A regulatory and financial stability perspective on global stablecoins
A regulatory and financial stability perspective on global stablecoins
Macroprudential Bulletin 10, May 2020.
Stablecoins with the potential for global reach (“global stablecoins”) could help to address unmet consumer demand for payment services that are fast, cheap and easy to use and can operate across borders. However, while there is indeed the potential for such benefits, global stablecoins also pose challenges and risks. This article focuses on the asset management function of global stablecoins, assessing their regulatory and financial stability implications. We start by looking at how global stablecoins could be classified under the current financial regulations, arguing that regulatory gaps may exist with certain design features. We also discuss the financial stability risks posed by global stablecoins and estimate the potential size of a global stablecoin arrangement, using the Libra initiative as an example. We conclude that the malfunctioning of a global stablecoin’s asset management function could pose risks to financial stability given its potential size and interlinkages with the financial system. In order to reap the potential benefits of global stablecoins, a robust regulatory framework needs to be put in place in order to address these risks before such arrangements are allowed to operate.
Introduction
Financial innovation has the potential to improve the efficiency of financial services and spread access to such services to all corners of the globe. While payment services have changed considerably in recent years, driven by new technology and shifts in consumer preferences, traditional financial service providers have struggled to develop faster and cheaper payment services that can operate across borders. Stablecoins promise to help cater for such unmet demand for payment services.[2]
While potential benefits exist, stablecoins could also bring about challenges and pose risks to the financial system. There are many different types of stablecoin,[3] and analysis of their individual features is crucial in order to understand their possible implications from a risk perspective and a regulatory point of view.
Stablecoins seek to provide a stable means of payment and a store of value. Stablecoins were initially developed for use in the trading of crypto-assets, but today’s initiatives often have a much broader scope. This article focuses on stablecoins which have the potential to achieve global reach.
Stablecoins may be backed by funds, traditional asset classes or crypto‑assets, or they may be reliant on expectations. Issuers of stablecoins may or may not be responsible for satisfying any associated claims by end users; and the value of a stablecoin and its stability relative to the currency (or currencies) of reference may or may not be fixed. For a detailed description and taxonomy of stablecoin arrangements, see Bullmann et al. (2019).
The system of entities behind a stablecoin arrangement can vary greatly. Stablecoins are characterised by their integration into a wider arrangement that fulfils various different functions, including issuance, reserve asset management, transfers and an interface with end customers. Taking a holistic view, a stablecoin arrangement represents a complex ecosystem that can be structured entirely around a single provider or distributed across several different entities.
Since they combine several different functions, stablecoin arrangements may fall under different regulatory, oversight and supervisory regimes. Of particular importance to the ECB is the asset management function, which has the potential to be a significant source of risks to financial stability. Another important area is the transfer function, with the relevant components of a global stablecoin arrangement potentially falling under the Eurosystem’s oversight regime for payment systems or the oversight framework for payment schemes or instruments as part of the ECB’s mandate to foster the smooth operation of payment systems.
This article focuses on the asset management function of global stablecoins and the attendant risks to financial stability. To this end, we first provide a general description of stablecoin arrangements, before looking at how certain asset management functions might potentially be classified under current financial legislation. We argue that, as things stand, depending on their specific design features regulatory gaps may exist. We then discuss the financial stability risks that are posed if a stablecoin arrangement reaches a global scale. And finally, we quantify potential financial stability risks by estimating the potential size of a global stablecoin arrangement, using the Libra initiative as an example.
1 Functionalities in a stablecoin ecosystem
Stablecoins aim to provide an alternative to volatile crypto-assets by reducing price volatility, potentially acting as a means of payment and a store of value. First-generation crypto-assets such as Bitcoin have suffered from severe price volatility and limited scalability. Consequently, they have served more as a risky asset class than a means of making payments. A typical stablecoin arrangement (made up of the coin itself and the associated transfer platform and ancillary functions) seeks to reduce price volatility by anchoring the coin to a “safe” low‑volatility reference asset or basket of assets.
A stablecoin arrangement will typically involve several interconnected and interdependent functions. It will feature three key functions: (i) payments, (ii) asset management, and (iii) a user interface. The first encompasses the crucial transfer functionality, whereby stablecoins are used as a means of making payments and transferring value. The asset management function (which is the focus of this article) invests the proceeds from the issuance of stablecoins in safe low-volatility assets. And the final function provides the interface that is needed to link end users with other functionalities (e.g. wallet providers).
2 Regulatory considerations
Given the complexity of its structure, a stablecoin arrangement could, depending on its specific design features, fall under one of a number of different regulatory frameworks – or, potentially, none of them. The payment and customer interface functions of a stablecoin arrangement are similar to those of a traditional payment system, scheme or instrument. As a result, the entities responsible for providing those functions could fall under the Eurosystem’s oversight framework.
The asset management function could qualify as an issuer of e‑money, an investment fund or even a bank. If the issuer of the coin does not grant credit and guarantees redeemability at par, and end users have a claim on the issuer, the coin will fall within the definition of e-money under EU legislation, with both the coin and its issuer being subject to the Electronic Money Directive (EMD).[4] In this case, the proceeds from coin issuance will be held at a custodian bank. In contrast, if the stablecoin arrangement guarantees redeemability at par but also provides credit, it will be classed as a deposit-taking institution and will need to obtain a banking licence from the ECB.[5]
A stablecoin’s asset management function may also qualify as an investment fund. An asset management function may be regarded as a collective investment undertaking (i.e. an investment fund) if (i) coin holders have a claim on the assets of the issuer, (ii) proceeds are invested in non-zero risk financial assets, and (iii) coin holders are entitled to a pro rata share of the value of the issuer’s assets. If the fund is based in the EU and/or marketed to EU investors, it will fall under the standard EU regulatory framework established by the UCITS Directive[6] or the AIFMD.[7] If the fund invests only in instruments with less than two years of residual maturity, it will qualify as a money market fund (MMF), in which case the requirements envisaged by the MMF Regulation[8] (e.g. liquidity limits) will apply on top of those envisaged by the UCITS Directive or the AIFMD.
Depending on its design, the stablecoin’s asset management function may, however, also fall outside of the EU’s existing regulatory framework, implying a potential regulatory gap for certain stablecoin arrangements. The question of whether a coin holder has a claim on the issuer or the assets backing the stablecoin arrangement plays an important role in the characterisation of such an arrangement. Under the EMD, a holder of e-money must have a claim on the issuer for the funds that were exchanged for the e-money. Similarly, under the regulations governing funds, a holder of a share in a fund must have a claim on that fund’s assets. Consequently, if a stablecoin arrangement does not give users a claim on the issuer or the assets backing the stablecoin, that arrangement may not qualify as an issuer of e-money or an investment fund, even though it performs similar functions and takes similar risks. A key question in this regard is whether, in the absence of a formal promise of a claim, a statement indicating that coins are fully backed creates a legitimate expectation that coin holders will have a claim on the underlying assets or a legal right to such a claim.
Furthermore, there is a risk that end users will regard the stablecoin as being equivalent to a deposit, given the promise of “stable” value and the possibility of converting coin holdings back into fiat currency at any time. The value of a stablecoin will depend crucially on its governance and risk management, as well as on the value of the underlying assets or fund portfolio. In this respect, the term “stablecoin” is a misnomer.[9] In order to minimise confidence shocks, stablecoin users should be informed that losses could occur and that they will not be covered by traditional safety nets such as deposit guarantee schemes and central banks’ lender of last resort functions.
3 Financial stability risks
If a stablecoin arrangement reaches a global scale (becoming a “global stablecoin”), any malfunctioning could pose a risk to financial stability. The G7 Working Group on Stablecoins has analysed and identified a vast array of risks to and from global stablecoin arrangements.[10] Without prejudice to issues and risks that may arise in other parts of a stablecoin ecosystem, we focus our discussion on the two most prominent issues for the asset management function: the risk of a liquidity run impairing the functioning of the stablecoin arrangement; and the risk of contagion spreading to the wider financial system as a result of an impaired stablecoin arrangement. The former represents a risk to the smooth functioning of the stablecoin arrangement itself (i.e. vulnerability of the arrangement), while the latter represents a risk to the wider financial system and the rest of the economy as a result of the arrangement’s distress (i.e. risk transmission to the broader economy).
If proceeds from coin sales are not held in a depository, but rather invested in non-zero risk financial assets, the value of the coin will be exposed to the risks that are inherent in such investment. For example, if the stablecoin arrangement invests those proceeds in bank deposits and government debt, it will be exposed to the credit and liquidity risks of the banks where the deposits are held, in addition to credit, liquidity, market and foreign exchange risks associated with the government bonds held.[11]
An important question when assessing risks to stablecoin arrangements is who ultimately bears investment risks. If the stablecoin arrangement does not guarantee a fixed value for the coin, the value of the coin will move in tandem with the value of the underlying assets. In this case, the end user bears all risks and the coin is equivalent in substance to a fund share, with its value equal to the fund’s net asset value. There is no solvency risk for such an arrangement, as it is akin to a “pass-through” structure.
A run on a stablecoin arrangement could occur if end users lose confidence in the issuer or its network. This could happen, for example, if an adverse event occurs (such as a cyberattack on the system or a large-scale theft from a wallet), or if end users realise that the assets backing the coin are losing value, thereby casting doubt on the value of the coin. A loss of confidence could trigger substantial redemptions of coin holdings, which could be amplified if end users have misinterpreted such holdings as a substitute for bank deposits. Unlike stablecoins, bank deposits are covered by the bank’s guarantee of redeemability at par and, should that fail, the appropriate deposit guarantee scheme. One can imagine such a situation arising if, for example, the stablecoin in question has been advertised on established social networks as a cost-efficient alternative to current payment and money transfer services.
The ultimate bearer of investment risks may be the stablecoin issuer if the stablecoin arrangement guarantees a fixed value for the coin. In this case, any losses stemming from its reserve assets are borne by the stablecoin issuer (or whoever provides such guarantees), including losses from exchange rate fluctuations if the value of the coin is fixed relative to a given fiat currency. Confidence in the coin and its arrangement then depends critically on the loss absorption capacity of the guarantor, and doubts in that regard may trigger a run on the coin. In the event of such a run, elements of the stablecoin arrangement (e.g. designated dealers) may stop functioning, potentially in a manner similar to the suspension of securitisation vehicles’ redemptions in 2007 in the context of the global financial crisis.
In the event of a run on a global stablecoin, the liquidation of assets to cover redemptions could have negative contagion effects on the financial system. The size of the stablecoin arrangement and its interconnectedness with the financial system and the wider economy will ultimately determine the severity of the financial stability impact. It should be noted in this regard that different components of the stablecoin arrangement are likely to be located in different jurisdictions. This means that a shock to the stablecoin arrangement that occurs in an emerging market (e.g. a loss of confidence triggered by an operational risk event in a weak institutional setting) could potentially spill over to the advanced economies where most of the pool of assets underlying the stablecoin are invested. As the next section shows, global stablecoin arrangements could conceivably reach a size where they are large enough to destabilise such markets.
Short-term government debt markets could be affected. If a stablecoin arrangement plays a dominant role in