In the second edition of “Stablecoin Policy 101,” we take a close look at the landscape for stablecoin regulation in the United States, examining state versus federal regulation of stablecoin issuers and the impact each regulatory pathway has on consumers and the broader market.
At present, there is no framework in place for stablecoins at the federal level, although there have been a number of efforts in Congress in recent years to create one. A growing number of U.S. states, however, are regulating stablecoin issuers.
Understanding Stablecoins and Stablecoin Issuers
Stablecoins are a class of cryptocurrency pegged to a stable value, such as the U.S. dollar. $160B+ of the current stablecoin market within the blockchain and digital asset industry is pegged to the U.S. dollar. A stablecoin issuer accepts dollars to “mint” – create new – stablecoins and then holds the reserves. The issuer also may be responsible for “burning” the stablecoins – removing them from available supply – when customers redeem the stablecoin for fiat.
Not all stablecoins and stablecoin issuers are built equally, especially when it comes to regulated versus unregulated stablecoin issuers. At a high level, a regulated stablecoin issuer has a primary prudential regulator that oversees stablecoin reserve composition and the segregation of customer and corporate assets. For example, stablecoin issuers regulated by the New York Department of Financial Services (NYDFS), like Paxos Trust Company, hold customer funds segregated from the issuer. This means stablecoin reserve funds are only available to the stablecoin holder. Regulated issuers place reserves in highly liquid, low-risk assets as required by the NYDFS and comply with all federal anti-money laundering and know-your-customer standards.
Unregulated issuers are those without a primary prudential regulator. This means that the oversight and protections provided by a regulated issuer do not apply.
Advantages of Regulation at the State Level
State regulators have a proven track record of effectively overseeing trust companies and money transmitters. State laws have empowered state regulators with robust consumer safeguards tailored to local needs. However, some attempts at stablecoin legislation in Congress have introduced the idea of federal preemption of stablecoins. At a high level, preemption is when federal law overrules that of the states. In the context of some proposed stablecoin legislation, it means explicitly granting oversight of stablecoins to the Federal Reserve – which lacks expertise in regulating firms other than bank holding companies – and jeopardizing the important role state regulators have played to date. Preemption threatens state-level funding streams, could stifle economic innovation, and undermines state-specific, localized consumer protections and regulation.
Risk to state-level funding
States generate significant revenue from regulating money transmitters and trust companies through licensing fees and fines. This is an important revenue source and impacts their ability to fund local regulatory and consumer protection activities. With federal preemption, states could lose access to potentially billions of dollars in licensing fines and fees.
Risk of stifling economic innovation
State regulatory frameworks are more agile and have a demonstrated ability to quickly adapt to innovations in fintech and digital assets. A top-down approach from the federal regulator is likely to impose rigid standards that constrain innovation, hinder local economic growth and limit the introduction of new technologies.
Risk of losing localized, specific regulation
States are better positioned to understand and address the specific risks and needs of their communities. For example, certain states have more stringent consumer protection standards on usury, disclosure, dispute resolution and other issues. With federal preemption, centralized regulation might not address specific local needs effectively.
Creating a State-Led Legislative Framework with Federal Option Pathways
Developing robust, consistent state and federal regulatory pathways for stablecoin issuers will support competition and growth while reducing the risks of regulatory concentration, regulatory capture and a race to the bottom among issuers.
Congress has done important thinking on how to build a framework for dual state and federal options for stablecoin issuers. The Clarity for Payment Stablecoins Act, which passed on a bipartisan basis out of the House Financial Services Committee in 2023, is a compelling example – it proposes the creation of “federal floor” standards, ensuring that all state regulators meet the same high standards regarding customer funds’ segregation, reserve composition, bankruptcy remoteness, regular examinations, audits and disclosures.
The Act also allows firms to choose to be federally regulated under the same standards, giving issuers the optionality to determine which regulatory pathway is best suited to their needs and business models.
If Congress sees the need for a federal payments regulator, it should ensure that all payments firms are regulated alike and to the same standards by either a federal or state primary prudential regulator. Hearings and legislative consideration should determine whether the Federal Reserve, OCC, or another regulator is most capable of managing this responsibility and addressing conflicts of interest between banks and non-bank payment firms.
To learn more about state versus federal regulation of stablecoin issuers, contact [email protected].