2024 turned out to be a pivotal year for the broad blockchain technology industry, with stablecoins emerging as an innovation with concrete real-world utility. With a market cap hovering around $200bn and monthly volumes in the trillions, Stablecoins represent perhaps the first blockchain technology positioned to impact everyday consumers' lives through improved global payments infrastructure.

However, this mainstream potential brings familiar risks.

The creation of the UK's Financial Services Compensation Scheme (FSCS) in 2001 represented the culmination of decades of evolving consumer protections, replacing a patchwork of independent compensation schemes that had previously safeguarded depositors from institutional failures.

As stablecoins move toward widespread adoption without equivalent compensation schemes in place, there's a growing risk that consumers could be left exposed to the very types of losses that traditional financial services have spent decades learning to protect against.

How did we get here?

A clear pattern of convergence had already been emerging across jurisdictions prior to the announcement in the UK. Consultation and discussion papers from the UK's Financial Conduct Authority (FCA), Abu Dhabi Global Markets (ADGM), Singapore's Monetary Authority (MAS), and Switzerland's FINMA demonstrate remarkable alignment on key regulatory principles across jurisdictions.

These frameworks universally emphasise full reserve backing, segregation of assets, regular independent attestation, and robust redemption rights. They also share common ground on operational resilience, risk management, and corporate governance requirements. This regulatory convergence suggests a growing consensus on how to manage the risks associated with stablecoins while fostering innovation.

Are these recommendations comprehensive enough?

In short, no. There is a notable gap across these published frameworks: the absence of consumer compensation schemes.

This stands in stark contrast to traditional financial services, where deposit insurance and investor compensation schemes are the cornerstone consumer protections. In the UK, for example, the Financial Services Compensation Scheme (FSCS) protects bank deposits up to £85,000, providing crucial security for consumers if their bank fails. Right now, none of the emerging stablecoin frameworks propose equivalent protection. In a 2023 discussion paper, the FCA explicitly states it won't propose to extend FSCS coverage to stablecoin activities. Whether this stance remains in the next iteration of regulatory discussion, remains to be seen.

Other regulators remain silent on the issue. Instead, these frameworks rely entirely on preventative measures like reserve requirements and prudential standards to protect consumers.

How could this shape stablecoin services?

The lack of compensation schemes creates a fundamental difference between traditional financial services and regulated stablecoin services. While a fiat banking customer knows they're protected if their institution fails, a stablecoin holder has no such guarantee. The only protection offered is indirect, where the PRA has determined that FSCS coverage might apply when a bank leveraging fiat-backed stablecoins to offer payments services fails, but not if the stablecoin issuer itself fails (source: FCA Discussion Paper, DP23/4, 2023)

In reality, the best stablecoin projects should be backed 1:1, but guidance or regulation to ensure this is not yet present in the UK. If an issuer does fail, the hope would be that firms maintain full capitalisation of issued stablecoins and would be able to redeem against them.

Unfortunately, this isn’t always the case with some projects holding illiquid financial instruments that cannot be disposed of quickly in the event of a collapse, leaving customers exposed to financial losses. A lack of transparency and global standards around how popular tier-1 stablecoins are backed has come under scrutiny in recent years (see: Tether and the issues around independent audits) and there still remains a protection gap for customers to be fully covered should a firm fail.

For stablecoin service providers and the broader industry, this regulatory gap presents both challenges and opportunities. While robust preventative measures are crucial, the lack of compensation schemes could impact consumer confidence and institutional adoption. As regulatory frameworks evolve, the industry might need to consider alternatives to traditional deposit insurance, perhaps leveraging the onchain technology that makes stablecoins possible.

The emergence of aligned regulatory frameworks is a positive development for the industry, providing clarity and consistency across major jurisdictions. However, the compensation gap remains a significant differentiator between traditional and digital finance – one that the industry will need to address as stablecoins move toward mainstream adoption.