The Hong Kong Monetary Authority (HKMA), Hong Kong’s central bank, announced that it is pressing ahead with the regulation of stablecoins, unveiling a slew of measures in a report released on 31 January — almost a year after it issued a discussion paper on the subject and invited feedback from stakeholders.
Starting with the regulation of stablecoins backed by fiat currencies, HKMA said that it will supervise key activities such as the issuance of stablecoins and the provision of wallet services. Entities that conduct such activities will soon be subject to licensing requirements, which will apply not only to entities that conduct such activities in Hong Kong, but also ones that market to the public in Hong Kong or are involved in stablecoins backed by the Hong Kong dollar.
HKMA will also require the issuers of stablecoins to maintain reserves matching the amount of cryptocurrency in circulation and no longer allow algorithmic stablecoins, a significant development.
In seeking to regulate stablecoins, Hong Kong is not alone — with various regulators currently engaged in the process of contemplating and working out stablecoin regulations. In Singapore, the MAS published a consultation paper about their proposed approach to stablecoin regulations and sought feedback from stakeholders late last year. In the US, Stablecoin legislation is high on the list of priorities for the newly formed subcommittee on digital assets, financial technology and inclusion in the Republican-led House of Representatives. A strengthened regulatory framework for stablecoins is also expected to be implemented in the EU, subject to formal rubber stamping by the European parliament.
But what exactly are stablecoins, and why is there such a rush to regulate them?
More-stable coins
Very simply, stablecoins are cryptocurrencies whose value is pegged or tied to that of another currency, commodity or financial instrument.
As its name suggests, this makes their valuation more “stable” than other cryptocurrencies like Bitcoin, for instance, whose prices are more volatile and prone to huge swings.
While the price of a Bitcoin might be USD$7,969 at the start of a day and plunge 55% to close at USD$3596 at the end of the same day, a stablecoin like TetherUSD — among the more popular stablecoins — will (ideally) always be worth USD$1.
By making cryptocurrency more predictable, stablecoins can be suitable for use in daily transactions; be it for crypto traders who want to go in and out of different crypto investments in a DeFi exchange and preserve their portfolio’s fiat value without having to cash out of the crypto market entirely, or the average individual who wants to participate in a DeFi project or pay for everyday goods and services like buy a pizza with cryptocurrencies.
There are two main methods by which the value of a token is fixed to a stable figure: via the backing of assets or via algorithms.
The first category of cryptocurrencies, which includes fiat, crypto and commodity-backed stablecoins, are cryptocurrencies whose value is pegged to that of fiat currencies, other cryptocurrencies and commodities, respectively. The issuer of the cryptocurrency holds in their reserve the asset the token is pegged to — with the reserves ideally equal to the amount of stablecoins in circulation, allowing any stablecoin holder to redeem their token for the asset it is pegged to.
This, while highly stable and safe, requires issuers to hold in their reserves a large amount of assets and is thus very capital intensive.
Algorithmic stablecoins, on the other hand, are not backed by any real-world commodities and instead utilise algorithms to maintain the value of a given token. By burning or minting tokens according to supply and demand, the value of a token can be dynamically maintained at a fixed level.
However, in extreme market conditions, the algorithms may fail to keep up — resulting in the value of a token de-pegging.
This happened to TerraUSD, an algorithmic stablecoin that was pegged to the US dollar not by cash reserves but with the use of a stabilisation mechanism involving another cryptocurrency, Luna.
Last May, it lost its peg to the US dollar after a series of large dumps of the token prompted a broader sell-off in the market, leaving them unable to reinstate the peg of TerraUSD to the US dollar.
The subsequent collapse of TerraUSD, the then largest algorithmic stablecoin by market capitalization, prompted the prices of other tokens throughout the crypto market to decrease significantly, setting into motion a wave of bankruptcies in the industry.
It is against this context that HKMA has announced plans to outlaw algorithmic stablecoins and require stablecoins to be backed by “reserve assets … of high quality and high liquidity” — seemingly to minimise the risk of stablecoins de-pegging and creating turmoil in the financial system in the future.
Why regulate stablecoins?
One large reason regulators are moving to regulate stablecoins is the contagion risks they pose to the broader financial system.
Eswar Prasad, a professor of economics at Cornell University, pointed out in a recent interview with CNBC that “if there were to be a loss of confidence in stablecoins, maybe because some exchanges come down or for other reasons, then we could have a wave of redemptions (of stablecoins), which would in turn mean that stablecoin issuers have to redeem their holdings of treasury securities, and the large volume of redemptions even in a fairly liquid market can create turmoil in the underlying securities market”. He added that regulators were therefore right to be concerned about stablecoins, especially given the importance of the treasury securities markets to the broader financial system.
“Risks will increase as … (stablecoins) become more interconnected with the existing financial system,” an IMF report notes, adding that this is especially the case if, in the future, stablecoins become more widely accepted and, therefore, interconnected with existing financial entities and payment infrastructures, a scenario not unlikely given Stablecoin’s potential to be used to improve the efficiency of cross-border transactions.
Should the substitution of currency through cryptocurrency markets accelerate, stablecoins could also be the source of spillovers into exchange rates markets, giving regulators much reason to step in and exercise oversight.
How about CBDCs
Another key consideration for central banks seeking to regulate stablecoins is how their own digital currencies fit into the broader picture.
Central Bank Digital Currencies (CBDCs) are essentially digital tokens not unlike cryptocurrencies but are issued and backed by the central bank.
An Atlantic Council tracker shows that 100 nations are developing, researching or have already launched a digital currency. CBDCs will potentially make the financial system more efficient by decreasing reliance on intermediaries such as clearing houses and banks, while also promoting the financial inclusion of the disenfranchised.
Despite their similarities, some experts believe that CBDCs and stablecoins can co-exist, with the use of stablecoins for specific purposes being complementary to the use of CBDCs as a general-purpose currency.
Central banks, however, may decide that even stablecoins backed by assets in a 1:1 ratio are not necessary in light of CDBCs and thus disallow stablecoins entirely.
A broader reckoning
While governments have an imperative to regulate stablecoins given the heightened risks they pose to the broader financial system, it remains to be seen if stablecoins will be an exception or if the regulation of stablecoins will create the impetus for governments to exercise further oversight over other areas of the cryptocurrency space, in the same way they regulate other financial institutions.
Questions about the appropriate regulatory approach to the broader cryptocurrency space are particularly pertinent in the aftermath of the crash of FTX. The crypto-exchange, once among the most high-profile ones in the world, was forced to suspend withdrawals and subsequently file for bankruptcy late last year and currently faces serious allegations, including the improper use of customers’ funds. Temasek Holdings wrote down its 275 million dollar investment in FTX last November and Sam Bankman-Fried, the founder of FTX, has since been extradited to the US and faces fraud charges.
Speaking at a panel at the World Economic Forum in Davos, Tharman Shanmugaratnam, the Chairman of the Monetary Authority of Singapore (MAS), said that there is a need to step back and ask a basic philosophical question before considering regulating cryptocurrencies the same way we do banks and insurance companies.
“Does (regulation of cryptocurrency) legitimise something that’s inherently purely speculative and in fact, slightly crazy? Or are we better off just providing ultra clarity as to what’s an unregulated market and if you go in, you go in at your own risk,” he said, adding that he leans a bit more towards the latter view.
With regards to the wider crypto space, the HKMA said in its report that it will continue its discussion with other stakeholders, adding that while it embraces financial innovation and encourages companies to explore the potential of distributed ledger technologies, it “will continue to monitor market developments and the risks that different categories of crypto-asset may pose to monetary and financial stability”.