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

• If a person buys BTC on a cryptocurrency exchange in their country and immediately sends a portion to their Coinbase wallet, another to their Binance wallet and another to their BlockFi wallet, they may be considered suspicious for immediately transferring funds to multiple virtual asset service providers.

• If a person makes multiple high-value cryptocurrency transactions in less than 24 hours by using a new account or one that has been inactive for a long time, it is also considered as an indicator of risk.

• If a person splits a high value transaction into multiple small amount transactions it is also considered a risk indicator whereby transactions are structured in small amounts and below record keeping or reporting thresholds.

• If you buy a cryptocurrency using fiat money at a price much higher than the market value, a risk indicator is also triggered by making a crypto-fiat exchange with a potential loss with no logical business explanation.

• Converting a large amount of one type of crypto-asset into other types of crypto-assets without logical commercial explanation triggers a risk indicator. Here fits inexperienced trading for example.

• Users with irregularities in their account creation and KYC process with a cryptoasset service provider will turn on a risk indicator.

• If the majority of a client's source of wealth derives from investments in virtual assets, ICOs or fraudulent ICOs, a risk indicator lights up.

Existing solutions

Something that catches our attention is that one of the major problems identified by FATF regarding the use of Stablecoins is anonymity and peer-to-peer transactions with non-custodied wallets, although the technology itself already solves the problem by helping with identification and traceability. This is possible even in protocols designed to generate greater anonymity such as Zcash and Monero (more information here, analysis of Carnegie Mellon).

Another great example of the traceability granted by Blockchain is the existence of firms such as Chainalysis (more information here) which provides Blockchain data and analytics to government agencies, exchanges and financial institutions in 40 countries.

Chainalysis is a forensic firm that assists with AML/CFT compliance. They have two very powerful solutions, KYT (Know-your-transaction) and Chainalysis Reactor.

Last June 9, the firm published a press release (more information here) in which they mention that they have added Dash and Zcash to their traceability and tracking software. As we know Dash and Zcash allow users to transact with greater privacy, but that doesn't mean they provide total anonymity. The privacy features of the two cryptocurrencies, both in the way they are built and the way they are used in the real world, leave room for investigators and compliance professionals to investigate suspicious or illicit activity and maintain compliance. With the support of the Chainalysis product, cryptocurrency businesses can now incorporate Dash and Zcash into their compliance programs.

This type of tracking is being adopted by most of the tracking firms on the Blockchain such as Eliptic (more information here) in which both Zcash and Horizen have been added to their lists.

In addition, the use of private cryptocurrencies is decreasing, most regulated exchanges are de-listing these coins and their value has greatly decreased (more information here).

Regarding the other residual risks, FATF non-cooperative jurisdictions or jurisdictions with weak AML/CFT regulatory frameworks ultimately generate risks for any type of financial product or service, not only for virtual assets. In that sense, we believe that this should not be one of the most important risks that FATF should consider for Stablecoins.

Finally, the decentralized governance of Stablecoins only generates more transparency and control in the hands of the users, as FATF rightly mentions, it is possible to generate a hybrid model between centralization and decentralization to protect the stability of the financial system and, in addition, take advantage of the benefits of decentralization.

AML/CFT Cryptoasset Supervision - BIS

The position of the BIS in its recent publication (more information here) recause the supervision of cryptoasset service providers (CSPs) is still in its infancy globally. While international AML/CFT standards exist, most jurisdictions have only just begun to implement and enforce them.

As jurisdictions finalize regulation, the key question remains who and what activities fall within the regulatory perimeter. The regulatory treatment of CSPs depends on the risks posed by both the type of cryptoassets offered by the CSP and the activity in which the companies engage. Authorities have chosen different criteria to classify cryptoassets in different jurisdictions and have differed in the definitions of the related activities that would fall within the scope of regulation.

Despite this heterogeneity, the authorities largely agree on the application of the basic principle of "same business, same risks, same rules." The question, in turn, depends on the authorities' assessment of the risks posed by cryptoassets and related activities that should be subject to regulation and, if so, whether those risks are covered by existing regulation or whether there is a gap that needs to be addressed.

In the case of gaps in AML/CFT regulation, the application of international standards, particularly those issued by FATF, should provide a sound basis for effective AML/CFT compliance and guidance.

The continued difficulty for supervisors and the private sector in defining which individuals or legal entities are covered by cryptoasset regulation and the generally limited level of awareness of AML/CFT regulatory requirements in the private sector, compared to what exists in more traditional financial services, requires collaboration between the public and private sectors.

While providers are ultimately responsible for understanding and implementing their obligations, broad disclosure and a gradual "ramp-up" of supervision are consistent with the launch of new regulations and rapid evolution in this industry. This approach helps avoid widespread lack of effective compliance.

Publication of Risk Assessments

Although much work remains to be done in terms of implementation, most jurisdictions have conducted or are in the process of conducting a national AML/CFT risk assessment. As is the case in Mexico (more information here).

These assessments largely conclude that the risks associated with cryptoassets are relatively high or have increased in recent years, and such assessments should provide a sound basis for calibrating regulation and oversight. However, some assessments may be more in-depth and others have not been made public.

When jurisdictions do not publish at least the main findings of their assessments, they miss an opportunity to educate the public, especially in such a new and evolving sector. In addition, failure to publish risk assessments can make it difficult for supervisors and the private sector to make AML/CFT decisions, such as rating customer risk in onboarding processes.

FATF Travel Rule

That said, more enforcement actions are expected in the future as supervisory frameworks mature in many jurisdictions. The travel rule is a binding FATF obligation, but most jurisdictions have not effectively implemented it. Several jurisdictions question whether they can reasonably impose the travel rule on CSPs until technological solutions exist that make compliance less burdensome.

Respondents also expressed concern that if these technological solutions were not commonly accepted or interoperable, compliance with the travel rule would remain burdensome. Other jurisdictions, however, are implementing the rule now, as it is currently feasible, albeit difficult.

P2P transactions

Some jurisdictions regard these transactions as the equivalent of exchanging cash and believe that the risk they pose falls within the risk tolerance of FATF standards and national regulation. This is particularly the case where authorities expect P2P transactions to remain limited in number, with most of these assets passing through CSPs before they can be used.

The availability of Blockchain analytical tools to track these assets also partly mitigates some authorities' concerns about P2P transactions, as it suggests that transparency is possible. However, others believe that the comparison with cash is not exactly apt and have concerns related to the disintermediation that P2P transactions may represent.

In addition, there is a clear risk that P2P transactions will grow rapidly in scale, especially as cryptoassets become more widely accepted. The potential risks posed by P2P transactions seem to suggest that additional mitigation measures may be necessary. In any event, many jurisdictions need a clearer assessment of the risks to guide their decisions going forward.

Financial Innovation and International Cooperation

Authorities are committed to supporting responsible financial innovation while ensuring adequate supervision. New supervisory methods and suptech applications could help pursue this balance and maximize their resources. This should enable them to make more intensive use of data and technological tools, such as blockchain analytics, to improve the effectiveness of their supervisory frameworks.

International cooperation to effectively oversee this sector is key. The inherently cross-border nature of cryptoassets, as well as the uneven global implementation of international standards in this area, make international cooperation a critical component of effective oversight. This is especially true in light of how new the sector is.

Supervisors appear to have the necessary legal authorities and channels for international cooperation in place, but the actual use of these is another area in need of improvement.

Financial Market Infrastructure Stablecoins

An October report this year by the BIS Committee on Payments and Market Infrastructures generated a report on the application of the principles for financial market infrastructures to Stablecoins arrangements (more information here).

In this report, the BIS provides some guidance on the application of the Principles for Financial Market Infrastructures (PFMI) to stablecoin systems, including the entities that are part of such systems. Although this report only provides guidance on a subset of principles, a systemically important stablecoin system or arrangement used primarily to make payments is expected to observe all relevant principles, including those principles for which no further guidance is provided in the report.

In this report, the BIS identifies four core principles:

• Governance

• Comprehensive risk management

• Settlement finality

• Money settlements

For each principle, BIS identified Stablecoins-related issues in complying with the principle and provides recommendations on how to comply.

Governance

Issues:

1. The governance of the stablecoin system may be partially or fully decentralized and there may be no legal entities or individuals controlling the function of the Financial Market Infrastructure (FMI).

2. FMIs operate in dynamic and changing environments and need to have mechanisms in place to make changes, when necessary, to their design or operations. However, this may not be feasible for certain models of stablecoin systems.

Guidance:

1. Clear and direct lines of responsibility and accountability, e.g., is owned and operated by one or more identifiable and accountable legal entities that are ultimately controlled by individuals.

2. The ownership structure and operation of the systems enable them to observe Principle 2 and the other relevant PFMI principles, independent of the governance arrangements of other interdependent functions.

Comprehensive risk management

Issues:

• Like other FMIs, stablecoin arrangements may rely for their transfer function on other entities (such as other FMIs, settlement banks, liquidity providers, or service providers) that could pose significant risks to the function.

• In addition, depending on the organizational structure of the stablecoin system, entities performing other system functions may be independent of the entity performing the transfer function and/or may not be participants or service providers of the FMI.

Guidance:

• Periodically review the material risks that the FMI function bears and poses to other system functions and to entities (such as other FMIs, settlement banks, liquidity providers, or service providers) that perform other system functions or on which the system relies for its transfer function.

• Develop appropriate risk management frameworks and tools to address these risks. In particular, appropriate mitigation measures should be identified and implemented, taking an integrated and comprehensive view of their risks.

Settlement finality

Problems:

1. Stablecoin systems or arrangements can exhibit "probabilistic settlement", where a mismatch can occur between the legal certainty that a transaction was made and the technical settlement in which technologically a transaction was already made. A mismatch occurs, for example, when legal certainty is believed to have been reached, but a "fork" causes the technical settlement to be reversed.

2. Without a responsible legal entity, there may be no way to enforce the legal settlement finality of a transaction or the resulting legal claim if it conflicts with the settlement status on the blockchain.

Guidance:

1. Clearly define the point at which a transfer on the blockchain becomes irrevocable and technical settlement occurs, and make transparent whether and to what extent there may be a mismatch between technical settlement and legal certainty.

2. Ensure adequate transparency regarding the mechanisms to reconcile the mismatch between technical settlement and legal finality and have measures in place to address potential losses that could be created in the event of a reversal arising from the mismatch between technical settlement and legal certainty.

Money settlements

Issues:

1. In stablecoin systems or arrangements, by using a stablecoin as a settlement asset, participants will be subject to the credit and liquidity risks of the stablecoin itself, the stablecoin issuer and/or the settlement entity. This may pose greater risk than "little or no" credit and liquidity risk and may not allow the FMI and its participants to easily transfer their assets to other liquid assets, such as claims on a central bank.

2. The manner and degree to which reserve assets serve as a backstop depends on the design and associated contractual arrangements of the stablecoin in question, as well as applicable law. These will have significant implications for the level of protection of the rights of stablecoin holders and other relevant system participants and their confidence in the value of the stablecoin as a settlement asset.

3. Participants may be exposed to credit risk if a stablecoin loses value relative to the fiat currency in which it is denominated or to which it is pegged, or if the issuer of the stablecoin defaults on its obligations to the participant.

Guidance:

1. Stablecoin systems should consider whether the stablecoin provides its holders with a direct legal claim on the issuer and/or a right, title or interest in the underlying reserve assets for timely convertibility at par into other liquid assets, such as claims on a central bank, and a clear and robust process for satisfying the rights of holders in both normal and stress times

2. It must be determined whether the credit and liquidity risks of the stablecoin it uses for money settlement are minimized and tightly controlled and the stablecoin is an acceptable alternative to the use of central bank money

Stablecoins vs CBDCs, who will win?

The consulting firm McKinsey & Company generated an article on the early coexistence of CBDCs with Stablecoins and speculates on the specific criteria we should take into account to determine possible future scenarios and the coexistence or primacy of either of the two assets (more information here).

In the article, McKinsey determines that the current state of the financial infrastructure in a country will play a key role in determining the speed and extent of adoption of CBDCs, stablecoins or non-stabilized cryptocurrencies. In developed economies with real-time payment systems, the short-term incremental benefits of reduced (even instantaneous) settlement time of CBDCs may be somewhat muted if financial institutions are reluctant to invest in the necessary additional infrastructure. In these cases, the various benefits of stablecoins (such as their ability to participate in smart contracts) may prove a more compelling and defensible use case in the long term, depending on the exact implementation of CBDC.

Residents of countries with sovereign currencies that lack historical stability are among the most active in adopting cryptocurrencies as a medium of exchange, especially when they are perceived as less risky than available alternatives (e.g., domestic acceptance of Bitcoin in El Salvador).

Ultimately, the fate of CBDCs and stablecoins may be decided by the important forces of regulation and adoption. While CBDCs will be issued under the auspices of central banks, stablecoins are potentially subject to regulatory oversight by multiple agencies, depending on their classification as assets, securities or even money market funds.

Under FATF scrutiny, this regulation may extend across borders. While it is too early to predict the impact of increased regulation on stablecoins, innovation continues apace with many more (and new ones) likely to emerge in the coming years.

While the market is too nascent to predict outcomes, those in all corners of the payments ecosystem can take valuable steps to position themselves for the inevitable changes ahead, regardless of what form those changes take:

• Financial services infrastructure providers should continually monitor the suitability of their design choices for future interoperability with digital currencies

• Retail banks, merchants and payment service providers may wish to consider the level of infrastructure investment likely to be required for the successful implementation of CBDCs and multiple stablecoin networks.

• The impact of CBDCs on private sector banks likely depends on the speed of adoption.

• Financial and risk managers will benefit from assessing the broad impact of digital currencies on bank liquidity and capital requirements taking into account potential policy changes.

• The task for government, central banks and regulators is somewhat simpler: to some extent, their decisions will dictate the moves of other parties, although any traction demonstrated by stablecoin solutions in the marketplace will necessarily factor into central bankers' approaches.

• Investors in highly popular and speculative cryptocurrencies - and their issuers - should anticipate the impact of CBDCs on their assets

Mckinsey concludes that the co-evolution of stablecoins and CBDCs will have a direct impact on society. While the future future is not yet clear, certain behaviors could determine the direction of this evolution: to what extent will physical cash continue to be used - and accepted - in society? In what medium of value will employees and bills be paid? What mediums will be used for commerce? especially if digital currencies issued in distributed public registries reduce the cost of hosting accounts and speeding up payment delivery, and to what extent could a single digital currency become a global currency? To what extent will citizens resist full payment traceability? And to what extent will citizens feel comfortable obtaining familiar banking services - such as high-yield deposits, collateralized loans and payment services (all available from DeFi today) - without relying on a traditional bank? And finally, how quickly will we see innovations in blockchain protocols that drastically reduce their environmental impact?

Conclusions

Considering that the German executive Marcus Pleyer has now taken over as head of the FATF (more information here) and taking into account the memorandum compiling the FATF's priorities for the next two years (more information here), we know that there will be many standards and regulations coming aimed at cryptocurrencies and the digital transformation of AML/CFT.

However, we believe that these regulations will always focus on the opportunities that technology can offer, mitigating ML/FT risks and taking the benefits of technology.

To support our statement, Pleyer in Germany, as Minister of Finance, took several decisions in favor of the use and acceptance of cryptocurrencies in his country, including exempting the payment of taxes on cryptocurrencies used as a means of payment (more information here).

FATF knows that a massive adoption of cryptocurrencies, specifically Stablecoins, is coming. We are glad to see that they are preparing the ground for that event.

We believe that the first approaches of FATF to the world of Stablecoins is right and always in favor of the Prevention of Money Laundering and Terrorist Financing, but it is important that they take into consideration all the projects, protocols, standards and solutions that exist in order to provide a focused regulation that allows innovation and adoption of cryptocurrencies, clearly considering the inherent benefits of Stablecoins.

The developed project maintains an excellent approach to one of the many use cases that Blockchain technology has.

The BIS, for its part, makes a very interesting analysis on the route to follow for the regulation of cryptoassets in PLD/CFT matters and even involves Stablecoins to be part of the financial market infrastructure as a settlement asset. An important aspect refers to the continued collaboration between the public and private sector for the better regulation of the technology and to continue fostering responsible technological innovation and international cooperation, enforcement of the travel rule and, of course, the challenges posed by the regulation of P2P transactions.

There are too many challenges in the world that Blockchain technology could address in different ways, we are sure that little by little will generate a massive adoption of this technology to improve our society.

At Legal Paradox®, we are aware of the risks involved with cryptocurrencies, however, we know that the benefits are much greater and that establishing certain mitigating factors and regulatory compliance will result in a safe and powerful use of cryptocurrencies in general.

We are confident that mass adoption will come and cryptoassets will prevail.

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Legal Paradox® is a 100% Mexican law firm focused on the FinTech & Blockchain sector.

Our challenge is to empower the sector. When we started, FinTech & Blockchain were not concepts of reference in the country; therefore, day by day we have pursued this mission and thus we have generated a change in the Mexican financial world. Since the creation of this firm, in June 2017, we have worked hand in hand with more than 250 companies in the sector, that is, more than 30% of the existing ones in the country.

In less than 2 years we were recognized by Chambers & Partners as part of the legal FinTech elite in Mexico. These results are due to the fact that we base our operation on technology, even working on our own developments such as the FinTech Tour map and Parabot, an artificial intelligence-based assistant that aims to help a person or company find FinTech solutions.

Understanding technology in depth has led us to find out how it is possible to achieve innovative disruption in the financial sector, that is why our clients recommend us mainly for understanding their business and even enhance it.

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