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Crypto Stablecoin Plummet Sparks Call for Banks to Keep Distance

May 18, 2022, 10:00 AM

The recent collapse of the TerraUSD stablecoin forces policymakers to rethink just how close they want other stablecoins to get to the federally insured banking system.

Lawmakers and other officials have been calling for increased regulation of stablecoins since TerraUSD lost its peg to the dollar and cost investors billions of dollars. The Biden administration last year floated the idea of requiring stablecoins backed by fiat currency to be issued only by federally insured banks.

But the collapse of TerraUSD, an algorithmic stablecoin not backed by reserves of fiat currencies or other tangible assets, puts the question of allowing any stablecoin issuers to have access to the Federal Deposit Insurance Corp.’s deposit insurance fund, which safeguards bank deposits up to $250,000, in a different light.

“I certainly think this has given pause to a lot of people to linking this to the FDIC insurance fund,” said Nathan Dean, a Bloomberg Intelligence analyst.

While the administration has been focused on putting stablecoins inside the federally-insured banking sector, lawmakers of both parties have been putting forward other ideas for regulation.

‘Key Gaps’

The President’s Working Group on Financial Markets, including the Treasury Department, the Securities and Exchange Commission, and other regulators, first floated the idea of requiring only federally insured banks to issue stablecoins in a November 2021 report on “key gaps” in oversight of the cryptocurrency products. President Joe Biden called for further studies on stablecoin regulation in a March executive order.

Sen. Pat Toomey of Pennsylvania, the ranking Republican on the Senate Banking Committee, issued his own principles for regulating stablecoins in December. Toomey envisioned Congress setting up three different licensing options for stablecoin issuers, including the option of becoming an insured bank.

Toomey also proposed the creation of a special-purpose banking charter, without deposit insurance, for stablecoin issuers or allowing issuers to operate with a state money transmitter license. He circulated a discussion draft of legislation for stablecoin rules in April.

“If Congress does not act in this space, then the danger is, at some point, a fiat-backed stablecoin might lose its dollar peg. And that could not only be very problematic for consumers who lose money, but it could have repercussions,” Toomey said on May 11.

The crash in TerraUSD and other stablecoins has put more urgency behind the push for stablecoin regulation. Treasury Secretary Janet Yellen and Toomey discussed attempting to get stablecoin legislation done by the end of the current congressional session at a May 10 Senate Banking Committee hearing.

Yellen told the House Financial Services Committee on May 12 that while stablecoins don’t yet pose a broader risk to the financial system, “they’re growing very rapidly and they present the same kind of risks that we have known for centuries in connection with bank runs.”

Despite Yellen and Toomey’s agreement on the need for stablecoin legislation, the calendar, a raft of other congressional priorities and the upcoming midterm elections mean that getting a law to the president’s desk is unlikely, Dean said.

Meanwhile, policymakers will weigh various proposals, including whether FDIC insurance for the products makes sense.

“They will analyze the conditions, the risks and whether and how the respective agencies can craft regulation to mitigate such risks and best provide appropriate consumer protection,” said Kari Larsen, the head of Perkins Coie LLP’s Blockchain, Digital Asset and Custody Group.

Different Coins

At the center of regulators’ discussions is what kinds of stablecoins banks should be issuing.

TerraUSD was an algorithmic stablecoin, meaning that while its value was pegged to the dollar, it was backed by a separate cryptocurrency called Luna. That left it especially vulnerable to runs.

The President’s Working Group report focused on fiat-backed stablecoins, not algorithmic ones like TerraUSD, said Matt Homer, a former New York Department of Financial Services official who led innovation efforts at the regulator.

The DFS was the first U.S. regulator to issue licenses for cryptocurrency firms.

“A risk-based approach would suggest other types of stablecoins, including algorithmic stablecoins, warrant more attention,” Homer, now an executive in residence at Nyca partners, a venture capital firm.

Regulators will have to decide whether to allow insured banks should be able to issue even non-algorithmic stablecoins because of those added risks.

Non-algorithmic stablecoin issuers have been trumpeting their safety since the TerraUSD collapse, saying that they weren’t infected by a contagion that led to a collapse in cryptocurrency prices, including bitcoin.

But even supposedly less vulnerable stablecoins, like those backed by fiat currency and issued by firms including Tether, Circle and Paxos, are riskier than more traditional financial instruments, said Hilary Allen, a professor at American University’s Washington College of Law.

“I hope that policymakers don’t take that at face value,” Allen said.

While much of the focus in the stablecoin meltdown has been on algorithmic coins, Tether—which is not algorithmic and claims to have full reserves—recently lost its dollar peg before quickly regaining it.

“People need to know that stablecoins are not the same as depositing money in an FDIC-insured account,” Consumer Financial Protection Bureau Director Rohit Chopra said in a May 15 Bloomberg Television interview.

Separately, the FDIC on Tuesday approved a final rule that outlines its authority to prosecute false advertising about deposit insurance and misuse of the agency’s name or logo. The CFPB also issued an enforcement memorandum saying it would also protect consumers against FDIC logo misuse, saying the issue has taken on renewed importance with the emergence of stablecoins.

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Liquidity Mismatch

Policymakers have already been worried about the liquidity mismatches and potential run risk that stablecoins present, even before the TerraUSD collapse.

Acting Comptroller of the Currency Michael Hsu said in an April 8 appearance at Georgetown University’s Institute of International Economic Law that creating separate units at banks to handle blockchain transactions, including stablecoin-related transactions, could limit the risks stablecoins pose.

The issue, according to Hsu, is that in traditional banking activities, banks settle transactions over the course of the day and can smooth out their payments. Blockchain activity, on the other hand, is “always on” and banks may not have sufficient cash on hand to cover blockchain-based transactions that build up over a weekend, Hsu said.

“One way to mitigate these and other blockchain-specific risks would be to require that blockchain-based activities, such as stablecoin issuance, be conducted in a standalone bank-chartered entity, separate from any other insured depository institution (IDI) subsidiary and other regulated affiliates,” Hsu said in prepared remarks.

To contact the reporter on this story: Evan Weinberger in New York at

To contact the editors responsible for this story: Keith Perine at; Michael Ferullo at