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What are Stablecoins and what is the reaction of FATF and BIS?



Authors: Carlos David Valderrama Narváez (more information here) and Diego Montes Serralde (more information here).


Context


In October 2019, the G20 asked FATF to consider AML/CFT issues related to Stablecoins, in particular global Stablecoins (i.e., those with the potential for mass adoption).


Last June 2019, the Financial Action Task Force ("FATF") (more information here), issued a report to G20 Finance Ministers and Central Bank Governors on Stablecoins ("Report") (more information here).


In addition, in supplemental reports of the Financial Stability Board ("FSB") (more information here) and the International Monetary Fund ("IMF") (more information here) examined other consequences of Stablecoins, including their financial stability and macroeconomic impact.


An additional study was conducted by the BIS just in October 2019 regarding the impact of global Stablecoins (more information here).


What is FATF?


The Financial Action Task Force is an independent inter-governmental body that develops and promotes policies to protect the global financial system against money laundering, terrorist financing and the financing of the proliferation of weapons of mass destruction. The FATF recommendations (more information here) are recognized as the global standard against money laundering ("AML") and terrorist financing ("CFT").


FATF was created in 1989 by the G-7 and currently has 37 members, 35 countries and 2 international organizations.


Mexico is a member of the FATF, and has been evaluated on three occasions in 2000 (when it was accepted as a full member), 2003 and 2008. in addition, it should be noted that Mexico assumed the presidency of the Group for the period from July 2010 to June 2011. (more information here).


What are Stablecoins?


Stablecoins are cryptoassets designed to mimic the value of fiat currencies such as the dollar or euro. They allow users to transfer value quickly and cheaply around the world while maintaining price stability.


Cryptocurrencies such as Bitcoin and Ether are notorious for their volatility when priced against fiat currency. This is to be expected, as Blockchain technology is still very new, and cryptocurrency markets are relatively small.


As a medium of exchange, cryptocurrencies are excellent from a technological point of view. However, fluctuations in their value have made them very risky investments, and they are not ideal for making payments.


By the time a transaction settles, the coins may be worth much more or less than they were at the time they were sent. But stablecoins don't have that problem. These assets see negligible price movement and closely track the value of the underlying asset or fiat currency they emulate. As such, they serve as safe and reliable assets amid volatile markets.


Types of Stablecoins


There are several ways in which a Stablecoin can maintain its stability, so here are some examples and types.


Binance, one of the largest exchanges and crypto ecosystems in the world, mentions that Stablecoins are divided into two main categories (more information here):


  • Stablecoins backed by fiat currencies, cryptocurrencies or commodities.


The most popular type of Stablecoin is one that is directly backed by fiat currency with a 1:1 ratio.


A central issuer (or bank) holds an amount of fiat currency in reserve and issues a proportional amount of Stablecoins.


For example, the issuer may hold one million dollars, and distribute one million Stablecoins of one dollar each. Users can trade freely with them as they would with cryptocurrencies, and at any time, holders can exchange them for their dollar equivalent.


Clearly, there is a high degree of counterparty risk that cannot be mitigated: ultimately, the issuer must be trusted. There is no way for a user to determine with confidence whether the issuer holds funds in reserve. At best, the issuing company can try to be as transparent as possible when it comes to publishing audits, but the system is far from trustworthy.


It is important to know that the underlying asset paired with the Stablecoin can be fiat currencies, cryptocurrencies such as Bitcoin or Ether and even commodities such as oil or gold.


Commodity-based Stablecoins do not compete directly with fiat currency Stablecoins due to the different nature of the underlying assets. By using both types, professional investors have an easy way to diversify risks (more information here).


Examples: USD Tether, True USD, Paxos Standard, USD Coin, Binance USD, DAI, Tiberius Coin, SwissRealCoin y Digix Gold.


  • Algorithmic Stablecoins

Algorithmic Stablecoins are not backed by a currency or cryptocurrency. Instead, their backing is achieved entirely by algorithms and smart contracts that manage the supply of the issued Stablecoins.


Functionally, its monetary policy is very similar to that used by central banks to manage national currencies.


Essentially, an algorithmic Stablecoin system will reduce the supply of issued Stablecoins if the price falls below the price of the fiat currency that follows.


If the price exceeds the value of the fiat currency, new Stablecoins enter circulation to reduce the value of the fiat currency.


Examples: Zigzag and Carbon.


Benefits of Stablecoins


  • Stablecoins can contribute to the increased use of cryptocurrencies and push them to mass adoption. As they are convenient due to the absence of huge price volatility (unlike most cryptocurrencies) while taking advantage of blockchain technology.


  • It is much more convenient for people to use stablecoins than fiat funds for their transactions, as transactions through brokerage services that accept traditional currencies usually charge high transaction fees.


  • Stablecoins can increase the level of decentralization of the exchange. Decentralized exchanges currently lack popularity, and Stablecoins can lead to a greater influx of new users.


  • Stablecoins decrease losses with a significant market crash. At the time of the cryptocurrency market collapse after 2018, during which many cryptocurrencies fell by 30-70%, Tether's drop was only about 8%.


Maker DAO, creators of DAI, even establishes 10 main benefits of Stablecoins (more information here):

  • Complete Financial Independence

  • Self-sovereign money generation

  • Savings

  • Stable in the midst of volatility

  • Convenient, fast and low-cost remittances

  • Service around the clock

  • Convenient entry/exit doors

  • Transparency above and beyond the traditional financial system

  • Ecosystem enabler and builder of decentralized finance

  • Inherent benefits of Blockchain technology.


Economic Design of Stablecoins


To really reap the benefits derived from the use of Stablecoins, a proper economic design is necessary.


In that sense, Prof. Christian Catalini, co-creator of Diem (formerly Libra) (more information here), together with Research Scientist Alonso de Gortari of Novi (formerly Calibra) (more information here) wrote a research paper called "On the Economic Design of Stablecoins", focusing on the reserve risk of different types of Stablecoins and how to generate a truly robust and durable stablecoin for widespread use (the "Article") (more information here).


The results of the Article are varied, but broadly speaking, two critical dimensions underpinning the economic design of any stablecoin are identified:

  • The volatility of the reserve assets versus the benchmark asset, which defines the stablecoin's risk profile for stablecoin holders; and

  • The degree of exposure of the stablecoin to the risk of a death spiral.


Given that the top five dollar stablecoins have issued more than $110 billion in cryptoassets, it is unclear how many of these stablecoins would be redeemed or refunded to their users at par with the benchmark in the event of a crisis.


From an economic design standpoint, stablecoins face a key challenge: "ensuring that their price trades at parity (or close to) their reference asset".


When their price exceeds parity, stablecoins can restore parity simply by issuing new coins. This increases the supply of coins and puts downward pressure on the price. The proceeds from the sale become reserve assets and are available to meet future redemptions.


Conversely, when the price trades below parity, stablecoins need to create upward pressure on the price by reducing the supply. To remove the coins from circulation, the stablecoin issuer must liquidate the reserve assets and repurchase the coins at (or near) par. In the Article, the authors graphically describe this situation:


The question is then, what type of assets should the stablecoin protocol and reserve be based on? At its core, this is a question about what can happen to the reserve between the issuance and redemption of stablecoins.


Recall that there are two dimensions of risk. First, whether the value of the reserve assets relative to the reference asset (e.g., the dollar) is volatile to begin with, and second, whether the reserve assets are susceptible to a death spiral. We will discuss each of these below.


Volatility


The volatility of the reserve assets relative to the reference asset determines how much of a stablecoin reserve is needed at any point in time to maintain stablecoin parity 1:1 or close to it.


At one extreme, the value of the reserve and the reference asset move in perfect synchrony, the ratio of assets needed to burn a given proportion of supply is constant, and the reserve has zero risk. This is only true for CBDCs (more information here), as the central bank controls both the digital and the reference asset. Although fiat currencies can have low volatility, they also need an adequate capital cushion to offset potential losses due to credit, market, liquidity and operational risk.


At the other extreme, a stablecoin that is backed by non-fiat assets (i.e. dollar, euro or peso), such as crypto-backed stablecoins, will have difficulty defending its parity. For these currencies, the proportion of reserve assets needed to repurchase a given share of the stablecoin supply will fluctuate dramatically over time.


Death Spiral


According to the Cambridge University Dictionary, a death spiral refers to a situation that keeps getting worse and worse and is likely to end badly, with great harm or damage (read more information here).


Now, with respect to stablecoins, death spirals are likely to occur whenever the reserve value of a stablecoin is linked to the future success of the stablecoin itself, for example through the inclusion of an investment token as part of the reserve assets. Since these tokens move in value with changes in expectations about the stablecoin's success, they are the riskiest asset class, as their volatility increases exactly when a stablecoin needs them most to meet redemptions and restore parity.


The authors of the Article generated a diagram demonstrating the probability of a death spiral depending on the stablecoin's reserve design:


Moreover, these tokens can trigger a cascade of redemptions and lose their value even if the stablecoin is initially overcollateralized. All it takes is an initial shock in expectations that triggers a first wave of redemptions and puts a strain on the stablecoin. Now, under stress, the stablecoin would suffer an additional loss of confidence and more redemptions. This negative feedback loop, if not stopped, can quickly turn into a death spiral. Additionally, since the market will know from the beginning how it could develop, even the fear of a financial run can trigger it.


A death spiral would be triggered as follows in these scenarios:


In conclusion, to address these risks (volatility and death spiral), fiat-backed stablecoins must be based on pools of high-quality liquid assets and be subject to a legal framework that protects users from credit risk, market risk and operational risk, as well as insolvency or bankruptcy of the issuer of such cryptoassets.


Although decentralized coin designs eliminate the need to rely on an intermediary, they are either exposed to death spirals or are very capital inefficient, as they must be heavily over-collateralized to compensate for the lack of an intermediary. While these tradeoffs may be acceptable for limited use cases within the cryptocurrency space, without a breakthrough in decentralized stablecoin design, they are likely to limit the utility of these coins for widespread adoption.


Decentralized stablecoin projects, by design, do not build an interface with the traditional banking system and operate without relying on legal agreements. As a result, they face the more difficult and higher intensity challenge of maintaining capital stability versus an offline currency, while only being able to use online and volatile assets such as cryptocurrencies for their reserve.


While the higher volatility risk this entails can be partly offset by high overcollateralization ratios (e.g., $1.5 of backing for every $1 of stablecoin issued), none of the existing designs can guarantee redemptions at par under extreme conditions. This is especially acute for algorithmic stablecoins, where the value of the reserve is tied to the stablecoin's own success via an investment token. While some decentralized stablecoins have shown some resilience to market stress, this is directly due to the fact that they rely heavily on fiat-backed stablecoins for their reserve, essentially inheriting some of the properties of their more centralized alternatives.


Consequently, fiat-backed stablecoins seem to be the only way to ensure long-term stability. But it is not enough to back a stablecoin with low-volatility assets against that benchmark asset. The backing assets must be of high quality, liquid and embedded in a legal framework that protects users. When these conditions are met, stablecoins can offer not only efficient means of payment, but also increased competition in financial services and new use cases.


FATF Report


Now, what does FATF say regarding Stablecoins? To find out, it is important to highlight how their FATF report begins:


"So-called Stablecoins have the potential to stimulate innovation and financial efficiency and enhance financial inclusion. While so-called Stablecoins have so far only been adopted on a small scale, the new proposals have the potential to be adopted en masse on a global scale, particularly when sponsored by large technology, telecommunications or financial companies. As with any other large-scale value transfer system, this propensity for mass adoption makes them more vulnerable to being used by criminals and terrorists to launder the proceeds of their crimes and finance their terrorist activities, thereby significantly increasing the risk that they will be misused for money laundering and terrorist financing purposes."


We know, as the FATF states, that Stablecoins have great potential to stimulate financial innovation and efficiency and enhance financial inclusion, but we also know that there are money laundering related risks associated with any cryptocurrency.


AML/FT Risks


The Report establishes the following associated risks:


As with the AML/FT risks posed by virtual assets more generally, the FATF identified (i) anonymity, (ii) global reach; (iii) layering; and (iv) mass adoption, as particular ML/FT vulnerabilities for Stablecoins.


  • Anonymity: Anonymity is one of the main potential AML/FT risks posed by virtual assets. Many virtual assets have public, permissionless and decentralized Blockchain. While the Blockchain may be accessible to the public, the record may not include any customer identifying information. There may also be no central administrator overseeing transactions. Other virtual assets are private and/or authorized, with only a limited group of entities able to initiate transactions or view and verify the Blockchain. Some virtual assets, known as privacy coins or anonymity coins, have additional cryptographic software that can further conceal transactions.


  • Global reach: Virtual assets can be traded and exchanged over the Internet and can be used for cross-border payments and fund transfers. In addition, virtual assets often rely on complex infrastructures involving multiple entities, often spread across multiple jurisdictions, to transfer funds or execute payments. One of the main use cases for so-called Stablecoins is their purported ability to be a much faster, cheaper and more efficient way to make cross-border transfers, while addressing the volatility issues posed by some virtual assets. Cross-border transfers (such as wire transfers or remittance payments) are inherently higher risk than domestic payments, and are subject to additional AML/CFT measures under Recommendation 16 of the FATF standards.


  • Layering: The ability to rapidly swap between different virtual assets, a technique known as "chain hopping," allows for multiple layering of illicit funds in a short period of time, enabling more sophisticated disguising of the origins of funds. Professional ML networks also appear to have begun exploiting this vulnerability and using virtual assets as one of their means of laundering illicit proceeds. So-called Stablecoins that can be quickly exchanged for virtual assets or fiat currencies could share this vulnerability.


  • Mass adoption: The widespread adoption of existing virtual assets as a means of payment by businesses and consumers has been held back by several factors, including their price volatility, the complexity of their use, trust and security concerns, and the general lack of acceptance of virtual assets as a means of payment. While the situation is still evolving, some of the proposed so-called Stablecoins have the potential to overcome several of these limiting factors. So-called Stablecoins are designed to overcome the problems of price volatility often associated with many virtual assets. Some of the proposed so-called Stablecoins were based on pre-existing communication and messaging systems, which promise to make them simpler and easier to use (e.g., by integrating into messaging or social networking applications with simple user interfaces and an existing global user base of hundreds of millions).


Standards


Now, in June 2019, FATF issued standards applicable in AML/CFT matters to virtual assets and their service providers establishing the first regulatory standard for virtual assets. New guidance was issued on the risk-based approach for virtual assets and virtual asset service providers ("VASPs") (more information here).


The FATF Standards define virtual assets and VASPs and apply to them the full range of AML/CFT requirements set out in Recommendation 15 and its Interpretative Note (more information here).


Under these standards, jurisdictions must assess the ML/FT risks posed by virtual assets and either permit and regulate virtual assets and the activities of VASPs or prohibit them. If jurisdictions regulate VASPs under the FATF Standards, they are subject to the same AML/CFT preventive measures as other financial institutions and entities required to comply with the AML/CFT rules, subject to qualifications on the customer due diligence and wire transfer rules (the "travel rule").


Jurisdictions must also have supervisory regimes in place to enable them to license or register VASPs and to respond to requests for international cooperation relating to VASPs. If a jurisdiction decides to ban VASPs, it must take action against non-compliance with the ban


Since their adoption in June 2019, the FATF has been working to ensure prompt and effective implementation of the Standards by all jurisdictions and to monitor the ML/TF risks posed by virtual assets. Accordingly, the FATF has undertaken a comprehensive 12-month review of the Standards (more information here).


This review has found that progress has been made by jurisdictions and the virtual asset industry in implementing the FATF Standards. 25 of the 39 FATF members, including 12 G20 members, reported that they have now transposed the FATF Standards into their national anti-money laundering and counter-terrorist financing framework.


Application of the Standards to Stablecoins


In the Report, FATF sought to apply the aforementioned Standards to the risks identified for Stablecoins.


In order to understand how the FATF Standards apply to Stablecoins and whether the Standards are sufficient to mitigate AML/TF risks, FATF assessed the five largest Stablecoins by market capitalization:


Tether;

  • USD Coin;

  • Paxos;

  • TrueCoin;

  • Dai

Two Stablecoins proposals were also evaluated:

  • Libra;

  • Gram.

A determining factor is the degree of centralization or decentralization of the stablecoin and whether there are companies performing activities that are covered by the FATF Standards.


In a centralized arrangement, one entity governs the arrangement, and may operate the stabilization and transfer mechanism, and act as a user interface (e.g., offering wallet custody and exchange and transfer services).


In a decentralized arrangement, there may be no central entity governing the system, and the stabilization and transfer functions and user interface may be distributed among a number of different entities or performed through software.


In some cases, there may be both centralized and decentralized elements, e.g., a governing body and third parties with responsibility for specific functions (e.g., exchange or portfolio provision). For example, a Stablecoin may operate stabilization centrally, but the user interface may be distributed among other VASPs.


There may be a limit to the extent to which a so-called Stablecoin can be fully decentralized before launch due to the need for someone to drive the development and launch of the project.


Based on the assessment of the various Stablecoins, the FATF concluded that the rules apply sufficiently to entities participating in these arrangements to mitigate ML/TF risks.


Where they exist and are sufficiently identifiable, central governing bodies will generally be obliged to comply with the AML/CFT standards. As will other entities in the arrangement, such as exchange and transfer services and custodian portfolio providers.


While decentralized arrangements, at first glance, may carry greater ML/TF risks due to their diffuse operation, these risks are limited by what appear to be their apparent natural barriers to mass adoption.


Centralized arrangements may have greater potential for mass adoption, particularly when intended to be integrated into telecommunications platforms, however, they are likely to have more clearly identified entities subject to PLD/CFT regulation. In addition, as noted above, even decentralized products may need a centralized point of control in the pre-launch stage.


Residual Risks


FATF considers that the preventive measures required of intermediaries under the FATF Standards have served to mitigate the ML/FT risks posed by the Stablecoins currently in place. Accordingly, FATF does not consider that the FATF Standards need to be amended at this time. However, FATF recognizes that this is a rapidly evolving area that should be closely monitored and that jurisdictions should effectively implement the Standards.


FATF has also identified potential residual risks that may require additional measures to be taken, including Stablecoins located in jurisdictions with weak or non-existent AML/CFT frameworks (which would not adequately apply AML/CFT preventive measures) and so-called "Stablecoins" with decentralized governance structures (which may not include an intermediary that can apply AML/CFT measures) and anonymous peer-to-peer transactions through non-custodian portfolios (which will not be conducted through a regulated intermediary).


FATF Action Plan


Accordingly, FATF proposes four actions:


a) FATF calls on all jurisdictions to implement the FATF Standards on virtual assets and VASPS as a matter of priority.


b) FATF will review the implementation and impact of the Standards by June 2021 and consider whether further updates are needed. This will include monitoring the risks posed by virtual assets, the virtual asset market and proposed arrangements with potential for mass adoption that may facilitate anonymous peer-to-peer transactions.


c) FATF will provide guidance to jurisdictions on so-called Stablecoins and virtual assets as part of a broader update to its guidance. This will set out in more detail how AML/CFT controls apply to so-called Stablecoins, including the tools available to jurisdictions to address the ML/TF risks posed by anonymous peer-to-peer transactions through non-custodian wallets.


d) FATF will enhance the international framework for VASP supervisors to cooperate and share information and strengthen their capabilities, in order to develop a global network of supervisors overseeing these activities.


Recommendation 15


All of the above is a product of the application of FATF Recommendation 15 which states:


Countries and financial institutions should identify and assess the money laundering or terrorist financing risks that may arise in connection with:


(a) the development of new products and new business practices, including new delivery mechanisms, and.


b) the use of new or developing technologies for both new and existing products.


In the case of financial institutions, such risk assessment should take place prior to the launch of new products, business practices or the use of new or developing technologies. They should take appropriate measures to manage and mitigate these risks.


To manage and mitigate the risks arising from virtual assets, countries should ensure that virtual asset service providers are regulated for AML/CFT purposes, licensed or registered and subject to effective systems for monitoring and ensuring compliance with relevant measures under the FATF Recommendations.


CBDC


The report also mentions digital currencies issued by central banks, also called CBDCs (Central Bank Digital Currencies) (more information here).


The report states that CBDCs could present greater AML/CFT risks than cash. CBDCs could be made available to the general public for use in retail payments or as accounts and, in theory, allow anonymous peer-to-peer transactions.


In this scenario, the CBDC would act as an instrument with the liquidity and anonymity of cash, but without the portability limitations that come with physical cash.


Because they would be backed by a jurisdiction's central bank, they could be widely accepted and used. This combination of anonymity, portability and mass adoption would be very attractive to criminals and terrorists for AML/CFT purposes. As in the case of so-called Stablecoins, these AML/CFT risks should be addressed prospectively prior to the implementation of any CBDC.


As for AML/TF risk mitigation, this will be led by the CBDC issuer.


At the CBDC design stage, the issuer may make design decisions that reflect and mitigate AML/CFT risks. This, for example, could include limiting the ability for anonymous peer-to-peer transactions to be conducted with the CBDC. Jurisdictions are already required under the revised FATF standards to identify AML/CFT risks related to new technologies and to implement appropriate measures to mitigate those risks.


FATF Red Flags


A new communiqué, issued on September 14, 2020 (more information here), FATF generated new recommendations for member countries, which detail the actions of users who transact with virtual assets, which should trigger certain alarms in regulators and security officers in each country, the so-called red alerts or red flags in the use of virtual assets.


The FATF report indicators are based on literature, open resources and more than 100 case studies, contributed by different jurisdictions in the years 2017 to 2020.


FATF mentions that the existence of a single indicator is not necessarily an indicator of criminal activity, but states that the existence of several indicators with no "business explanation" may raise suspicions of criminal activity.


Risk indicators are divided into:

  • Transaction-related indicators

  • Indicators related to transaction patterns

  • Indicators related to anonymity

  • Indicators related to senders and receivers

  • Indicators related to the origin of resources

  • Indicators related to geographic risks


Examples of activities that constitute an alert