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Maintaining stability in the era of stablecoins


Published: 16 Jan 2024

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Stablecoins emerge as a prospective form of future money, offering a plausible alternative to traditional fiat paper money and commercial bank deposits.

Their appeal lies in their unique feature of referencing a backing asset, such as cash or government debt, tethering the coin's value to high-quality liquid assets . This anchoring effect distinguishes stablecoins from other cryptocurrencies like Bitcoin or Ethereum whose value can fluctuate significantly even through the course of a day, and thereby providing for a more stable means of exchange.

In November, the Bank of England introduced a discussion paper outlining potential regulatory approaches for systemic stablecoins in the UK . This move signals the Bank's comfort with broadening transaction methods and acknowledging the possibility of non-bank entities issuing money that could play a significant role, potentially overshadowing other forms of private and public money. The FCA has in tandem released it’s own discussion paper on non-systemic stablecoins.

The proposals outlined in the discussion paper, especially the constraints are similar to those designed for a digital pound. The proposed regulatory framework targets retail-based payments, with suggested holding limits for coinholders falling within the £5-20k range. Seniorage, the interest earned on balances, is proposed to be prohibited for both coinholders and issuers. It also proposes that there should be restrictions on fees when users look to redeem their coins . By restricting usage, the proposals currently prevent financial stability issues that might arise from significantly larger wholesale transactions. The Bank also favours backing assets solely comprised of central bank reserves.

The constraints built into the proposals raise questions about the feasibility of a business model, as they restrict the firm's revenue-earning capabilities. Unlike commercial banks that offer free transactional banking to consumers using bank deposits for funding and earning interchange fees, stablecoin issuers may struggle to compete with explicit fees if imposed. Restrictions may also limit potential use cases, such as in the settlement and clearing of large trades .

On the flip side, arguments suggest that an unrestricted stablecoin, free from holding limits, backing asset constraints, and interest reward opportunities, could pose significant risks from a financial stability and monetary policy perspective .

Managing such risks , particularly during a period of widespread adoption and transition away from other forms of money, might pose challenges for the Bank. The risks will be in part driven by consumer and merchant demand for stablecoins. The unknown implications further complicate the scenario, making it crucial to carefully navigate the evolving landscape of money alternatives.

The Bank has chosen to keep its options open in defining the conditions under which a stablecoin could attain systemic status. It's conceivable that, in some scenarios, these criteria might be satisfied even prior to the issuance of the first coin. The existing role of the financial institution involved will determine the status, particularly if a high street bank with a significant market share in current accounts and transactional banking decides to issue. In such a case, one could argue that the adoption of their stablecoin offering is more likely to achieve scale and systemic importance .

Bank deposits and stablecoins operate under distinct models, each with unique characteristics. Banks exercise considerable discretion in using funds from deposits, enabling them to engage in activities such as lending. In contrast, stablecoins must be backed by secure assets held in custody, leading to differences in the application of the Financial Services Compensation Scheme (FSCS) between the two.

Depositor insurance is not included in the proposed regime. Nonetheless, with backing assets consisting of reserves at the central bank, specific risks, notably counterparty credit risk associated with bank deposits, are considerably diminished. Despite this reduction, some risks persist, particularly concerning accurate record-keeping and the potential misappropriation or loss of customer funds.

To mitigate against such risks, much like the regulations that govern e-money providers, issuers will be required to comply with a custody and safeguarding regime. The purpose of which will be to ensure there are robust systems and controls and record keeping are in place to ring fence client funds away from issuers and custodians. Third party audit requirements as seen with the CASS regime for custody of client assets will also be mandated.

One unique feature of stablecoins that potentially differs from traditional client money arrangements is the likelihood of having two forms of asset that require safeguarding. The first of which being the backing asset, in the case of systemic stablecoins this consists of central bank reserves. The second being the issued coin that references the backing asset .

Frequency of movement between counterparties will differ greatly between the two assets, with the backing assets ideally only moving in and out of custody as stablecoins are newly minted and then redeemed. It is assumed that once markets reach maturity these activities will reduce significantly as stablecoins are adopted as a means of payment and remain in circulation for longer periods of time. On the other hand, the stablecoins themselves are expected to move frequently between different individuals, businesses and the intermediaries that provide custody for them in the same way as other forms of money circulates through the economy.

An area requiring further clarification is how the two custody activities and the regulatory requirements associated with them interact. This is especially pertinent throughout the lifecycle of a stablecoin, spanning from its initial issuance, circulation as a payment alternative, to its redemption back into fiat.

Prudential requirements for the issuer, while in there early stages, give insight into the Banks main concerns. Capital will need to be held to cover operational risks, potential losses and wind-down costs. While additional liquidity above and beyond the value of issued coins is proposed to accommodate potential spikes in redemptions. While the excess liquidity does not need to be held in central bank reserves it will have to meet a narrow definition of high-quality liquid assets. Which likely means, on demand or short-term commercial bank deposits or short-term government debt.

Business models are likely to vary and we could see variations where the custodian, issuer and wallet provider all sit vertically within a group. Alternatively, each of these functions could be undertaken by separate firms. In order to manage the risks of the latter, the Bank is considering the ability to capture wallet providers within the regime where they reach significant market share. This is to address some of the touch points that give rise to significant risks that exist between the wallet provider and the user. These include money laundering and fraud risks, security of private keys and different custody arrangements.

The Bank has indicated it sees risks with unhosted wallets, where the user takes sole responsibility for their stablecoins. Unhosted wallets might simply consist of software that is designed to hold information about a holders stablecoins. Unhosted wallets may come with fewer or no due diligence at the point of opening a wallet and allow for transactions that do not require a regulated intermediary. Unsurprisingly as a result they pose a significant money laundering and fraud risk. They may also be more vulnerable to cyber breaches.

A hugely challenging and complicated area to get right. The Bank has unsurprisingly taken a cautious approach in it’s first set of proposals. Now it is over to those in the sector to consider the business case for a stablecoin given the guardrails set out.

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