The Bank of England (BoE) and the European Banking Authority (EBA) are the latest financial authorities to outline proposals for regulating the use of stablecoins.
The U.K. suggests that stablecoin issuers should be regulated in the same way as commercial banks, while the EBA is consulting on standards for liquidity requirements and stress testing. Financial regulators in Hong Kong and Singapore are also moving forward with stablecoin regulations.
What do these attempts to bring stablecoins closer to the traditional financial system mean for the sector?
UK, Europe Apply Banking Standards to Stablecoins
Stablecoins “are a new form of privately issued digital asset that purport to maintain a stable value against a fiat currency and may offer advantages in terms of cost, convenience, and functionality,” the Bank of England stated in its discussion paper.
“Stablecoins have the potential to be used by many people in the UK for everyday payments. It is important for policymakers to set out the regulatory requirements so innovators can plan ahead and so that innovation can be adopted safely,”
The paper was published alongside a discussion paper from the Financial Conduct Authority (FCA) on their regulatory approach to stablecoin issuers and custodians, a letter from the Prudential Regulation Authority (PRA) to bank Chief Executive Officers on innovations in the way banks could use deposits, e-money, and stablecoins, and a roadmap paper detailing how the various regimes interact.
The proposed environment addresses the risks of stablecoins in terms of their use as a form of money and a means of payment in systemic payment systems. It seeks to accommodate different business models in which other legal entities carry out various functions, including payment systems/transfer, the issuance of stablecoins as settlement assets, and the customer interface and storage of stablecoins. The transfer function or payment system would remain the BoE’s “regulatory hook”.
The paper states:
“To the extent that systemic payment systems using stablecoins pose similar risks as other systemic payment systems, they should be subject to equivalent regulatory standards. And, as a new form of privately issued money, issuers of stablecoins used in systemic payment systems should meet standards that are at least equivalent to those that apply to commercial banks.”
The BoE will require an entity in the payment chain identifiable as the payment system operator, which would need to be able to assess the risks in the different parts of the payment chain and ensure there are appropriate controls.
“Issuers would be required to fully back stablecoins with deposits at the Bank of England. No interest would be paid on these deposits,” the paper states. “Combined with the other protections proposed… this would aim to ensure that the stablecoins maintain their value and can be used for payments with full confidence.”
Wallet providers would be responsible for safeguarding coinholders’ means of control over their stablecoins and would need to ensure that their legal rights and ability to redeem the stablecoins for fiat currency at par are always protected.
While recognizing the benefits of new forms of payments, the BoE expresses concern that some stablecoin payment chains using public permissionless ledgers do not have centralized governance. Any digital payment system would have to have a legal entity or person who could be held accountable and responsible for risk management and regulatory compliance. The central bank stated clearly that “unbacked crypto assets, or any other unbacked digital settlement assets, would not be suitable for widespread use in retail payments in the U.K.”
While the BoE will regulate “systemic stablecoins” that are circulated widely enough to cause potential disruptions to financial stability, the FCA will oversee the broader cryptocurrency sector.
This approach, while aiming to safeguard consumers from the risks of instability in stablecoins – informed by the collapse of the Terra Luna algorithmic stablecoin ecosystem – introduces a degree of centralization that is opposed to the central ethos of cryptocurrencies.
None of the current stablecoins comply with the proposal, as they are predominantly used for on-ramping and off-ramping between cryptocurrencies and fiat rather than retail payments. However, with a clear regulatory framework in place providing certainty, new issuers could emerge, or existing stablecoin issuers could form partnerships with payment firms.
The EBA is taking a similar approach in applying requirements common to the traditional financial system to stablecoins. The authority has launched three consultations on draft regulatory technical standards (RTS) to specify reserve requirements for stablecoins and the basis for liquidity management policy and procedures of token issuers.
The EBA has also issued draft guidelines to establish the reference parameters for the scenarios to be included in liquidity stress testing to determine issuers’ risk tolerance. The consultations form part of the Markets in Crypto-Assets Regulation (MiCA), which came into effect in June 2023.
The draft standards would require stablecoin issuers to ensure that they hold sufficient asset reserves that meet the market value of the asset referenced for any redemption request “at all times.”
The EBA “does not set any minimum or maximum amount required in the form of the assets referenced within the reserve of assets but considers it as part of the risk management of the issuer to mitigate volatility by ensuring correlation and taking into account its risk appetite.”
An issuer will need to review its risk management policies if its total weighted reserve assets are lower than the weighted amounts of the assets referenced by the tokens.
Asian Regulators Advance Stablecoin Adoption
While Western regulators are getting to grips with stablecoin regulation, financial authorities in Asia are moving towards official adoption of stablecoins.
Hong Kong – which has shifted its initial opposition to cryptocurrencies to aim to become a regional industry hub – is in its second phase of consultations. The Financial Services and Treasury Bureau (FSTB) announced three major initiatives during Hong Kong Fintech Week and will soon release policy documents and advisories on stablecoins, tokenized assets, and cryptocurrencies.
“As for the regulatory regime for stablecoin issuers, the FSTB and the Hong Kong Monetary Authority (HKMA) will issue a joint consultation on the legislative proposal for implementing the regime in due course. On banks’ provision of digital asset custodial services, the industry is being consulted on HKMA’s guidance to ensure client assets are adequately safeguarded and that the risks involved are properly managed,” the authority stated.
In August, the Monetary Authority of Singapore (MAS) finalized its regulatory framework “to ensure a high degree of value stability for stablecoins”. The framework considers feedback received from its public consultation in October 2022.
It applies to single-currency stablecoins (SCS), pegged to the Singapore Dollar or any G10 currency, which are issued in Singapore. Issuers will have to meet several key requirements, including:
- Value stability: Reserve assets must meet standards for composition, valuation, custody, and audit.
- Capital: Issuers must maintain minimum base capital and liquid assets to reduce the risk of insolvency and enable an orderly wind-down if necessary.
- Redemption at par: Issuers must return the full value of a stablecoin to holders within five business days following a redemption request.
- Disclosure: Issuers must provide appropriate disclosures to users, including information on the stablecoin’s value stabilizing mechanism, holders’ rights, and the results of audits on reserve assets.
Issuers must fulfill all the requirements under the framework to apply MAS for their stablecoins to be recognized and labeled as “MAS-regulated stablecoins”, which will distinguish them from other digital payment tokens, including non-compliant stablecoins.
The Impetus to Treat Stablecoins Like Traditional Banking Assets
Why are regulators worldwide keen to treat stablecoins as traditional banking assets with bank-like requirements for liquidity, transparency, and capital?
In a key sense, stablecoins are similar to banks in that their deposits are intended to be redeemable on demand with minimal risk, but they can be backed by riskier, less liquid assets than cash – making them vulnerable to runs by panicked deposit holders.
That was seen in the collapse of Terra, which was unable to maintain its U.S. dollar peg as token holders attempted to make withdrawals en masse.
Tether (USDT), the largest stablecoin and the third largest cryptocurrency by market capitalization, has come under scrutiny as the company has, at times, failed to hold sufficient reserves to back its token issuance. In 2021, Tether, along with crypto exchange operator iFinex, was fined $18.5 million in penalties by the New York Office of the Attorney General and required to increase transparency.
“Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie. These companies obscured the true risk investors faced and were operated by unlicensed and unregulated individuals and entities dealing in the darkest corners of the financial system.” Attorney General Letitia James stated at the time.
In its most recent quarterly attestation for the period to September 30, 2023, Tether reported an issuance of $83.2 billion in tokens, backed by $72.6 billion in direct and indirect Treasury Bills, $1.7 billion in Bitcoin, $3.1 billion in gold, $2 billion in secured loans, and $3.7 billion in other assets, along with excess reserves of $3.2 billion in secured loans. That breakdown represented Tether’s highest percentage of cash and cash equivalents, at 85.7%, and a reduction in secured loans.
An over-reliance on commercial paper in stablecoin reserves could make it difficult for an issuer to cover the value of all of its tokens if its borrowers default on loans. Stablecoins have often been likened to money market funds, which failed to maintain the value of their shares at a dollar in the 2008 global financial crisis. Tether’s attestations are not as robust as full audits and do not meet the standards that apply to commercial banks.
Although regulators are approaching stablecoins like banks, Jan van Eck, CEO of asset management firm VanEck, has argued that stablecoins have more in common with mutual funds and ETFs and regulators should base their recommendations for stablecoins around the mutual fund and ETF regimes.
“Because ETFs have to use qualified custodians, this should address the primary regulatory concern of stablecoins not having the assets they claim to,” van Eck said.
The push towards regulation will accelerate as the adoption of stablecoins and broader cryptocurrencies continues.
The lack of legislation and regulation so far has left companies confused about how to handle digital assets, and individuals have fallen victim to scams and fraud with limited protection, notes law firm Penningtons Manches Cooper.
“The market is likely to welcome some regulation of the riskier parts of the digital asset landscape to offer consumers protection, providing that it does not stifle innovation or seek to control the way in which blockchain and distributed ledgers work (i.e., by consensus, without one controlling party).
“How the regulation transpires and whether it ends up stifling innovation or undermining the very reasons why the DeFi [decentralized finance] community came together in the first place remains to be seen.”
In particular, financial authorities in Europe and Asia are advancing proposals to regulate stablecoins, much like banks, and bring them into the traditional financial system.
This will provide certainty but also compliance challenges to issuers of digital assets that have emerged from a decentralized system.
Regulators need to strike a balance between limiting the risks posed by bringing digital assets into the mainstream payment system and supporting, rather than constraining, innovation.