What is the key to the success of stablecoins?

Author: Liu Xiaochun, Vice President of Shanghai New Finance Institute

Source: Caijing

On May 21, the Hong Kong Legislative Council passed the Stablecoin Bill. At about the same time, on May 20, US time, the US Senate passed the Stablecoin Uniform Standards Safeguarding Act (GENIUS).

For a time, the cryptocurrency circle was in an uproar, and various comments were rampant. However, most commentators did not conduct a specific study of the two legal documents. Some people also confused the concepts of stablecoins, cryptocurrencies, and crypto assets for various purposes, which misled people's understanding of stablecoins. Therefore, it is necessary to make a brief and specific analysis of the two legal documents, and on this basis, analyze the demands of all relevant parties.

As a new type of financial product, stablecoins must have their functions and effects, but the relevant parties of the innovation must also have their economic demands. Whether the demands of all parties can be met is the key to the ultimate success of financial products. Different stablecoin issuance and supervision methods will also have different impacts on the future development of stablecoins, currency circulation, and monetary policy.

1. Analysis of the Stablecoin Bill in Hong Kong, China

The “Draft” clearly defines stablecoins, with a total of five articles.

The first one is relatively simple, which is the presentation form of the stablecoin: "expressed in the form of a unit of account or a store of economic value." For example, the Hong Kong dollar stablecoin must clearly state that it is a Hong Kong dollar stablecoin and how much the par value is in Hong Kong dollars.

Article 2 clearly defines the scope of application of stablecoins: payment for goods or services; repayment of debts; investment and trading. In other words, the Hong Kong dollar stablecoin is a means of payment, not an asset to be invested or speculated. The "trading" here should be considered that Hong Kong is an open economy, and the exchange of local currency and foreign currency will occur in the circulation of currency. The Hong Kong dollar stablecoin can also be traded and exchanged with foreign currencies in circulation.

Article 3 clarifies the storage and transfer methods of stablecoins: they can be transferred electronically.

Article 4 further clarifies that it is to be operated on a “distributed ledger or similar information repository.” These two articles can be said to limit the application areas of stablecoins, that is, stablecoins can only be digital and can only be operated and circulated online.

Article 5 clarifies the value basis of the stablecoin: a single asset; a group or basket of assets. As for the Hong Kong stablecoin, the anchored assets are mainly Hong Kong dollars, and the reserve assets must be high-quality, highly liquid, and low-risk assets.

The draft has made some specific provisions on the regulation of stablecoins. First, the issuer of stablecoins must be a "company", that is, a for-profit commercial organization. Hong Kong has specially stipulated that authorized institutions outside Hong Kong can also issue stablecoins pegged to the Hong Kong dollar, but they must be regulated by the Hong Kong Monetary Authority. Secondly, the capital requirement is a minimum of 25 million Hong Kong dollars or other approved currencies of equivalent value, that is, the capital must be sufficient monetary funds.

The third is the requirements for the underlying assets of stablecoins: (1) The market value of the reserve assets must always be greater than or equal to the face value of unredeemed stablecoins; (2) The reserve assets must be isolated from other funds of the company, that is, the reserve assets are earmarked for specific purposes and can only be used as redemption funds for stablecoins and cannot be used for other business activities of the company; (3) The reserve assets must be high-quality, highly liquid, and low-risk assets; (4) The reserve assets must undergo regular risk management and asset audits; and (5) The details of the reserve assets must be disclosed to the public, and the granularity of the disclosure must meet audit requirements.

The fourth is the risk management requirements. (1) Stablecoin issuers must meet the holders’ redemption requirements in a timely manner and may not impose overly strict conditions, but may charge reasonable fees; (2) Issuers must establish KYC and AML systems that meet the requirements of the Hong Kong government; (3) Establish information security management, anti-fraud and other regulatory requirements that meet the requirements of the Hong Kong government; (4) Establish reasonable user complaint reporting channels and violation mechanisms. All these regulations show that even if the Hong Kong dollar stablecoin uses distributed accounts and conducts peer-to-peer cross-border payments on the blockchain, it cannot escape supervision.

Fifth, the requirements for the positions of CEO, director, stablecoin manager, etc. of the subject applying to issue stablecoins are the same as the requirements for senior executives of exchanges required by the CSRC. Sixth, stablecoin issuers must publish a white paper to provide the public with comprehensive information about stablecoins.

Finally, there are other conditions. (1) The licensee shall not pay or allow the payment of interest on stablecoins. This is to prevent stablecoins from becoming deposits or investment assets in disguise, and to prevent the licensee from deviating from the operating track of stablecoins as payment tools; (2) The licensee can only operate stablecoin business and may not conduct other businesses beyond the license. This clause further limits the business scope of the stablecoin issuer (licensee), that is, it can only issue and redeem Hong Kong dollar stablecoins, and ensure the smooth, safe and compliant circulation of stablecoin payments.

In short, Hong Kong hopes to provide an innovative payment tool for new economic sectors such as WEB3 and encrypted asset transactions, while not causing risk impact on the existing system. This is a new payment tool, not an invested asset; it is a regulated payment tool that emphasizes information security but does not allow circumvention of regulation.

2. Analysis of the U.S. Stablecoin Uniform Standards Safeguards Act

The overall regulatory logic of the US "Bill" and the Hong Kong "Draft" is not much different, but each has its own characteristics.

The "Bill" has similar contents to the "Draft": First, it is also an asset anchored to a fiat currency (US dollar) for payment and settlement. Second, stablecoins must be 100% backed by US dollars or high-quality assets (such as US Treasury bonds). Third, the issuer must disclose a monthly report on reserve assets and be audited by a third party. Fourth, it must comply with anti-money laundering and anti-terrorist financing requirements. The issuer is included in the regulatory scope of the Bank Secrecy Act and must fulfill obligations such as KYC and reporting suspicious transactions. Fifth, it is prohibited to pay interest or income on stablecoins. Sixth, the "Bill" gives the Secretary of the Treasury and the newly established "Stablecoin Certification Review Committee" regulatory powers to strengthen supervision of foreign stablecoin issuers.

The main difference between the "bill" and the "draft" is the regulatory framework. Hong Kong is a primary regulator, while the US regulatory framework is divided into two levels: stablecoin issuers with a market value of more than US$10 billion are subject to federal regulation; issuers with a market value of less than US$10 billion can choose state-level regulation, but must meet federal minimum standards.

There are also some differences in details. For example, the United States has relatively clear requirements on the types of stablecoin reserve assets, while Hong Kong only puts forward requirements on the nature of reserve assets, leaving room for exploration.

In general, both Hong Kong and the United States have legalized their own stablecoins and included them in the scope of regulation, providing new settlement tools for emerging economic sectors while preventing such innovative settlement tools from having a negative impact on sovereign currencies and financial markets. The key is to clarify the nature of stablecoins, that is, legal currency stablecoins are payment and settlement tools, which are strictly distinguished from securities tokens, strengthen reserve asset supervision and information disclosure, and strengthen anti-money laundering and anti-terrorist financing requirements.

3. Cashier’s Draft and Stablecoins

Judging from the legal documents on stablecoins in Hong Kong and the United States, the issuance and management rules of stablecoins are basically the same as those of bank drafts, and are also somewhat similar to authorized banknote issuance.

The three note-issuing banks in Hong Kong must deposit an equivalent amount of US dollars into the Hong Kong Monetary Authority and obtain a deposit certificate from the Hong Kong Monetary Authority before they can issue Hong Kong dollars. That is, the note-issuing banks must have 100% US dollars as reserves to ensure that they can meet the requirements of Hong Kong dollar holders to redeem an equivalent amount of US dollars at any time.

The basic rules of bank drafts are as follows: a customer exchanges a bank draft of equal value for a currency of equal value. The holder can use the draft to pay for goods or services, repay debts, or exchange it for cash at other banks. When the holder finally requests payment from the issuing bank, the bank will pay the bank draft in a currency equal to the face value of the draft upon sight.

In fact, the original paper money was produced in this way, and the banknotes of money houses also follow this rule. It can be said that legal currency stablecoins are quasi-currencies under legal currency conditions.

The origin of promissory notes is the same as the origin of paper money and banknotes, that is, physical cash is heavy and unsafe to carry over long distances. Now that electronic payment is popular, the environment for the use of bank promissory notes basically no longer exists, so promissory notes are hard to find.

The invention and popularization of paper is a prerequisite for the creation of banknotes, promissory notes, and banknotes, but the inconvenience and insecurity of carrying physical currency over long distances is a fundamental application demand issue. Encryption code technology is a technical prerequisite for stablecoins and encrypted assets, so what are the specific application requirements of stablecoins as a payment tool and quasi-currency?

Many years ago, JPMorgan Chase Bank issued the Morgan Coin, and the issuance rules are the same as stablecoins and bank drafts. As the most important US dollar clearing bank, JPMorgan Chase Bank intends to consolidate its leading position in cross-border US dollar clearing, but for many years, it has not found an applicable scenario in interbank cross-border clearing. In recent years, JPMorgan Chase Bank has begun to cooperate with other institutions to explore the application of some alternative scenarios, and it seems to have made some progress. However, whether it can eventually achieve commercial application remains to be seen.

In addition, the Western Union remittance model is similar to that of a promissory note. The customer hands over the currency to any Western Union remittance outlet, and the outlet gives the customer a remittance voucher. The customer can keep the voucher for himself or transfer it to someone else. The voucher holder can present the voucher to any Western Union remittance outlet in the world to obtain the remittance. Stablecoin is a voucher that can be redeemed for an equal amount of legal currency.

All of the above are payment tools in history. As payment tools, they have common characteristics. On the one hand, the reasons and processes for the emergence of payment tools are similar. They all need to have a clear value scale and stable value. Whether it is face-to-face payment or cross-space payment, instant payment or forward payment, it must be safe, convenient and fast; on the other hand, the issuer has the urge to over-issue, which is prone to the risk of mixing good and bad, and the risk of passing off fakes as real ones. These risks are not imaginary, nor are they only present under the conditions of traditional paper money.

Unfortunately, technology, including blockchain technology and encryption technology, cannot solve the problems of human greed and capital greed. For the United States, the risk of stablecoin runs is real and has already happened. In May 2022, the dollar-pegged stablecoin TerraUSD suffered a serious run and collapsed, which sounded the alarm for supervision. Therefore, both the Hong Kong and US bills have put forward strict and clear requirements on the quantity, quality and management of stablecoin reserve assets.

4. Demands of various parties involved in stablecoins

Everything in human society is created because of demand, and behind the demand are the interests of all parties involved. Only when the different demands of different stakeholders are met can a payment tool be truly accepted.

On the surface, payment tools only involve the payer and payee of a transaction. As long as they meet the needs of exchange and can achieve convenient, safe, fast and accurate value transfer, they are fine. However, behind the smooth operation of payment tools is a complete set of issuance, management and operation systems, which themselves require huge cost investment. With investment, there must be a demand for returns. Therefore, stablecoin issuers or investors of stablecoin issuing institutions are more important stakeholders.

The first party involved in stablecoins is the payer. First, for the payer, in a specific field or scenario, paying with stablecoins is faster, more convenient and safer than paying with legal tender. Otherwise, he would not have to go to great lengths to convert the legal tender on hand into stablecoins. Secondly, the exchange of legal tender into stablecoins should be 1:1, with no financial cost. Thirdly, the cost of paying with stablecoins should generally be lower than paying with legal tender. At least the benefits of transactions realized with stablecoins should be higher than the benefits of transactions realized with legal tender.

For recipients of stablecoins, firstly, it is easier to complete transactions by accepting stablecoins than legal tender. Secondly, the stablecoins received must be exchangeable for legal tender at a 1:1 ratio, that is, there must be no loss of value. Thirdly, stablecoins can be used for other payment scenarios as needed.

The transactions mentioned above that are easier to complete with stablecoins than with legal tender, or specific transaction scenarios, may fall into two categories: one is the digital economy supported by emerging digital technologies. Due to technical reasons, legal tender is currently difficult to support payments in this field, or even if it can be paid, the efficiency and cost are not economical; the other is transactions that are currently prohibited or restricted by law. Therefore, the bills of Hong Kong and the United States have regulatory requirements such as anti-money laundering and anti-terrorist financing.

Stablecoin issuers invest huge costs in the issuance, management and operation of stablecoins. There is no need to invest without satisfactory returns. For issuers, the most direct and crudest return is to directly issue stablecoins or even currencies without reserves, and the next best is to issue stablecoins with excess reserves. This kind of phenomenon has always existed in the history of currency and payment, and has caused crises of varying sizes.

The second is the stablecoin exchange fee, including the fee charged for the redemption of the stablecoin issued by itself, and the fee charged for the exchange of other stablecoins. This is a very common fee under the conditions of metal currency, paper currency, and paper bank notes, because different metal currencies have different fineness and value, and the final holder of the bill has a certain physical distance from the issuer. It costs a certain amount of money to finally redeem the value to the issuer, and there is even a risk of non-redeemability.

However, under online conditions such as blockchain, whether stablecoin holders are willing to pay exchange fees remains to be determined by the market. Hong Kong's "Draft" takes this issue into consideration and allows reasonable fees to be charged during the redemption process.

The third possible source of income is to use the funds from issuing stablecoins to make various investments to obtain returns. There are countless bloody lessons in history in this regard. The lighter ones are caused by the liquidity of stablecoin redemption due to the large scale of investment and the long term, and the heavier ones are caused by the inability to redeem stablecoins due to investment failure. Therefore, the "acts" of Hong Kong and the United States have strict regulations on the types of reserve assets, and require that stablecoin business and reserve assets be strictly isolated from other businesses and assets of the issuer, which is actually a restriction on the investment of the issuer.

Under such constraints, the issuer's main income may be investment in high-quality, high-liquidity assets such as government bonds. Since the yield of such assets is relatively low, the issuer will inevitably pursue economies of scale. However, although government bonds are liquid, they are not legal tender themselves. Excessive investment will also affect the liquidity of stablecoin redemption. It will depend on the specific regulations of the regulator on the structure of stablecoin reserve assets in the future.

Unlike physical payment tools such as paper, cryptocurrencies such as stablecoins require a series of technical support such as uninterrupted network operation. Although physical payment tools are not efficient, they do not have such conditions. Therefore, technology companies related to these technical supports are also related to stablecoins. These technical support institutions may be the same institution as the stablecoin issuer, or they may be different institutions. They also need to get a share of the stablecoin issuance and operation.

In addition, governments and regulatory agencies are also stakeholders in stablecoins. Their demands are: to promote economic growth, maintain the stability of legal tender, and maintain the security of financial operations.

Whether the demands of the above stakeholders can be met satisfactorily is the fundamental factor for the success of stablecoins. The advantages provided by technology in the payment link are secondary. The result of the game between the parties may be that stablecoins are widely used, or different stablecoins are used in their own limited fields and then become professional stablecoins, or they may be replaced by central bank digital currencies. Unless the existing state form changes, stablecoins will never be able to completely replace legal tender.

At present, stablecoins as payment tools mainly play a role in some specific digital economic fields, but their scope of application is constantly expanding. On the one hand, the digital economy is the future development direction, and on the other hand, the scale of stablecoin applications has been large enough to affect the stability of the financial system. Therefore, whether from the perspective of inclusive innovation or from the perspective of maintaining financial stability, it has reached a stage where standardized management is needed.

5. Stablecoins and Monetary Policy and Currency Circulation Management

As a payment tool, stablecoins pegged to legal tender are a type of quasi-currency, which is essentially a currency in circulation. If the issuer uses all the legal tender obtained from issuing stablecoins for lending, it is equivalent to releasing an equal amount of currency into the market.

If, as required by the laws of Hong Kong and the United States, part of the legal tender obtained from issuing stablecoins can be used to purchase high-quality assets such as government bonds, then it is equivalent to increasing the amount of money released into the market. If all the legal tender obtained is used as reserve assets without any investment, there will be no increase in money supply.

However, if the reserve assets of stablecoins must be held in a third-party custody, then it depends on the regulatory requirements for third-party custodians. If the custodian is required to 100% guarantee that the reserve assets can be redeemed at any time, then the money supply will not increase. Otherwise, the money supply will increase.

An effective payment tool will bring vitality to economic operations and will also have a huge impact on the money supply. Therefore, the issuance scale and regulatory model of stablecoins must be considered in formulating monetary policy.

Stablecoins are based on a distributed ledger system and are a disintermediation payment method. They may have completely different circulation rules from traditional cash in circulation. Today, when the bank account system is electronic, networked, and digital, cash in circulation is more often paid offline by individuals, with small single amounts, low frequency, and scattered usage. Stablecoins are mainly used in virtual economic fields such as WEB3 and DeFi, where institutions and retail investors coexist, with large single amounts and high transaction frequencies. Although they are distributed and can be paid point-to-point, except for payments for the purpose of value transfer, most of them are exchanges or platform transactions of virtual assets and encrypted assets.

As a stablecoin issuer, whether anti-money laundering, anti-terrorist financing, and KYC are only implemented in the issuance and redemption of stablecoins, or whether they must be implemented on the trading behavior of stablecoin holders remains to be seen. At present, neither the Hong Kong nor the US "bill" has a clear explanation.

Cross-border payment is a hot spot and selling point in the current exploration of stablecoins. Direct payment between the payer and the payee is of course more direct and efficient than remittance through intermediaries such as banks. However, payment is only one link in the operation of market entities. The ultimate goal is to obtain income denominated in legal currency and reflected in legal currency. Therefore, stablecoins must eventually be cashed in legal currency and recorded in bank accounts to obtain interest income. In addition, the exchange of different currencies in cross-border payments is not something that can be solved by stablecoins, and it must ultimately be achieved through the bank clearing system.

It can be seen that the real success of stablecoins is not to break away from the banking system, but to connect with the banking system efficiently and seamlessly. Moreover, the stablecoin issuers must issue stablecoins and accept legal tender, the issuers invest in bonds and other reserve assets with legal tender, and the issuers redeem stablecoins with legal tender, etc., all of which must be achieved through bank accounts. This is also an issue that needs to be paid attention to in currency circulation management and stablecoin supervision. At present, there is no clear arrangement in the Hong Kong and US "acts" for this.

In history, any bank could issue currency. In the 1840s and 1950s, more than 8,370 currencies were circulating in the US market at the same time. Its inefficiency and chaos are imaginable. If each stablecoin issuing institution only issues and applies stablecoins in limited specific fields, and the stablecoins in the market have a little cross-application, then there is no problem for multiple institutions to issue stablecoins; but if all stablecoins are circulated in the whole market, it will inevitably bring about certain confusion and inefficiency. If such a phenomenon really occurs, both the market and the regulator will choose moderate concentration. Therefore, the development model and scale of stablecoins after legalization still need to be tested by the market and regulators.

6. Seven suggestions for China

First, we should adhere to the principle of technological neutrality and encourage innovative applications of various technologies in the financial field. Blockchain and encryption technology have already had some successful applications in the financial field, such as the green bonds issued by Hong Kong. In the fields of virtual asset trading and DeFi, various cryptocurrencies have excellent applications in payment and settlement. Although many transactions in these fields are gray transactions or even illegal transactions that are not recognized by existing laws, this does not deny the feasibility of cryptocurrency technology in payment and settlement functions. It is entirely possible for cryptocurrency technology to play a role in the field of legal transactions.

Secondly, stablecoins are the product of real needs. From the existing applications of stablecoins, the demand comes from two categories. One is the emerging economic field, such as virtual asset transactions, on-chain transactions, etc. The current payment and settlement methods of legal currency cannot meet the payment and settlement needs of such transactions; the other is some gray and illegal transactions, such as illegal transfer of assets, etc., using stablecoins and other cryptocurrencies for the purpose of circumventing supervision. Emerging fields may also include legal transactions and gray or illegal transactions. As long as illegal transactions can be effectively identified, corresponding regulatory methods can be found.

Third, legislation for stablecoins is both a need for innovation and a need for financial security. The "bill" in Hong Kong and the United States is a follow-up to innovation and a precaution against innovation risks. Stablecoins, as an innovation in payment tools, are intended to promote the development of emerging economic forms such as virtual asset transactions. The issuance of stablecoins itself is not the purpose. At the same time, since payment tools have two sides, legislative regulation is to prevent risks.

It is particularly noteworthy that both Hong Kong and the United States have included foreign stablecoins pegged to their own currencies in the scope of regulation. The reason is that foreign stablecoins pegged to their own currencies, if not effectively regulated, will also have a risk impact on the local currency system.

With the internationalization of the RMB, as long as there is demand, stablecoins pegged to the RMB will inevitably appear overseas, and the Chinese financial system will inevitably face the risk shocks that may be brought about. It is necessary to formulate regulations to prevent them. As an equivalent, there is no distinction between offshore and onshore stablecoins, but from a regulatory perspective, the scope of use of different issuers or different stablecoins can be limited.

Fourth, there are no substantial regulatory barriers to China's issuance of RMB stablecoins. Stripping off the technical coat, the rules of stablecoins are the same as bank drafts. Paper cash can be digitized, paper bills can be electronicized, and paper bank drafts are also bills, and of course they can also be put on the chain. Two options can be considered: one is to incorporate RMB stablecoins into the current bank bill management system; the other is to consider the current application areas of stablecoins. Considering the certain particularity of Hong Kong and the United States, separate regulations for stablecoins are formulated. For the sake of caution, the scope of application of stablecoins can be limited in the initial stage.

Fifth, the issuance of RMB stablecoins can open up more suitable application scenarios for digital RMB. Technically, stablecoins and central bank digital currencies are the same, so why are there stablecoins? There are many international participants who want to circumvent regulation, but the key is that the mechanisms are different and the motivations for exploring and innovating application scenarios are different.

Central bank digital currency is issued by the central bank and is the driving force behind the expansion of application scenarios. Commercial banks have little motivation to actively expand application scenarios due to the lack of a sustainable commercial return mechanism. Stablecoins are issued by commercial institutions, and there are commercial interests in issuing stablecoins, so they will definitely do their best to expand application scenarios.

At the same time, due to the high degree of adaptability between application scenarios and stablecoin characteristics, on the one hand, the transaction frequency of application scenarios will increase, and on the other hand, system maintenance will be easier and less costly. The scenarios where stablecoins can be successfully applied must also be scenarios where central bank digital currencies are applicable. Therefore, the issuance of RMB stablecoins actually helps the promotion and application of digital RMB.

Sixth, innovatively build a RMB stable currency payment system that is seamlessly connected to the bank account system. In the process of innovation, the technology community often views the speed of the payment link in isolation, ignoring the connection between the economic operation behind the payment, resulting in the isolation of the virtual world and the real world. The emergence of stable currency itself hopes to build a bridge between the virtual world and the real world. The purpose of issuing stable currency is to obtain the benefits of legal currency. If the RMB stable currency can solve the connection with the bank account system in the institutional arrangement from the beginning, the RMB stable currency will not only be more competitive, but also easier to regulate.

Seventh, the competition of international currencies is a competition of national comprehensive strength and credibility. A certain payment settlement method or technical application of a currency may facilitate the use of the currency, but it will not play a decisive role in the competition. Once the credibility of the US dollar collapses, the US dollar stablecoin cannot save the US dollar at all. However, when the US dollar is still the main international reserve currency and transaction currency, it is a normal phenomenon that the US dollar stablecoin is widely used for payment and settlement in an international emerging economy. If China issues a RMB stablecoin, its primary purpose should not be to compete with the US dollar stablecoin, but to serve the development of emerging economies and the internationalization of the RMB.