Cryptocurrencies or crypto assets continue to evoke mixed reactions among the knowledgeable and the lay public.
Do they portend a new world order and which would reshape the entire financial system? Or are they a new form of “tulip mania” or a South Sea Bubble or other mass belief suspending hysteria[1] and just a financial scam awaiting a damning expose?
In this context, stablecoins — a form of crypto assets — appears to present a halfway house, and deserves a closer review and a deeper understanding.
What are “Stablecoins”?
Stablecoins are a class or type of crypto assets that are backed by a commodity, a currency or an asset. Accordingly, the value of the stablecoins are pegged to, or derived from, the value of such underlying commodity, currency or assets.
Having such an underlying commodity, currency or assets serves to reduce the price volatility of stablecoins (or manages to peg it to the volatility that one observes in the prices of underlying commodity, currency or asset) as compared to other crypto assets. Crypto assets by contrast have shown wild swings in their prices, driven more by speculative forces rather than any practical or real world application (though always spoken as if they do).
Having such an underlying commodity, currency or assets also distinguishes stablecoins from other crypto assets which have no intrinsic worth or value and cannot be redeemed into anything.
Furthermore, any number of stablecoins can be created (subject to availability of the underlying commodity, currency or assets and its acquisition) unlike bitcoins or other crypto assets which are quite so often, by design, limited to a specific number that can be mined and create an artificial scarcity (while projecting the same as an anti-inflation measure).
The (relative) price stability of stablecoins (compared to the volatile prices of other crypto assets) is intended to provide a comfort to investors and merchants in anchoring the prices of goods, services or even other crypto assets.
Stablecoins draw upon the technology and protocols of crypto assets and are backed by or exchangeable into the designated underlying commodity, currency or asset, and hence are considered to represent best of both the worlds: of an important, emergent technology, and of being anchored in real world assets with intrinsic worth that is realisable on demand.
Popular stablecoins and how they describe themselves[2]
Costs, Income and Risks
Stablecoins are usually expressed in round numbers. Fresh issuance requires the stablecoin issuer to purchase an equivalent value of the commodity, currency or asset that backs such stablecoin.
Given the underpinning of the commodity, currency or asset for stablecoins, one needs to factor in the following costs:
- Transaction costs for acquisition or sale of the commodity, currency or asset in form of brokerage, fees, costs, charges and/or stamp duty.
- Assayers fees, charges and costs when the commodity or asset is in a physical form for verifying and validating the quality and quantity of the underlying commodity or asset.
- Storage, custody and insurance costs when the commodity or asset is in a physical form.
- Bank, depository or custodian charges for holding the currency or financial assets.
- Auditors fees, charges and costs for verifying and validating the underlying.
Separately, for a holder of stablecoin, there could be costs for purchasing or acquiring stablecoins, storage costs (in a wallet), or transaction costs when making or receiving payments via stablecoins. There are marginal income generation opportunities, for instance by lending the owned stablecoins (with attendant risks).
On the income front, certain underlying assets could generate income for the issuer (akin to but not the same as central banks earning seigniorage[3]), and help offset its costs. Such income streams can include:
- When commodity or physical assets are the underlying: can be lent to earn interest income.
- When financial assets are the underlying: these could generate dividend or interest income.
- When currency is the underlying asset and has been placed with a bank: interest on deposit.
- When the underlying significantly appreciates in value: capital gains.
Such income earning opportunities bring their own commensurate risks.
When the commodity or physical asset has been lent, the risk of borrower failing to return such commodity or asset in a timely manner or failing to service the interest payment obligation or both. Risk of financial assets failing to generate any income. If such financial assets are bonds, debentures or commercial paper of corporations, the risk of such corporations defaulting or failing. When the financial asset is a bank deposit, there is the risk of bank failure[4]. Price appreciation of an underlying could also mean a later day price correction: if gains have been realised through sale, the issuer may need to purchase the underlying afresh to preserve the equivalence assured for the stablecoin.
Perspectives for a Stablecoin Holder
Acquiring stablecoins closely resembles keeping money as a bank deposit or investing in a liquid mutual fund scheme. The fact that there is an underlying of a commodity, currency or an asset backing the stablecoin and its redeemability inspires enormous confidence.
Apart from the perception of lower transaction costs, stablecoin holders should also evaluate the nature and quality of the income generated from the underlying commodity, currency or asset, even if they are not entitled to the same. This is because any such income brings commensurate risks. Hence, while the income stream may belong to the issuer, when the risks materialise, it could be the stablecoin holders who are left holding the can, and who would have to face the permanently diminished value of the stablecoins.
A further factor to consider is the expectation of quick, simple and ready redemption of stablecoins. Depending on the commodity, currency or asset underlying the stablecoin, unusual high levels of redemption could cause the collapse of the stablecoin. This is akin to how usually high levels of withdrawals of bank deposits can cause a run on such a bank and even lead to its collapse.
Bear in mind that banks have obligations to maintain statutory or cash reserves, are subjected to regulatory supervision and inspection and which is subject to prudential standards for capital adequacy, income recognition and provisioning.
Stablecoins and their issuers have no such obligations or supervisory or regulatory requirements governing them. This can make the issuers of stablecoins susceptible to errors, mistakes or even fraud, which may go undetected for long periods of time. The aspect of underlying commodity, currency or asset if incorrectly valued, not adequately safeguarded or if is uninsured or underinsured may serve to bring operational risks that issuers of stablecoins may not be properly equipped to evaluate and address, but with risks and losses having to be borne by the stablecoin holders.
Given the digital only nature of stablecoins, an investor should be mindful of cyber risks – of hacking, security breaches or compromises of credentials[5] – that can result in theft or loss of the stablecoins whether at the investor’s end, at any platform where these are traded, at the issuer’s end or at the service providers engaged by the issuer.
Finally, to a large degree, ambiguity over the legal status of crypto assets and of stablecoins should dissuade an investor from putting her hard earned money into such a class of assets. Once there is clarity on the legal status of stablecoins, confidence that one will not run afoul of laws, rules or regulations, and clarity on several aspects mentioned in this paper, is when one could consider making such an investment[6].
Perspectives for Policymakers, Legislators and Regulators: More Questions than Answers
Stablecoins (or as many a central bank or even Bank of International Settlement (BIS) are known to say: “so-called stablecoins” perhaps with a latent fear of endorsing such coins or tokens as indeed being stable) have projected a halfway house between crypto assets and tokens (which display high volatility and price fluctuations) and local currency and payments systems (which are construed as slow or costly or both).
However, a much stronger look at the following aspects is necessary for stablecoins:
- Is the issuer “fit and proper”?
- Is the underlying duly acquired, and acquired on an arm’s length basis?
- Is the underlying duly validated and verified both at the time of its acquisition and at periodic intervals?
- Are the costs incurred by the issuer of the stablecoin fair and appropriate for acquisition, storage or custody, insurance or other related costs and charges? Are the arrangements with such service providers arrived at on an arm’s length basis, and are they regulated or inspected and audited at periodic intervals?
- Are the underlying assets available in a risk free (or at least, low risk), liquid, easily convertible to cash basis, and can meet redemption requirements?
- If the underlying assets are risky, illiquid and difficult to convert to cash when needed, then has there been due disclosure of such risks to the holders of stablecoins?
- Can there be avoidance or reduction of the moral hazard of income belonging to the issuer (who, in all fairness it should be said, quite so often also bears some or all of the costs), while the risks are allocated to the stablecoin holders?
- Inasmuch as stablecoins resemble bank deposits (or even liquid mutual fund schemes) albeit with features of being digital, transferable and redeemable, should its issuers or its issuance or its holders be regulated? If so, should the regulator be the Reserve Bank of India (if treated akin to bank deposits, with appropriate reserving for the liability and prudential norms for the assets apply) or Securities and Exchange Board of India (SEBI) (if treated akin to liquid mutual fund schemes, with due offer document, disclosure and investments in financial assets, arm’s length and caps on costs) in either situation after the issuer has passed muster with either regulator as “fit and proper”?
- Given the projected utility of stablecoins in facilitating payments, should it and its issuers be regulated as a payment and settlements system and its operators respectively?
- In case of existing stablecoins issued outside India, what should be the approach? Is such purchase by a holder compliant with foreign exchange remittances limits[7]? Should the overseas issuer be required to hold or store the underlying in India to the extent Indians hold the stablecoin? Can the underlying be ring fenced? Is localisation and ring fencing desirable, feasible and necessary?
- Given the key and material factor of stablecoin requiring or having an underlying commodity, currency or asset, is it collective investment scheme, or a “derivative” and a “securities” in terms of the Indian securities law[8]? Do its issuers adhere to the securities law on creation of stablecoins? Do stablecoins as a derivative or as securities or both, require being listed and traded only as contemplated in the securities law? Do holders of stablecoins need to hold it only in demat accounts or can they hold it in crypto wallets?
The American View
On 1-11-2021, the President’s Working Group on Financial Markets (PWG), joined by the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), released a report on stablecoins[9].
The press release[10] notes that: “To address the risks of payment stablecoins, the agencies recommend that Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal framework on a consistent and comprehensive basis. Such legislation would complement existing authorities with respect to market integrity, investor protection, and illicit finance, and would address key concerns:
- To address risks to stablecoin users and guard against stablecoin runs, legislation should require stablecoin issuers to be insured depository institutions.
- To address concerns about payment system risk, in addition to the requirements for stablecoin issuers, legislation should require custodial wallet providers to be subject to appropriate federal oversight. Congress should also provide the federal supervisor of a stablecoin issuer with the authority to require any entity that performs activities that are critical to the functioning of the stablecoin arrangement to meet appropriate risk management standards.
- To address additional concerns about systemic risk and concentration of economic power, legislation should require stablecoin issuers to comply with activities restrictions that limit affiliation with commercial entities. Supervisors should have authority to implement standards to promote interoperability among stablecoins. In addition, Congress may wish to consider other standards for custodial wallet providers, such as limits on affiliation with commercial entities or on use of users’ transaction data.”
In short, the recommendations appear to place the issuance of stablecoins with banks, and ensuring banking level of supervision extends to such issuance, wallet providers and requiring arm’s length treatment.
Concluding Remarks
The halfway house approach of stablecoins — in providing low volatility, being speedy and low cost — can bring broader acceptance and adoption, and even provide a playbook or a template for central bank digital currency (CBDC) to follow. These require the questions posed above being satisfactorily addressed.
What also requires being evaluated is that in a country where digital payment tools and technologies such as Unified Payments Interface (UPI) (value across rising volumes of which have crossed USD 100 billion in a single month[11]), Immediate Payment Service (IMPS), National Electronic Funds Transfer (NEFT), Real Time Gross Settlement (RTGS) being available at a low cost and 24×7 basis and which are within the regulated domain requires stablecoins or crypto assets? These stablecoins or crypto assets could bring risks that are still not fully understood by the lay public, have unaddressed moral hazards, lack of transparency and could be inherently unstable.
Asking that such stablecoins be regulated requires also an understanding and acceptance by the crypto ecosystem that the legal and regulatory framework will bring its scrutiny of fitness and propriety of the players, their dealings and bring additional compliance costs, impose all too necessary fetters (which creators of crypto assets quite so often decry), and perhaps take away the relative cost advantages currently enjoyed over the regulated financial services sector.
For those who already own or hold crypto assets and particularly stablecoins, it is perhaps time to take a closer look at what are the terms of such crypto assets and stablecoins: are these terms fair, appropriate and does the underlying exist, with sufficient assurance that whenever required, redemption will happen. It should not be that in times to come that we discuss and describe these as “so-called stablecoins” or as unstable coins.
† Pramod Rao, Group General Counsel at ICICI Bank. Views are personal.
[1]Recommended reading: HERE and HERE.
[2] Source and a recommended read: HERE accessed on 12-11-2021.
[4] While the last risk may seem remote, bank failures have been known to happen. Take Northern Rock in the UK, umpteen bank failures in the US where FDIC undertakes an orderly dissolution (which does not necessarily translate to depositors receiving higher than the insured limit in all situations) and closer home where many a cooperative banks have failed (while commercial banks have been by and large rescued by way of forced or voluntary mergers or recapitalisation, and with moratoriums of varying lengths being specified until such rescue took effect).
[5] There are even incidents of an investor forgetting the password to the wallet resulting in losing access to the crypto asset HERE.
[6] Read here for views of a SEBI registered investment advisor HERE
[7] See HERE for RBI posted FAQs on liberalised remittance scheme.
[8] See definition of “derivatives”, “commodity derivatives” and “securities” in Securities Contracts (Regulation) Act, 1956 (SCRA): Ss. 2(ac), 2(bc), and 2(h); additionally, legality of transactions in derivatives requires such transactions to be in adherence of S. 18-A or of S. 30-A of SCRA.
