Prepared with the assistance of Adina Chis of the Firm's London office.

The International Organization of Securities Commissions (“IOSCO”) and the Committee on Payments and Market Infrastructures (“CPMI”) have issued a report (the “Report”) highlighting some regulatory concerns and providing general guidance on the application of the Principles for Financial Market Infrastructures (“PFMIs”) to systemically important stablecoin arrangements (“Stablecoin Arrangements”). The Report does not seek to create new standards for Stablecoin Arrangements but rather outline how existing PFMIs will apply to Stablecoin Arrangements. IOSCO and CPMI are inviting comments on the Report by December 1, 2021.

The two standard-setting bodies share the view that the “transfer function” of a Stablecoin Arrangement (i.e. the ability to transfer value between users) is similar to the “transfer function” in other types of financial market infrastructures (FMIs)[1] and constitutes a FMI function. Where Stablecoin Arrangements are used for making payments, they attract the relevant principles applicable to all payment systems, notably: Principle 2 (Governance), Principle 3 (Comprehensive Risk Management), Principal 8 (Settlement Finality) and Principal 9 (Money Settlements).

This Report follows previous reports with respect to stablecoins issued by both the G7 Working Group on Stablecoins and the Bank for International Settlements.

Novel Features of Stablecoin Arrangements

The Report notes that Stablecoin Arrangements have certain novel and unique features, namely:

• settlement occurring through a method other than central bank money or commercial bank money;
• interdependencies between multiple functions;
• decentralisation of operations and governance; and
• new technologies such as distributed ledger technology (“DLT”).

Systemically Important Stablecoin Arrangements

In determining whether a Stablecoin Arrangement is systemically important, the Report recommends that authorities consider the following factors alongside general PFMI guidance and any other aspects that the authority considers relevant:

• the size of the Stablecoin Arrangements, including the number of users and the number and value of the transactions and the value of stablecoins in circulation;
• the nature and risk profile of the Stablecoin Arrangement’s activity, considering the type of stablecoin user (retail customer or financial entities), and the type of transaction (time criticalness, purpose, denomination and retail or wholesale);
• the interconnectedness and interdependencies of the Stablecoin Arrangements with the real economy and financial system; and
• the substitutability of the Stablecoin Arrangements as means of payment or settlement for time-critical services.

Reconciling the Novel Stablecoin Arrangement Features and the PFMI

A: Governance – Principle 2

Context: Principle 2 outlines the expectation that an FMI governance framework should promote the safety and efficiency of the FMI and support the stability of the broad financial system. To be compliant with Principle 2, the FMI’s risk-management framework should be documented, have clear and direct guidelines of responsibility, accountability, and include defined FMI directors and management roles and responsibilities for risk decisions and decision-making in crisis situations. Further, where an FMI is composed of more than one legal entity, Principle 2 should equally apply to both parents and affiliated organisations.

Compliance issues:

• Partial or full decentralised governance - Where the Stablecoin Arrangement’s governance is partially or fully decentralised with no legal entity controlling the FMI functions such as, for example, where the transfer function is set up as a smart contract on a permissionless public ledger, the governance structure is fully performed by software with no legal entity responsible or accountable for the risks involved.
• Inflexible software – Governance implemented solely by software is unlikely to be sufficiently flexible for the dynamic environment in which FMIs operate. Even though, the software may foster predictability and transparency, it lacks the discretionary decision making in unforeseeable circumstances and therefore effective execution cannot be achieved without human intervention.
• Other Stablecoin Arrangement functions - The governance of other Stablecoin Arrangement functions may impact an Stablecoin Arrangement’s ability to be compliant with Principle 2 as effective governance cannot be achieved without the alignment in governance arrangements of all the Stablecoin Arrangement functions.
• Guidance: Stablecoin Arrangements should have appropriate governance arrangements that clarify the lines of responsibility and accountability within the identifiable structural organisation(s); Stablecoin Arrangements should ensure that Principle 2 and the other relevant principles of the PFMI are adhered to irrespective of the governance arrangements of other interdependent functions.

B: Risk Management – Principle 3

Context: Principle 3 of the PFMI aims to promote integrated and comprehensive views of the risks FMIs pose on their participants and customers as well as on other FMIs, banks, and liquidity and service providers. The expectation is that FMIs will have sound and comprehensive risk-management frameworks to manage their risk portfolio.

Compliance issues: Stablecoin Arrangements fulfil a variety of functions, some of which, may not fall within the scope of the PFMI as they do not constitute an FMI function. Furthermore, based on a Stablecoin Arrangement’s organisational model some of these functions might be performed by different entities independent from the entity performing the transfer function and/or may not qualify as participants or service providers to the FMI. What’s more, other Stablecoin Arrangement functions and the entities that perform them can impact the transfer function and vice versa, which can make it difficult to comprehensively manage risk as required by Principle 3. Similarly, the multitude of interdependent Stablecoin Arrangement functions may hinder the identification of the responsible entity required to comply with Principle 3.

• Guidance: A Stablecoin Arrangement should systematically and regularly review the material risks presented by FMI functions, and ensure that appropriate risk-management frameworks and tools as well as related risk mitigation policies are implemented.

C: Settlement finality – Principle 8

Context: Principle 8 of the PFMI defines final settlement as “the irrevocable and unconditional transfer of an asset or financial instrument, or the discharge of an obligation by the FMI or its participants in accordance with the terms of the underlying contract. In addition, Principle 1 defines the finality of the settlement as a legally defined moment. And, the use of a distributed ledger may create friction between the legal finality and the technical settlement.

Compliance issues:

• “Probabilistic settlement”[2]- With probalistic settlements, even if there is a defined point at which final settlement occurs, the possibility remains that forks emerge that could lead to a reversal of the technical settlement of transactions. The probability of a technical settlement being conclusive increases as more transactions are added to the ledger. At the same time, settlement risk implications of a fork increase with the number of transactions added to the ledger as well, as they are subject to a potential reversal.
• Absence of responsibility for transfers – The absence of a legal entity responsible for Stablecoin Arrangements transfer function can exacerbate the friction between the technical and legal settlement, as there is no legal entity against which to enforce the legal settlement. Even in situations where the legal finality and technical settlement are aligned, the transaction with the technical settlement could continue on the basis of a forked[3] This has the consequence of the new transactions on the forked ledger being potentially subject to full or partial reversal, even if they might have achieved technical settlement.
• Guidance: A systemically important Stablecoin Arrangement should seek to clarify the point at which a transfer on the ledger becomes technically irrevocable and ensure transparency as to whether and to what extent misalignments in type of settlements might occur. A systemically important Stablecoin Arrangement should also seek to implement transparent mechanisms to reconcile misalignments and adopt measures to address potential losses stemming from such misalignments.

D: Money Settlements - Principle 9[4] 

Context: Credit risk is where there is a risk that a provider of the settlement asset defaults on its obligations to the participant and liquidity risk is where the assets are not readily transferable into liquid assets. These risks have systemic implications because, where more than one participant holds a settlement asset, all participants are exposed to the risks simultaneously.

Compliance issues:

• Credit and liquidity risks- where a stablecoin is used as a settlement asset, it is inevitable that the participants will be subject to the credit and liquidity risks of the stablecoin itself, the issuer and/or the settlement institution. The consequence of this is that the FMI and its participants will not benefit from having readily transferable assets into other liquid assets. Stablecoin as a settlement asset is envisaged by both standard setting-bodies as being a greater risk than the acceptable “little or no risk” yardstick because the settlement asset may be subject to an insolvency of the settlement institution, private third party claims on the issuer, etc.
• Reserve assets[5] - A Stablecoin Arrangement has a great degree of flexibility in the manner and extent to which it sets up and handles reserve assets. Flexibility in choosing a technical design, a contractual framework governing the relationship within the multiple participants and a favourable jurisdiction are all important factors when it comes to the protection of the rights of stablecoin holders and their confidence in a particular Stablecoin Arrangement. To ensure protection of participants, Stablecoin Arrangements should promote high levels of transparency and clarity. The levels of protection and confidence in the system will also depend on the sufficiency of the regulatory and supervisory frameworks that apply to issuers, reserve managers and custodians of reserve assets.
• Exposure to other credit and liquidity risks - Participants might be exposed to credit risk where the value of the stablecoin decreases in response to the sovereign currency in which it is denominated or pegged or if the issuer defaults on its obligations to the participant. Similarly, liquidity risk can also occur where the stablecoin cannot be promptly converted into a liquid asset. This is problematic because the participant cannot be sure that the settlement asset will provide the value of the settlement award agreed to. The risk is even greater in some Stablecoin Arrangement models where the two institutions perform two different functions, such as settlement and issuance, because the participant can face both credit and liquidity risks from both of these institutions. To mediate and limit these risks, collateral pools supporting committed lines of credit and third-party guarantees and procedures should be part of the Stablecoin Arrangement risk-adverse measures.
• Run risk - the insufficiency of reserve assets or their inability to become liquidated, at or close to market values, in a timely manner can result in loss of stablecoin value which can ultimately lead participants to lose confidence in the Stablecoin Arrangement. The consequence of such loss is that it might result in large scale redemptions or large scale “fire sales” of reserve assets which could reduce the value of the stablecoin even further. This may have systemic implications when they spread to non-retail participants who hold the stablecoin or financial assets in which the stablecoin’s reserve assets are invested. The absence of proper means to monitor, mitigate and manage these risks put the stablecoin at greater risk than a commercial bank held asset.
• Variety of models – The variety of Stablecoin Arrangement models cause them to be intertwined with the safety and efficiency of Stablecoin Arrangements’ transfer function - some non-banks may issue stablecoins that represent assets held in safeguarded custody in the name of the Stablecoin Arrangement rather than stabilising the stablecoin’s value by actively managing the reserve asset. This feature places credit and liquidity risks on both the Stablecoin Arrangement and the participants if the custodian of the assets defaults on their obligation to either of the parties.

Guidance

A stablecoin used by a systemically important Stablecoin Arrangement for money settlement should have little or no credit or liquidity risk. The stablecoin should provide its holders with a direct legal claim on the issuer and/or claim on title to, or interest in, the underlying reserve assets and have a robust process for fulfilling holders’ claims in both normal and stressed times.

• Similarly, in determining acceptable alternatives to central bank money, it would be necessary to consider the following factors: clarity and enforceability of legal claims, title, interests and rights of stablecoin holders and Stablecoin Arrangement participants, the nature, sufficiency and liquidity of the Stablecoin Arrangements reserve assets, clear stablecoin conversion procedures for different liquid assets, the creditworthiness, capitalisation, access to liquidity and operational reliability of the issuer of the stablecoin, provider of the settlement accounts and custodian(s) of the reserve assets, sufficiency of the regulatory and supervisory frameworks that apply to all parties involved and risk management measures.

Conclusion

Given recent issues involving certain Stablecoin Arrangements, the guidance in the Report is especially welcome in providing clarity on how to apply the PFMIs to such arrangements, and how to assess and mitigate the various risks associated with this novel type of FMI.

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[1] FMI is defined within PFMI as a multilateral system among participating institutions, including the operator of the system, used for purpose of clearing, settling or recording payments, securities, derivatives, or other financial transactions.

[2] Where there is a misalignment between the legal finality and technical settlement, for example where a legally finality has been contemplated to be achieved but the occurrence of a “fork” in the source code delays or sometimes reverses the technical settlement.

[3] We refer here to hard forks, representing either a scheduled major update or an attack on the source code causing the current state of the ledger to conflict with this update. Since blockchain is immutable, the updated source code needs to split from the initial source code and creates an entirely new separate ledger.

[4] Principle 9 of the PFMI seeks to ensure the FMI conducts its money settlement in either central bank money or, where it can minimise and strictly control the credit and liquidity risks, commercial bank money can be used.

[5] The underlying funds, securities or other assets backing the stablecoin.