reality is any physical-digital marriage is going to have a guest list from each family. The digital side has smart contracts and software, the physical side has regulatory bodies and promulgated regulations. Both sides need to speak now or forever hold their peace.

Changing Tax Implications

The argument can and should be made that if stablecoins tied to fiat currencies are to be regulated and subject to oversight by the Federal Reserve, paying for goods and services in that stablecoin should not be a taxable event. Currently, the IRS treats a payment made in any cryptocurrency, including a stablecoin, as the functional tax equivalent of a sale or exchange of an asset—subject to capital gains treatment. Similarly, the conversion of value from one stablecoin to another is currently a taxable event. This will need to change.

Indeed, a well-regulated stablecoin market should give rise to tax treatment no different from that of foreign currencies. A foreign currency has its price determined by supply and demand on currency markets or has its price pegged to an underlying asset or currency. Stablecoins, with their value pegged to an underlying asset, currency, or commodity, should only give rise to tax liability owing to a change in value relative to its underlying asset and upon the exchange for fiat currency—just as with foreign currencies. The similarities are so clear as to render differential treatment, absent some clear regulatory purpose, indefensible.

Since their inception, digital assets have been given the legislative and regulatory cold shoulder by the federal government and treated as property. An acknowledgment that a digital asset can be something more by one agency will necessitate changes throughout the system. A simple change such as rendering purchases made via stablecoin non-taxable events for the purchaser could be a huge boon to an already booming industry.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Andrew Leahey is a tax and technology attorney in Pennsylvania and New Jersey.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

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