Stable (or not-so-stable) coins

Noise around regulation has intensified over the past few months, particularly in the wake of the mid-May collapse of a prominent algorithmic stablecoin. As this component of the crypto-ecosystem continues to forge deeper connections with traditional finance, many regulators are pushing for a formalised regulatory framework to be developed as soon as possible.

Stablecoins are cryptocurrencies whose value is pegged to the value of another asset. As such, they are typically held-up as a strain of cryptoasset which minimises volatility. Most are collateralised with 'safe' backing assets (typically cash or highly liquid assets like money market funds or commercial paper). However, other algorithmic stablecoins seek to maintain their peg (or stability) through algorithms which increase or decrease a coin's supply in response to changes in demand. These algorithmic coins have been at the centre of controversy following the crash of US Terra (and associated cryptocurrency Luna USD) in May, where an estimated $42 billion of investment was lost in one week.

The total market capitalisation for stablecoins continues to rise and is now estimated to have reached over $180 billion. Moreover, the interconnectedness of stablecoins with the wider financial system continues to deepen. Not only are these coins being used to facilitate retail crypto trading and support decentralised finance (DeFi) (through liquidity provision for exchanges and leveraged borrowing), but they are increasingly being adopted as a means of payment. As reiterated (PDF 1.4MB) by the BIS, if left unchecked, these interlinkages could result in “risks from cryptocurrencies easily transfer(ing) to banks and other established financial institutions”.

Consequently, governments and regulators are ramping up efforts to address systemic risks and close regulatory gaps, while still harnessing the potential benefits of the innovative technology. In particular, there is a desire to remove arbitrage opportunities that could exist if stablecoin business models are subject to looser regulation than commercial bank equivalents.  

In the UK, the regulatory approach continues to evolve. HM Treasury (HMT) originally supported the idea that stablecoins be regulated through a money market fund (MMF) model. The Bank of England (BoE), on the other hand, posited a commercial bank deposit-backed (DB) model (in its Discussion Paper on New Forms of Digital Money — the response to which was published in March 2022). The latter approach would be similar to the backing model used by e-money firms, although would require enhanced safeguarding and additional prudential conditions.

In the March 2022 Financial Stability in Focus report, the Financial Policy Committee (FPC) raised concerns about the DB model, suggesting that it would pose an unacceptable risk to financial stability in the event of bank runs. Instead, the FPC proposed a high-quality liquid asset (HQLA) alternative where “systemic stablecoin issuance would likely need to be fully backed with high quality and liquid assets”. The report also proposed that:

• If backing assets have liquidity risk, the BoE would need to consider offering access to central bank lending facilities
• Backing assets should be held in a way that protects them from the failure of the issuer or other significant parts of the stablecoin arrangement (e.g. wallets, asset custodians)
• Additional capital requirements may be needed to mitigate market risk
• Supervisors would need to be able to verify that the coins are fully backed at all times, including preventing any unbacked issuance

The April 2022 response to HMT's consultation (PDF 445KB) on the regulatory approach to cryptoassets and stablecoins, demonstrated alignment to this proposed HQLA model — indicating that this may be the chosen route forward. As part of the response, HMT:

• Confirmed that the government will focus the first phase of legislative changes on bringing certain 'payment' stablecoins (those that reference fiat currencies — either a single currency or basket of currencies) within the regulatory perimeter. This would involve amending Electronic Money Regulations 2011, the Payment Services Regulations 2017 and Parts 5 of the Banking Act 2009, and the Financial Services (Banking Reform) Act 2013
• Confirmed original proposals to:
  • Establish an FCA authorisation and supervision regime for stablecoin issuers and other entities facilitating stablecoin activities (e.g. wallet providers, custody providers) — where requirements would be lighter for smaller firms, and certain exclusions would be permitted (in line with e-money regulation)
  • Establish enhanced requirements for stablecoins that become systemic (whereby the BoE would become the lead prudential regulator in line with its responsibilities for systemic payments systems)
  • Exclude certain stablecoins (namely algorithmic stablecoins, or those that may be linked to assets other than fiat currency) from scope
• Proposed that stablecoins ensure convertibility into fiat currency, at par and on demand
• Proposed a legal claim for the customer — either against the stablecoin issuer or, where appropriate, the consumer facing entity (e.g. wallet)

Although the original consultation determined that no resolution regime or deposit guarantee scheme was needed for stablecoins, following the BoE's DP and the FPC report, HMT now considers that there should be appropriate backstop arrangements to manage risks related to stablecoin failure. HMT published an open consultation (PDF 271KB) in May, proposing that a modified Financial Market Infrastructure Special Administration Regime (FMI SAR) be applied.

The spring Queen's Speech (PDF 406KB) formally introduced a Financial Services Bill which, based on the proposals made by HMT and BoE, is expected to present primary legislation for stablecoin regulation. The final framework that would apply would likely be subject to additional BoE and FCA consultations, pending HMT's legislative process.

The Bill is also expected to provide secondary powers (PDF 305KB) allowing HMT to more-quickly address consumer risks posed by other crypto-assets (e.g., unbacked exchange tokens). A further consultation on this broader set of crypto-assets is expected later in 2022.

In the EU, the recent market turmoil will likely increase pressure to conclude negotiations on the Markets in Crypto-assets legislation (MiCA) and accelerate its implementation. Currently, the delayed second and third trilogues are set to take place before the end of June. The key point of contention appears to lie with the supervision of systemic stablecoins — with Parliament (who view the coins as akin to securities) advocating for ESMA to supervise, and Member States (who view the coins more as private money) favouring the EBA.

Under MiCA's current proposals, algorithmic stablecoins cannot be issued or offered in the EU. The proposals are instead focussed on two other types of stablecoin: asset-referenced tokens (which reference a basket of goods — including fiat currencies, securities, commodities and even other crypto assets), and e-money tokens (which reference a single fiat currency).

The draft legislation proposes that:

• Both asset-referenced tokens (AFT) and e-money tokens (ET) must produce whitepapers in order to participate in any trading activity
• AFT and ET issuers must provide additional disclosures related to (i) their asset reserves (including custody arrangements and associated investment policies) and (ii) the composition / qualifications of their management bodies
• ET issuers must provide full redemption rights (immediately and at par)
  • AFT issuers, on the other hand, are not required to provide redemption rights. However, this must be clearly articulated in their white paper - and some mechanisms to ensure token liquidity must exist
• AFT and ET issuers must register as legal entities and obtain authorisation from Member State authorities
  • Specifically, ET issuers must be authorised as credit or e-money institutions
• AFT and ET issuers must maintain asset reserves — invested only in highly liquid financial instruments with minimum market and credit risk
  • The EBA and ESMA plan to develop joint draft technical standards specifying which instruments meet these conditions
  • These reserves must be verified through mandatory independent audits conducted every 6 months at the expense of the issuer
  • These reserves must be separated from the issuer's own funds and entrusted to a credit institution
• AFT and ET issuers must comply with own capital provisions — holding funds greater than or equal to either €350,000 or 2% of the average amount of their reserve assets
  • These required provisions would increase if:
    • ET issuers become engaged in activities such as payment services
    • The national competent authority (NCA) determines that an AFT or ET offering is 'significant'

European Parliament is currently lobbying for MiCA to be brought into force 18 months after negotiations conclude — as opposed to the 24 months original proposed by the Council. If Parliament is successful, MiCA is expected to apply sometime in H1 2024, with stablecoin rules applying first.

According to Ian Taylor, KPMG's UK Head of Crypto and Digital Assets, “the industry largely supports this UK and EU approach — while opposing the alternative approach chosen by some jurisdictions to regulate stablecoins as banks. This is because the latter approach places a much larger regulatory burden on new innovative firms”.

Regulators from across the UK and EU acknowledge the importance of promoting international consistency in this space. This is important not least because systemic coins will likely be used to transact across borders. Recent events such as the pandemic and the war in Ukraine have further emphasised the overall need to ensure payment systems are robust whilst maintaining financial stability and protecting against consumer harms.

The FSB's 2020 high-level recommendations for stablecoin regulation and CPMI-IOSCO's 2021 guidance (PDF 453KB) on applying systemic stablecoin arrangements for payments under the international Principles for Financial Market Infrastructures (PFMIs) provide examples of how international standard-setting bodies are attempting to build the foundations of an approach that could avoid (or at least minimise) regulatory divergence. In fact, in May of this year, G7 finance ministers reaffirmed that “no global stablecoin project should begin operation until it adequately addresses relevant legal, regulatory and oversight requirements through appropriate design and by adhering to applicable standards”.

Given the increasing scrutiny and desire to develop a clear regulatory framework for stablecoins, market players already operating in (or considering operating in) this space should carefully analyse their strategy and pipeline of products accordingly.