Historical Stability of State-Regulated Trusts and Systemic Risk Contrast
State-regulated trusts have a longstanding history of conservative asset management and customer protection, with origins tracing back over a century. This track record shows that state-regulated trusts have consistently operated with prudential oversight, avoiding high-risk activities that could impact broader economic stability. Unlike banks or investment advisors, state-regulated trusts maintain a reputation for insulating customer assets from institutional risk and avoiding entanglements in financial crises.
Financial institutions have periodically introduced systemic risks with significant economic fallout.
For instance, the 2008 financial crisis saw major banks amass and then leverage over $600 billion in high-risk mortgage-backed securities, triggering widespread financial instability and trillions in mark-to-market losses.3 Similarly, cases like Bernie Madoff’s Ponzi scheme, which resulted in $65 billion in losses due to unchecked advisor risk, and MF Global’s failure, where $1.6 billion in customer funds were misappropriated, underscore the risks tied to lax oversight and highly leveraged positions. Even earlier, the 1984 failure of Continental Illinois, one of the largest banks in the U.S., required a massive government intervention to prevent systemic collapse, giving rise to the concept of “too big to fail.” Also within the banking sector, failures like Washington Mutual’s collapse with $307 billion in assets further reveal vulnerabilities tied to aggressive risk-taking in the fractionalized banking system.
Key takeaway
These examples highlight how different risk profiles and regulatory approaches can impact systemic stability, with state-regulated trusts standing out for their resilience and prudent operational focus.
In stark contrast, failures among state-regulated trusts have been rare and relatively small in scale.
Examples like the Lincoln Trust Company in Nebraska during the Great Depression4 and First American Bank & Trust Company of North Dakota5 in the 1970s highlight the limited impact of such failures. In each instance, state regulators intervened effectively to manage the insolvency, and losses were contained without triggering broader market instability or systemic risk.
Key takeaway
The above cases underscore the conservative and low-risk nature of state-regulated trusts, as none have led to market disruptions and state oversight has proven effective at managing such situations without expanding risk exposure.
Rehypothecation and Systemic Stability
A key differentiator of regulated trusts is the fiduciary obligation of the trustee and the outright prohibition on rehypothecation, or the reuse of customer collateral to fund the financial firms’ taking on of additional debts or investments in securities. While banks reuse customer funds as collateral, introducing layers of systemic risk, state-regulated trusts prohibit this practice entirely. This prohibition ensures that customer assets remain insulated from broader market risks, as trusts are forbidden from using client funds to secure external debts or obligations. Banks, in contrast, rely on rehypothecation to bolster profit, exposing customer assets to market dependencies. 6
Key takeaway
By adhering to a zero-rehypothecation standard, state-regulated trusts minimize risk and maximize customer asset security, making them uniquely suited for managing stablecoins within a transparent and low-risk framework.
Conservative Asset Management and Security
The asset management strategies employed by state-regulated trusts are among the most conservative in the financial industry. State trusts, including digital trusts, segregate customer assets and invest exclusively in cash, short-term U.S. Treasury bills and overnight repos – limiting exposure to volatility.7 In contrast, banks and investment advisors hold a variety of assets, including loans and other instruments, that introduce heightened market and credit risk. Money market funds also allow for limited diversification into illiquid assets, amplifying liquidity risks. By maintaining a strict 1:1 asset backing for each digital dollar, state-regulated trusts ensure that every stablecoin is matched by a liquid, low-risk asset.
Key takeaway
This conservative approach avoids the inflationary effects of new money creation and asset bubbles often triggered by leveraged and high-risk investments.
Insolvency Protections: A Structural Advantage
State-regulated trusts provide superior insolvency protections often lacking in other financial institutions. For instance, in New York under Banking Law §100, customer assets in state-regulated trusts are legally segregated and shielded from the trust’s liabilities, even in cases of insolvency. This ensures that trust customers maintain priority over creditors, a safeguard not afforded by traditional FDIC insurance, which covers only deposit accounts and is capped at $250,000.8 Investment advisors are regulated under the SEC’s framework but lack similar statutory protections, leaving customer assets exposed in cases of financial distress.
Key takeaway
For stablecoin holders, the robust insolvency protections embedded in state laws present a vital shield, reinforcing the integrity of state-regulated oversight.
Asset Segregation and Custodial Integrity
A key requirement of state-regulated trusts is the rigorous segregation of customer assets from the trust’s operational funds. In New York, for example, state law mandates that each dollar is kept distinct from the institution’s financial activities. Banks and investment advisors commonly commingle client funds with operational assets, increasing the risk of exposure to institutional credit and operational risks.
Key takeaway
Given the strict adherence to segregation of customer assets from a trust’s operational funds, state-regulated trusts uphold custodial principles that eliminate exposure to institutional credit and related operational risks, reinforcing a prudential foundation for the issuance of fully backed USD stablecoins.
Leverage Constraints: Anchoring Stability
State-regulated trusts operate under strict leverage prohibitions, unlike many other financial models. With no leverage, trusts do not expose customer assets to interest rate fluctuations, credit, or market risks associated with leveraged positions. Banks, by comparison, routinely leverage assets to enhance returns, with bank ratios reaching up to 25x for US banks.9 Investment advisors may leverage customer assets but only with customer permission.
Key takeaway
By refraining from leveraged strategies, state-regulated trusts provide an inherently stable and conservative financial model that minimizes risk and avoids inflating the money supply – an ideal structure for managing stablecoins.
Consumer Protections: A Comparative Advantage
Consumer protection is a core principle in the regulatory framework governing state-regulated trusts, especially those managing U.S. dollar stablecoins. State-regulated trusts are bound by a fiduciary duty to act exclusively in the interest of their customers, ensuring that assets are protected, insulated from institutional risks and held separately from operational funds. Unlike banks, where deposit insurance covers only a fraction of deposits (up to $250,000), state-regulated trusts are required to maintain a 1:1 backing of customer funds, effectively removing counterparty risk and providing each digital dollar with full transparency and security.
Investment advisors, regulated under SEC rules such as the Investment Advisers Act of 1940, are required to act as fiduciaries but do not offer statutory protections like SIPC or FDIC guarantees for customer assets. Typically, customer assets are held by third-party custodians, reducing risks in cases of advisor insolvency, but there is no absolute guarantee against losses. Similarly, money market funds are subject to SEC regulations, including Rule 2a-7, which enforces strict liquidity and diversification standards, but these funds are not insured by the FDIC or SIPC and remain subject to market risks such as ‘breaking the buck.’
Key takeaway
By contrast, state-regulated trusts are explicitly required to segregate customer assets and protect them from creditors. This legal framework creates an added layer of security, ensuring that, even in the event of a trust’s insolvency, customer assets remain fully available to customers.
Dual Regulatory Oversight: Institution and Issuance Scrutiny
The prudential regulation of state-regulated digital trusts ensures trustworthiness and security of the stablecoins themselves, with the NYDFS proscribing clear standards for stablecoin products that they approve and oversee.10 Through the NYDFS, digital trusts are subject to annual examinations, blockchain approvals, approvals of new products and programs, regular audits and stringent asset backing that must be publicly disclosed.11 This dual scrutiny ensures both institutional soundness and asset transparency and provides stablecoin holders with real-time assurance of solvency and security. In contrast, many financial institutions lack such comprehensive and tailored oversight.
Key takeaway
The regulatory oversight of state-regulated trusts is robust, comprehensive and requires explicit approval of new programs and products.
Conclusion: The Prudential Adequacy of State Oversight
The framework governing state-regulated digital trusts underscores their suitability for managing digital assets with the rigor of a tested prudential model. Through strict rehypothecation rules, conservative asset management, statutory insolvency protections, mandated asset segregation and leverage constraints, state-regulated trusts present a model of transparency and stability that serves the best interests of digital asset holders.
Final takeaway
Legislators and policymakers should recognize the prudential adequacy of state-regulated oversight, which both aligns with and exceeds the protections offered by federal models. With state regulators effectively managing these digital trusts, additional federal oversight would complicate and duplicate existing regulatory protections.
To learn more about state versus federal regulation of stablecoin issuers, contact [email protected].
- Release: Money Market Fund Assets. (2024, November 21). Investment Company Institute. https://www.ici.org/research/stats/mmf
- FDIC: State Tables. (2022, August 31). FDIC. https://state-tables.fdic.gov/
- The Financial Crisis Inquiry Commission. (2011). The financial crisis inquiry report. In The Financial Crisis Inquiry Report. https://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf
- First Trust Co. of Lincoln, Neb., v. Ricketts, 75 F.2d 309, 310 (8th Cir. 1934)
- First Am. Bank & Trust Co. v. Ellwein, 198 N.W.2d 84, 1972 N.D. LEXIS 177 (N.D. April 12, 1972)
- NYDFS to Crypto Custodians Proceed with Caution. (2023, February 9). Morganlewis.com. https://www.morganlewis.com/blogs/finreg/2023/02/nydfs-to-crypto-custodians-proceed-with-caution
- See examples at: Harris, A. A. (2022, June 22). Industry Letter – June 8, 2022: Guidance on the Issuance of U.S. Dollar-Backed Stablecoins. Department of Financial Services. https://www.dfs.ny.gov/industry_guidance/industry_letters/il20220608_issuance_stablecoins; 2023 Wyoming Statutes – Title 13 – Banks, Banking and Finance – Chapter 12 – Special Purpose Depository Institutions – Section 13-12-105 – Required Liquid Assets. (2023). Justia Law. https://law.justia.com/codes/wyoming/title-13/chapter-12/section-13-12-105/
- Are My Deposit Accounts Insured by the FDIC? | FDIC. (2024). Fdic.gov. https://www.fdic.gov/resources/deposit-insurance/financial-products-insured
- 12 CFR 217.10
- (see Footnote 7)
- See, as example: Harris, A. A. (2022, June 22). Industry Letter – June 8, 2022: Guidance on the Issuance of U.S. Dollar-Backed Stablecoins. Department of Financial Services. https://www.dfs.ny.gov/industry_guidance/industry_letters/il20220608_issuance_stablecoins