Author: Marcelo Prates, CoinDesk; Translated by: Baishui, Golden Finance

In a recent podcast, Hilary Allen, a law professor at American University, portrayed stablecoins as a dangerous threat to the banking system and the public at large. In her view, stablecoins could destabilize banks and ultimately require government bailouts.

Her comments come amid a push in the U.S. Congress to regulate stablecoins at the federal level. While the chances of any stablecoin bill becoming law in a presidential election year are slim, Allen is concerned that these bills “give public support for stablecoins.” For her, “stablecoins do not have any significant use and, frankly, should be banned.”

Are her concerns justified? Only for those who oppose competition and dislike regulatory clarity. The scary and useless trend Allen describes is an updated version of one of the most revolutionary financial innovations of the past 25 years: electronic money issued by non-bank institutions, or e-money for short.

In the early 2000s, the European Union decided that it was time to give more people access to faster and cheaper digital payment methods. With this in mind, E.U. lawmakers developed a regulatory framework for e-money and allowed startups to take full advantage of technology, so-called fintechs, to offer payment instruments in a regulated and secure manner.

The idea behind it is simple. Since banks are complex institutions that offer multiple services and face higher risks and stricter regulation, it is usually difficult and costly to open a bank account for digital payments. The solution is to create a separate licensing and regulatory regime for non-bank institutions, focusing on one service: converting the cash they receive from customers into electronic money that can be used for digital payments via prepaid cards or electronic devices.

In practice, e-money issuers operate like banks in the narrower sense. They are required by law to safeguard or insure the cash they receive from customers so that e-money balances can always be converted back into cash without loss of value. Because they are licensed and regulated entities, customers know that, barring serious regulatory failures, their e-money is safe.

Therefore, it is easy to see that the vast majority of existing stablecoins, that is, stablecoins denominated in sovereign currencies such as the US dollar, are just electronic currencies with certain functions: because they are issued on the blockchain, they are not restricted by national payment systems and can be circulated globally.

Rather than being a horrible financial product, stablecoins are truly “e-money 2.0” that have the potential to continue to deliver on the original promise of e-money: increasing competition in the financial sector, lowering costs for consumers, and improving financial inclusion.

But to deliver on these promises, stablecoins do need to be properly regulated at the federal level. Without federal law, U.S. stablecoin issuers will continue to be subject to state money transmitter laws, which are not uniformly designed or consistently enforced with respect to segregation of customer funds and the integrity of reserve assets.

Taking into account the EU’s decades of experience in the field of electronic money and the improvements brought by other countries, effective stablecoin regulation should be built around three pillars: the granting of non-bank licenses, direct access to central bank accounts, and bankruptcy protection for backing assets.

First, it is contradictory to restrict the issuance of stablecoins to banks. The essence of banking is the possibility of holding deposits from the public, but these deposits are not always 100% backed, traditionally known as "fractional reserve banking". This allows banks to make loans without using their capital.

For stablecoin issuers, on the other hand, the goal is for each stablecoin to be fully backed by liquid assets. Their only job is to receive cash, provide stablecoins in return, safely store the received cash, and return the cash when someone brings the stablecoin to exchange. Lending money is not part of their business.

Stablecoin issuers, much like e-money issuers, are designed to compete with banks in the payments space, especially in cross-border payments. They are not supposed to replace banks, or worse, become banks.

That is why stablecoin issuers should obtain a specific non-bank license, just like e-money issuers in the EU, UK and Brazil: a license with simpler requirements, including capital requirements, proportional to their limited activities and lower risks. They do not need a banking license, nor should they be required to obtain one.

Second, to reduce the risk of the status quo, stablecoin issuers should be able to have a central bank account to hold their backing assets. Transferring cash received from customers to bank accounts or investing in short-term securities are usually safe options, but both options may also carry greater risks.

Circle, a US stablecoin issuer, is in trouble due to the collapse of Silicon Valley Bank (SVB), and its $3.3 billion cash reserves (almost 10% of total reserves) deposited in SVB are temporarily unavailable. Several banks holding US Treasury bonds, including SVB, suffered losses after interest rates rose in 2022, and the price of Treasury bonds fell in the market, causing some banks to be short of liquidity and unable to withdraw funds.

To avoid problems in the banking system or Treasury markets from spreading to stablecoins, issuers should be required to deposit their backing reserves directly with the Federal Reserve. This rule would effectively eliminate credit risk in the U.S. stablecoin market and enable real-time regulation of stablecoin backing—without the need for deposit insurance and without bailout risk, as with electronic money, as opposed to bank deposits.

Note that non-bank central bank accounts are not unprecedented: E-money issuers in countries such as the UK, Switzerland and Brazil can protect users’ funds directly through the central bank.

Third, customer funds should be considered separate from the issuer’s funds under the law and should not be subject to any bankruptcy regime if the stablecoin issuer fails (for example, due to the emergence of operational risks such as fraud).

With this additional layer of protection, stablecoin users can quickly regain access to their funds during a liquidation process, as general creditors of a bankrupt issuer will not be able to seize customer funds. Again, this is considered best practice for e-money issuers.

In the public debate about stablecoin regulation, shocking approaches may impress distracted viewers. But for those paying attention, balanced arguments based on successful examples and experiences from around the world should prevail.