On November 24, 2020, the Bank for International Settlements (“BIS”) released its report on the risks, potential and regulation of stablecoins (the “Report”), discussing the benefits, risks and regulatory considerations in respect of privately issued stablecoins.
This Report follows an earlier report of the G7 on the same topic. In fact, as noted in the Report, discussions with respect to the regulation of stablecoins and digital assets are currently taking place through each of the G20, G7, the Financial Stability Board (FSB), the International Organization of Securities Commissions (IOSCO), the Basel Committee on Banking Supervision (BCBS), the Financial Action Task Force (FATF) and others.
What Are Stablecoins?
The Report defines stablecoins as a “cryptocurrency that aims to maintain a stable value relative to a specified asset, or a pool or basket of assets”, often fiat currencies (e.g., the Canadian Dollar), or precious metals such as gold or silver. Examples of US Dollar stablecoins include Tether (USDT), USD Coin (USDC), the Gemini dollar (GUSD), Paxos Standard (PAX) and Dai (DAI), while Canadian Dollar stablecoins include QCAD and CADT. The purpose of pegging the value of a stablecoin to an asset class is to reduce the price volatility to provide a “stable” value amount.
The Report notes that non-volatile nature of stablecoins can make them a useful tool for the private and public sector, such as settling automated financial products and creating smart contracts. At a micro-payment level, stablecoins can be used to execute payment instructions in the world of “Internet of Things” (IoT). They can also be used as a convenient digital means of payment for e-commerce. From a public sector perspective, governments could use stablecoins to create “programmable money” that can restrict the purposes of government-to-person payments. For example, government funding to individuals can be restricted to purchases of groceries or these funds can expire after a certain period.
As noted in the Report, stablecoins typically use one of two mechanisms to preserve their value over time:
- Asset-linked Stablecoins: Stablecoin issuers purport to back stablecoins with fiat currency, assets or other cryptocurrencies; and
- Algorithm-based Stablecoins: Algorithms are used to increase or decrease the supply of stablecoins in response to changes in demand.
Key Market Insights
As noted in the Report, the market value of stablecoins have reached USD 14 billion in August 2020, dominated by Tether.. The current trend with stablecoins have provided the following key insights:
- The value of stablecoins against reference assets may still fluctuate more than existing digital instruments like e-money;
- Stablecoins are less susceptible to speculative bubble like Bitcoin, but their market capitalization can rise and fall rapidly;
- Runs on stablecoins could provoke fire sales of the assets used to back their value and have spillover effects on the rest of the financial system; and
- Indicators for monitoring stablecoins are available in real time.
The Report notes that it is important to draw a distinction between stablecoins in general and “global stablecoins” (such as for example, Facebook Libra), also called “significant stablecoins” under the proposed European Union framework for crypto-assets. Although it can be difficult to precisely define what constitutes a global stablecoin, elements that would dictate this distinction would involve size, scale and interconnectedness. Global stablecoins pose a higher level of risk with respect to financial stability, monetary policy transmission and monetary sovereignty, triggering the need for further oversight and regulation.
Principles for Regulating Stablecoins
The Report outlines the following principles for consideration with respect the regulation of stablecoins:
- Licensing - An appropriate registration or licensing regime for stablecoins, which allows for adequate information and monitoring, combined with prudential requirements will be required.
- Cross-border coordination - Since stablecoins have cross-border applications, regulatory authorities will need to establish information sharing arrangements with each other, such as through memorandums of understanding (MoUs) and multilateral memorandums of understanding (MMoUs). In addition to information sharing and coordination on enforcement, international standards could be used to implement “embedded supervision”, further discussed below. Other regulatory and supervisory tools could include a supervisory college or a specific legal and regulatory systems via cooperative design between private and public participants (i.e. SWIFT, CLE and Euroclear). Given the global impact of stablecoins, a cooperative regulatory and supervisory approach is needed between countries.
- Consumer protection - Strong market integrity, consumer and investor protection measures will be needed, as well as measures to prevent stablecoin providers from engaging in anti-competitive behavior.
- Preserving reserves - Since stablecoin providers face strong incentives to invest their reserves in risky assets or lend out assets backing stablecoins to achieve a higher return, asset segregation and collateralization requirements, as well as market surveillance and disclosure requirements, are key measures to consider. These measures could help reduce the ability and incentive of stablecoin providers to engage in such risky activities.
- Operational and cyber risks - Given the global scale of stablecoins, measures will also be needed to address operational and cyber risks with respect to stablecoins.
- Disintermediation risks - The Report notes that another concern with stablecoins is the potential disintermediation of the traditional banking sector. If consumers move traditional deposits or savings to stablecoins, traditional bank lending could become costlier, potentially impacting banks’ balance sheet and the transmission of monetary policy.
The Report defines “embedded supervision” as a “framework that provides for compliance to be automatically monitored by reading the ledger of a DLT based market”. This mechanism allows information to be directly fed to regulators for supervisory purposes, reducing the need for entities to actively collect, verify and report data to authorities. “Embedded supervision” also facilitates the development of asset “tokenization”, which allows claims on or ownership in real and financial assets to be digitally represented by tokens.
In order to successfully implement “embedded supervision”, the Report highlights a few principles to consider:
- Legal system support: The process of tokenization requires the legal system to recognize the claim on or ownership in the underlying asset. Without an effective legal and judicial system supporting the enforcement of tokenization, these claims would carry less weight.
- Irrevocable and final: Transactions and transfer of ownership must be irrevocable and final. Without this assurance, parties would face the risk that their settled transactions are subject to change.
- Market reaction: Market reaction to being automatically supervised has a huge impact on the adoptability of the stablecoins. Although one of the goals of “embedded supervision” is to offer economic finality, this concept could be seen as intrusive.
- Societal goals: Broader societal goals should be considered when designing “embedded supervision”. Such goals include:
- Reducing the cost of compliance in an effort to reduce barriers to competition in the financial services industry;
- Developing an open-source suite of monitoring tools to encourage more innovation in the regulatory field and increase transparency to the process;
- Ensuring the legal finality of payments; and
- Creating regulatory frameworks or standards that assist with dispute handling.
Central Bank Digital Currencies
The Report notes that stablecoins are not necessarily the only way to provide some of the benefits noted above. The value proposition for digital representation of value exists. However, central bank infrastructures, like central bank digital currencies (“CBDCs”), could also offer many of the benefits without the inherent fluctuation in value or conflicts of interest inherent in stablecoins.