Liu Xiaochun: What is the key to the success of stablecoins?

In May 2024, the United States and Hong Kong successively passed legislation related to stablecoins, marking the formal entry of stablecoins into a compliant development track. From the definitions in the two regions' legislation, stablecoins are essentially a digital payment tool, with issuance and management rules that are fundamentally consistent with bank notes, requiring reserve assets to support them, strict information disclosure, and risk management.

The ultimate success of stablecoins depends on their ability to balance the demands of all stakeholders: users need a convenient and secure payment experience, issuing institutions require reasonable commercial returns, and regulatory authorities need to maintain financial stability. As a quasi-currency tool, stablecoins will have a significant impact on monetary policy and currency circulation, and their issuance scale and regulatory model must be incorporated into monetary policy considerations.

In response to the international trend of stablecoin development, China should actively respond with the following suggestions: adhere to the principle of technological neutrality, encourage financial innovation applications; formulate specific regulations for stablecoins to promote innovation while preventing risks; include offshore RMB stablecoins within the regulatory scope; innovate and build a payment system that seamlessly connects with the banking account system; aim to serve the development of emerging economies and the internationalization of the RMB, rather than simply competing with USD stablecoins. The issuance of RMB stablecoins will help enhance the motivation of commercial institutions to explore application scenarios, and can open up more suitable application scenarios for digital RMB.

— Liu Xiaochun, Vice President of Shanghai New Financial Research Institute (SFI)

Main Text

On May 21, the Hong Kong Legislative Council passed the "Stablecoin Bill," almost simultaneously with the U.S. Senate passing the "Stablecoin Uniform Standards Protection Act" (GENIUS) on May 20.

In no time, the cryptocurrency community was abuzz, with various comments flooding in. However, most commentators did not conduct a specific study of the two legal documents, and some, for various purposes, confused the concepts of stablecoins, cryptocurrencies, and crypto assets, leading to some misunderstanding of stablecoins. Therefore, it is necessary to provide a brief and specific analysis of the two legal documents and, based on that, analyze the demands of all stakeholders.

As a new type of financial product, stablecoins will inevitably have their functions and roles, but the relevant parties involved in innovation will also have their economic demands. Whether these demands can be met is the key to the ultimate success of the financial product. Different methods of issuing and regulating stablecoins will also have different impacts on the future development of stablecoins, currency circulation, and monetary policy.

1. Analysis of Hong Kong's "Stablecoin Bill"

The "Bill" provides a clear definition of stablecoins, consisting of five articles.

The first article is relatively simple, defining the presentation form of stablecoins: "expressed in the form of a unit of account or storage of economic value." For example, a Hong Kong dollar stablecoin must clearly state that it is a stablecoin of Hong Kong dollars and specify its face value in Hong Kong dollars.

The second article explicitly limits the applicable scope of stablecoins: for payment for goods or services; to settle debts; for investment and trading. This means that Hong Kong dollar stablecoins are a means of payment, not assets to be invested in or speculated on. 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 Hong Kong dollar stablecoins can also be traded and exchanged with foreign currencies in circulation The third article clarifies the storage and transfer methods of stablecoins: they can be conducted electronically.

The fourth article further specifies that operations are to be conducted on "distributed ledgers or similar information storage repositories." These two articles can be said to limit the application scope of stablecoins, meaning stablecoins can only be digital and can only operate and circulate online.

The fifth article clarifies the value basis for stablecoins: a single asset; a group or a basket of assets. In the case of Hong Kong stablecoins, the anchored asset is primarily the Hong Kong dollar, and the reserve assets must be high-quality, highly liquid, and low-risk assets.

The "draft" has made some specific regulations regarding the supervision of stablecoins. First, the issuer of stablecoins must be a "company," meaning a profit-making 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 HKD 25 million or an approved equivalent amount in currency, meaning 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, meaning the reserve assets are earmarked for specific use and can only be used as redemption funds for stablecoins, not 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) The stablecoin issuer must timely meet the redemption requests of holders and cannot impose excessively strict conditions, but can charge reasonable fees; (2) The issuer must establish KYC and AML systems that comply with Hong Kong government requirements; (3) Establish information security management, anti-fraud, and other regulatory requirements that meet Hong Kong government standards; (4) Establish reasonable user complaint reporting channels and violation mechanisms. All these regulations indicate that even if the Hong Kong dollar stablecoin utilizes distributed accounts for 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 for executives of exchanges set by the Securities and Futures Commission. Sixthly, stablecoin issuers must publish a white paper to provide comprehensive information about the stablecoin to the public.

Finally, 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 can only operate stablecoin businesses and must not exceed their license to conduct other businesses. 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 hopes to provide an innovative payment tool for new economic fields such as WEB3 and cryptocurrency 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 for evasion of regulation

II. Analysis of the U.S. Stablecoin Uniform Standards Protection Act

The U.S. "Act" and Hong Kong's "Draft" have similar regulatory logic overall, but each has its own characteristics.

Similarities between the "Act" and the "Draft": First, both anchor assets to fiat currency (U.S. dollars) for payment and settlement. Second, stablecoins must be 100% backed by U.S. dollars or high-quality assets (such as U.S. Treasury bonds). Third, issuers are required to disclose reserve asset reports monthly, which must be audited by a third party. Fourth, they must comply with anti-money laundering and anti-terrorism financing requirements, with issuing institutions falling under the regulation of the Bank Secrecy Act, and must fulfill obligations such as KYC and reporting suspicious transactions. Fifth, paying interest or returns on stablecoin is prohibited. Sixth, the "Act" grants regulatory powers 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 "Draft" lies in the regulatory framework. Hong Kong has a single-tier regulation, while the U.S. regulatory framework is divided into two tiers: stablecoin issuers with a market capitalization exceeding $10 billion must accept federal regulation; those with a market capitalization below $10 billion may choose state-level regulation but must meet federal minimum standards.

There are also some differences in details, such as the U.S. having clearer requirements for the types of reserve assets for stablecoins, while Hong Kong only specifies the nature of reserve assets, leaving some room for exploration.

Overall, both Hong Kong and the U.S. legalize local currency stablecoins and bring them under regulatory oversight, providing new settlement tools for emerging economic sectors while preventing such innovative settlement tools from negatively impacting sovereign currencies and financial markets. The key is to clarify the nature of stablecoins, specifically that fiat-backed stablecoins are payment and settlement tools, distinctly separated from security tokens, while strengthening reserve asset regulation and information disclosure, as well as enhancing anti-money laundering and anti-terrorism financing requirements.

III. Bank Notes and Stablecoins

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 resemble 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 note-issuing banks must have 100% U.S. dollar reserves to ensure they can meet the demand for dollar redemption from Hong Kong dollar holders 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 value, and the holder can use the bank note to pay for goods or services, repay 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 produced in this manner, and the rules also applied to the notes issued by money shops. It can be said that fiat-backed stablecoins are a type of currency under the condition of fiat currency.

The emergence of bank notes is due to the same reason as that of paper currency and money shop notes, which is the heavy and unsafe nature of physically carrying cash over long distances. Now that electronic payments are widespread, the environment for using bank notes has largely disappeared, making them difficult to find The emergence of paper money, promissory notes, and bonds is predicated on the invention and widespread use of paper, but the fundamental application demand issue is the inconvenience and insecurity of physically carrying currency over long distances. Cryptographic code technology is the technical prerequisite for stablecoins and crypto assets. So, what are the specific application demands for stablecoins as payment tools and quasi-currencies?

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

In addition, the model of Western Union is also similar to that of promissory notes. Customers hand over currency to any Western Union outlet, which provides them with a remittance receipt. Customers can keep this receipt or transfer it to others. The holder of the receipt can present it at any Western Union outlet worldwide to collect the remittance. A stablecoin is essentially a receipt 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 require a clear measure of value and stable value, whether for face-to-face payments, cross-space payments, immediate payments, or deferred payments, all of which must be safe, convenient, and quick. On the other hand, issuers have the impulse to overissue, which easily leads to risks of 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 United States, the risk of stablecoin runs is real and has already occurred. In May 2022, the dollar-pegged stablecoin TerraUSD experienced a severe run that led to its collapse, ringing alarm bells for regulators. Consequently, both the Hong Kong and U.S. bills have imposed strict and clear requirements on the quantity, quality, and management of stablecoin reserve assets.

IV. Demands of Relevant Parties for Stablecoins

The emergence of any phenomenon in human society is driven by demand, which is backed by the interests of various relevant parties. A payment tool will only be truly accepted if it meets the different demands of various stakeholders.

On the surface, payment tools only involve the two parties in a transaction; as long as the demand for exchange is met, the functionality can achieve convenient, safe, quick, and accurate value transfer. However, the smooth operation of payment tools is supported by a complete system of issuance, management, and operation, which requires significant cost investment. With investment, there is inevitably a demand for returns. Therefore, the issuers of stablecoins or the investors in stablecoin issuing institutions are the more important stakeholders.

The relevant parties of stablecoins primarily include payers. First, for payers, using stablecoins for payment in specific fields or scenarios should be quicker, more convenient, and safer than using fiat currency; otherwise, they would not go through the trouble of converting their fiat currency into stablecoins. Secondly, the conversion of fiat currency into stablecoins should be at a 1:1 ratio, with no financial cost Third, the cost of payments made with stablecoins should generally be lower than those made with fiat currency; at the very least, the returns from transactions conducted with stablecoins should be higher than those conducted with fiat currency.

For the recipient of stablecoins, first, accepting stablecoins makes it easier to complete transactions compared to accepting fiat currency. Secondly, the stablecoins received must be redeemable 1:1 for fiat currency, meaning there should be no loss in value. Furthermore, stablecoins can be used in other payment scenarios that the recipient requires.

The transactions mentioned above, where payments made with stablecoins are easier to complete than those made with fiat currency, or specific transaction scenarios, may fall into two categories: one is the digital economy supported by emerging digital technologies, where, due to technical reasons, fiat currency currently struggles to support payments in this field, or even if it can, the efficiency and cost are not economical; the second is transactions that are currently prohibited or restricted by law. Therefore, both Hong Kong and U.S. legislation have regulatory requirements for anti-money laundering, anti-terrorist financing, and so on.

Stablecoin issuers invest significant costs in the issuance, management, and operation of stablecoins; without acceptable returns, there is no need to invest. For issuers, the most direct and crude return is the direct issuance of stablecoins or even currency without reserves, followed by the issuance of stablecoins with over-reserves. Such phenomena have existed throughout monetary and payment history, leading to crises of varying magnitudes.

Next is the exchange fee for stablecoins, which includes fees charged for redeeming the stablecoins they issue, as well as fees charged for exchanging other stablecoins. Under conditions of metallic currency, paper currency, and paper bank notes, this is a very conventional fee, 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 exchange fees is still subject to market dynamics. The "draft" in Hong Kong considers this issue and allows for reasonable fees to be charged during the redemption process.

The third possible source of income is using the funds obtained from issuing stablecoins for various investments to generate returns. Historically, there have been countless lessons learned in this area; mild cases involve excessive investment scale and long durations affecting the liquidity of stablecoin redemptions, leading to runs, while severe cases involve investment failures resulting in an inability to redeem stablecoins. Therefore, both the "bills" in Hong Kong and the U.S. have strict regulations on the types of reserve assets and require that stablecoin operations and reserve assets be strictly separated 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. Future developments will depend on specific regulatory requirements regarding the structure of stablecoin reserve assets.

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, despite their inefficiency, do not have such conditional constraints. Therefore, technology companies related to these technical supports are also stakeholders in stablecoins These technical support institutions and stablecoin issuing institutions may be the same entity or different entities, and they also need to share in the profits from the issuance and operation of stablecoins.

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

Whether the demands of the above 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 various parties' negotiations may lead to the widespread use of stablecoins, or it may result in different stablecoins being used in their respective limited fields, thus becoming specialized stablecoins, or they may even be replaced by central bank digital currencies. Unless the existing national forms change, stablecoins will never fully replace fiat currency.

Currently, stablecoins as payment tools mainly play a role in certain specific digital economy sectors, 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 has reached a stage where regulatory management is necessary.

V. Stablecoins and Monetary Policy and Currency Circulation Management

As a payment tool, stablecoins linked to fiat currency are a type of quasi-currency and are essentially circulating currency. If the issuer uses all the fiat currency obtained from issuing stablecoins for lending, it is equivalent to injecting an equal amount of currency into the market.

If, according to the requirements of Hong Kong and U.S. legislation, part of the fiat currency obtained from issuing stablecoins can be used to purchase government bonds and other high-quality assets, it would mean an increase in the amount of currency injected into the market. If all the fiat currency obtained is held as reserve assets without any investment, it will not increase the currency injection.

However, 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 are required to guarantee that 100% of the reserve assets can be redeemed at any time, it will not increase currency injection; otherwise, it will also increase currency injection.

An effective payment tool will bring vitality to economic operations and have a significant impact on the money supply, so the scale of stablecoin issuance and regulatory models must be considered in the formulation of monetary policy.

Stablecoins, based on distributed ledger technology, represent a disintermediated payment method that may have completely different circulation rules compared to traditional cash in circulation. In today's electronic, networked, and digital banking account systems, cash in circulation is more about personal offline payments, with small individual transaction amounts, low frequency, and dispersed usage. Stablecoins are mainly applied in virtual economic fields such as WEB3 and DeFi, where both institutions and retail investors coexist, with large individual transaction amounts and high trading frequency. Although they are distributed and can facilitate peer-to-peer payments, most transactions are still exchanges or platform trades of virtual assets and cryptocurrencies, aside from payments aimed at value transfer.

As a stablecoin issuing institution, anti-money laundering, anti-terrorist financing, and KYC measures are only implemented during the issuance and redemption of stablecoins, and it remains to be seen whether they must also be applied to the trading behaviors of stablecoin holders Currently, neither the "bill" in Hong Kong nor in the United States has made clear statements.

Cross-border payments are currently a hot topic and selling point in the exploration of stablecoins. Direct payments between the payer and payee are, of course, more straightforward and efficient than remittances through intermediaries like banks. However, payment is just one aspect of market operations, ultimately aimed at obtaining returns denominated in and reflected by fiat currency. Therefore, stablecoins must ultimately be converted into fiat currency and deposited into bank accounts to earn interest income. Additionally, the exchange of different currencies in cross-border payments cannot be resolved by stablecoins and must ultimately be realized through the banking clearing system.

It is evident that the true success of stablecoins is not to detach from the banking system, but to efficiently and seamlessly integrate with it. Moreover, the issuance of stablecoins by issuing institutions, the acceptance of fiat currency, the investment in bonds and other reserve assets with fiat currency, and the redemption of stablecoins with fiat currency must all be realized through bank accounts. This is also a concern for currency circulation management and stablecoin regulation, and currently, there are no clear arrangements in the "bills" in Hong Kong and the United States regarding this.

Historically, there have been instances where banks could issue currency. In the 1840s and 1850s, the United States had over 8,370 different currencies circulating in the market, and the inefficiency and chaos of that situation are imaginable. If various stablecoin issuing institutions only issue and apply stablecoins in limited specific areas, and there is slight overlapping application among different stablecoins in the market, then it is not a problem for multiple institutions to issue stablecoins; however, if all stablecoins circulate throughout the market, it will inevitably lead to some chaos and inefficiency. If such a phenomenon occurs, both the market and regulation will choose moderate centralization. Therefore, the development model and scale of stablecoins after legalization still need to be tested by the market and regulation.

Six 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 encryption technologies have already seen some successful applications in finance, such as the green bonds issued in Hong Kong. In areas like 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 trades not recognized by existing laws, this does not negate the feasibility of cryptocurrency technology in payment and settlement functions. Cryptocurrency technology can indeed play a role in legitimate trading.

Second, stablecoins are a product of real demand. From the existing applications of stablecoins, the demand comes from two categories. One is emerging economic fields, such as virtual asset trading and on-chain transactions, where the current fiat currency payment and settlement methods cannot meet the needs of such transactions; the second 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 legitimate trading alongside gray or illegal trading. As long as illegal transactions can be effectively identified, corresponding regulatory methods can be found.

Third, legislation for stablecoins is both a need for innovation and a need for financial security. The "bills" in Hong Kong and the United States are a response to innovation and a precaution against innovation risks. The innovation of stablecoins as payment tools aims to promote the development of emerging economic forms such as virtual asset trading; issuing stablecoins is not the end goal itself At the same time, due to the dual nature of payment tools, regulatory legislation is aimed at preventing risks.

Particularly noteworthy in this regard is that both Hong Kong and the United States have included offshore stablecoins pegged to local currencies within the regulatory scope. The reason is that offshore stablecoins pegged to local currencies, if not effectively regulated, can also pose risks to the local currency system.

With the internationalization of the Renminbi, as long as there is demand, offshore stablecoins pegged to the Renminbi are bound to emerge, and the Chinese financial system will inevitably face the risk shocks they may bring, making it necessary to formulate regulations to prevent them. As equivalents, stablecoins do not distinguish between offshore and onshore, but from a regulatory perspective, the usage scope can be limited based on different issuers or different stablecoins.

Fourth, there are no substantial regulatory obstacles to the issuance of Renminbi stablecoins in China. Stripping away the technical veneer, the rules for stablecoins are similar to those for bank promissory notes. Physical cash can be digitized, paper notes can be electronic, and physical bank promissory notes are also notes, which 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 current special nature of stablecoin application fields and, referencing Hong Kong and the United States, formulate separate regulations for stablecoins. To be cautious, the initial application scope of stablecoins can be limited.

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? Some international participants are indeed trying to evade regulation, but more critically, the mechanisms differ, and the motivation for exploring and innovating application scenarios varies.

Central bank digital currency is issued by the central bank and leads the expansion of application scenarios, while commercial banks have lower motivation to actively expand application scenarios due to a lack of sustainable commercial return mechanisms. Stablecoins are issued by commercial entities, and there are commercial interests in issuing stablecoins, which naturally drives them to diligently explore application scenarios.

At the same time, due to the high compatibility of application scenarios with the characteristics of stablecoins, on one hand, the transaction frequency of application scenarios will increase, and on the other hand, system maintenance will also be relatively easy and cost-effective. The scenarios where stablecoins can be successfully applied are also necessarily applicable to central bank digital currencies. Therefore, the issuance of Renminbi stablecoins actually helps promote the application of digital Renminbi.

Sixth, innovatively build a Renminbi stablecoin payment system that seamlessly integrates with the bank 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 is itself an attempt to bridge the gap between the virtual and real worlds, with the goal of obtaining the benefits of legal currency forms. If Renminbi stablecoins can initially resolve the connection with the bank account system in institutional arrangements, 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. Certain payment settlement methods or technological applications of a currency may facilitate its use, but they will not play a decisive role in the currency's competition. Once the credibility of the US dollar collapses, US dollar stablecoins will not save the dollar However, in a situation where the US dollar remains the primary international reserve currency and transaction currency, it is a normal phenomenon to use US dollar stablecoins for payment settlements in an internationalized emerging economic field. If China issues a renminbi stablecoin, its primary purpose should not be to compete with US dollar stablecoins, but to serve the development of emerging economies and the internationalization of the renminbi.

Author of this article: Liu Xiaochun, Source: China Financial Forty Forum, Original title: "Liu Xiaochun: What is the key to the success of stablecoins?"

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