Author: Liu Xiaochun
On May 21, the Legislative Council of the Hong Kong Special Administrative Region of China passed the "Stablecoin Regulation Draft" (hereinafter referred to as the "Draft"). On May 20, U.S. time, the U.S. Senate passed the "Stablecoin Uniform Standards Protection Act" (hereinafter referred to as the "Act"). The cryptocurrency community was abuzz, with various comments circulating, but most did not conduct a specific study of the two legal documents. Some individuals, for various purposes, confused the concepts of stablecoins, cryptocurrencies, and crypto assets, leading to some misunderstanding of stablecoins.
It is necessary to provide a brief and specific analysis of the two legal documents and, based on this, analyze the demands of the relevant parties. As a new type of financial product, stablecoins must have their functions and roles, but the parties involved in the innovation also inevitably have their economic interests. Whether these demands can be met is key to the ultimate success of the financial product. Different methods of issuing and regulating stablecoins will also have varying impacts on the future development of stablecoins, currency circulation, and monetary policy.
Different Regulatory Frameworks in the U.S. and Hong Kong
The "Draft" provides a clear definition of stablecoins, consisting of five points. The first point is relatively simple, describing the form of stablecoins: "expressed in the form of a unit of account or a store of economic value." For example, a Hong Kong dollar stablecoin must clearly state that it is a stablecoin pegged to the Hong Kong dollar and specify its face value in Hong Kong dollars. The second point clearly limits the scope of stablecoins: for payment for goods or services; to settle debts; for investment and trading. This means that the Hong Kong dollar stablecoin is a means of payment, not an asset for investment or speculation. The term "trading" here considers that Hong Kong, as an open economy, will involve exchanges between local and foreign currencies, and the Hong Kong dollar stablecoin can also be traded against foreign currencies in circulation. The third point clarifies the storage and transfer methods of stablecoins: they can be conducted electronically. The fourth point further specifies that operations must be on "distributed ledgers or similar information storage repositories." These two points can be said to limit the application field of stablecoins, meaning that stablecoins can only be digital and can only operate and circulate online. The fifth point clarifies the value basis for stablecoin anchoring: a single asset; a group or basket of assets. For Hong Kong dollar stablecoins, the anchored assets are primarily in Hong Kong dollars, and the reserve assets must be high-quality, highly liquid, and low-risk assets.
The "Draft" also includes specific regulations regarding the supervision of stablecoins. First, the issuer of stablecoins must be a "company," meaning a profit-oriented commercial entity. 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 regulated by the Hong Kong Monetary Authority.
Secondly, there is a capital requirement, with a minimum of 25 million Hong Kong dollars or an approved equivalent amount in currency. This means that 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. This means that reserve assets are earmarked for specific use and can only be used as funds for redeeming 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 promptly meet the redemption requests of holders without imposing excessively strict conditions, but reasonable fees may be charged; (2) The issuer must establish KYC (Know Your Customer) and AML (Anti-Money Laundering) systems that comply with the requirements of the Hong Kong SAR government; (3) Establish information security management and anti-fraud regulatory requirements that meet the Hong Kong SAR government's standards; (4) Establish reasonable channels for user complaints and feedback mechanisms. All these regulations indicate that even if the Hong Kong dollar stablecoin utilizes distributed accounts and conducts 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 issuing entity, which are the same as the qualifications for executives of exchanges set by the Securities and Futures Commission.
Sixthly, the stablecoin issuer 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 may only operate stablecoin businesses and must not engage in other businesses beyond their license. 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 aims to provide an innovative payment tool for new economic fields such as WEB3 (protocolization of internet functions) and crypto asset trading, while avoiding risks 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.
The U.S. "Act" and Hong Kong's "Draft" have similar regulatory logics overall, but each has its own characteristics.
Similarities between the "Act" and the "Draft": First, both anchor assets to fiat currency (the U.S. dollar) 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, and issuing institutions are subject to the Bank Secrecy Act, requiring them to fulfill KYC and report suspicious transactions. Fifth, the payment of interest or returns on stablecoins is prohibited. Sixth, the "Act" grants regulatory authority 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.
Additionally, there are some differences in details, such as the U.S. being more specific about the types of reserve assets for stablecoins, while Hong Kong only sets requirements for the nature of reserve assets, leaving some room for exploration.
Both Hong Kong and the U.S. have legalized local currency stablecoins and brought them under regulatory oversight, providing new settlement tools for emerging economic fields while preventing such innovative settlement tools from negatively impacting sovereign currencies and financial markets. The key is to clarify the nature of stablecoins, namely that fiat-backed stablecoins are payment and settlement tools, strictly distinguishing them from securities tokens, and strengthening the regulation and disclosure of reserve assets, as well as enhancing anti-money laundering and anti-terrorism financing requirements.
Stablecoins Are Similar to Bank Notes
From the legal documents regarding stablecoins in Hong Kong and the U.S., the rules for issuing and managing stablecoins are fundamentally similar to those for bank notes, and they also bear some resemblance to 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 they can issue Hong Kong dollars. This means that the note-issuing banks must have 100% U.S. dollar reserves to ensure they can meet the demand for redemption of equivalent U.S. dollars by 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 this bank note to pay for goods or services, settle 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 generated in this way, and the rules for pawnshop notes are similar. It can be said that fiat-backed stablecoins are a type of currency under the conditions of legal tender.
The emergence of bank notes, paper currency, and pawnshop notes is due to the same reason: physical cash is heavy and unsafe to carry over long distances. With the widespread adoption of electronic payments, the environment for using bank notes has largely disappeared, making them hard to find. The emergence of paper currency, bank notes, and pawnshop notes was predicated on the invention and popularization of paper, but the fundamental demand was the inconvenience and insecurity of carrying physical currency over long distances. The technological premise for stablecoins and crypto assets is encryption code technology. Therefore, what are the specific application needs for stablecoins as payment tools or quasi-currencies?
Years ago, JPMorgan Chase issued JPM Coin, with issuance rules similar to those of stablecoins and bank notes. As the most important U.S. dollar clearing bank, JPMorgan Chase intended to consolidate its leading position in cross-border U.S. dollar clearing. However, over the years, it has not found applicable scenarios for interbank cross-border clearing. In recent years, JPMorgan Chase has begun to collaborate with other institutions to explore some alternative application scenarios, seemingly making progress. However, whether commercial applications can ultimately be realized remains to be seen.
Additionally, the model of Western Union is also quite similar to that of bank 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. Stablecoins are essentially a certificate that can be redeemed for an equivalent amount of legal 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 all require a clear measure of value and stable value. Whether for face-to-face payments, cross-space payments, immediate payments, or deferred payments, they must be safe, convenient, and quick. On the other hand, issuers have the impulse to overissue, which can lead to risks such as mixed quality and counterfeit issues. These risks are not imaginary and do not only exist under traditional paper currency conditions. Unfortunately, technology, including blockchain and encryption technology, cannot solve the problems of human greed and capital avarice. For the U.S., the risk of stablecoin runs is real and has already occurred. In May 2022, the U.S. dollar-pegged stablecoin TerraUSD experienced a severe run, leading to its collapse and ringing alarm bells for regulators. Consequently, both Hong Kong and the U.S. have imposed strict and clear requirements on the quantity, quality, and management of stablecoin reserve assets in their respective acts.
Demands of Stakeholders Related to Stablecoins
The emergence of any phenomenon in human society is driven by demand, and behind that demand are the interests of various stakeholders. Only by meeting the different demands of various stakeholders can a payment tool be truly accepted. On the surface, a payment tool involves only the two parties in a transaction; as long as the exchange demand is met, it can functionally achieve convenient, safe, quick, and accurate value transfer. However, the smooth operation of a payment tool relies on a complete system of issuance, management, and operation, which requires significant cost investment. With investment comes the inevitable demand for returns. Therefore, the issuers of stablecoins or the investors in stablecoin issuing institutions are the more important stakeholders.
The first stakeholder related to stablecoins is the payer. For the payer, using stablecoins for payment in specific fields or scenarios is quicker and safer than using legal currency; otherwise, there would be no need to go through the trouble of converting legal currency into stablecoins. Secondly, the exchange rate for converting legal currency into stablecoins should be 1:1, with no financial cost. Finally, the cost of using stablecoins for payment should generally be lower than that of using legal currency, at least the returns from transactions using stablecoins should be higher than or equal to those from transactions using legal currency.
For the payee, first, accepting stablecoins makes it easier to complete transactions than accepting legal currency. Secondly, the stablecoins received must be redeemable at a 1:1 ratio for legal currency, meaning there should be no loss of value. Finally, stablecoins can be used in other payment scenarios that the payee requires.
The aforementioned ease of completing transactions using stablecoins compared to legal currency, or specific transaction scenarios, may fall into two categories: first, the emerging digital economy supported by new digital technologies, where, due to technical reasons, legal currency currently struggles to support payments in this field, or even if it can, the efficiency and cost are not economical; second, transactions that are currently prohibited or restricted by law. Therefore, both Hong Kong and the U.S. acts include regulatory requirements for anti-money laundering and anti-terrorism financing.
The issuer of stablecoins invests significant costs in the issuance, management, and operation of stablecoins. Without acceptable returns, there is no incentive to invest. For issuers, the most direct and crude profit comes from issuing stablecoins or even currency without reserves, followed by issuing stablecoins with over-reserves and high leverage. Such phenomena have existed throughout monetary history and payment history, leading to crises of varying magnitudes.
Secondly, there are exchange fees for stablecoins, which include fees charged for redeeming the stablecoins they issue, as well as fees for exchanging other stablecoins. Under conditions of metallic currency, paper currency, and paper bank notes, these fees are quite conventional, 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 some 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 this fee remains to be seen in market dynamics. The "Draft" from Hong Kong considers this issue and allows for reasonable fees to be charged during the redemption process.
The third potential source of income is using the funds obtained from issuing stablecoins for various investments to generate returns. Historically, there have been countless bloody lessons in this regard, with lighter cases causing liquidity issues for stablecoin redemptions due to overly large investment scales and long durations, and heavier cases resulting in the inability to redeem stablecoins due to investment failures.
Therefore, both the Hong Kong and U.S. acts impose strict regulations on the types of reserve assets and require that stablecoin operations and reserve assets be strictly isolated 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 are liquid, they are ultimately not legal tender, and excessive investment can also affect the liquidity of stablecoin redemptions.
Additionally, fluctuations in market interest rates can affect the returns on reserve assets and may also impact the operational safety of issuing institutions. Future regulations will need to clarify the structure of reserve assets for stablecoins and the ratio of stablecoin issuance scale to capital.
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 may not be highly efficient, they do not have such conditional constraints. Therefore, technology companies related to these technical supports are also stakeholders in stablecoins. These technical support institutions may be the same as the stablecoin issuing institutions or different entities, and they also need to share in the benefits during the issuance and operation of stablecoins.
Moreover, governments and regulatory agencies are also stakeholders in stablecoins, with their demands being to promote economic growth, maintain the stability of legal tender, 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, with the advantages provided by technology in the payment process being secondary. The outcome of the various parties' negotiations may result in different stablecoins being widely used or in different stablecoins being used in their respective limited fields, potentially becoming specialized stablecoins, or they may be replaced by central bank digital currencies. Unless the existing state structure changes, stablecoins will never fully replace legal tender; they can only serve as an auxiliary payment tool for legal tender. Currently, stablecoins as payment tools mainly play a role in specific digital economic fields, 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 already grown large enough to impact the stability of the financial system. Therefore, from both the perspective of inclusive innovation and maintaining financial stability, it is time to implement regulatory management.
Stablecoins Impact Monetary Policy
As payment tools, stablecoins linked to legal tender are a form of quasi-currency and are essentially circulating currency. If the issuer uses all the legal currency obtained from issuing stablecoins to grant loans, it is equivalent to injecting an equal amount of currency into the market. If, according to the requirements of the Hong Kong and U.S. acts, part of it can be used to purchase government bonds or other high-quality assets, it means that a portion of currency is added to the market. If all the legal currency obtained is held as reserve assets without any investment, it will not increase the currency supply.
If stablecoin reserve assets 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 reserve assets can be redeemed at any time, it will not increase the currency supply; otherwise, it will also increase the currency supply. Therefore, the investment of stablecoin reserves in government bonds and other assets, due to the volatility of stablecoin redemptions, will also have a considerable impact on the market for government bonds. An effective payment tool will invigorate economic operations and significantly impact the money supply and market interest rates. Thus, the scale of stablecoin issuance and regulatory models must be considered in formulating monetary policy.
Stablecoins, based on distributed ledger systems, represent a disintermediated payment method that may have completely different circulation rules compared to traditional cash. In today's electronic, networked, and digital banking account systems, cash circulation is more about personal offline payments, characterized by small transaction amounts, low frequency, and dispersed usage. Stablecoins are primarily applied in virtual economic fields such as WEB3 and DeFi (Decentralized Finance), where both institutions and retail investors coexist, with larger transaction amounts and higher trading frequencies. Although they are distributed and can facilitate peer-to-peer payments, most transactions are still exchanges of virtual assets or crypto assets on trading platforms. As stablecoin issuing institutions, the legal obligations for anti-money laundering, anti-terrorism financing, and KYC are implemented only during the issuance and redemption of stablecoins, and it remains to be seen whether they must also monitor the trading behaviors of stablecoin holders. Currently, neither the Hong Kong nor the U.S. acts provide clear guidance on this.
Cross-border payments are currently a hot topic and selling point in the exploration of stablecoins. Direct payments between the payer and payee are certainly more straightforward and efficient than remitting through banks or other intermediaries. However, payment is just one aspect of market operations, ultimately aimed at obtaining returns denominated in legal currency. Therefore, stablecoins must ultimately be converted into legal currency and recorded in bank accounts to earn interest income. Additionally, the exchange of different currencies in cross-border payments is not something stablecoins can resolve; it ultimately needs to be achieved through the banking clearing system. Thus, the true success of stablecoins does not lie in separating from the banking system but rather in achieving efficient and seamless integration with it. Moreover, stablecoin issuing institutions issue stablecoins and accept legal currency; they invest in bonds and other reserve assets using legal currency; and they must redeem stablecoins through bank accounts. This is also a concern for currency circulation management and stablecoin regulation, and currently, there are no clear arrangements in the Hong Kong and U.S. acts regarding this.
Historically, there have been instances where banks could issue currency. In the 1840s and 1850s, the U.S. had over 8,370 different currencies circulating in the market, and the inefficiency and chaos of this situation are easy to imagine. If each stablecoin issuing institution only issues and applies stablecoins in limited specific fields, with slight overlaps in their applications, there is no problem with multiple institutions issuing stablecoins. However, if all stablecoins circulate throughout the market, it will inevitably lead to some confusion and inefficiency. If such a phenomenon occurs, both the market and regulators will choose to moderate concentration. Therefore, the development model and scale of stablecoins after legalization still need to be tested by the market and regulation.
Seven Recommendations 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 the fields of 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 under current laws, this does not negate the feasibility of cryptocurrency technology in payment and settlement functions, which can certainly play a role in legal trading fields.
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 payment and settlement methods using legal currency cannot meet the needs of such transactions. The other 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 both legal and gray or illegal transactions. As long as illegal transactions can be effectively identified, corresponding regulatory methods can be found.
Third, legislation for stablecoins is necessary for innovation and financial security. The acts in Hong Kong and the U.S. follow innovation while also preventing innovation risks. The innovation of stablecoins as payment tools aims to promote the development of new economic forms such as virtual asset trading; issuing stablecoins is not the end goal. At the same time, it is also due to the recognition of the dual nature of payment tools, and legislative regulation is intended to mitigate risks. It is particularly noteworthy that both Hong Kong and the U.S. have included foreign currency-pegged stablecoins in their regulatory scope. The reason is that foreign currency-pegged stablecoins, if not effectively regulated, can also pose risks to the domestic currency system. With the internationalization of the renminbi, as long as there is demand, it is inevitable that foreign currency-pegged stablecoins will emerge, and the Chinese financial system will inevitably face the potential risks they may bring, making it necessary to formulate regulations to prevent such risks. As equivalents, stablecoins do not distinguish between offshore and onshore, but from a regulatory perspective, the usage scope of different issuers or different stablecoins can be limited.
Fourth, there are no substantial regulatory obstacles to issuing renminbi stablecoins. Stripping away the technical facade, the rules for stablecoins are similar to those for bank notes. Physical cash can be digitized, paper notes can be electronic, and paper bank 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 specific nature of the current stablecoin application fields and, referencing Hong Kong and the U.S., formulate separate regulations for stablecoins. To be cautious, the initial application scope of stablecoins can be limited. Considering the issuers' impulse to overissue and the impact of excessive stablecoin issuance on the money supply and market interest rates, the issuance volume of stablecoins should be included in the regulatory scope of institutional capital adequacy ratios.
Fifth, the issuance of renminbi stablecoins can create more suitable application scenarios for digital renminbi. Technically, stablecoins and central bank digital currencies are the same; why do stablecoins still exist? Part of this is to evade regulation, but more critically, the mechanisms differ, leading to different motivations for exploring and innovating application scenarios. Central bank digital currency is issued and promoted by the central bank, which leads the expansion of application scenarios, while the central bank's ability to explore application scenarios is limited. Stablecoins are issued by commercial institutions, which have commercial interests in issuing stablecoins and are dedicated to expanding application scenarios. At the same time, due to the high compatibility of application scenarios with the characteristics of stablecoins, the transaction frequency in application scenarios will increase, and system maintenance will also be relatively easy and cost-effective. The central bank digital currency attempts to cover all possible application scenarios, some of which have low transaction frequencies. From a technical and theoretical perspective, the scenarios where stablecoins can be successfully applied are also likely to become applicable scenarios for central bank digital currencies. Therefore, the issuance of renminbi stablecoins actually helps promote the application of digital renminbi.
Sixth, innovate and build a renminbi stablecoin payment system that seamlessly integrates with the banking account system. The technology sector often views the speed of payment in isolation, 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 purpose of issuing stablecoins still being to obtain returns in the form of legal currency. If renminbi stablecoins can initially resolve the connection with the banking account system in their 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. The application of a certain payment settlement method or technology for a currency may facilitate its use, but it will not play a decisive role in its competition. If the credibility of the U.S. dollar collapses, dollar-pegged stablecoins will not save the dollar. However, as long as the dollar remains the primary international reserve and transaction currency, it is normal for dollar-pegged stablecoins to be widely used for payment and settlement in an internationalized emerging economic field. If China issues renminbi stablecoins, its primary goal should not be to compete with dollar-pegged stablecoins but to serve the development of emerging economies and the internationalization of the renminbi.
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