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European Central Bank Issues Paper on Stability of Stable Coins

The European Central Bank has released a paper entitled “In search for stability in crypto-assets: are stablecoins the solution?”  The paper identifies the nature of Stable Coins and aims to create a line of demarcation between the different coin archetypes.

Defining Stable Coins

The report defines Stable Coins as digital units of value that are not a form of any specific currency but which rely on particular stabilisation tools and try to minimise fluctuations in their price. Such coins aim to stabilise major currencies whose prices are volatile by nature.

The paper holds that different types of Stable Coin initiatives can be identified in accordance with the criteria that characterise crypto-assets.

Such criteria entail:

(i) the existence/absence of an issuer that is responsible for satisfying any attached claim;

(ii) the decentralisation/centralisation of responsibilities over the Stable Coin initiative; and

(iii) what underpins the value of a Stable Coin and its stability in the currency of reference.

Stabilisation Mechanisms

The stabilisation mechanism is crucial to determine whether the units issued can maintain a stable value or not.

Stable Coins may be either:

  • backed by funds which an issuer or custodian needs to hold for safekeeping, implying a commitment to their full redeemability and these are known as “tokenised funds”;
  • backed by other traditional asset classes that require a custodian for their safekeeping and are in the Issuer’s possession only as long as the user does not redeem the Stable Coins, or what is left of them in the case of default; these are known as “off-chain collateralised Stablecoins”;
  • backed by assets, typically crypto-assets, which can be recorded in a decentralised manner and do not need either an issuer or a custodian to satisfy any claim; these are known as “on-chain collateralised Stablecoins”; and
  • backed by users’ expectations about the future purchasing power of their holdings, which does not need the custody of any underlying asset, and whose operation is completely decentralised “algorithmic Stablecoins”.

Price Stability – Tokenised Funds

In order for the value of tokenised funds to be stable, users must trust the entity backing the Stable Coin initiative. Tokenised funds do not entail a new type of asset but are representative of existing currency units on a distributed ledger, mirroring either the traditional electronic money approach to retail payments or the prefunding of some existing payment systems.

Price Stability – Collateralised Stable Coins

Collateralised Stable Coins may have a stable price only to the extent that the volatility of issued collateral is addressed by the applied margins. It is to be noted that off-chain collateralised Stable Coins strive to make traditional assets tokenised on a distributed ledger while on-chain collateralised Stable Coins aim to turn highly volatile collateral in the form of crypto-assets into a stable asset, by providing economic incentives to their holders.

Off-chain collateralised Stable Coin initiatives require custodians and issuers for both the safekeeping of collateral and to allow its redemption. On the other hand, On-chain collateralised Stable Coin initiatives can work without the intervention of any accountable party as this is often a decentralised operation.

Price Stability – Algorithmic Stable Coins

Algorithmic Stable Coins have not yet proven capable of withstanding market shocks and maintaining a stable value in the currency of reference. Such Stable Coin initiatives do not involve the intervention of any accountable party and can be seen as an evolution of crypto-assets.

The Future of Stable Coins

In its paper the ECB noted that while stable coins do not seem to be a game changer in the area of retail payments for economies with a stable currency and well-functioning payment systems, they may nevertheless offer a solution in developing economies where trust in the currency and in the payment system is low. The use of blockchain technology and crypto assets has already been lauded as a step in the right direction for helping the unbanked in these developing countries.

The paper concludes that stable coins requires clear governance, procedures to update the smart contracts at the core of the initiative and a strong cyber-security framework. 

The Regulation of Stable Coins in Malta

Although the Maltese Virtual Financial Assets Act does not define the concept of a “stable coin”, the Act categorises such coins under the overarching notion of “DLT Assets”. The Financial Instrument Test devised by the MFSA under the Act, is then used to determine the legal nature of the stable coin (being a virtual token, financial instrument, electronic money or a VFA) and the applicable regulatory regime.

The VFA Regime has highlighted the importance of having a robust framework regulating DLT Assets, particularly from a cyber-security point of view, and this has been further echoed by the MFSA in its recent Consultation Document on Security Token Offerings.

Article written by Dr Cherise Abela Grech and Dr Luke Mizzi.

For more information on the Regulation of Cryptocurrencies in Malta please contact Dr Ian Gauci on igauci@gtgadvocates.com Dr Cherise Abela Grech on cabelagrech@gtgadvocates.com and Dr Terence Cassar on tcassar@gtgadvocates.com  

This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them.