The ticking time bomb inside the proposed stablecoin legislation

Stablecoin legislation represents an opportunity to bring a surging payments rail into the sunshine of law enforcement, which is a good thing. But first we have to fix the current bill under debate.

Photo by CoinWire Japan on Unsplash

I wrote last week that I am generally in favor of stablecoin legislation that brings these new payment rails into some version of the banking perimeter. I stand by that assessment. Here’s why.

Principles in support of stablecoin legislation

This intuition is based on three distinct principles. First, money is hydraulic, whether we like it or not. Stablecoins are already among us (even as Substack’s red squiggly lines under the word are trying to bully me out of this conclusion). When money-candidates become useful as mediums of exchange, they will become even more useful almost arithmetically to criminals to the extent of their ease in evading the law. Our entire anti-money laundering ecosystem is built on giving governments and financial institutions flexible tools to adapt to changing technologies of money. Stablecoins are, by some estimates, among the greatest sources of money laundering in the world today. It is time to bring them into the sunshine of anti-money laundering enforcement.

The second principle is that my own estimations about the lack of pro-social utility to the vast majority of crypto aren’t a good basis for the exclusion of stablecoin from the regulatory perimeter. This conclusion represents a change in view for me. For the last ten years I have mostly resisted efforts to mainstream cryptocurrencies into the regulatory perimeter, in large part because my interactions with the most sophisticated players in this space convinced me that the enthusiasm here was evangelistic and ideological.

But the same can be said of nearly every innovative revolution. I think most early adopters and especially early entrepreneurs are more than a little crazy. (Remind me to write another day about my purchase of a Lucid Air electric car and why I deeply regret it.) That clarity of world-changing vision seems almost to be a sine qua non for innovative change. Just because the most outspoken enthusiasts for an innovation are not the brightest bulbs in the box—a fair description of much of the crypto industry—does not mean we should block that innovation full stop.

That said, there is a third countervailing principle at play. We cannot simply cheer innovation for innovation’s sake. We need to be clear that spectacular and costly failure does not impose itself on those who want the freedom to stay the heck away from those evangelical entrepreneurs. That need creates a condition: we want innovation where risks are well understood and the inevitable uncertainties that arise with new innovations have guardrails in place to protect the innocent against failures that had nothing to do with them.

On these principles, I am persuaded that we need stablecoin legislation. And the stablecoin legislation we have is mostly on point.

Except where it fails my third condition.

How Stablecoins work, how they should work, and how they can go wrong

The basic model of a stablecoin goes something like this. In the beginning, PCB creates a cryptocurrency called PCB Coin. I copy-and-paste from a ready-to-use website to get it out into the world. I want you to “buy” it from me, in quotes because I, a true believer, think that what we are doing is more akin to trading, not selling. I offer it for sale full of hope and wonder at Satoshi Nakamoto and Bored Ape NFTs and…it goes nowhere. I can’t even convince my children to buy it. Now it has a name: a memecoin, the only obvious utility for which is to satisfy my own vanity (or perhaps for gamblers and fraudsters to exploit it for their purposes).

What does a crestfallen crypto enthusiast do in such a situation? The biggest problem I am trying to solve is to make people interested in PCB Coin as an alternative to other available forms of currency. Most people—including yours truly, the real PCB—will never come by that interest because they (we) don’t see cryptocurrency solving any problem of relevance to our lives. But even the crypto enthusiasts will be cautious about PCB Coin’s inherent worthlessness. To make it more palatable to those already inclined to buy into cryptocurrency, I need to anchor PCB Coin to an alternative bucket of value.

So it is that PCB Stablecoin is born. I tell the world that I will issue—not sell, mind you—PCB Stablecoin and take proceeds from that issuance in US Dollars and put those US Dollars in a place that (1) I will announce to all and (2) that everyone will agree will be “safe.” When people want to “redeem”—again, not sell!—PCB Stablecoin they will receive back again the same value in US Dollars. Indeed, PCB Stablecoin will even be quoted in the same unit of account—the US Dollar—despite the fact that it is no such thing.

Now things will get interesting. I need to make sure that PCB Stablecoin is redeemable at par value in US Dollars. The next question for me is what I do with all the actual US dollars that come my way in exchange for PCB Stablecoin so that they can be safeguarded for that future day of eventual redemption.

Maybe I will build an addition on my house and swim in it Scrooge McDuck style, giving the image of vast wealth that in fact I am only safeguarding. Less disgustingly, maybe I put them in a safety deposit box, under lock and key. Or maybe I take these to a broker-dealer who can exchange them for US Treasury securities, giving me a little bit of yield. Or maybe I can take them into a bank and get a little more. The key is that whatever I do with the reserves I receive in exchange for PCB Stablecoin, the users of that coin will know exactly what I have done and will agree that come the day of redemption, I will make good on the basic bargain.

The question why any non-gambler, non-criminal would transact in PCB Stablecoin mostly stumps me as I sit here today. The question why I personally would issue PCB Stablecoin makes more sense. It’s not because I want to swim in money like Scrooge McDuck. It is because I see in the issuance of PCB Stablecoin a way to make some money. In the parlance of finance, I will seek to monetize the float, taking what you have given me and making money on it while I await your decision to redeem.

For that reason, safety deposit boxes are out of the question; those cost me money, demonetizing the float. Scrooge McDuck warehouses are out too, for similar reasons (because, also, gross.)

Treasury securities on the other hand look great. The three-month Treasury is 4.3%. This is essentially free money. If I issue $1 billion of PCB Stablecoin and put all of it in Treasuries, that’s $43 million a year. Not too bad for a professor! My overhead will be minimal, so most of this will be pure profit.

The problem is that I will be tempted to do more. I will be tempted to lever up and explore more investable options. Suppose I issue bonds for an additional $1 billion at 6% and invest in other kinds of cryptocurrency that I am just so sure will be to the moon in a year’s time, with a 10% appreciation. For collateral I use my $1 billion of US Dollars I received for the PCB Stablecoin issuance. Now we are making real money. At the end of that year, I don’t have the boring $43 million from Treasuries. I have $140 million, plus I had a ton of fun investing in crypto. To the moon!

But you see the problem here. If my crypto investments perform only adequately—at 2.9%, to be exact—then I will not be able to meet redemptions. PCB Stablecoin will be a bust and I will enter bankruptcy.

The loophole that makes the GENIUS Act a failure

The tempting and catastrophic economics of stablecoin make legislation all the more important. I have no confidence, for example, that Tether is supported on anything like par value in stable investments. (I have every confidence that Tether’s genius is in its impressive utility for criminals of the most nefarious sort.) The entire raison d’être of such legislation would be to solve this problem: this ironclad reserve is what makes stablecoin stable.

Here is the relevant language of the GENIUS Act, from section 4(a)(7):

(7) LIMITATION ON PAYMENT STABLECOIN ACTIVITIES.—

(A) IN GENERAL.—A permitted payment stablecoin issuer may only—

(i) issue payment stablecoins;

(ii) redeem payment stablecoins;

(iii) manage related reserves, including purchasing, selling, and holding reserve assets or providing custodial services for reserve assets, consistent with State and Federal law;

(iv) provide custodial or safekeeping services for payment stablecoins, required reserves, or private keys of payment stablecoins, consistent with this Act; and

(v) undertake other activities that directly support any of the activities described in clauses (i) through (iv).

So far so good. This means that generating other liabilities—the $1 billion loan at 6% in my example above—are off the table under the GENIUS Act. It also means that stablecoin issuers cannot go adventuring off into HODL investments—the $2 billion crypto investment in my example above.

But then comes Section 4(a)(7)(B):

(B) RULE OF CONSTRUCTION.—Nothing in subparagraph (A) shall prevent a permitted payment stablecoin issuer from engaging in non-payment stablecoin activities that are allowed by the primary Federal payment stablecoin regulator or the State payment stablecoin regulator, as applicable.

This “rule of construction” hides the elephant in the mousehole. So long as a willing state or federal regulator permits any other kind of “non-payment stablecoin activity,” the stablecoin issuer can do anything it wants. This is, in a word, unstable.

The promise and peril of federalism in banking

Our banking system is built on principles of federalism and divided power at the national level. This means that states can treat financial institutions differently than the federal government would do, and that the Fed and OCC and FDIC can have differences among them, too. I think this is mostly to the good; regardless, neither aspect of our system is going anywhere soon.

I have written in defense of these principles elsewhere, including in this very space of crypto-adjacent banks seeking to issue stablecoins. It is good for states to experiment in ways that the federal government would not otherwise abide. They key question is if there is a limit for specific types of activities and, if so, where that limit exists for stablecoin.

The answer to the first question is yes, there are limits. The states cannot create new entities that completely violate federal law, for example. Even in my expert defense of Wyoming’s ability to create new bank charters, the argument has always been that federal bank regulators can exclude or punish state banks that violate federal law.

But the question for stablecoins is not about whether these state or federal banking regulators can violate the law. The question is about what that law should be. The current bill creates an escape hatch that allows a single motivated person—one human being—who happens to occupy one of they crucial positions in federal or state government to permit stablecoin issuers to undertake whatever adventures that will please them. This we cannot do. If we do, the entire virtue of stablecoin inclusion in the banking perimeter will be lost.

The solution is simple. Drop the Rule of Construction. They wreak more mayhem than clarity in general; in this specific instance, they swallow the many virtues of the GENIUS Act entirely.