What is the key to the success of a stablecoin?

Author: Liu Xiaochun

On May 21, the Legislative Council of the Hong Kong Special Administrative Region of China passed the "Stablecoin Bill" (hereinafter referred to as the "Draft"). On May 20, US time, the US Senate passed the "Stablecoin Unified Standard Guarantee Act" (hereinafter referred to as the "Act"). For a time, the currency circle was in full swing, and various comments were rampant, but most of them did not conduct specific research on the two legal documents. Some people also confuse the concepts of stablecoins, cryptocurrencies and crypto assets for various purposes, which has a certain misleading effect on people's understanding of stablecoins.

It is necessary to make a brief and specific analysis of the two legal documents and analyze the demands of each relevant party on this basis. As a new type of financial product, stablecoins must have their functions and functions, but the parties involved in innovation must also have their economic interests. Whether they can meet the demands of all parties is the key to whether the financial product will ultimately succeed. Different stablecoin issuance methods and regulatory methods will also have different impacts on the future development of stablecoins, monetary circulation and monetary policy.

The regulatory framework of the United States and Hong Kong is different

The "draft" clearly defines stablecoins, with a total of five items. The first article is relatively simple, which is the display form of stablecoins: "expressed in the form of valuation units or storage of economic value." For example, the Hong Kong dollar stablecoin must be clearly defined as the stablecoin of the Hong Kong dollar and its face value. Article 2 clearly defines the scope of application of stablecoins: payment for goods or services; repayment of debts; investment and trading. That is to say, the Hong Kong dollar stablecoin is a means of payment, not an asset that is invested or hyped. The "buying and selling" here should be considered that as an open economy, Hong Kong, China, will exchange local currency and foreign currency during currency circulation, and Hong Kong dollar stablecoins can also be traded and exchanged with foreign currency during circulation. Article 3 clarifies the storage and transfer methods of stablecoins: they can be electronically. Article 4 further clarifies that it is to operate on "distributed ledgers or similar information repositories". These two items can be said to limit the application field of stablecoins, that is, stablecoins can only be digital and can only be operated and circulated online. Article 5 clarifies the value basis of stablecoin anchoring: a single asset; a group or a basket of assets. As for the Hong Kong stablecoin in China, 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 stablecoin supervision and other aspects. First of all, the main body of the stablecoin issuance must be a "company", that is, a for-profit commercial institution. This time, Hong Kong, China specifically stipulates that recognized institutions outside Hong Kong can also issue stablecoins pegged to the Hong Kong dollar, but must be regulated by the Hong Kong Monetary Authority of China.

The second is capital requirement, with a minimum of HK$25 million or other approved equivalent amounts of currencies. 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 reserve assets must always be greater than or equal to the face value of the unredeemed stablecoin; (2) The reserve assets must be isolated from other funds of the company. That is, reserve assets are used exclusively for special funds, and can only be used as the redemption funds of stablecoins and cannot be used for other business activities of the company; (3) Reserve assets must be high-quality, highly liquid, and low-risk assets; (4) Reserve assets must be risk management and asset audits regularly; (5) Details of reserve assets must be disclosed to the public, and the granularity of disclosure must meet the audit requirements.

The fourth is risk management requirements. (1) The issuer of stablecoin must meet the holder's redemption requirements in a timely manner and shall not attach excessively strict conditions, but may charge reasonable fees; (2) The issuer must establish a KYC (understanding customers) and AML (anti-money laundering) system that meets the requirements of the Hong Kong SAR government of China; (3) Establish information security management, anti-fraud and other regulatory requirements that meet the requirements of the Hong Kong SAR government of China; (4) Establish a reasonable user complaint and reporting channels and feedback mechanisms. All these regulations show that even if the Hong Kong dollar stablecoin uses distributed accounts, peer-to-peer cross-border payments on the blockchain cannot evade supervision.

Fifth, the requirements for positions such as CEO, director, stablecoin manager, etc. that apply for the issuance of stablecoins are the same as the CSRC's requirements for senior executives of the exchange.

Sixth, stablecoin issuers must publish a white paper to provide the public with comprehensive information on stablecoins. Finally, there are other conditions. (1) The licensee shall not pay or be allowed to pay interest in stablecoins. This is to prevent stablecoins from becoming deposits or invested assets in disguise, and to prevent licensees from deviating from the business track of stablecoins as payment tools; (2) Licensees can only operate stablecoin business and must not conduct other businesses beyond the license. This article further limits the business scope of stablecoin issuers (licensors), that is, they can only issue and redeem Hong Kong dollar stablecoins, and ensure smooth, safe and compliant stablecoin payment circulation.

In short, Hong Kong, China, hopes to provide an innovative payment tool for new economic fields such as WEB3 (protocolization of Internet functions), crypto asset transactions, etc., without causing risk impact on the existing system. This is a new type of payment tool, not an invested asset; it is a regulated payment tool. Although it emphasizes information security, it does not allow evasion of supervision.

The regulatory logic of the US "Bill" and the "Draft" in Hong Kong, China is generally not much different, but it has its own characteristics.

The "Bill" is similar to the "Draft": First, it is also an asset anchored to the fiat currency (USD) for payment and settlement. Second, stablecoins must be 100% backed by US dollars or high-quality assets such as U.S. Treasury bonds. Third, the issuer must disclose the reserve asset report every month and be audited by a third party. Fourth, it must meet the requirements of anti-money laundering and anti-terrorism financing. Issuing institutions are included in the regulatory scope of the Bank Confidentiality Law and must fulfill KYC and report suspicious transactions. Fifth, it is prohibited to pay interest or income on stablecoins. Sixth, the "Bill" gives the Finance Minister and the newly established "Stable Coin Certification Review Committee" regulatory power to strengthen supervision of foreign stablecoin issuers.

The difference between the "Bill" and the "Draft" is mainly the regulatory framework. Hong Kong, China, is a first-level regulation, while the US regulatory framework is divided into two levels: stablecoins with a market value of more than US$10 billion need to be subject to federal supervision; 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, such as the United States is relatively clear about the types of stablecoin reserve assets, while Hong Kong, China, only puts forward requirements on the nature of reserve assets, leaving a certain room for exploration.

Both Hong Kong and the United States have legalized their local currency stablecoins and included them in the scope of regulation, and while providing new settlement tools for emerging economies, they will prevent such innovative settlement tools from having negative impacts on sovereign currencies and financial markets. The key is to clarify the nature of stablecoins, that is, fiat currency stablecoins are payment and settlement tools, and are strictly distinguished from securities tokens, strengthen reserve assets supervision and information disclosure, and strengthen anti-money laundering and anti-terrorism financing requirements.

Stablecoins are similar to bank promissory notes

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

Three Hong Kong banknote issuing Hong Kong dollars must deposit equal amounts of US dollars into the Monetary Authority and obtain a certificate of deposit from the Monetary Authority before issuing Hong Kong dollars. That is, the issuing bank must have 100% US dollars in reserves to ensure that it can meet the requirements of Hong Kong dollar holders to repay equal US dollars at any time.

The basic rules of bank promissory notes are as follows: Customers exchange bank for the same amount of promissory notes in equal amount of money. The holder can use the promissory notes to pay the payment or services, repay the debt, and exchange cash with other banks. When the holder finally requests redemption from the issuing bank, the bank will pay the same amount of currency as the face amount of the promissory notes when he sees the bill. In fact, this is how the original banknotes were generated, and the banknotes of the banknotes were also the same rule. It can be said that fiat currency stablecoins are currency-like under the conditions of fiat currency.

The generation of promissory notes is one reason for the generation of paper money and banknotes, that is, physical cash is heavy and unsafe for long-distance carrying. Now that electronic payments are popular, the use environment for bank promissory notes is basically no longer there, so promissory notes are hard to find. The emergence of paper money, promissory notes, and banknotes, and the invention and popularization of paper are prerequisites, but the inconvenience and insecurity of physical currency long-distance carrying is a fundamental need. Crypto code technology is a technical prerequisite for stablecoins, crypto assets, etc. So, as a payment tool and currency, what are the specific application requirements of stablecoins?

Many years ago, JPMorgan Chase issued Morgan coins, and the issuance rules are the same as stablecoins and bank promissory notes. JPMorgan Chase, as the most important dollar clearing bank, intends to consolidate its leading position in cross-border dollar clearing. However, no applicable scenarios have been found in interbank cross-border clearing for many years. In recent years, JPMorgan Chase has begun to cooperate with other institutions to explore the application of some alternative scenarios, and it seems to have made progress. However, it remains to be seen whether commercial applications can be achieved in the end.

In addition, the Western Union model is similar to the promissory notes. The customer handes the currency to any Western Union outlet, and the outlet gives the customer a remittance voucher. The customer can hold the certificate himself or transfer it to others. The certificate holder can obtain the remittance by presenting the certificate to any Western Union outlet in the world. A stablecoin is a voucher that can be redeemed for the same amount of legal currency.

The above are all payment tools in history. As a payment tool, it has its common characteristics. On the one hand, the reasons and processes of payment tools are similar, and they all need to have clear value standards and stable value. Whether it is face-to-face payment, cross-space payment, instant payment or forward payment, they must be safe, convenient and fast; on the other hand, issuers have the urge to over-issuance, which is prone to accumulating the situation and risk of being fake or being fake. These risks are not imagined, nor are they only found 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 realistic and has happened. In May 2022, the US dollar-pegged stablecoin TerraUSD collapsed due to a serious run, which sounded the alarm for regulation. Therefore, the bills in Hong Kong and the United States have put forward strict and clear requirements on the quantity, quality and management of stablecoins reserve assets.

The demands of stablecoin parties

Everything in human society is born because of demand, and behind the demand is the interest demands of all relevant parties. Only when different demands of different relevant people are met can a payment tool be truly accepted. On the surface, payment tools only have both the receipt and payment parties of the transaction. As long as they meet the exchange needs, they can function to achieve convenient, safe, fast and accurate value transfer. However, behind the smooth operation of payment tools is a complete set of issuance, management and operation systems, which themselves require huge cost investment. If you have investment, you will inevitably have the desire to get rewards. Therefore, stablecoin issuers or stablecoin issuers are more important relevant parties.

The parties involved in stablecoins are first and foremost the payer. First of all, for the payer, in a specific field or scenario, paying with stablecoins is faster and safer than paying with legal currency, otherwise he does not have to spend much effort to convert the legal currency at hand into stablecoins. Secondly, the conversion of fiat currency to stablecoins should be 1:1, without financial costs. Finally, the cost of paying with stablecoins should generally be lower than the cost of paying with fiat currency, and at least the profit of achieving transactions with stablecoins should be higher than or equal to the profit of paying with fiat currency.

For payees, first of all, accepting stablecoins is easier to make transactions than accepting fiat currency. Secondly, the stablecoins collected must be exchanged 1:1 into legal currency, that is, there is no value loss. Finally, stablecoins can be used in other payment scenarios that they need.

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

Stablecoin issuers invest huge costs in the issuance, management and operation of stablecoins, and there is no need to invest without desirable returns. For issuers, the most direct and rough income is to issue stablecoins or even currencies without reserves, and the following is to issue stablecoins with super reserves and high leverage. This kind of phenomenon has always existed in the history of currency and payment, and has triggered large or small crisis events.

The second is the stablecoin exchange fee, including the handling fee charged for the redeemable stablecoins issued by oneself, and also the handling fee charged for the exchange of other stablecoins. This is a very conventional handling fee under the conditions of metal currencies, paper bank bills, and paper bank promissory notes. Because different metal currencies have different colors and values, the final holder of the bill has a certain physical distance from the issuer, and a certain fee is required in the process of ultimately cashing the value to the issuer, and there is even a risk that it cannot be cashed. However, under online conditions such as blockchain, whether stablecoin holders are willing to pay this fee remains to be played by the market. Hong Kong's "draft" takes this into account and allows reasonable fees to be charged during the redemption process.

The third possible source of income is to use the funds obtained from issuing stablecoins to make various investments to obtain profits. There are countless bloody lessons in history. The minor ones are caused by the large scale of investment and the long term affecting the liquidity of stablecoin redemption, while the major ones are unable to repay stablecoin due to the failure of investment.

Therefore, the bills in Hong Kong and the United States strictly stipulate the types of reserve assets and require stablecoin business and reserve assets to be strictly isolated from the issuer's other businesses and assets. This is actually a limitation on issuer's investment. Under such constraints, the issuer's main income may be investment in high-qualified and high-liquid assets such as treasury bonds. Since the yield on this type of asset is relatively low, issuers will inevitably pursue economies of scale. However, although treasury bonds and other government bonds are liquid, they are not the legal currency themselves after all. Too much investment will also affect the liquidity of stablecoin redemption.

In addition, fluctuations in market interest rates will not only affect the returns of reserve assets, but also affect the operating safety of the issuer. The subsequent decisions will also depend on the regulatory requirements on the structure of stablecoin reserve assets and the ratio of stablecoin issuance scale to capital.

Unlike physical payment tools such as paper, cryptocurrencies such as stablecoins require a series of technologies 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 support are also stakeholders of stablecoins. These technical support institutions and stablecoin issuing institutions may be the same institution or different institutions, and they also need to get a share of the stablecoin issuance and operation.

In addition, governments and regulatory agencies are also stakeholders of stablecoins, and 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 are the fundamental factors for the success of stablecoins, and the advantages provided by technology in the payment process are second. The result of the game between all parties may be that different stablecoins have been widely used, or that different stablecoins are used in their respective limited fields and become professional stablecoins, and may also be replaced by central bank digital currencies. Unless the existing country forms change, stablecoins will never be able to replace legal currency in full and can only be an auxiliary payment tool for legal currency. At present, stablecoins, as payment tools, mainly play a role in some specific digital economy fields, but their application scope is constantly expanding. On the one hand, the digital economy is the future development direction, and on the other hand, the scale of stablecoins application has become so large that it affects the stability of the financial system. Therefore, from the perspective of inclusive innovation or from the perspective of maintaining financial stability, it has reached a stage where standardized management is needed.

Stablecoins affect monetary policy

As a payment tool, a stablecoin pegged to fiat currency is a type of currency, which is essentially a currency in circulation. If the issuer uses all the fiat currency obtained from issuing stablecoins to issue loans, it is equivalent to investing an equal amount of currency into the market. If the regulations required by Hong Kong and the United States of China, some of which can purchase high-qualified assets such as treasury bonds, it is equivalent to increasing the amount of money added to the market. If all the legal currency obtained is used as reserve assets, no investment will be made, no additional currency issuance will be added.

If all stablecoin reserve assets must be custodianed by a third party, it depends on the regulatory requirements for third-party custodian institutions. If the custodian is required to ensure that reserve assets can be redeemed at any time, there will be no additional monetary infusion, otherwise monetary infusion will also be increased. Therefore, stablecoin reserve currency investment in assets such as treasury bonds will also have a considerable impact on markets such as treasury bonds. An effective payment tool will bring vitality to economic operation and have a huge impact on the money supply and market interest rates. Therefore, the issuance scale and regulatory model of stablecoins must become considerations for formulating monetary policies.

Stablecoins are based on distributed ledger systems and are a disintermediated payment method, which may have completely different circulation rules from cash in traditional circulation. In today's electronic, networked and digital bank account system, cash in circulation is more of personal offline payment, with a small amount of single transactions, low frequency, and scattered scope of use. Stablecoins are mainly used in virtual economy fields such as WEB3 and DiFi (decentralized finance). Institutions and retail investors coexist, with a large amount of single transactions and a high transaction frequency. Although they are distributed and can be paid to point-to-point, in addition to payments for value transfer, most of them are exchange transactions or platform transactions of virtual assets and crypto assets. As a stablecoin issuing agency, the legal obligations such as anti-money laundering, anti-terrorism financing and KYC are only implemented in the issuance of stablecoins and the repayment of stablecoins. It remains to be seen whether the transaction behavior of stablecoin holders must be implemented. At present, there is no clear explanation for the bills in Hong Kong and the United States.

Cross-border payment is a hot spot and selling point in the current exploration of stablecoins. The direct payment between the receiving and paying parties is of course more direct and efficient than remittance through banks and other intermediaries. However, payment is only a link in the operation of market entities. In the end, in order to obtain the income denominated in legal currency and reflected in legal currency. Therefore, stablecoins must eventually be cashed in ashore as legal currency and recorded in bank accounts to obtain interest income. In addition, the exchange of different currencies in cross-border payments cannot be solved by stablecoins, and ultimately it must be achieved through the bank clearing system. It can be seen that the true success of stablecoins is not to break away from the banking system, but must be efficient and seamlessly connected with the banking system. What's more, stablecoin issuing institutions issue stablecoins and accept legal currency; issuers invest in bonds and other reserve assets in legal currency; issuers use legal currency to repay stablecoins through bank accounts. This is also an issue that needs to be paid attention to in the management of currency circulation and the regulation of stablecoin. Currently, there is no clear arrangement in the "Bills" of China, Hong Kong and the United States.

There has been a historical phenomenon that banks can issue currencies. In the 1840s and 1850s, more than 8,370 currencies were circulated in the market at the same time, and their inefficiency and chaos were conceivable. If each stablecoin issuing and applying stablecoins in a limited specific field, and each stablecoin is slightly cross-applied in the market, there will be no problem with multiple institutions issuing stablecoins. But if all stablecoins are circulated in the entire market, it will inevitably bring about some chaos and inefficiency. If such a phenomenon really occurs, both the market and the supervision will choose to be moderately concentrated. Therefore, the development model and scale of stablecoins after legalization still need to be tested by market and supervision.

Seven suggestions for China

First, adhere to the principle of technology neutrality and encourage the innovative application of various technologies in the financial field. Blockchain and encryption technology have already had some successful applications in the financial field, such as green bonds issued in Hong Kong, China. In the fields of virtual asset trading, DiFi, etc., 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 the payment and settlement function and is completely possible to play a role in the field of legal transactions.

Secondly, stablecoins are the product of real demand. Judging from the existing applications of stablecoins, demand comes from category II. First, in emerging economic fields, 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; second, some gray and illegal transactions, such as illegal asset transfers, use stablecoins and other cryptocurrencies for the purpose of evading supervision. Emerging areas may also include legal transactions versus gray or illegal transactions. As long as illegal transactions can be effectively identified, corresponding regulatory methods can be found.

Third, legislation for stablecoins is a need for innovation and financial security. The "Bills" in Hong Kong and the United States are a follow-up to innovation and a prevention of innovation risks. The innovation of stablecoins as payment tools is to promote the development of emerging economic forms such as virtual asset trading. Issuing stablecoins itself is not the purpose. At the same time, it is also because we see the two sides of payment tools, and legislation and regulation are to prevent risks. It is particularly worth noting in this regard that both Hong Kong and the United States have included stablecoins pegged to their local currencies overseas in the scope of supervision. The reason is that if stablecoins pegged to the local currency are not effectively regulated, they 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 China's financial system will inevitably face the risk impact it may bring, and it is very necessary to formulate laws and regulations to prevent it. As an equivalent, stablecoins are not divided into offshore and onshore, but from a regulatory perspective, the scope of use of different issuers or different stablecoins can be limited.

Fourth, there are no substantial regulatory obstacles to issuing RMB stablecoins. Stripping off the technical cloak, the rules of stablecoins are the same as those of bank promissory notes. Paper cash can be digitized, paper bills can be electronicized, and paper bank bills are also bills, and of course they can also be on-chain. Two solutions can be considered: one is to include the RMB stablecoin in the current bank bill management system; the other is to consider the specificity of the current stablecoin application field, refer to Hong Kong and the United States, and formulate separate regulations for stablecoins. To be cautious, the scope of application of stablecoins can be limited in the early stage. Considering that the issuing institutions have the urge to over-issuance, and also considering the impact of the excessive scale of stablecoin issuance on currency issuance and market interest rates, the issuance of stablecoin should be included in the scope of institutional capital adequacy supervision.

Fifth, the issuance of RMB stablecoins can develop more adaptable application scenarios for the digital RMB. Technically, stablecoins are the same as central bank digital currencies. Why are there still stablecoins? Some of this is to evade supervision, but more importantly, the mechanisms are different and the motivation for exploring and innovating application scenarios is different. The central bank's digital currency is issued by the central bank and leads the expansion of application scenarios, while the central bank's exploration of application scenarios is limited. Stable coins are issued by commercial institutions. There are commercial interests in issuing stable coins, and they also do their best to explore application scenarios. At the same time, due to the high adaptation of application scenarios and stablecoin characteristics, on the one hand, the transaction frequency of application scenarios will be increased, and on the other hand, the system maintenance is relatively easy and the cost is low. The central bank's digital currency is trying to connect all possible application scenarios, some of which are trading at a low frequency. From a technical and principle perspective, the scenario where stablecoins can be successfully applied is also expected to become a scenario for central bank digital currency. Therefore, the issuance of RMB stablecoins actually helps the promotion and application of digital RMB.

Sixth, innovate and build a RMB stablecoin payment system that is seamlessly connected with the bank account system. In innovation, the technology community often view the speed of payment links in isolation, and ignores the connection between the economic operation behind payment, which has caused the isolation between the virtual world and the real world. The emergence of stablecoins itself is to build a bridge between the virtual world and the real world. The purpose of issuing stablecoins is to obtain returns from the fiat currency form. If the RMB stablecoin can solve the connection with the bank account system in institutional arrangements from the beginning, the RMB stablecoin will not only be more competitive, but also more easily regulated.

Seventh, the competition for international currency is a competition between the country's comprehensive strength and credibility. A certain payment and settlement method or technical application of a currency may facilitate the use of the currency, but 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. However, when the US dollar is still the main international reserve currency and trading currency, it is a normal phenomenon to use US dollar stablecoins for payment and settlement in an international emerging economic field. If China issues RMB stablecoins, its primary purpose should not be to compete with the US dollar stablecoins, but to serve the development of emerging economies and the internationalization of the RMB.