What is the key to the success of stablecoins?

Author: Liu Xiaochun

On May 21, the Legislative Council of the Hong Kong Special Administrative Region of China passed the "Stablecoin Regulation Bill" (hereinafter referred to as the "Bill"). On May 20, U.S. time, the U.S. Senate passed the "Stablecoin Uniform Standards Protection Act" (hereinafter referred to as the "Act"). The cryptocurrency community was abuzz, with various comments emerging, but most did not conduct a specific study of the two legal documents. Some people, for various purposes, confused concepts such as stablecoins, cryptocurrencies, and crypto assets, which misled people's understanding of stablecoins to some extent. It is necessary to provide a brief and specific analysis of the two legal documents and, based on this, analyze the demands of the relevant parties. As a new type of financial product, stablecoins must have their functions and roles, but the relevant parties involved in innovation must also have their economic interests. Whether these demands can be met is key to the ultimate success of the financial product. Different issuance and regulatory methods for stablecoins will also have different impacts on the future development of stablecoins, currency circulation, and monetary policy.

Different Regulatory Frameworks in the U.S. and Hong Kong

The "Bill" provides a clear definition of stablecoins, consisting of five points. The first point is relatively simple, which is the presentation form of stablecoins: "expressed in the form of a unit of account or a store of economic value." For example, a Hong Kong dollar stablecoin must clearly state that it is a stablecoin pegged to the Hong Kong dollar and specify its face value in Hong Kong dollars. The second point explicitly limits the scope of stablecoins: for payment for goods or services; to settle debts; for investment and trading. This means that the Hong Kong dollar stablecoin is a means of payment, not an asset for investment or speculation. The term "trading" here should consider that Hong Kong, as an open economy, will involve exchanges between local and foreign currencies in currency circulation, and the Hong Kong dollar stablecoin can also be traded and exchanged with foreign currencies in circulation. The third point clarifies the storage and transfer methods of stablecoins: they can be done electronically. The fourth point further clarifies that operations are conducted on "distributed ledgers or similar information storage repositories." These two points can be said to limit the application field of stablecoins, meaning that stablecoins can only be digital and can only operate and circulate online. The fifth point clarifies the value basis to which stablecoins are pegged: a single asset; a group or basket of assets. In the case of Hong Kong stablecoins, the pegged assets are primarily in Hong Kong dollars, and the reserve assets must be high-quality, highly liquid, and low-risk assets.

The "Bill" also makes some specific regulations regarding the supervision of stablecoins. First, the issuer of stablecoins must be a "company," meaning a profit-oriented commercial institution. This time, Hong Kong specifically stipulates that recognized institutions outside of Hong Kong can also issue stablecoins pegged to the Hong Kong dollar, but they must be subject to the supervision of the Hong Kong Monetary Authority.

Secondly, there is a capital requirement, with a minimum of 25 million Hong Kong dollars or an approved equivalent amount in currency. This means that the capital must be sufficient monetary funds.

Thirdly, there are 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 the unredeemed stablecoins; (2) The reserve assets must be isolated from the company's other funds. This means that reserve assets must be used exclusively for the redemption of 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; (5) Details of the reserve assets must be disclosed to the public, with the granularity of disclosure meeting audit requirements.

Fourthly, there are risk management requirements. (1) Stablecoin issuers must promptly meet the redemption requests of holders without imposing excessively strict conditions, but reasonable fees may be charged; (2) Issuers must establish KYC (Know Your Customer) and AML (Anti-Money Laundering) systems that comply with the requirements of the Hong Kong SAR government; (3) Establish information security management, anti-fraud, and other regulatory requirements that comply with the Hong Kong SAR government; (4) Establish reasonable user complaint and reporting channels and feedback mechanisms. All these regulations indicate that even if the Hong Kong dollar stablecoin utilizes distributed accounts and conducts peer-to-peer cross-border payments on the blockchain, it cannot evade regulation.

Fifthly, there are requirements for the positions of the CEO, directors, and stablecoin managers of the entities applying to issue stablecoins, which are the same as the qualifications required by the Securities and Futures Commission for executives of exchanges.

Sixthly, stablecoin issuers must publish a white paper to provide comprehensive information about the stablecoin to the public. Lastly, there are other conditions. (1) Licensees must not pay or allow the payment of interest on stablecoins. This is to prevent stablecoins from becoming disguised deposits or investment assets and to prevent licensees from deviating from the operational track of stablecoins as payment tools; (2) Licensees may only operate stablecoin businesses and must not engage in other businesses beyond their license. This further limits the business scope of stablecoin issuers (licensees), meaning they can only issue and redeem Hong Kong dollar stablecoins and ensure the smooth, safe, and compliant circulation of stablecoin payments.

In summary, Hong Kong aims to provide an innovative payment tool for new economic fields such as WEB3 (protocol-based internet functions) and crypto asset trading, while not causing risk shocks to the existing system. This is a new type of payment tool, not an investment asset; it is a regulated payment tool that, while emphasizing information security, does not allow evasion of regulation.

The U.S. "Act" and Hong Kong's "Bill" have a similar overall regulatory logic but have their own characteristics.

The "Act" has similar content to the "Bill": first, it also involves assets pegged to a fiat currency (the U.S. dollar) for payment and settlement. Secondly, stablecoins must be 100% backed by U.S. dollars or high-quality assets (such as U.S. Treasury bonds). Thirdly, issuers must disclose reserve asset reports monthly, which must be audited by a third party. Fourthly, they must comply with anti-money laundering and anti-terrorist financing requirements, and issuing institutions are subject to the Bank Secrecy Act, requiring them to fulfill KYC and report suspicious transactions. Fifthly, it prohibits paying interest or returns on stablecoin payments. Sixthly, the "Act" grants regulatory authority to the Secretary of the Treasury and the newly established "Stablecoin Certification Review Committee," enhancing oversight of foreign stablecoin issuers.

The main difference between the "Act" and the "Bill" lies in the regulatory framework. Hong Kong has a single-level regulation, while the U.S. regulatory framework is divided into two levels: stablecoin issuers with a market value exceeding $10 billion must accept federal regulation; those with a market value below $10 billion can choose state-level regulation but must meet federal minimum standards.

Additionally, there are some differences in details, such as the U.S. being more specific about the types of reserve assets for stablecoins, while Hong Kong only sets requirements for the nature of reserve assets, leaving some room for exploration.

Both Hong Kong and the U.S. have legalized local currency stablecoins and brought them under regulatory oversight, providing new settlement tools for emerging economic fields while preventing such innovative settlement tools from negatively impacting sovereign currencies and financial markets. The key is to clarify the nature of stablecoins, namely that fiat stablecoins are payment settlement tools, strictly distinguishing them from security tokens, and strengthening the regulation of reserve assets and information disclosure, as well as enhancing anti-money laundering and anti-terrorist financing requirements.

Stablecoins Are Similar to Bank Notes

From the legal documents regarding stablecoins in Hong Kong and the U.S., the rules for the issuance and management of stablecoins are essentially the same as those for bank notes, and they also bear some resemblance to authorized currency issuance.

In Hong Kong, the three note-issuing banks must deposit an equivalent amount of U.S. dollars with the Monetary Authority to obtain a deposit certificate from the Monetary Authority before issuing Hong Kong dollars. This means that the note-issuing banks must have 100% of their U.S. dollar reserves to ensure they can meet the redemption requests of Hong Kong dollar holders for an equivalent amount of U.S. dollars at any time.

The basic rules for bank notes are as follows: customers exchange an equivalent amount of currency for a bank note of the same amount from the bank, and the holder can use that bank note to pay for goods or services, settle debts, or exchange for cash at other banks. When the final holder requests redemption from the issuing bank, the bank pays the equivalent amount of currency upon presentation of the note. In fact, the original paper currency was generated in this way, and the rules for pawnshop notes are similar. It can be said that fiat stablecoins are a type of currency under the condition of fiat currency.

The emergence of bank notes is due to the same reason as the emergence of paper currency and pawnshop notes, namely that carrying physical cash over long distances is heavy and unsafe. Now that electronic payments are widespread, the usage environment for bank notes has largely disappeared, making them difficult to find. The emergence of paper currency, bank notes, and pawnshop notes was predicated on the invention and popularization of paper, but the fundamental demand is that carrying physical currency over long distances is inconvenient and unsafe. The technology of cryptographic codes is the technical premise for stablecoins, crypto assets, etc. So, what are the specific application needs for stablecoins as payment tools or quasi-currencies?

Years ago, JPMorgan Chase issued JPM Coin, with issuance rules similar to those of stablecoins and bank notes. As the most important U.S. dollar clearing bank, JPMorgan Chase intended to consolidate its leading position in cross-border U.S. dollar clearing. However, over the years, it has not found applicable scenarios in interbank cross-border clearing. In recent years, JPMorgan Chase has begun to collaborate with other institutions to explore some alternative application scenarios, seemingly making progress. However, whether commercial applications can ultimately be realized remains to be seen.

In addition, the model of Western Union is also similar to that of bank notes. Customers hand over currency to any Western Union outlet, which provides them with a remittance receipt. Customers can keep that receipt or transfer it to others. The holder of the receipt can present it at any Western Union outlet worldwide to collect the remittance. Stablecoins are essentially a certificate that can be redeemed for an equivalent amount of fiat currency.

All of the above are historical payment tools. As payment tools, they share common characteristics. On one hand, the reasons and processes for the emergence of payment tools are similar; they all require a clear measure of value and stable value, whether for face-to-face payments, cross-space payments, immediate payments, or deferred payments, they must be safe, convenient, and quick. On the other hand, issuers have the impulse to overissue, which can easily lead to risks such as mixed quality and counterfeit. These risks are not imaginary and do not only exist under traditional paper currency conditions. Unfortunately, technology, including blockchain technology and cryptographic technology, cannot solve the problems of human greed and capital greed. For the U.S., the risk of stablecoin runs is real and has already occurred. In May 2022, the U.S. dollar-pegged stablecoin TerraUSD experienced a severe run, leading to its collapse and ringing alarm bells for regulators. Therefore, both the Hong Kong and U.S. bills have imposed strict and clear requirements on the quantity, quality, and management of stablecoin reserve assets.

Demands of Stakeholders Related to Stablecoins

The emergence of any phenomenon in human society is driven by demand, and behind demand are the interests of various stakeholders. Only by meeting the different demands of different stakeholders can a payment tool be truly accepted. On the surface, payment tools only involve the two parties in a transaction; as long as the exchange demand is met, the function can achieve convenient, safe, quick, and accurate value transfer. However, the smooth operation of payment tools relies on a complete set of issuance, management, and operational systems, which require significant cost investment. With investment, there will inevitably be demands for returns. Therefore, stablecoin issuers or investors in stablecoin issuance institutions are the more important stakeholders.

The first stakeholder related to stablecoins is the payer. First, for the payer, using stablecoins for payment in specific fields or scenarios is quicker and safer than using fiat currency; otherwise, they would not go to the trouble of converting their fiat currency into stablecoins. Secondly, the exchange rate from fiat currency to stablecoin should be 1:1, with no financial cost. Lastly, the cost of paying with stablecoins should generally be lower than that of paying with fiat currency; at the very least, the returns from transactions using stablecoins should be higher than or equal to those from transactions using fiat currency.

For the payee, first, accepting stablecoins makes it easier to complete transactions than accepting fiat currency. Secondly, the stablecoins received must be redeemable at a 1:1 ratio for fiat currency, meaning there should be no loss of value. Lastly, stablecoins can be used for other payment scenarios that the payee needs.

The aforementioned ease of completing transactions with stablecoins compared to fiat currency, or specific transaction scenarios, may fall into two categories: one is the emerging digital technology-supported digital economy field, where, due to technical reasons, the current fiat currency payment and settlement methods cannot meet the payment and settlement needs of such transactions; the other is transactions that are currently prohibited or restricted by law. Therefore, both the Hong Kong and U.S. bills include regulatory requirements for anti-money laundering and anti-terrorist financing.

Stablecoin issuers invest significant costs in the issuance, management, and operation of stablecoins; without acceptable returns, there is no incentive to invest. For issuers, the most direct and crude return is to issue stablecoins or even currency without reserves, followed by over-reserving and high-leverage issuance of stablecoins. Such phenomena have always existed in the history of currency and payments, leading to crises of varying magnitudes.

The second potential source of income is the transaction fees for redeeming their issued stablecoins, as well as fees for exchanging other stablecoins. This is a very conventional fee in the context of metallic currency, paper currency, and paper bank notes, as different metallic currencies have different purities and values, and there is a certain physical distance between the final holder of the note and the issuer, necessitating certain costs in the process of redeeming value from the issuer, with even the risk of non-redemption. However, under online conditions such as blockchain, whether stablecoin holders are willing to pay this fee remains to be seen in market dynamics. The Hong Kong "Bill" considers this issue and allows for reasonable fees to be charged during the redemption process.

The third potential source of income is to use the funds obtained from issuing stablecoins for various investments to generate returns. There are countless historical lessons regarding this aspect; minor issues arise from overly large investment scales and long durations affecting the liquidity of stablecoin redemptions, while severe issues arise from investment failures leading to an inability to redeem stablecoins.

Therefore, both the Hong Kong and U.S. bills impose strict regulations on the types of reserve assets and require that stablecoin businesses and reserve assets be strictly isolated from the issuer's other businesses and assets, effectively limiting the issuer's investments. Under such constraints, the issuer's main income may come from investments in high-quality, highly liquid assets such as government bonds. Since the yields on such assets are relatively low, issuers will inevitably pursue economies of scale. However, while government bonds have liquidity, they are ultimately not fiat currency itself, and excessive investment can also affect the liquidity of stablecoin redemptions.

Moreover, fluctuations in market interest rates can affect not only the returns on reserve assets but also the operational safety of issuing institutions. Future regulations will need to clarify specific requirements regarding the structure of reserve assets for stablecoins and the ratio of stablecoin issuance scale to capital.

Unlike physical payment tools such as paper currency, stablecoins and other cryptocurrencies require a series of technical supports, such as uninterrupted network operations. While physical payment tools may not be highly efficient, they do not have such conditional constraints. Therefore, technology companies related to these technical supports are also stakeholders in stablecoins. These technical support institutions may be the same as the stablecoin issuing institutions or different entities, and they also need to share in the benefits of stablecoin issuance and operation.

Additionally, governments and regulatory agencies are also stakeholders in stablecoins, with their demands being to promote economic growth, maintain the stability of fiat currency, and ensure the safety of financial operations.

Whether the demands of these various stakeholders can be satisfactorily met is a fundamental factor in the success of stablecoins, while the advantages provided by technology in the payment process are secondary. The outcome of the competition among various parties may result in different stablecoins being widely used, or different stablecoins being used in their respective limited fields, thus becoming specialized stablecoins, or they may be replaced by central bank digital currencies. Unless the current state of nations changes, stablecoins will never fully replace fiat currency; they can only serve as an auxiliary payment tool for fiat currency. Currently, stablecoins as payment tools mainly play a role in specific digital economy fields, but their application scope is continuously expanding. On one hand, the digital economy is the future direction of development; on the other hand, the scale of stablecoin applications has become large enough to impact the stability of the financial system. Therefore, from both the perspective of inclusive innovation and maintaining financial stability, it is time to regulate and manage stablecoins.

Stablecoins Impact Monetary Policy

As payment tools, stablecoins pegged to fiat currencies are a form of quasi-currency, essentially functioning as circulating currency. If issuers use all the fiat currency obtained from issuing stablecoins to grant loans, it is equivalent to injecting an equal amount of currency into the market. If, according to the requirements of the Hong Kong and U.S. bills, part of it can be used to purchase high-quality assets such as government bonds, then it is equivalent to increasing the amount of currency injected into the market. If the fiat currency obtained is entirely held as reserve assets without any investment, it will not increase the currency supply.

If the reserve assets of stablecoins must be held in third-party custody, it will depend on the regulatory requirements for third-party custodians. For example, if custodians must guarantee that reserve assets can be redeemed at any time, it will not increase the currency supply; otherwise, it will also increase the currency supply. Therefore, the investment of reserve currency in government bonds and other assets by stablecoins, due to the volatility of stablecoin redemptions, will also have a considerable impact on the market for government bonds and other assets. An effective payment tool can invigorate economic operations and significantly impact the money supply and market interest rates. Thus, the scale of stablecoin issuance and regulatory models must be considered in formulating monetary policy.

Stablecoins, based on distributed ledger systems, represent a disintermediated payment method that may have completely different circulation rules compared to traditional cash. In today's electronic, networked, and digital banking account systems, cash circulation is more about personal offline payments, with small transaction amounts, low frequency, and dispersed usage. Stablecoins are mainly applied in virtual economic fields such as WEB3 and DeFi (Decentralized Finance), where both institutions and retail investors coexist, with large transaction amounts and high trading frequencies. Although they can facilitate peer-to-peer payments, most transactions are still exchanges or platform transactions of virtual assets and crypto assets, rather than payments solely for value transfer. As stablecoin issuing institutions, the legal obligations for anti-money laundering, anti-terrorist financing, and KYC must be implemented not only during the issuance and redemption of stablecoins but also in monitoring the transaction behaviors of stablecoin holders, which remains to be observed. Currently, neither the Hong Kong nor the U.S. bills have explicitly stated this.

Cross-border payments are currently a hot topic and selling point in the exploration of stablecoins. Direct payments between payers and payees are certainly more straightforward and efficient than remitting through banks or other intermediaries. However, payment is just one aspect of market operations, ultimately aimed at obtaining returns denominated in fiat currency and reflected in fiat currency. Therefore, stablecoins must ultimately be converted into fiat currency and deposited into bank accounts to earn interest income. Furthermore, the exchange of different currencies in cross-border payments cannot be resolved by stablecoins; it must ultimately be realized through the banking clearing system. Thus, the true success of stablecoins does not lie in detaching from the banking system but rather in achieving efficient and seamless integration with it. Moreover, stablecoin issuing institutions issue stablecoins and accept fiat currency; they invest in bonds and other reserve assets using fiat currency; and they must redeem stablecoins using fiat currency through bank accounts. This is also an issue that monetary circulation management and stablecoin regulation need to pay attention to, and currently, there are no clear arrangements for this in the Hong Kong and U.S. "Acts."

Historically, there have been instances where banks could issue currency. In the 1840s and 1850s, the U.S. had over 8,370 different currencies circulating in the market, and the inefficiency and chaos of this situation are easy to imagine. If each stablecoin issuing institution only issues and applies stablecoins in limited specific fields, and there is some overlap in the application of different stablecoins in the market, then multiple institutions issuing stablecoins is not a problem. However, if all stablecoins circulate throughout the entire market, it will inevitably lead to some chaos and inefficiency. If such a phenomenon occurs, both the market and regulation will choose to concentrate appropriately. Therefore, the development model and scale of stablecoins after legalization still need to be tested by the market and regulation.

Seven Suggestions for China

First, adhere to the principle of technological neutrality and encourage the innovative application of various technologies in the financial sector. Blockchain and cryptographic technologies have already seen some successful applications in finance, such as the green bonds issued in Hong Kong. In the fields of virtual asset trading and DeFi, various cryptocurrencies have outstanding applications in payment and settlement. Although many transactions in these areas are gray or even illegal under current laws, this does not negate the feasibility of cryptocurrency technology in payment and settlement functions, and it is entirely possible for it to play a role in legal trading fields.

Second, stablecoins are products of real demand. From the existing applications of stablecoins, the demand comes from two categories. One is the emerging economic fields, such as virtual asset trading and on-chain transactions, where the current fiat currency payment and settlement methods cannot meet the payment and settlement needs of such transactions. The other is some gray and illegal transactions, such as illegal asset transfers, where stablecoins and other cryptocurrencies are used to evade regulation. Emerging fields may also include both legal transactions and gray or illegal transactions. As long as illegal transactions can be effectively identified, corresponding regulatory methods can be found.

Third, legislating for stablecoins is necessary for innovation and financial security. The "Acts" in Hong Kong and the U.S. are responses to innovation and also serve to mitigate the risks associated with it. The innovation of stablecoins as payment tools aims to promote the development of new economic forms such as virtual asset trading, and issuing stablecoins is not the end goal. At the same time, it is also due to the recognition of the dual nature of payment tools, and legislation is intended to prevent risks. It is particularly noteworthy that both Hong Kong and the U.S. have included stablecoins pegged to foreign currencies in their regulatory scope. The reason is that foreign stablecoins pegged to local currencies, if not effectively regulated, can similarly pose risks to the local currency system. With the internationalization of the renminbi, as long as there is demand, it is inevitable that foreign stablecoins pegged to the renminbi will emerge, and the Chinese financial system will inevitably face the potential risks they may bring. Therefore, it is necessary to formulate regulations to prevent such risks. As equivalents, stablecoins do not have distinctions between offshore and onshore, but from a regulatory perspective, the usage scope of different issuers or different stablecoins can be limited.

Fourth, there are no substantial legal obstacles to issuing renminbi stablecoins. Stripping away the technical veneer, the rules for stablecoins are similar to those for bank notes. Physical cash can be digitized, paper notes can be electronic, and paper bank notes are also negotiable instruments, so they can certainly be put on the blockchain. Two options can be considered: one is to incorporate renminbi stablecoins into the existing bank note management system; the other is to consider the specific nature of the current stablecoin application fields and, referencing Hong Kong and the U.S., formulate separate regulations for stablecoins. Cautiously, the initial application scope of stablecoins can be limited. Considering the issuers' impulse to overissue and the potential impact of large-scale stablecoin issuance on the currency supply and market interest rates, the issuance volume of stablecoins should be included in the regulatory scope of institutional capital adequacy ratios.

Fifth, the issuance of renminbi stablecoins can open up more suitable application scenarios for digital renminbi. Technically, stablecoins and central bank digital currencies are the same; why do stablecoins still exist? Part of this is to evade regulation, but more critically, the mechanisms differ, and the motivations for exploring and innovating application scenarios are different. Central bank digital currency is issued and promoted by the central bank, which leads the expansion of application scenarios, but the central bank's ability to develop application scenarios is limited. Stablecoins are issued by commercial institutions, which have commercial interests in issuing stablecoins and are committed to expanding application scenarios. At the same time, due to the high compatibility of application scenarios with the characteristics of stablecoins, the transaction frequency in application scenarios will increase, and system maintenance will also be easier and less costly. Central bank digital currencies attempt to cover all possible application scenarios, some of which have low transaction frequencies. From a technical and theoretical perspective, the scenarios where stablecoins can be successfully applied are also likely to become applicable scenarios for central bank digital currencies. Therefore, the issuance of renminbi stablecoins actually helps promote the application of digital renminbi.

Sixth, innovate and build a renminbi stablecoin payment system that seamlessly integrates with the banking account system. The tech community often views the speed of payment in isolation during innovation, neglecting the connection to economic operations behind payments, leading to a separation between the virtual world and the real world. The emergence of stablecoins itself aims to bridge the gap between the virtual and real worlds, with the purpose of issuing stablecoins still being to obtain returns in the form of fiat currency. If renminbi stablecoins can resolve the connection with the banking account system in institutional arrangements from the outset, they 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. The application of a certain payment settlement method or technology for a currency may facilitate its use, but it will not play a decisive role in the currency's competitiveness. Once the credibility of the U.S. dollar collapses, U.S. dollar stablecoins will not save it. However, as long as the U.S. dollar remains the primary international reserve and transaction currency, it is normal for U.S. dollar stablecoins to be widely used for payment and settlement in an internationalized emerging economic field. If China issues renminbi stablecoins, its primary goal should not be to compete with U.S. dollar stablecoins but to serve the development of emerging economies and the internationalization of the renminbi.