3 Concerns Investors Have if the Cryptocurrency-Focused Genius Act Becomes Law

Cryptocurrency legislation is gathering steam. On June 17, the Senate passed the Guiding and Establishing National Innovation for U.S. Stablecoins Act (Genius Act for short), which is designed to give a framework for the stablecoin industry. If it becomes law, it will be the first cryptocurrency legislation passed by the U.S. government and set the stage for increased adoption of crypto.

The House must now approve it -- and may push for changes based on its own legislation -- before it reaches the president's desk.

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Stablecoins are built on the blockchain but peg their value to other assets, such as the U.S. dollar. They are an increasingly important part of the crypto economy.

The Genius Act sets rules on who can issue them, including what reserves, audits, and money laundering preventions they need to enforce. However, some aspects of the bill are raising concerns. Sen. Elizabeth Warren, the Massachusetts Democrat who has been a vocal critic, told the Senate, "This weak bill is worse than no bill at all."

Should crypto investors be worried -- or rejoicing? Let's dive into some of the concerns to find out.

1. There are not enough consumer protections

Our banking system has evolved over centuries, and there are a host of safety nets now built into it. Without regulation, few protections extend to stablecoin issuers. For example, I've written before about the dangers of Tether (CRYPTO: USDT), which is less-than-transparent about what cash it has in reserve.

The Genius Act certainly answers some of those concerns and would give investors increased peace of mind about their deposits. For starters, it says stablecoin issuers will have to prove they have money in reserve to cover the tokens they issue.

However, critics say it doesn't go far enough. Without getting too deep into the weeds, one concern is how stablecoin issuers would refund fraudulent transactions, given that blockchain transactions are irreversible.

Another surrounds what would happen if the issuer goes bankrupt. The Senate bill says investors will be at the front of the line to reclaim their money. That's progress.

But that isn't the same as coverage by the Federal Deposit Insurance Corporation (FDIC), which provides up to $250,000 per depositor if a bank collapses. Being first in line won't help a lot if the issuer doesn't have enough money in reserve to repay people.

Image source: Getty Images.

2. It opens the door to systemic risks

Systemic risks are threats that could cause a breakdown in the whole financial system, not just crypto. The collapse of Lehman Brothers is an often-cited example because the ensuing panic exacerbated the 2008 financial crisis.

That's why there is so much concern about integrating stablecoins further into the financial system. If those projects fail, the guardrails need to be strong enough that any ensuing sell-off does not drag down the wider economy. The bill's opponents think they aren't strong enough.

To give you one specific issue, the bill would allow nonbanks to issue stablecoins, and it isn't clear what the ramifications would be. Banks can access short-term emergency credit from the Federal Reserve; nonbanks can't. That could make it harder for them to handle liquidity risks.

And if nonbanks are forced to quickly sell the U.S. Treasuries they hold in reserve, that could put pressure on short-term government debt and shake the whole financial system.

3. There is a high risk of failure

Moreover, some argue that stablecoin issuers are more likely to fail than banks. Indeed, JPMorgan says more than 20 stablecoins collapsed between 2016 and 2022. If a dollar-pegged stablecoin loses its peg -- so each one is no longer worth $1 -- it can quickly spiral into a run on the token.

The loss of a peg won't always lead to collapse, but it has happened. Corey Frayer, director of investor protection at the nonprofit Consumer Federation of America, says that instances of de-pegging are too frequent. As recently as March 2023, USDC (CRYPTO: USDC), the stablecoin of Circle Internet Group -- which specializes in peer-to-peer payments technology -- fell 13 cents short of its dollar peg.

Frayer also worries that there is no give in the system to handle extraordinary circumstances, such as the COVID pandemic. He says that by design, stablecoins -- which rely on smart contracts and decentralized systems -- don't allow for regulatory intervention if things go wrong.

Not only may consumers lose money if an issuer fails, Frayer argues, but it would also expose the financial system to the consequences of these failures. He says introducing this level of instability into America's financial system could prove disastrous.

What the Genius Act means for crypto investors

Passing stablecoin legislation could be another huge leap into the mainstream for cryptocurrency. It may be another boost for the industry, particularly as big banks and retail giants are considering launching their own stablecoins.

Whatever way you look at it, that would be a boon for blockchain ecosystems like Ethereum (CRYPTO: ETH) and Solana (CRYPTO: SOL), where those coins are built.

But in the long term, it is important to get the foundations right. The collapse in 2022 of Terra's Luna stablecoin and the FTX exchange hit the crypto industry hard and cost investors billions of dollars. A stablecoin implosion might make that look like a blip on the radar.

As the bill moves to the House, crypto investors should watch the debate around consumer protections, systemic risks, and potential bailouts. Those will give strong indications about whether the new legislation will be the backbone for a thriving stablecoin industry or a Trojan horse rolling into the heart of the U.S. financial system.

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Emma Newbery has positions in Ethereum and Solana. The Motley Fool has positions in and recommends Ethereum and Solana. The Motley Fool has a disclosure policy.