In the early 1800s, banks issued currency with no federal oversight. In what has become known as the “free banking era,” each bank could issue notes that were supposed to hold the value of a dollar that could be exchanged for goods and services. But some banks were not as reputable as others, and discrepancies in reputation led to the values of those privately-issued “dollars” regularly fluctuating below their face values. Over time, regulations and market forces helped stabilize banking into the much more consistent and reliable system currently in place.
While institutions issuing stablecoins, a type of cryptocurrency that is backed one-to-one with cash or cash equivalents, today are generally considered more safe and reputable than many banks in the free banking era, they may present some of the same risks as privately-issued representations of a dollar from the past. For example, stablecoins, like privately-issued currency, have been known to occasionally trade below their face value. We can learn from these similarities between modern stablecoins and the free banking period to explore the positive effects that newly proposed regulation might have on the stablecoin sector.
The Free Banking Era
From 1837 to1863, the United States did not have a federal bank. During this period, many states relaxed the barriers to entry for new banks to form within their borders. The “free banking era” was characterized by frequent economic downturns and bank closures as well as perceptions of high corruption, including the prevalence of financial fraud and scams. During this time, the average lifespan of a bank was approximately five years.
It was not until 1861 that the federal government issued paper money. Instead, private banks registered under state-issued charters were allowed to issue notes redeemable for assets held by those banks on reserve. For example, an individual could deposit a dollar’s worth of gold with a bank and receive a dollar note representing the deposited gold. That privately-issued dollar could then be used and spent as currency, and eventually redeemed by a holder in exchange for the gold on deposit. During that period, over 1,600 private banks were authorized by state authorities to issue these private bank notes, resulting in over 7,000 varieties of currency in circulation.
While each of these private bank notes were, in theory, worth the face value of assets on reserve at the banks that issued them, in practice, their real values fluctuated wildly. This volatility reflected the reality that banks frequently were incapable of redeeming all of their outstanding notes, rendering many of them prone to collapse. This was commonplace because banks’ asset values were themselves volatile and would degrade below the value of notes that had been issued. For example, Bank A might have $1,000 worth of gold on deposit, for which it issued $1,000 of Bank A notes. Bank A might have exchanged that gold for $1,000 of certain types of approved securities so that it could recognize a profit from its banking activities. However, if the value of those securities fell to $900, the bank would no longer be able to redeem all of its outstanding notes. Often, these notes could trade at a discount to their face value, reflecting that concern. In fact, discounts were so common and well-understood that major newspapers published the discounts of various bank notes from all over the country. Banks that printed more currency than they were capable of redeeming were known as “wildcat banks.”
Congress passed the National Bank Acts of 1863 and 1864 (the “National Bank Acts”), which installed the initial frameworks that led to the national banking system. The National Bank Acts established federally chartered banks that could issue banknotes backed with U.S. Treasury bonds. High taxes were also levied on transactions using banknotes other than those issued by federally chartered banks. This successfully reined in the proliferation of wildcat banks and banknotes while generally allowing more reputable banks to continue to operate.
While smoothing out volatility in the banking system was one of the goals of the new regulation, bank panics and severe economic instability persisted for decades. Eventually, the US enacted the Federal Reserve Act in 1913, establishing the federal reserve system to serve as a lender of last resort to backstop failing banks. This step instilled a higher degree of confidence in the banking system, smoothing financial volatility compared to the previous century.
Is This the Free Banking Era of Stablecoins?
Today, stablecoins operate in an environment that is substantially different from the free banking period. One obvious reason is that many of the more prominent stablecoins emerged in an environment already subject to regulatory oversight, such as rules applicable to money service business or money transmission. Additionally, news of issuer solvency – or insolvency – can be transmitted rapidly and internationally. Further, stablecoins seem to exhibit higher switching costs than bank-issued notes, which has led to network effects that have consolidated around just a few players. In general, concerns around stablecoin-issuing institutions seem to have subsided, leading to the $120+ billion dollar market capitalization the stablecoin sector exhibits today. Despite skepticism about the credibility of stablecoins or their issuers, their ability to maintain their pegs has not generally been as volatile or unreliable as the wildcats during the free banking era.
Nonetheless, some have argued that stablecoins may present risks similar to the privately-issued banknotes that circulated during the nineteenth century. For example, the issuers generally take in short-term deposit-like assets in one form of value and provide some form of a representation of a dollar that may be redeemed for the underlying asset. The dollar representation can fluctuate based on the market’s perception of the issuing entity.
Stablecoin volatility over time. Stablecoins represented are top 3 by market cap.
While reputable stablecoin-issuing entities will publicly disclose all of the assets backing their tokens, others have been alleged to issue more representations of the dollar than underlying assets they hold on deposit. Regardless of the assets an issuer holds, collapses of issuing entities can cause systemic risk to their respective ecosystems.
Will the Stablecoin Bill Promote Reputable Stablecoins While Discouraging Others?
The proposed Clarity for Payment Stablecoins Act of 2023 (the “Stablecoin Bill”) aims to bring regulatory clarity to stablecoins and the crypto-asset ecosystem at large. Under the Bill’s provisions, a variety of federal regulators would share authority. Depending on a stablecoin issuer’s disposition, they could find themselves responsible to the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), or the National Credit Union Administration (NCUA). This structure aims to bring stablecoins within the federal banking system, providing guidelines to the $120+ billion dollar stablecoin market and potentially unlocking even more issuance and functionality in the ecosystem. But how does the Stablecoin Bill address some of the free banking-esque pressures we’ve seen in existing stablecoins?
Some key provisions of the Stablecoin Bill include (among many others):
- A limitation on the types of assets a stablecoin issuer may hold in reserve, and how reserve assets may be used;
- A requirement that all stablecoins be backed by reserve assets on a one-to-one basis;
- A two-year moratorium on new algorithmic stablecoins;
- An authorization for subsidiaries of FDIC or NCUA insured entities to issue stablecoins;
- A prohibition on commingling customer and firm assets.
Overall, we believe the Stablecoin Bill is a step in the right direction for the legitimacy of the stablecoin sector. And while the Bill’s requirements are already met by some of the more reputable stablecoins and their issuers, clear regulatory oversight is important to their longtime viability. By bringing stablecoin issuers under the purview of existing bank regulators, economic actors may transact with the issuers (and their stablecoins) with confidence that operations are regulated by independent oversight they are already familiar with. This may bring clarity to startups trying to navigate unclear regulations, while also removing some hurdles for larger institutions to start experimenting with stablecoins. These improvements might be analogous to how the National Bank Acts brought oversight to the free banking marketplace.
Further, guardrails guiding stablecoin issuers’ reserve assets may help ensure the solvency of these entities the same way the National Banking Acts standardized asset management practices among banks. By bringing consistency through safe reserve asset management, the Stablecoin Bill effectively levels the playing field by reducing pressures on issuers to pursue riskier opportunities with their assets under management in order to compete. These rules may also help quell condemnations around reserve asset management practices levied between stablecoin providers. Furthermore, the prohibition on commingling customer and firm assets can help mitigate the probability of a stablecoin-issuer collapse.
While we believe the Stablecoin Bill answers calls for much needed regulation in the stablecoin space, it might not solve all of the issues facing the sector. For example, this version of the Stablecoin Bill does not provide stablecoin issuers access to the Federal Reserve’s payment systems and discount windows, which effectively locks non-bank stablecoin issuers out of the Federal Reserve System. This may tilt the playing field in favor of subsidiaries of insured banks who might be able to access Federal Reserve payment rails through their parent entities. Importantly, without lifelines like access to the Federal Reserve as a lender of last resort, stablecoin issuers might be more prone to insolvency during liquidity crunches reminiscent of the post-free banking era, which may leave some pressures on stablecoin issuers that have been resolved for traditional banks. This may harm stablecoin users in the event a stablecoin issuer becomes insolvent, a concern that is especially worrisome for institutions that are not insured by the FDIC or NCUA.
Nonetheless, we believe the Stablecoin Bill, as currently proposed, will bring more confidence to the stablecoin sector. The clarity and oversight the Stablecoin Bill brings may help ward off potential failures that could do significant harm to the crypto ecosystem while enabling new entrants to the field who might have been hesitant or even forbidden from entering previously. And while we hope that as the stablecoin industry continues to evolve, it may soon be included in the Federal Reserve system. Inclusion in the banking system certainly represents progress.
Stablecoins are one of the most promient and easy-to-understand use cases of crypto-asset technology. By reinforcing the stablecoin sector through regulatory clarity, we can help the entire blockchain industry flourish. Legislative forces like the Stablecoin Bill build upon prior reforms, such as those that ended the free banking period, and build towards a stronger and more resilient stablecoin field. Thus, by learning from the past, we can shape a future where fair competition thrives.
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