Cryptocurrency “double-edged sword” is about to usher in legislative regulation？Current situation and prospect of stablecoin regulation

A Stablecoin is a cryptocurrency that is anchored by fiat or other assets and aims to reduce price volatility, improve payment efficiency and financial inclusion. Since stablecoins are linked to sovereign currencies, they can have implications for financial stability, consumer protection, anti-money laundering, taxation, and more. It even threatens the status of sovereign currencies. This paper aims to discuss the current situation and problems of international stablecoin regulation and analyze the importance of stablecoin regulation. After that, this paper reviews the regulatory attitudes and policies of various countries on stablecoins, discusses the relationship and influence between stablecoins, fiat currency and DeFi, and puts forward suggestions and prospects for the future stablecoins regulation.

1 The Imperative of stablecoin regulation: Concepts and background

1.1 Concept and classification of stablecoins

[if !supportLists]1.1.1 [endif]Concept of stablecoins: Development in practice

Stablecoins are cryptocurrencies anchored by fiat or other assets that aim to reduce price volatility and improve payment efficiency and financial inclusion. Stablecoins emerged to solve the problem of high volatility and low liquidity of traditional cryptocurrencies, while retaining their advantages of decentralization, transparency, and programmability.

The earliest stablecoin projects appeared in 2014, such as BitUSD and NuBits. They issue stablecoins using other cryptocurrencies as collateral. Stablecoins issued in this way are less stable, as other cryptocurrencies always have violent market fluctuations. In 2015, Tether launched USDT, a fiat backed stablecoin anchored in the US dollar, which is currently the most valuable and traded stablecoin.

In 2018, fiat collateralized stablecoins flourished, and famous stablecoins such as USDC, PAX, and TUSD all appeared in this period. They all claim to have adequate reserves of fiat currency and are audited and regulated by third parties. In addition, a number of commodity-backed stablecoins have emerged, such as PAXG, DGX, etc., which use physical commodities such as gold as anchors.

In 2019, Facebook announced plans for Libra, an algorithmic stablecoin anchored by a basket of fiat currencies and bonds, to create a global payments network. But because of its size and influence, it has triggered strong opposition and concern from governments and regulators.

From 2020 to the present, algorithmic stablecoins have become the new hot spot, they do not have any anchor or collateral, but algorithmically adjust the supply to achieve price stability. Representative algorithmic stablecoins include Ampleforth, Basis Cash, Frax, etc.

1.1.2 Classification of stablecoins

The historical development process of stablecoins also reflects the differences between stablecoins. Stablecoins can be divided into four categories based on their stabilization mechanism: Fiat-collateralized Stablecoin, Crypto-collateralized Stablecoin, Algorithmic Stablecoin and Commodity-backed Stablecoin.

Fiat backed stablecoins: These are the most common class of stablecoins, which are anchored by fiat currency or other traditional assets (such as gold, US dollar bonds, etc.) and held by a centralized issuer or custody institution. The price of such stablecoins is consistent with or close to the anchor, with high liquidity and convertibility.

Crypto-collateralized stablecoin: This is a stablecoin that uses other cryptocurrencies (such as Bitcoin, Ethereum, etc.) as an anchor and is managed decentralized through smart contracts or other mechanisms. The price of such stablecoins is negatively correlated with the anchor, that is, when the anchor price falls, the stablecoin price rises, and vice versa.

Algorithmic stablecoins: These are stablecoins that do not have any anchor, but instead use algorithms to adjust supply and demand to achieve price stability. The price of such stablecoins is positively correlated with market demand, that is, when the market demand increases, the algorithm increases the supply, thereby lowering the price.

Commodity-backed stablecoins are stablecoins that have a commodity (such as gold, silver, oil, etc.) as an anchor and are held by a centralized or decentralized issuer or custodianship. The price of this class of stablecoins is consistent with or close to the anchor, which has a high anti-inflation ability and a store of value.

1.2 Market status and risks of stablecoins

The market size of stablecoins has grown rapidly in recent years. According to CoinGecko's report, as of September 2023, the global stablecoin market value was $138.4 billion. Among them, USDT accounted for 49% of the market share; USDC and BUSD accounted for 30.9% and 11.4% of the market, respectively. At the same time, the importance and influence of stablecoins in the cryptocurrency market is also increasing. In January 2022, stablecoins accounted for 7.3% of the total cryptocurrency market capitalization. By January 2023, that number had risen to 12.9 percent.

However, behind the surge in the size of the stablecoin market, there is also a growing shadow, which is mainly reflected in the following aspects.

First, as with other cryptocurrencies, stablecoins carry tax regulatory risks and financial business risks. The cross-border nature and anonymity of stablecoins increase the risk of tax evasion and tax evasion, and their transactions also involve multiple financial business areas, creating regulatory challenges for tax authorities in various countries.

Secondly, the potential credit risks of centralized stablecoins have also been concerned by governments around the world. In the case of USDT, Tether claims that for every USDT issued, it will deposit $1 in the margin account to keep the value of the USDT stable. However, the issuance of USDT does not have a national credit endorsement and lacks adequate regulatory mechanisms. As a result, Tether is often suspected of being at risk of overissuing USDT for profit. If the exchange does not deposit enough collateral, the value of the stablecoin will be decouped from the assets it anchors, leading to a direct decline in financial markets.

More important are the monetary policy risks posed by the development of stablecoins. If stablecoins (especially global stablecoins) are widely used, it may affect the money supply of countries, and then affect the effectiveness of monetary policy tools such as exchange rates and interest rates, and even threaten the monetary sovereignty and financial stability of countries.

In view of the above risks, the International Monetary Fund (IMF) has on several occasions called for the establishment of a global unified regulatory system for stablecoins. According to the IMF blog Crypto Contagion Underscores Why Global Regulators Must Act Fast to Stem Risk, published in January: Without proper regulation, stablecoins could undermine the effectiveness of monetary policy and trigger financial crises in both developed and developing economies. Previously, in its September 2022 Fintech Note paper, the IMF emphasized the need for strong, comprehensive, and globally consistent regulation of crypto assets.

2. Status quo of stablecoin supervision: Seeking unity in decentralization

2.1 Origin of stablecoin regulatory policy

Overall, stablecoin regulation has gradually received attention from governments since 2019. Previously, stablecoins were generally subject to unified regulation along with other digital assets, rather than having their own regulatory requirements.

In 2019, the issuance plan of Libra triggered global attention and concerns about stablecoins, and the financial risk issues related to stablecoins also began to "come to the fore." The G7 Stablecoin Working Group released the Global Stablecoin Assessment Report in October 2019. For the first time, the concept of a "global stablecoin" was formally proposed, and its potential challenges to financial stability, monetary sovereignty, consumer protection and other aspects were pointed out. Subsequently, the G20 commissioned the Financial Stability Board (FSB) to review the Libra project and issued two regulatory recommendations on global stablecoins in April 2020 and February 2021, respectively.

2.2 Regulatory dynamics of stablecoins in major countries and regions

Under the guidance of the FSB's regulatory recommendations, some countries and regions have also put forward their own stablecoin regulatory policies. Among them, the United States, the European Union, Hong Kong and Singapore have more advanced regulatory policies. This article collates the major regulatory policies in these four countries since 2019.

2.2.1 United States

Stablecoim TRUST Act: The act was introduced on April 6, 2022. The bill requires stablecoin issuers to register with the Office of the Comptroller of the Currency or state agencies and maintain reserve assets equal to the value of the stablecoin. The bill also requires stablecoin issuers to provide transparent disclosure of information, including the type, value, and risk of reserve assets, as well as the rights and obligations of stablecoin holders.

Digital Asset Market Structure and Investor Protection Act: The act was introduced on June 30, 2022. The bill aims to provide a comprehensive and consistent regulatory framework for the digital asset market. It also clarifies the definition and classification of digital assets, and stipulates the rules and standards that digital asset trading platforms, custodians and other service providers should abide by. The bill also requires the Federal Reserve to issue digital dollars and authorizes the U.S. Treasury Secretary to conduct oversight of cross-border payments.

Stablecoim Payment Act: The act was introduced on April 19, 2023. The bill is a 73-page draft legislation released by the U.S. House of Representatives Financial Services Committee that seeks to regulate stablecoin payments and address other related issues.Its main contents include:

[if !supportLists]· [endif]The bill defines the primary federal payment stablecoin regulators as the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration;

[if !supportLists]· [endif]The bill stipulates the conditions for the issuance and requirements of stablecoins, such as having to be linked to fiat currency or other highly liquid assets in a 1:1 ratio, having to apply for permission from the Board of Governors of the Federal Reserve System within 90 days, and having to be audited and reported.

[if !supportLists]· [endif]The act provides for regulatory and enforcement measures, such as giving the Board of Governors of the Federal Reserve System emergency intervention and penalty powers. It provides for fines of $100,000 per day for unlicensed stablecoin issuers and up to five years in prison for stablecoin issuers who violate the law.

[if !supportLists]· [endif]The Act provides for the eligibility of qualified payment stablecoin issuers in the State.

[if !supportLists]· [endif]The bill considers interoperability issues, requires payment stablecoin issuers to be compatible with other payment systems, and requires the Board of Governors of the Federal Reserve System to study the feasibility and impact of CBDCS.

This draft bill represents the first major crypto legislation to be passed in the United States in 2023. It reflects the U.S. government's emphasis and concern on the stablecoin market, and also shows the U.S. government's support and encouragement for crypto innovation.

2.2.2 European Union

MiCA: The bill was introduced on September 24, 2020. MiCA is the EU's first comprehensive regulatory framework for crypto assets, covering the issuance, trading and service provision of crypto assets. The bill also puts forward higher requirements for stablecoins, including licenses, reserves, and disclosure governance structures. MiCA divides crypto assets into electronic Money Token (EMT) asset reference Token (ART) and other crypto assets, of which EMT and ART belong to stablecoins. MiCA also limits the size of non-euro-denominated stablecoins that can be traded within the EU.

Opinion of the European Central Bank on the Crypto Asset Market Supervision Bill: The Bill was presented on February 19, 2021. The European Central Bank (ECB) has made a number of comments and recommendations on the MiCA bill, including the following points:

(1)MiCA should clearly distinguish between central bank digital currencies (CBDCS) and other crypto assets to avoid confusion;

(2)MiCA should give the ECB a special role in the regulation of stablecoins, in particular with regard to global stablecoins that may affect financial stability and monetary policy in the euro area;

(3) The MiCA should stipulate that stablecoin issuers must establish an entity within the European Union and be subject to ECB supervision;

(4) The MiCA should require stablecoin issuers to provide the necessary data and information to the ECB for risk assessment and monitoring.

Agreement Reached on European Crypto-assets Regulation: The Bill was introduced on 30 June 2022. The European State Parliaments and the Council have reached a provisional agreement on the MiCA Bill, reaching consensus on a number of key issues, including the following:

(1)MiCA will require stablecoin issuers to establish an adequate liquidity reserve at a 1:1 ratio and partly in the form of deposits to protect consumers and maintain the value of stablecoins;

(2)MiCA will limit the trading size of non-euro-denominated stablecoins within the EU to 1 million transactions and 200 million euros per day;

(3)MiCA will give the European Banking Authority (EBA) a special role in the regulation of stablecoins, responsible for issuing licenses, monitoring compliance, maintaining public registers, etc.;

(4)MiCA will require crypto asset service providers to be aware of the names of the sender and recipient of crypto asset transactions in any amount of money transferred from January 2026.

2.2.3 Hong Kong, China

Discussion paper on crypto assets and stablecoins: The Bill was introduced on January 12, 2022. The Hong Kong Monetary Authority (HKMA) has published a discussion paper on crypto assets and stablecoins, inviting stakeholders to provide feedback. The discussion paper Outlines the HKMA's thinking on prioritizing the development of a regulatory framework for payment-related stablecoins, arguing that such stablecoins may have the potential to evolve into a widely accepted payment method while also providing institutional flexibility.

Conclusion of Discussion Paper on crypto assets and stablecoins: The Bill was introduced on January 31, 2023. The HKMA has published a consultation summary of the Crypto Assets and stablecoins Discussion paper, summarizing the views previously collected and the HKMA's responses to the paper, which includes the following:

The HKIMA proposes to bring a number of stablecoin-related activities under regulation and sets out the intended scope of regulation and key regulatory requirements in the document.

The HKMA will prioritize the regulation of stablecoins that reference fiat currencies and may be used to make payments, known as "payment related stablecoins," and details the regulatory activities, target implementation time, licenses, and regulatory principles.

The HKMA will apply differentiated regulatory requirements to payment-related stablecoin issuers and operators of different types and sizes in accordance with risk-sensitive principles, including reserve management, capital requirements, disclosure audits and redemptions.

The HKMA will maintain communication and coordination with international organizations and other jurisdictions to address possible cross-border risks posed by global stablecoins, and support research and exploration of central bank digital currencies (CBDCS).

2.2.4 Singapore

Payment Services Act: The bill was introduced on 14 January 2019. The Monetary Authority of Singapore (MAS) has enacted the Payment Services Act to regulate payment service providers, including stablecoin issuers and traders, which treats stablecoins as digital payment tokens (DPT). The bill requires agencies to comply with anti-money laundering and anti-terrorist financing obligations, as well as measures to protect consumers from cyber risks.

Proposed Regulatory Approach for Stablecoin-Related Activities: The bill was introduced on October 26, 2022. The MAS has released a consultation paper on the regulatory framework for stablecoins to seek views from the public and the industry. The document sets out regulatory proposals for single currency stablecoins (SCS), including areas such as reserve management, capital requirements, information disclosure, audits and redemptions.

Response to Public Consultation on Proposed Regulatory Approach on Stablecoims-related Activities: The Bill was introduced on August 15, 2023. MAS has released the conclusions of its consultation paper on the regulatory framework for stablecoins, summarizing the feedback received and identifying the final regulatory framework. The framework, which will apply to SCS pegged to the Singapore dollar or any G10 currency, requires issuers to obtain a major payment institution license and meet a series of rules to ensure the value stability of stablecoins.

The first part of the document sets out the background and purpose of the document, reviews the content and scope of the MAS Consultation issued on 26 October 2022, and provides an overview of the feedback received.

The second part of the document details MAS 'response to the issues and recommendations raised in the consultation paper, including amendments and clarifications to the rules and standards on regulatory scope, licensing requirements, reserve management, capital requirements, disclosure, audit and return.

The third part of the document summarises the final regulatory framework identified by MAS, including the implementation of differentiated regulatory requirements for SCS issuers and operators, classifying them according to their business model, size and risk sensitivity, and developing corresponding rules based on risk-sensitivity principles.

The fourth part of the document describes the follow-up measures that MAS will take, including amendments to the Payment Services Act and related regulations, to implement the new regulatory framework. The document emphasizes communication and coordination with international organizations and other jurisdictions to address the challenges that may arise from cross-border stablecoins.

Among them, the United States' draft Stablecoin Payment Bill is expected to become the world's first formal legislation specifically regulating stablecoins. Policy discussions in Hong Kong and Singapore are still some way from forming formal legislation. Looking at the current legislative trend, it can be found that the commonalities of stablecoin regulation are as follows:

Treat stablecoins as special crypto assets and regulate them specifically, rather than being included in existing financial regulatory frameworks;

Require stablecoin issuers and operators to obtain the appropriate license or registration, and accept the supervision and audit of the relevant authorities;

Require stablecoin issuers and operators to maintain reserves equal to the value of stablecoins and to make transparent disclosures about the type, value, and risk of such reserves;

Requiring stablecoin issuers and operators to comply with anti-money laundering and anti-terrorist financing obligations, and designing measures to protect traders and prevent cyber risks;

Restrict or prohibit stablecoins denominated in non-domestic currencies to maintain the sovereignty and stability of domestic currencies;

Maintain communication and coordination with international organizations and other jurisdictions to deal with cross-border stablecoins.

3. Stablecoin regulation: Policy Outlook

3.1 Stablecoins and fiat currencies: Entanglements and the future

In the cryptocurrency exchange market, the main role of stablecoins is to "act" as fiat currency, as a measure of value for other asset transactions. This is because the exchange between fiat and cryptocurrencies usually needs to go through a centralized exchange or other first-party institution, which increases the time, cost and risk of the transaction. Stablecoins can conduct decentralized transactions directly on the blockchain, improving transaction efficiency and security.

Stablecoins depend on fiat currencies, but fiat currencies are also influenced by stablecoins. On the one hand, fiat collection-type stablecoins rely on fiat currency as the anchor object to maintain the stability of its value, and are also affected by the regulatory policy of fiat currency. For example, according to the U.S. Stablecoin Draft, fiat collection-type stablecoins require a centralized issuer and custodian to hold fiat assets and provide a reserve proof mechanism to prove that they have sufficient collateral assets. However, on the other hand, stablecoins also have the potential to challenge the status of fiat currencies because of their higher transaction efficiency, anonymity and transparency, which may attract more users and capital inflows. If a stablecoin (such as USDT) is widely accepted, it could play a similar role to M0 or M1 in the national monetary system, thereby affecting the money supply. At this time, the money supply is no longer completely determined by the central bank, but is jointly determined by the central bank and the stablecoin issuer, which is equivalent to the loss of a part of the country's coinage rights.

Because of this, countries are often cautious about the regulation of stablecoins, especially the ultra-sovereign currencies linked to fiat currencies. Looking at the existing policy direction, the supervision of legal currency collateral stablecoins should be more and more stringent.

3.2 DeFi and stablecoins: Twin flowers

Stablecoins are the underlying asset and medium of exchange for DeFi and can promote DeFi's development and innovation.

Stablecoins are critical to DeFi. Stablecoins maintain an anchor price in the highly volatile virtual currency space, thus separating the risk/return calculation of DeFi services from the high volatility of digital assets. For DeFi services, financial transactions require stable prices for value exchange. Its investors also need stable units of account. Stablecoins play a variety of roles in DeFi, such as:

Stablecoins can be used as borrowings or collateral in the lending market, providing low-cost, efficient and risk-free lending services. For example, MakerDAO is an Ethereum-based decentralized lending platform that allows users to generate DAI (decentralized stablecoins anchored to the US dollar) by over-pledging crypto assets such as ETH. Users can use DAI to trade or invest, or redeem collateral at any time.

Stablecoins can be used as trading pairs or liquidity providers in the trading market, providing trading services with low slip points, high liquidity, and no market maker risk. Uniswap, for example, is an Ethereum-based decentralized trading protocol where users can deposit tokens into a liquidity pool to earn transaction fees. Stablecoins make up a large percentage of the liquidity pool in Uniswap because they can reduce impermanent losses and improve trading efficiency.

Stablecoins can be used as payment or insurance funds in the insurance market, providing insurance services with low threshold, high coverage and no trust risk. Nexus Mutual, for example, is an Ethereum-based decentralized insurance platform where users purchase or provide insurance against smart contract failures based on a risk sharing pool (RSP) mechanism to earn interest and rewards, or assume liability for insurance claims. In Nexus Mutual, stablecoins are the only assets that can be used to purchase or provide insurance.

       To sum up, stablecoins and DeFi promote and rely on each other. Stablecoins provide a stable value basis and transaction medium for DeFi, and DeFi provides a broad application scenario and innovation space for stablecoins.