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Central banks should take advantage of stablecoins current low risks and build up a regulatory framework, the European Central Bank (ECB) has declared in its Financial Stability Review.
Twice a year, the ECB publishes its Financial Stability Review, which provides an overview of potential risks to financial stability in the euro area.
In its latest report, the central bank has warned that appropriate regulatory, supervisory and oversight frameworks must be put in place urgently before stablecoins pose greater risks to financial stability.
Stablecoins are a form of digital currency, whereby the price is pegged to the value of fiat money or a type of commodity like precious metals.
Although they have encountered momentum through big-name investors such as Facebook (and supposedly Amazon as well), the road has not been clear for this form of digital money.
The Facebook-backed Libra Association, for example, started off with much fanfare, but has since found itself surrounded by suspicious, anxious regulators and politicians which have stifled its route to market.
This controversy and almost endless scrutiny led to a rebrand, becoming the Diem Association at the end of 2020, and the launch of a new charm offensive aimed at regulators.
The ECB name-checks Diem as an example of a stablecoin launching without a proper regulatory grip.
“There are still few connections with the traditional financial system. However, the stablecoin landscape is evolving rapidly, with the growing participation of retail and institutional investors and a potentially larger role for banks,” the report says.
“It is currently planned that the Diem stablecoin will be issued by a commercial bank which will also manage the underlying reserve assets,” it points out.
Yet the Diem Association is just part of the conundrum for the ECB, as Facebook has its fingers in other pies too.
The use of stablecoins may accelerate if large technology companies (bigtechs) start offering their own or integrate existing stablecoins into their wallets, the Frankfurt-headquartered central bank warns.
For example, Facebook recently launched a pilot of its Novi wallet in the United States and Guatemala using the stablecoin Pax Dollar.
However, high transaction fees are limiting the use of stablecoins as a form of payment, the ECB points out.
“For users to consider making payments with stablecoins, issuers need a blockchain with stable and low transaction fees,” the ECB says.
And yet, the fees on the Ethereum blockchain, where most stablecoins are currently issued, are considered too high and too volatile for payment use.
The situation could result in stablecoin users switching to a cheaper blockchain, the ECB says, pointing out that the supply of Tether on Tron – a blockchain that offers users a daily number of free transactions and generally low transaction fees – has now surpassed that taking place on Ethereum.
Full disclosure needed
According to the ECB, stablecoins also have a lack of transparency and risk prompting losses for consumers who choose to invest in them.
“Too few details on the reserve asset composition of major stablecoins have been disclosed for the risks within these reserves to be fully understood,” the ECB highlights in its report.
For example, Tether, the largest stablecoin by market capitalisation, published a reserve breakdown which shows half of the reserve assets were invested into commercial paper and 21 percent in cash and bank deposits. The ECB points out that a lack of more granular information on its commercial paper investment makes it difficult to form a clear view of the liquidity of its holding.
Although stablecoins have a reputation as being more stable than the incredibly volatile crypto offerings such as Bitcoin, the ECB still warns that they risk consumer losses.
“Stablecoin liquidity providers run the risk of incurring significant losses, even if the stablecoin itself remains stable,” the report warns.
This is due to trading and lending activities between crypto-assets and stablecoins, which are governed by software protocols, otherwise known as smart contracts.
Trades between stablecoins and crypto-assets are enabled by liquidity pools, and liquidity providers earn income from the transaction fees paid for the trades they facilitate.
Although this can have its upsides, such as if the crypto-asset increases in value, the smart contract governing a liquidity pool requires the asset pair in that pool to maintain a constant total value, the ECB points out.
“As a result, a price decrease for Ether creates arbitrage opportunities that increase the supply of Ether in the Ether/Tether pool but reduce the supply of Tether,” the report says.
In turn, the liquidity providers suffer a reduction in the total value of the liquidity pool in fiat currency, which could drop to zero if the Ether price falls to zero.
Can MiCA save the day?
In spite of its worries, the ECB is not alone in wanting to address the problem. The European Union last year proposed the Markets in Crypto-Assets (MiCA) Regulation to establish a regulatory framework for crypto, which the ECB highlights as a “significant step forward” in its review.
MiCA has a significant focus on requirements for stablecoins, referred to in the European Commission’s draft text as e-money tokens (stablecoins whose value is pegged to a single fiat currency) and significant asset-referenced tokens.
Unlike other cryptocurrencies, stablecoins need to be authorised by regulatory institutions to be traded within the EU and the authorisation requirement applies also to stablecoins already in circulation.
As a result, when the regulation has passed through the political negotiations between member state governments, the European Commission and the Parliament, existing stablecoins will have to seek authorisation from the regulatory authorities to be traded in the EU.
What is more, the stablecoin rules will be fast-tracked into applicability as member states are concerned about how long the legislative process could take, EU civil servants confirmed last year.
The prospect of such strict rules has not gone down well with some parts of the industry.
One e-money insider told VIXIO earlier this year that the regulation needs to adjust its focus, considering it comes across like a knee-jerk reaction to Diem.
Europe’s parliamentarians want to go even further. In a draft report by the influential Economic and Monetary Affairs Committee, members of the European Parliament amended the MiCA to state that EU institutions need to be equipped with more legal powers to veto the use of digital currencies in the trading bloc.
If successful, this would mean that crypto-asset providers will have to be approved by EU-level institutions once the MiCA regulation becomes law.
