Author: Qiao Zheyuan, Zhou Jingbo, Cheng Xiaoyu, Chen Yushi, Shen Luwen, Zhang Lu, Liang Guoqiang, Liao Yuhui, Xiao Xinzhuang, Huang Kaijie, Chen Lu
Table of contents
1. What are crypto assets and stablecoins?
2. The latest developments in the regulation of stable currencies in major countries and regions around the world
3. Conclusion
What are cryptoassets and stablecoins What are cryptoassets
Since the birth of Bitcoin in 2009, various types of crypto assets have emerged, such as stablecoins, utility tokens, and non-fungible tokens. The Financial Stability Board (FSB) defines crypto assets as "a private digital asset that primarily relies on cryptography and distributed ledger technology or similar technologies."
What is a Stablecoin
According to the FSB, a stablecoin is a “crypto-asset that attempts to maintain a stable value by being linked to a specific asset or pool of assets.” The Bank of International Settlements considers a stablecoin to be a “crypto-currency whose value is pegged to a fiat currency or other asset.”
As a subcategory of crypto assets, stablecoins are gradually gaining more and more attention. The most distinguishing feature of stablecoins compared to other crypto-assets is that they are designed to be pegged to or backed by fiat currencies and/or other crypto-assets. It is precisely based on this feature that market participants believe that stablecoins may be more likely to develop into a widely accepted payment method and/or value storage method, and therefore have a higher potential to be accepted by the global mainstream financial system. Accordingly, they will have a more direct impact on currency and economic activities. In view of this, the FSB urges financial regulators to prepare for the supervision of stablecoins, especially global stablecoins that may be more widely used in cross-regional payments.
Based on the different stabilization mechanisms, the common stablecoins on the market can be roughly divided into three categories: (1) centralized stablecoins pegged to fiat currencies; (2) stablecoins with over-collateralized crypto assets; and (3) algorithm-based stablecoins.
1 Centralized stablecoins pegged to fiat currencies (e.g. USD, GBP)
The backing assets of stablecoins pegged to fiat currencies (such as the US dollar and the British pound) are usually held by a centralized issuer and stored in a custodian or bank account. There is a fixed correspondence between the backing assets and the stablecoins (for example, 1 US dollar corresponds to 1 stablecoin). When the backing assets are sent to the issuer, the stablecoin is created. When the backing assets are returned to the redeemer by the issuer, the corresponding number of stablecoins will be destroyed. In order to achieve the peg between the value of the stablecoin and the number of backing assets, centralized issuers usually hire independent accounting firms or auditing agencies to regularly verify the backing assets in the custodial account. Representatives of this type of stablecoins are USDT and USDC.
2 Stablecoins with Overcollateralized Crypto Assets
The second type of stablecoin is a stablecoin based on assets on the blockchain (i.e. other crypto assets) (also known as providing "collateral" in the market). In this case, the collateral is held by the smart contract, so it is decentralized in nature and relatively transparent. Users can review the code and view the total amount of collateral. Users can obtain these stablecoins by depositing collateral, or deposit stablecoins again to get back the collateral. Because the value of crypto assets often fluctuates greatly, in order for smart contracts to maintain the relative stability of the stablecoin price, users usually need to deposit excess collateral at a ratio higher than 1:1. The representative of this type of stablecoin is DAI.
3 Algorithmic Stablecoins
Stablecoins based on algorithms are usually not 100% backed by assets, but use other methods to try to maintain the stability of a fixed correspondence (for example, 1 US dollar corresponds to 1 stablecoin). When the price of stablecoins rises, the algorithm creates more stablecoins, expands the supply, and lowers the price; when the price of stablecoins falls, the algorithm reduces the number of stablecoins and reduces the supply to increase the price, thereby making the price of stablecoins relatively stable. The essence of algorithmic stablecoins is decentralization: algorithms, currency issuance and circulation, and transaction information are public on the blockchain, and the information on the blockchain is difficult to tamper with. Representatives of this type of stablecoin are UST, FEI, and Basis.
The latest developments in the regulation of stablecoins in major countries and regions around the world
At present, the regulatory stances of major countries and regions around the world on crypto assets (including stablecoins) vary, and the corresponding regulatory frameworks and legislation are at different stages. The following article briefly introduces the latest developments in Hong Kong, Mainland China, the United States, Singapore and the European Union. This article hopes to provide readers with some general references and guidance on the regulation of the following countries and regions.
1 Hong Kong, China
On January 12, 2022, the Hong Kong Monetary Authority published a discussion paper on extending Hong Kong's regulatory framework to stablecoins, inviting the industry and the public to provide opinions on the regulatory model for crypto assets and stablecoins. The discussion paper sets out the Hong Kong Monetary Authority's conception of a regulatory model for crypto assets, especially stablecoins used for payment purposes. The Hong Kong Monetary Authority expects to formulate a plan by July next year with a view to enacting a new regulatory regime by 2023/24.
The Hong Kong Monetary Authority believes that stablecoins are increasingly seen as a widely accepted payment method, and in fact the growth in their usage increases the potential for stablecoins to be integrated into the mainstream financial system. In the view of the Hong Kong Monetary Authority, this will trigger broader monetary and financial stability impacts, making stablecoins a regulatory focus of the HKMA.
The discussion paper further analyses seven main risks associated with the use of stablecoins, including financial stability risks, currency stability risks, settlement risks, user protection, financial crime and cyber risks, international compliance and regulatory arbitrage. The HKMA proposes eight specific discussion questions related to stablecoins for the industry to consider, which are outlined below.
1. Do we need to regulate all types of stablecoin activities, or should we prioritize the regulation of stablecoins related to payment functions and that pose greater risks to the monetary and financial system, and provide flexibility in the mechanism to adjust the scope of stablecoins that may need to be regulated in the future?
The HKMA noted that it is appropriate to first expand the scope of regulation to cover payment-related stablecoins, while not ruling out the possibility of regulating other forms of stablecoins. The HKMA hopes that any new regime introduced will be flexible enough so that it can be extended to other types of stablecoins in the future.
2. What types of stablecoin-related activities should fall within the scope of regulation, such as issuance and redemption, custody and management, and reserve management?
The HKMA proposes to regulate a wide range of stablecoin-related activities, including issuing, creating or destroying stablecoins; managing reserve assets to ensure the stability of the value of stablecoins; verifying transactions and records; storing private keys used to access stablecoins; facilitating redemption of stablecoins; transferring funds for settlement of transactions; and executing transactions in stablecoins.
3. What approval and regulatory requirements will there be for entities that are intended to be subject to the new stablecoin licensing regime?
The HKMA’s recommendations mainly cover four categories of requirements: (1) authorization and prudential requirements, including sufficient financial resources and liquidity requirements; (2) suitability requirements regarding management and ownership; (3) maintenance, management and system requirements regarding supporting asset reserves; and (4) control, governance and risk management requirements.
4. Under the proposed regulatory mechanism, which institutions need to apply for a license?
In its discussion paper, the HKMA stated that foreign companies carrying out regulated activities under the new regulatory regime provided by Hong Kong or actively promoting such activities in Hong Kong should incorporate their companies in Hong Kong and apply for a licence from the HKMA.
If the regulatory mechanism is implemented, it will have a significant impact on global cryptocurrency exchanges that currently provide stablecoin transactions to Hong Kong users from offshore. These companies will face the choice of either registering in Hong Kong and applying for a license or stopping transactions for Hong Kong users.
5. When will this risk-oriented regulatory mechanism for stablecoins be implemented? Does it overlap with other financial regulatory systems in Hong Kong, including the virtual asset service provider licensing system of the Hong Kong Securities Regulatory Commission and the stored value facility (SVF) licensing system in the Payment Systems and Stored Value Facilities Ordinance?
The HKMA said it will cooperate and coordinate with other financial regulators in defining the HKMA's regulatory scope, while also striving to avoid regulatory arbitrage, including areas that may be regulated by multiple local financial institutions.
6. Stablecoins may be subject to runs and become a potential substitute for bank deposits. As recommended by the US President’s Working Group on Financial Markets in the Stablecoin Report, will the Hong Kong Monetary Authority require that stablecoin issuers should be “authorized institutions” under the Banking Ordinance?
Although the Hong Kong Monetary Authority did not explicitly state that it would not require stablecoin issuers to be regulated as authorized institutions under the Banking Ordinance, it said it expected that the requirements applicable to stablecoin issuers would draw on Hong Kong's existing regulatory framework for stored value payment instruments. The Hong Kong Monetary Authority further stated that certain stablecoin issuers may be subject to stricter prudential requirements due to their systemic impact.
7. Given that unbacked crypto-assets are increasingly connected to the mainstream financial system and pose higher risks to financial stability, does the HKMA plan to regulate these unbacked crypto-assets?
The HKMA did not explicitly rule out regulating unbacked crypto assets, and said it was necessary to continue monitoring the risks posed by such crypto assets.
8. Before the HKMA announces its regulatory mechanism, what should existing and future entities in the stablecoin ecosystem do?
The HKMA recommends that existing and potential participants in the stablecoin ecosystem provide feedback on the proposals set out in the discussion paper, noting that in the meantime it will continue to supervise authorized institutions’ crypto-asset-related activities and implement a licensing regime for stored value facilities.
In addition, according to the Hong Kong Securities and Futures Ordinance, unless there is a specific exemption, conducting regulated activities related to "securities" (such as securities trading, providing services for securities trading, providing opinions on securities, etc.) requires obtaining a license issued by the Hong Kong Securities and Futures Commission in advance. Therefore, before conducting stablecoin-related business, a specific analysis and judgment should be made as to whether the stablecoin involved falls within the scope of "securities" under the Ordinance. If the stablecoin involved constitutes the scope of "securities" under the Securities and Futures Ordinance, conducting business related to the stablecoin will be deemed to be conducting regulated activities, and the corresponding license issued by the Hong Kong Securities and Futures Commission must be obtained in advance.
It is worth noting that if stablecoins have traditional payment functions, Hong Kong’s current stored value payment tools and payment system supervision methods should also be within the scope of consideration of stablecoin operators.
2 Mainland China
China's mainland regulatory policy on crypto assets began with the "Notice on Preventing Bitcoin Risks" issued by the People's Bank of China and five other ministries on December 5, 2013. On September 4, 2017, the People's Bank of China and seven other ministries issued the "Announcement on Preventing Risks of Token Issuance and Financing", which is the 94 ban. The announcement clearly stipulates that no organization or individual shall illegally engage in the exchange of legal currency and tokens, "virtual currency", shall not buy or sell tokens or "virtual currency" or act as a central counterparty to buy or sell tokens or "virtual currency", and shall not provide pricing, information intermediary and other services for tokens or "virtual currency".
In June 2021, the People's Bank of China summoned some banks and payment institutions to discuss the issue of "virtual currency" transaction speculation, requiring them to effectively fulfill their customer identity identification obligations, and not to provide account opening, registration, trading, clearing, settlement and other products or services for related activities, and not to carry out or participate in "virtual currency" related business activities.
On July 8, 2021, Fan Yifei, Deputy Governor of the People's Bank of China, pointed out at the State Council's regular policy briefing on July 8, 2021, when answering the question of what actions the state will take against service providers of "virtual currency" related activities, that private digital currencies (including various so-called stablecoins) pose potential risks that threaten financial security and social stability; at the same time, they have also become payment tools for some money laundering and illegal economic activities. Stablecoins of some commercial institutions, especially global stablecoins, may bring risks and challenges to the international monetary system, payment and clearing systems, etc. After expressing its concern about this issue, the central bank also made it clear that it would take some measures.
On September 24, 2021, the People's Bank of China and ten other ministries and commissions issued the "Notice on Further Preventing and Dealing with the Risks of Virtual Currency Trading Speculation", or the 924 Notice. Compared with the 94 ban, the 924 Notice clearly states that the following five types of virtual currency "related business activities" are "illegal financial activities": (1) conducting legal currency and virtual currency exchange business, and virtual currency exchange business; (2) buying and selling virtual currency as a central counterparty; (3) providing information intermediary and pricing services for virtual currency transactions; (4) token issuance financing; and (5) virtual currency derivative transactions, etc. Given that the stablecoins issued by some commercial institutions discussed in this article are a type of virtual currency defined in the 924 Notice, conducting "related business activities" related to stablecoins falls within the scope of "illegal financial activities" and is prohibited by the 924 Notice.
3 United States
On June 18, 2019, Facebook released the Libra white paper, but the project soon attracted regulatory attention. Regulators are concerned about a series of issues, including how to prevent Libra from being used by criminals for money laundering purposes and how to prevent Libra from posing financial stability risks.
In November 2021, the President's Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency jointly issued a report on stablecoins. To address the risks of payment stablecoins, the report recommends that the U.S. Congress quickly legislate to ensure that payment stablecoins and related arrangements are regulated under a unified and comprehensive federal framework to fill the current legislative gaps in stablecoins in terms of market integrity, investor protection, and illegal financing, and will work to address the following important concerns: (1) To prevent stablecoin runs, legislation should require all stablecoin issuers to be insured deposit institutions and be appropriately regulated at the depository institution and holding company levels; (2) To mitigate payment system risks, legislation should be passed to subject custodial wallet providers to appropriate federal supervision; and (3) To address systemic risks and the risk of concentrated economic power, legislation should require stablecoins to comply with activity restrictions that limit affiliations with commercial entities. Regulators should have the power to impose standards to promote interoperability between different stablecoins. In addition, the U.S. Congress may also consider other standards for custodial wallet providers, such as limiting their affiliations with commercial entities or users' transaction data.
On March 31, 2022, Senator Bill Hagerty introduced the Stablecoin Transparency Act in the Senate; the bill aims to improve the transparency of the stablecoin market and set reserve standards for reserve assets. The bill requires stablecoin issuers to (1) hold government securities with a term of less than 12 months; (2) have fully collateralized securities repurchase agreements; and (3) have reserves backed by US dollars or other non-digital currencies, and publish a third-party audited report on the reserve assets held by the stablecoin issuer on its website every month.
On April 6, 2022, Pat Toomey, a member of the U.S. Senate Banking Committee, released a discussion draft of the Stablecoin TRUST Act. The draft bill proposes to limit the issuers of payment stablecoins to the following three types of institutions: (1) state-registered money transmitters; (2) institutions holding new federal licenses specifically designed for stablecoin issuers; and (3) insured depository institutions, and requires payment stablecoin issuers to disclose their reserve assets, formulate redemption policies, and accept regular certifications from registered accounting firms.
In May 2022, U.S. Treasury Secretary Janet Yellen stated at a Senate hearing that stablecoins are fast-growing products and that they carry risks associated with rapid growth. She also stressed that it is very important for the U.S. Congress to pass legislation on stablecoins, and that it is “very appropriate” for Congress to pass legislation before the end of 2022.
On the other hand, Gary Gensler, chairman of the U.S. Securities and Exchange Commission (SEC), recently told the House Appropriations Financial Services Subcommittee that according to the SEC's definition, many cryptocurrency trading platforms are trading securities rather than commodities, and therefore asked legislators to increase the SEC's enforcement budget to require cryptocurrency trading platforms to register with the SEC. Therefore, cryptocurrency trading platforms should also pay attention to whether stablecoins will be identified as "securities."
4. Singapore
The Payment Services Act, which was enacted by Singapore in 2019 and implemented on January 28, 2020, brings digital payment tokens (DPT) and electronic money (e-money) under regulation; according to the Act, DPT services and electronic money issuance services are regulated activities under the Payment Services Act and require an application for a payment service provider license.
What is DPT
As defined in Section 2 of the Payment Services Act, a digital token that represents value in a digital form and meets the following characteristics is a DPT under the Act: (1) it is expressed in units; (2) it is not denominated in any currency and is not pegged to any currency by the issuer; (3) it is or is intended to be a medium of exchange for the public or a particular group of the public for payment of goods or services or for settlement of debts; (4) it can be transferred, stored or traded electronically; and (5) it meets other characteristics specified by the MAS.
What is electronic money
In relation to electronic money, Section 2 of the Payment Services Act defines it as any monetary value stored electronically that (1) is denominated in any currency or pegged to any currency by its issuer; (2) is prepaid for the purpose of effecting a payment transaction through the use of a payment account; (3) is accepted by a person other than the issuer; and (4) represents a claim against the issuer; but does not include any deposit received in Singapore from a person in Singapore.
The Monetary Authority of Singapore believes that stablecoins do not meet the characteristics of electronic currency because the exchange rate between them and fiat currencies cannot be fixed and stablecoin holders do not need to have a contractual relationship with the stablecoin issuer or open an account with the issuer. Therefore, they do not belong to electronic currency under the Payment Services Act.
The Monetary Authority of Singapore further stated that it will examine the characteristics of specific stablecoins on a case-by-case basis from a technology-neutral standpoint to determine appropriate regulatory measures. In the view of the Monetary Authority of Singapore, based on the characteristics currently displayed, USDC and USDT should be identified as DPT, so the provision of DPT services related to these two types of stablecoins should be subject to the Payment Services Act and should apply for corresponding licenses.
In addition, the Monetary Authority of Singapore launched a public consultation in December 2019, seeking public opinion on the interactions between fiat currencies, electronic currencies and cryptocurrencies (including stablecoins), and the appropriate regulatory approach for cryptocurrencies (especially stablecoins).
Recently, Ravi Menon, the CEO of the Monetary Authority of Singapore, expressed his views on the regulation of stablecoins on different occasions. Ravi Menon expressed the urgency of solving the problem of stablecoins, questioned the stability of stablecoins pegged to legal currencies, and if stablecoins do not receive sufficient support, it will be difficult to imagine that they can play the role of currency. Therefore, he believes that the key to regulating stablecoins is to ensure that stablecoins can have support, and this support should be liquid and can be used when needed.
It is worth noting that if the stablecoin offered or issued constitutes a capital markets product under the Securities and Futures Act (such as securities or shares of a collective investment scheme), such offering or issuance will be regulated by the Securities and Futures Act; intermediaries assisting in such offering or issuance (including platform operators that provide a platform for the offering, issuance and/or trading of the stablecoin and intermediaries that provide financial advice related to the stablecoin) will be subject to the licensing requirements and other compliance requirements under the Securities and Futures Act and/or the Financial Advisers Act.
5. European Union
In September 2020, the European Commission proposed a draft of Markets in Crypto-Assets Regulation (MiCA), aiming to establish a broad and comprehensive regulatory framework for all crypto-assets, including stablecoins, to protect the interests of consumers and investors and maintain market integrity and financial stability.
For "e-money tokens", that is, stablecoins that are pegged to a single legal tender and used for payment, the existing regulatory provisions for e-money apply. If an issuer issues e-money tokens, MiCA stipulates that the issuer must be one of the two types of authorized entities, namely, either a "credit institution" authorized under the Capital Requirements Directive for Financial Services or an "electronic money institution" authorized under the EU e-money directive. Issuers should comply with the relevant operational requirements of the EU e-money directive and should publish a white paper and notify the white paper to its competent authority. Token holders should be given the right to claim compensation from the issuer and be able to redeem at any time for an amount equal to the face value of the legal tender that the token is backed by, and the redemption right should be stated in the white paper. For the white paper of the token, MiCA requires it to state: (1) the procedures and conditions for exercising the aforementioned redemption right; (2) the relevant technologies and corresponding standards on which the holding, storage and transfer of the tokens are based; (3) all relevant information related to the issuer's issuance of tokens or allowing them to be traded on crypto asset trading platforms; and (4) operational risks related to the issuer. The issuer is also required to invest the funds received in safe, low-risk assets, and the currency of the invested assets should be the same as the legal currency supporting the token to avoid cross-currency risks.
In March 2022, the European Parliament's Economic and Monetary Affairs Committee voted to pass the MiCA draft regulations. The MiCA draft regulations will currently be discussed in the European Parliament, the European Commission and the European Council.
Conclusion
Looking around the world, the regulatory situation of stablecoins varies from country to country, and the legislation is at different stages. Regulatory agencies in various countries are paying close attention to stablecoins, and the regulation of them is also evolving. For institutions engaged in related businesses, they should assess risks and applicable laws and regulations at any time, and quickly adjust their business models to comply with relevant regulations on stablecoins and avoid potential compliance risks.
