Stablecoins and the Challenge for Regulators
The G7’s investigation into the impact of global stablecoins
Cryptocurrencies currently present one of most dynamic interplays between innovation and regulation in Financial Services. Against this backdrop, the G7’s Working Group on Stablecoins last month released a report investigating the potential global impact of stablecoins - cryptocurrencies designed to avoid the extreme volatility observed in some other cryptoassets. For the full report, please see here.
Cyptocurrencies and stablecoins, as with any innovative area of financial technology, have the potential to significantly disrupt established systems. The global ambitions of recent stablecoin propositions (such as Libra, backed by Facebook) have the potential to scale up both the possible rewards and challenges. The G7’s report has sought to consider the possible impacts and regulatory response both to stablecoins generally and also to those with a wider global impact, which have been labelled “global stablecoins” or “GSCs”.
Potentials of Stablecoins
As well as considering potential challenges, the report touches on the huge promise of stablecoins. Millions around the world, the report notes, have no access to financial services or efficient payment systems. Insufficient payment infrastructure and the volatility of domestic fiat currencies can leave broad sections of the global community without an sound store of value, nor an effective method of payment – in particular cross-border payments. Stablecoins, by presenting simple access to cryptoassets without the threat of dramatic volatility, have the potential to bring the 1.7 billion adults without access to a transaction account¹ within the remit of the global financial system. Instead of relying on sometimes volatile and inefficient domestic currencies and payment systems, stablecoins may allow access to reliable stores and transfers of value.
Risks of Stablecoins
The report highlights possible challenges and risks posed by stablecoins, and assesses whether these are limited concerns for individual users and institutions, or broader systemic risks.
Risks from All Stablecoins
Amongst the immediate challenges that stablecoins might pose, the report highlights:
- Legal certainty – it is important that any stablecoin infrastructure is transparent and lends certainty to the rights, obligations and processes applicable to issuers and users.
- Governance – stablecoins vary in their degree of centralised control, but regardless of the permissions, privacy, hierarchy or source code of the coin’s infrastructure, opaque governance might prove detrimental to users.
- Financial integrity – whilst seen by many as an advantage for cryptoassets, the anonymity and speed of transfer some provide present an enormous challenge in halting money laundering and terrorist financing.
- Cyber security – as with other cryptoassets and digital technologies, cyber vulnerabilities might expose users to theft, fraud and other digital threats.
- Market integrity – a core feature of stablecoins is the method by which their prices are stabilised, which might be through face-value redemption by issuers or pegging to a managed basket of assets. The effectiveness of this price management, along with liquidity in secondary markets, can pose significant risks to users looking to receive a fair and sustainable price for their stablecoins.
- Data protection – stablecoins risk the collection and misuse of potentially sensitive personal data, of which users may not have oversight or control.
- Consumer protection – without sufficient clarity of information, users may not understand the risks, rights and features associated with their chosen stablecoin.
- Tax compliance – the nature and classification of stablecoins is in itself debated, which may make their tax treatment unclear. The possibly opaque associated infrastructure may also enable tax avoidance if not effectively monitored.
Risks of Global Stablecoins
In addition to the scaled-up impact of the risks above, the report notes that GSCs may present a number of novel challenges from a national and global perspective:
- Integrity of payment systems – the report highlights that an improperly managed or designed payment system may cause or exacerbate financial shocks by failing to provide liquidity when needed, or generate interdependencies that cause systemic risk.
- Fair competition in financial markets – contemplating the possibility of a GSC leveraging an existing network to ensure large-scale adoption and high costs of establishing efficient infrastructure acting as a barrier to entry, the report highlights concerns that a GSC might obtain widespread market dominance and stifle competition.
- Fragilities in infrastructure – a GSC’s scale may generate instabilities itself. Possible fragilities in a GSC’s infrastructure, such as poor governance or inadequate liquidity may generate fear that users will not be able to redeem at proper value, and trigger a run, undermining the GSC as a whole. In addition, GSCs would inevitably be of such a scale that the infrastructure would contain various components. Unclear obligations between these components and unforeseen complexities might fundamentally undermine the functioning of the stablecoin.
- Damage to the financial system – the report notes a number of potential instabilities which GSCs may cause in the broader financial system. As a viable alternative to bank deposits as a store of value, GSCs may increase bank dependence on expensive and volatile funding sources, and may exacerbate bank runs when confidence in a financial institution erodes. New financial intermediaries in the GSC ecosystem may reduce bank profitability, driving financial institutions to riskier business, and stablecoin reserves may also deplete the availability of high-liquidity assets.
- Economic instability – a widely used GSC may impact the real economy. In addition to the disruption that vulnerabilities in a widely adopted means of settlement might cause, the adoption of GSCs by the unbanked as a store of value means that fluctuations in value may impact consumers’ wealth and spending patterns, as well as company balance sheets – particularly if lending was denominated in GSCs. Financial institutions might themselves take on heavy exposure to a GSC and therefore its fluctuating value, and the sheer scale of transactions undertaken by a GSC asset pool might in itself shift prices and liquidity in other asset markets.
- Undermining monetary policy – whilst GSCs might present a viable alternative for users with unstable domestic currency, the report highlights that wide use as a store of value may reduce the effectiveness of domestic monetary policy in economies with a high adoption rate. Conversely, the pressure on deposit-starved banks to seek wholesale funding might amplify monetary policy as dependent institutions react to central interest-rate adjustment. In addition, ongoing conversion of fiat currencies to stablecoins may place additional pressure on domestic currencies, and distort the effect of monetary policy. Capital outflows could be exacerbated by international investors looking to hold those currencies that feature in prominent GSC asset baskets, abandoning non-selected currency.
A Way Forward
The G7 report highlights extensive risks but does not conclude that those risks justify a total prohibition on GSCs. Instead, the working group stresses the importance of international collaboration, alignment of the different jurisdictions and regulatory spheres into which components of a stablecoin ecosystem might fall. International standards and practices may be used to guide and promote safe payment infrastructures, strong compliance practices, adequate data protection and generally fit-for-purpose regulatory frameworks. As the report notes, the growth of stablecoins presents an extensive challenge for global regulators, but also an opportunity to encourage the development of potentially revolutionary access to the modern financial world.
¹Demirgüҫ-Kunt et al (2018)
If you would like to know more about the regulation of stablecoins and cryptoassets in the UK, please contact Jed Wilsher, or another member of the Financial Services team at Charles Russell Speechlys.