In the second edition of “Stablecoin Policy 101,” digital assets firm Paxos take a careful look at the landscape for stablecoin regulation in the United States, examining state versus federal regulation of stablecoin issuers as well as the overall impact each regulatory pathway has on consumers as well as the larger market.
As noted in a blog post by Paxos, there is presently no clear framework in place for stablecoins at the federal level, even though there have reportedly been a number of efforts in Congress in recent years to establish one.
Paxos further noted that the number of U.S. states, however, are regulating stablecoin issuers.
As explained in the update from Paxos, stablecoins are described as being a class of cryptocurrency pegged to a stable value, such as the U.S. dollar. $160B+ of the current stablecoin market within the blockchain and digital asset industry is pegged to the U.S. dollar.
Paxos further noted that a stablecoin issuer accepts dollars to “mint” – create new – stablecoins and then holds the reserves.
Paxos also mentioned in its extensive update that the issuer also may be responsible for “burning” the stablecoins – removing them from available supply – when customers redeem the stablecoin for fiat.
But Paxos also clarified that not all stablecoins and stablecoin issuers are built equally, particularly when it comes to regulated versus unregulated stablecoin issuers.
At a high / more general level, Paxos explained that a regulated stablecoin issuer has a primary prudential regulator that oversees stablecoin reserve composition and the segregation of customer and corporate assets.
For instance, Paxos noted that stablecoin issuers regulated by the New York Department of Financial Services (NYDFS), like Paxos Trust Company, hold customer funds segregated from the issuer.
According to the detailed update shared by Paxos, this essentially means that stablecoin reserve funds are only available to the stablecoin holder.
Paxos added that regulated issuers place reserves in highly liquid, low-risk assets as required by the NYDFS and comply with “all federal anti-money laundering and know-your-customer standards.”
Paxos added that unregulated issuers are those without “a primary prudential regulator.” As explained in the comprehensive update, this means that the oversight and protections “provided by a regulated issuer do not apply.”
Paxos further explained that State regulators have “a proven track record of effectively overseeing trust companies and money transmitters.”
State laws have empowered state regulators with robust consumer safeguards tailored to local needs.
But Paxos also noted that some attempts at stablecoin legislation in Congress have introduced the idea of federal preemption of stablecoins.
At a high level, preemption is when federal law overrules that of the states. In the context of some proposed stablecoin legislation, it means explicitly granting “oversight of stablecoins to the Federal Reserve – which lacks expertise in regulating firms other than bank holding companies – and jeopardizing the important role state regulators have played to date.”
Preemption threatens state-level funding streams, could stifle “economic innovation, and undermines state-specific, localized consumer protections and regulation.”
States generate significant revenue from “regulating money transmitters and trust companies through licensing fees and fines.”
According to the update from Paxos, this is an vital revenue source and impacts their ability to fund “local regulatory and consumer protection activities.”
With federal preemption, states could lose access to potentially billions of dollars in licensing fines and fees.
State regulatory frameworks are more agile and have a demonstrated ability to quickly “adapt to innovations in fintech and digital assets.”
A top-down approach from the federal regulator is likely to impose “rigid standards that constrain innovation, hinder local economic growth and limit the introduction of new technologies.”
States are better positioned to “understand and address the specific risks and needs of their communities.”
For example, Paxos pointed out that certain states have more stringent consumer protection standards “on usury, disclosure, dispute resolution and other issues.”
With federal preemption, centralized regulation might “not address specific local needs effectively.”
Creating a State-Led Legislative Framework with Federal Option Pathways
Developing robust, consistent state and federal regulatory pathways for stablecoin issuers will support “competition and growth while reducing the risks of regulatory concentration, regulatory capture and a race to the bottom among issuers.”
Congress has done important thinking on how to build “a framework for dual state and federal options for stablecoin issuers.”
Paxos added that the Clarity for Payment Stablecoins Act, which passed on a bipartisan basis out of the House Financial Services Committee in 2023, is a compelling example – it proposes the creation of “federal floor” standards, ensuring that all state regulators meet the “same high standards regarding customer funds’ segregation, reserve composition, bankruptcy remoteness, regular examinations, audits and disclosures.”
Paxos also noted that the Act enables companies to choose to be “federally regulated” under the same standards, giving issuers the optionality to determine which regulatory pathway is “best suited to their needs and business models.”
Paxos pointed out that if Congress actually sees or realizes the need for a federal payments regulator, it should ensure that all payments firms are regulated alike and to the “same standards by either a federal or state primary prudential regulator.”
Digital assets firm Paxos concluded in its latest crypto and blockchain industry update that hearings and legislative consideration should determine whether the Federal Reserve, OCC, or another regulator is most capable of managing this responsibility while also “addressing conflicts of interest between banks and non-bank payment firms.”