Getting to grips with stablecoins
Facebook’s plans to issue its own cryptocurrency, Libra, has triggered questions on its potential impact on traditional payment systems, monetary policies and, more broadly, financial stability. This has raised a range of concerns among regulators, who have teamed up in an effort to address potential risks stablecoins might pose, while also defining their future destiny. Deutsche Bank regulatory expert Polina Evstifeeva investigates
On 18 June this year Facebook unveiled a plan to create its own digital currency, Libra, through a non-profit consortium in partnership with the original 28 founding members and with a planned mid-2020 launch date1. With its declared ambition to provide a new global payment method the announcement2 triggered controversial reaction of the industry and “fierce criticism” from regulators around the world, who wasted little time in coming up with specific plans aiming at addressing the perceived risks within the much broader topic of stablecoins3.
What is a stablecoin?
The term “stablecoin” lacks a single agreed definition, but broadly speaking it is a type of crypto asset that uses stabilisation mechanisms, which can minimise price fluctuations. Such mechanisms involve backing the stablecoin with an underlying asset, or a basket of assets. Without stabilisation mechanisms, cryptocurrencies are prone to extremely high volatility, as witnessed with Bitcoin, Ether XRP, Litecoin - just to name a few.
Falling within the “tokenised funds”4 category of stablecoins, the Libra token will be backed by a basket of bank deposits and short-term government bonds in various hard official currencies (Libra Reserve) which, in fact, is only one of several stabilisation mechanisms – although the most commonly used by stablecoin issuers to back its value. Other traditional assets, or a mixture of those and fiat currency, can also be used to stabilise the value of a coin (for example, as with one of the most commonly used stablecoins, Tether5). In some cases it could be other crypto assets; for example as for Dai, which is backed by Ether (a crypto asset on the Ethereum blockchain).
While they constitute much of what makes a stablecoin distinct from other types within the crypto assets family, the stabilisation mechanisms are only one of its features. In fact, there’s a universe of interconnected elements that form stablecoin’s unique footprint. Governance mechanisms; infrastructure and entities enabling the issuance of stablecoins and managing underlying assets; exchanges and wallet providers; these are just a few of the other components of the stablecoin framework.
The promise of stablecoins
At least 54
There’s much speculation as to the role of stablecoins in the finance industry. Some initiatives are global in nature and focus on international remittances. They are supposed to avoid using the channels of financial institutions and also the inconvenience of carrying cash6, and by doing so envision addressing the challenges faced by the traditional payment system (principally slow and expensive cross-border retail payments). Other initiatives aim to allow the exchange of an inherently volatile crypto-asset into less volatile assets without leaving the crypto-ecosystem7.
The potential of a global stablecoins launch has opened the door to discussion around the shortcomings in cross-border payments that certain stablecoins aim to resolve8. This hasn’t gone unnoticed by central banks and financial ministries, which were recommended by the G7 Working Group on Stablecoins “to develop road maps for supporting and scaling up ongoing efforts to improve the efficiency and inclusiveness of payment and financial services”9.
Central bank digital currencies could be one of possible solutions. Already, the European System of Central Banks (ESCB) is analysing the opportunities and challenges associated with making a digital form of the euro available to the general public10, although the approach still varies by country. For instance, the Swedish central bank’s “e-krona” project and recent plans of France to test its central bank digital currency in Q1 202011. And earlier this year, Deutsche Bundesbank president Jens Weidmann noted that the widespread use of digital central bank money could have “severe impacts” and should not be introduced without being “carefully considered”12.
However, the reality is that to date the use of stablecoins remains only limited. Currently, at least 54 stablecoin initiatives are in existence, 24 of which are operational. The market capitalisation of these 24 operational initiatives peaked at €4.3bn in July 2019. This total pales in comparison to other crypto assets, whose market capitalisation was €96bn in January 201913.
There are numerous practical challenges to the greater acceptance of stablecoins. Exposure to price volatility is still one of the limitations they face. According to the ECB14, the average volatility, expressed as the annualised average seven-day standard deviation of daily returns between 27 December 2017 (the earliest date when all three stablecoins considered were traded) and 28 July 2019, are 10% for Tether, 27% for Dai, and 37% for NuBits15.
The associated cyber security risks, with the potential of hacking and theft, is a further challenge. In total, about US$1.7bn worth of cryptocurrency was stolen from exchanges or scammed from investors last year16.
Another challenge which seems to persist as one of the most prominent is regulatory uncertainty. This has left many institutions and corporates adopting a cautious strategy with regards to stablecoins. Without a clear regulatory framework, potential users will struggle with various practical legal issues, such as clarity around legal rights attributable to stablecoin; legal protections that the owner of stablecoins can rely on (disclosures, and other investor protections); and the legal duties of parties involved in dealing with such stablecoin. Each represents a cornerstone for any investment decisions.
As we note in our September 2019 report “Regulation driving banking transformation”17 – recent developments (such as the FCA Guidance on Cryptoassets18, and reports by EBA19 and ESMA20 on crypto assets) form a first step towards developing greater clarity of regulatory treatment of crypto assets in Europe. Yet, the number of stablecoins that would fall within this regulatory perimeter is still relatively low. Their allocation to any existing asset class – and thus the application of a precise regulatory framework – is complicated by the fact that stablecoins may represent a combination of features attributable to various assets, such as deposits, e-money, commodities, collective investment funds and other financial instruments.
When there is global outreach – as with a global stablecoin (GSC) – the situation is further complicated by the fact that the approach of regulators towards stablecoin arrangements can vary greatly by country. From a user perspective the lack of international regulatory alignment means the same stablecoin might be treated differently by the respective regulator in each country, triggering different processes for its use. Not only does that complicate the decision of whether to use it or not, but the lack of international regulatory cohesion is potent of fundamentally undermine the implementation of the concept of universal currency.
"Regulatory and systemic concerns, as well as policy considerations, should be addressed before any such [stablecoin] initiatives are implemented"
Stablecoins – source of systemic risk?
However, these challenges are only the tip of an iceberg that could interrupt a flawless journey of stablecoins. Ambitious plans for becoming a truly global currency also means onboarding the regulators, who need first to be convinced that such an endeavour is not going to undermine the safety of investors, monetary systems and the global economy.
“Regulatory and systemic concerns, as well as policy considerations, should be addressed before any such [stablecoin] initiatives are implemented”: that was the agreement voiced by G7 finance ministers and central bank governors during their meeting in July 201921.
Further to this, there were several noteworthy reports by policymakers (and more to come) defining their position on the perceived risks of stablecoins for financial stability. These analyses have also set out specific plans to deal with such risks at an international level, and outlined new policy solutions as a possible response.
In its note “Regulatory issues of stablecoins”22 issued in October 2019, the FSB concludes that “stablecoin arrangements could potentially become a source of systemic risk”, pointing out that they have the potential to grow quickly as an attractive payment instrument. Stablecoins are predicted to become of systemic importance in individual jurisdictions (including through the substitution of domestic currencies), if they can offer low volatility and great scalability; especially where linked to other digital services offered by BigTech firms. Given the potential of stablecoin for impactful linkages to the financial system, it could have significant financial stability implications in the event something goes wrong.
Elaborating further on this topic, the G7 Working Group of Stablecoins in its report “Investigating the impacts of global stablecoins”23 (October 2019) notes that GSCs pose challenges to cross-jurisdictional efforts to combat money laundering and terrorist financing, and “raise concerns around fair competition and anti-trust policy, including in relation to payments data.”
There’s a separate chapter in the report dedicated to analysis of potential impacts that the GSCs may have on monetary policies of individual countries. And no surprise, GSCs have a potential of being a true game changer posing a fundamental question of central banks’ ability to efficiently manage the monetary policy. The private nature of GSCs could place them outside of control. In particular, the report notes that, if GSCs were widely held as a store of value, the effect of domestic monetary policy may become weaker. GSCs may also affect the amount of domestic currency deposits and thus deposit and loan interest rates, further diluting the effectiveness of the interest rate channel of monetary policy.
The report concludes that these risks, which are of a systemic nature, “merit careful monitoring and further study”.
To take action on it, FSB suggests that not only it would be necessary for policymakers to understand how existing regulations could apply to a stablecoin arrangement, but concluding what are the gaps within existing regulations – which would be the goal before any new policy recommendations are put in place24. As for any global solution, avoiding the dangers of regulatory arbitrage would be crucial, requiring that regulators around the world maintain the high level of coordination.
As a way forward, the FSB will deliver a report, analysing whether existing regulations sufficiently address financial stability and systemic risk concerns arising in relation to stablecoins, with a particular focus on cross-border issues. Available for public consultation in Q2 2020, the report will also advise on possible next steps, including developing regulations to address financial stability, monetary policy and systemic risk concerns at global level25.
Niche or mainstream?
With the unfolding regulatory concerns around potential threats that a launch of GSCs could pose to the financial systems, global policymakers have made it clear that before any such newcomer can be admitted to the payments club there should be in place effective mechanisms ensuring it is as safe as any traditional payment tool.
Although a noble intention, global regulatory alignment is hard to achieve in practice. Even with the same objective in mind, there are inevitably going to be specifics of national rulemaking, driving divergent practices. Whether or not such inconsistencies would be prohibitive for GCSs - would really depend on the final rule of law. As always, the devil is in details.
Regulators’ alertness, potential gaps in existing regulatory frameworks and lack of alignment across jurisdictions will therefore remain key challenges for a widespread adoption of stablecoins, at least in a short term. A marked change in regulatory direction would be needed to enable stablecoins becoming a permanent resident in the wallets of billions of users, fuelling global payments and reaping the benefits of new technologies.
1 The non-profit consortium, the Libra Association, originally had 28 backers who said they would join, see https://cnb.cx/2Jx1McK at cnbc
2 See https://bbc.in/3hztEtw at bbc.com
3 See https://bit.ly/3hx6UKs at ecb.europa.eu
4 See endnote 3
5 According to ECB, Tether’s trading volumes hovering around 95% of the overall stablecoin market. See https://bit.ly/3mX51I8 at ecb.europa.eu
6 See endnote 3
7 See endnote 3
8 See https://bit.ly/35FpJXc at bis.org
9 See endnote 8
10 See https://bit.ly/3i8Qs3u at ecb.europa.eu
11 See https://bit.ly/38I5NEX at cointelegraph.com
12 See https://bit.ly/2XDS7V9 at bundesbank.de
13 See endnote 3
14 See endnote 3
15 See endnote 3
16 See https://reut.rs/2KbQIC6 at reuters.com
17 See Regulation driving banking transformation at corporates.db.com
18 See https://bit.ly/35WIOo7 at fca.org.uk
19 See https://bit.ly/3qqoNy1 at eba.europa.eu
20 See https://bit.ly/37ZHJx6 at esma.europa.eu
21 See endnote 10
22 See https://bit.ly/3ie3rAX at fsb.org
23 See endnote 8
24 See https://bit.ly/3bDuRPf at fbs.org
25 See endnote 22
Head of Regulatory Strategy, New Ventures for Deutsche Bank’s Corporate Bank
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