Why is the Federal Reserve pushing for stablecoin regulation?

Looks like the Federal Reserve is steering America toward a future where stablecoins are not just acknowledged but also regulated. In his recent meetings with House Democrats, Jerome Powell made it plain that a legal framework for stablecoins is an absolute must if the United States is to effectively traverse these unexplored seas. This position shows a major change in attitude toward digital currencies, which is indicative of the increasing awareness of the possible effects they may have on the conventional financial system.

The Case for Regulatory Frameworks

Financial experts have come to a common understanding, as Powell has pointed out, that without a regulated framework, digital currencies might face problems as they gain popularity. One way to protect one’s wealth from the ever-changing cryptocurrency market is to invest in stablecoins, which are tethered to conventional currencies such as the US dollar. In addition to allowing merchants to make rapid transactions, they also provide a way to store or transfer funds independently of banks and are becoming more integrated into the traditional financial system. But this connection isn’t risk-free.

Recent events at Silicon Valley Bank and Circle Internet Financial Ltd. show how stablecoins are susceptible to swings in the conventional banking industry. Circle Internet Financial Ltd. had a large amount of USD Coin reserves stuck in the failing bank. Even while stablecoins are intended to be stable, they may still be affected by actual financial crises, which can impact both their value and the market as a whole. As an example of how closely linked digital currencies are to the conventional banking system, consider the USD Coin event, in which its value fell below $1 during a banking crisis before recovering due to government intervention.

The Ripple Effect on Monetary Policy

Stablecoin regulation is important to the Federal Reserve for a number of reasons, including but not limited to avoiding market volatility and mitigating their influence on monetary policy. Conventional methods of monetary regulation face a serious threat from the advent of narrow banks, stablecoins, and central bank digital currencies (CBDCs). One example of how financial regulation is changing is the way the Federal Reserve has changed its monetary policy practices since 2007. These include paying interest on reserves and using reverse repos and central bank reserves to influence interest rates.

Looking at digital currency makes this transition even more apparent. Interest rate setting and the total amount of the Federal Reserve’s balance sheet are only two areas where CBDCs and stablecoins have the ability to cause significant systemic disruption. In their published study, the Federal Reserve examines these effects and notes that monetary policy adjustments may be required to forestall a decline in lending and preserve economic stability in the case of digital currency integration.

Based on the similarities between stablecoins and CBDCs, the study concludes that digital currencies with higher interest rates would attract more investors and deter depositors from going to conventional banks, which might have an effect on lending volumes. As a result, the equilibrium interest rate would fall and the central bank would have less room to manoeuvre in times of crisis if this scenario plays out.

Another nuance comes from the idea of “narrow banks,” which compete with traditional commercial banks for customers’ deposits but do not provide loans themselves. Commercial banks may see a decline in lending capacity and repercussions to the loan market as a whole if depositors flee to these institutions due to their lower interest rates and easier structure.