Potential benefits and key risks of fiat-referenced cryptoassets

Introduction

Prices of cryptoassets such as Bitcoin are very volatile (Chart 1). This makes it difficult for these cryptoassets to perform all the functions of money, namely, to be used as a means of payment, store of value and unit of account. To address this issue, cryptoassets that reference a national fiat currency or other assets have emerged.1 These types of cryptoassets are commonly known as stablecoins because they aim to maintain a one-to-one peg to the reference asset. However, this term is not entirely accurate since these types of cryptoassets can deviate significantly from their peg or lose it entirely, and therefore prove to be unstable as occurred in the spring of 2022 (Chart 2). Most fiat-referenced cryptoassets (such as Tether, USD Coin and Binance USD) maintain their peg by holding a reserve of traditional financial assets (such as cash or sovereign bonds, denominated in the reference national currency). This reserve is equal to the value of the cryptoasset in circulation.2

Currently, these fiat-referenced cryptoassets are mainly being used as a means of payment on crypto-trading platforms, playing a similar role to fiat currency. Given the increased interest in cryptoassets, the global market value of fiat-referenced cryptoassets increased more than thirtyfold between the beginning of 2020 and the middle of 2022 to US$161 billion (Chart 3).

Since these fiat-referenced cryptoassets have the potential to perform many of the functions of money, households and businesses could more broadly adopt them as a means of payment for goods and services.3 If well designed and appropriately regulated, these cryptoassets could bring efficiencies and greater competition to payment services, especially in a more digitalized economy. However, without safeguards, they could pose significant risks to the stability of the financial system. We briefly examine the key entities and activities involved in creating, distributing and using these cryptoassets, then explore some of their potential benefits and key risks to financial stability.

Creation and distribution

A network of entities, activities and technologies supports the creation, distribution and use of each fiat-referenced cryptoasset. Such a network is determined by the issuer and typically referred to as an arrangement. Depending on its design, an arrangement can involve one or many entities that may be either related or completely unaffiliated. This is possible due to the distributed ledger technology (DLT) that cryptoassets are built and circulated on. DLTs are chronological record-keeping systems whose records and operations are shared among multiple participants (i.e., decentralized databases) rather than a central authority (i.e., centralized databases). Blockchain systems are a common type of distributed ledger, and some of these—such as Ethereum, on which Tether and some other fiat-referenced cryptoassets are built—are public, meaning anyone can participate in them without permission from or knowledge of other participants. Due to these features as well as others, blockchains can perform and record the transfer of ownership and therefore have the potential to be used as a payment system.

However, because fiat-referenced cryptoassets are pegged to fiat currency and use a reserve of traditional financial assets, the arrangement involves both “on-chain” (on the blockchain) and “off-chain” (off the blockchain) activities and entities.

Creation

To create a fiat-referenced cryptoasset, the issuer performs both on- and off-chain activities (Figure 1). On-chain, the issuer selects the blockchain(s), writes the code that creates the units of the fiat-referenced cryptoassets (i.e., tokens) and manages the supply of tokens. Off-chain, the issuer also sets the investment policy for reserve assets and usually engages third parties, such as an asset manager to manage the reserve and a custodian to hold it.4 The issuer therefore serves as a bridge between the cryptoasset ecosystem and the traditional financial system.

Once the issuer has created the fiat-referenced cryptoasset, they can distribute it for use in trading or payments via the blockchain or another system. The ongoing role of the issuer is limited until redemption, which is the reverse of the creation and distribution process.

Figure 1: The creation of fiat-referenced cryptoassets requires both on- and off-chain activities

Figure 1: The creation of fiat-referenced cryptoassets requires both on- and off-chain activities

Distribution

Issuers do not often make their fiat-referenced cryptoassets directly available to the public. Instead, they usually work with intermediaries, such as cryptoasset trading platforms and custodial wallets. These intermediaries buy large sums of these assets to then distribute them (Figure 2).5 Consequently, end users typically buy, store and transfer the tokens of fiat-referenced cryptoassets through these intermediaries. Intermediaries also provide custody services and off-chain transactions, which are settled on their own ledger rather than on the blockchain, as their ledger is often less costly.6

If end users wish to hold their tokens themselves and make on-chain transactions, they can submit a transfer request to their intermediary, who will then transfer the tokens via the blockchain to their personal wallet. The blockchain participants will process the transfer for a fee.

Potential benefits

Currently, fiat-referenced cryptoassets play a prominent role as the medium of exchange and store of value on many large centralized crypto exchanges as well as on decentralized finance (DeFi) platforms.7 Using these assets instead of fiat currency in the crypto ecosystem offers a few potential benefits, including providing DLT-based financial services.

It is also likely cheaper and more efficient for exchanges to manage their liquidity in fiat-referenced cryptoassets rather than fiat currency since:

• crypto blockchain transactions can settle faster than fiat currency transactions
• blockchains operate continuously, while many fiat payment systems are limited to banking business hours
• some exchanges may not have the banking relationships needed to support certain fiat currencies8

As a result, there are more crypto-crypto trading pairs than crypto-fiat pairs. This generates greater market depth and smaller bid-ask spreads for crypto-crypto trading pairs relative to crypto-fiat pairs, especially for the more popular pairs such as Tether-Bitcoin. Moreover, keeping money in fiat-referenced cryptoassets may offer investors greater flexibility since transfers between centralized exchanges and digital wallets can be done without exiting the crypto environment.

In addition to their current role in the crypto ecosystem, fiat-referenced cryptoassets could be adopted more broadly as a means of payment for everyday goods and services and in peer-to-peer transactions. These cryptoassets could therefore play a significant role in the financial system in the future (Catalini and Massari 2021). They can also be used in “smart contracts,” which allow automatic payments based on specific, pre-defined conditions, supporting the notion of “programmable money” (Lipton and Levi 2018; Lee 2021). Often-cited examples of such use cases include the transfer of funds for a house purchase once an inspection report has been received and confirmed, or funds that can only be used for specific purchases or that expire after a specified time (Arner, Auer and Frost 2020). Use of fiat-referenced cryptoassets in smart contracts can also support micropayments, including autonomous machine-to-machine payments (Milkau 2018). For instance, computers could make payments to each other for processing power or file storage space. Another often-cited benefit is the potential to promote financial inclusion: the networks used for these cryptoassets are, in theory, available for anyone to use, although currently costs can be prohibitive.

The Financial Stability Board (FSB) has also noted that the decentralization of financial services can eliminate the need for traditional intermediaries, for instance, for record-keeping. This could make a range of transactions, including in trade finance and capital markets, more efficient (FSB 2019). The FSB, in coordination with the Committee on Payments and Market Infrastructure (CPMI) and others, is considering whether and how a well-designed global fiat-referenced cryptoasset arrangement can enhance cross-border payments (FSB 2021). This work is expected to be completed by the end of 2022.

Proponents claim that these potential benefits stem from the underlying technology that makes these assets always available, easy to divide and borderless, potentially enabling a more convenient and efficient means of payment. However, such benefits have so far been largely theoretical.

Key risks to financial stability

Fiat-referenced cryptoassets pose risks to holders, the financial system and the economy. We discuss a few key risks, both current and emerging, that are particularly important for financial stability.

Run risk

A run can be triggered if holders of fiat-referenced cryptoassets no longer believe they can redeem their tokens at par with the reference currency. Runs on these cryptoassets have already occurred this year.9 Once a run is triggered, holders rush to redeem their money, which forces the issuer to sell the reserve assets quickly and therefore at a discount. This in turn motivates further redemptions, causing a downward price spiral. Many possible factors can contribute to run risk. For example:

• If the reserve assets fall in price or become illiquid during a period of stress, the issuer may be unable to redeem the tokens in a timely manner or at par value, triggering a run.
• A lack of adequate disclosure—for example, about the composition of reserve holdings, whether reserve assets are appropriately safeguarded and whether redemption gates or fees are imposed when assets drop below a liquidity threshold—could worsen a run.

Runs could threaten the stability of the traditional financial system, including the payments ecosystem, if these types of cryptoassets become widely adopted and sufficiently integrated with it.

Contagion risk

Since 2016, fiat-referenced cryptoassets have taken an increasingly large share of cryptoasset trading volumes and now account for around 50% of the total (Chart 4). Fiat-referenced cryptoassets play an important role in cryptoasset markets, both on centralized exchanges (e.g., Coinbase, Binance) and in DeFi platforms. However, if there is a run on these assets, this larger presence can cause disruptions in cryptoasset markets and their affiliated services.

Traditional financial assets in the reserves, as well as participation by traditional institutional investors and banks in both cryptoasset and traditional financial markets, create linkages between these markets. Such links can spread a run on fiat-referenced cryptoassets to the traditional financial system, in particular through the fire sale of reserve assets as the size of these reserves grows. Further, fire sales of commercial paper and bank certificates of deposits could lead to stress in funding markets, which can cause liquidity issues for financial institutions that rely on these markets for short-term funding. Funding constraints for banks could in turn have broader impacts on the financial system and real economy.

The turmoil in cryptoasset markets in 2022 illustrates the interconnectedness and resulting contagion within the crypto ecosystem. Some firms were forced to suspend trading and client fund withdrawals after other firms filed for bankruptcy. Luckily, the links to the traditional financial system were very limited but could grow in the future.

Concentration risk

Another risk related to the financial system is concentration risk, in terms of both the dominance of a small number of fiat-referenced cryptoassets in the market and the small number of entities holding large concentrations of these cryptoassets. Currently the top three fiat-referenced cryptoassets have 90% of the total fiat-referenced cryptoasset market; Tether, USD Coin and Binance USD account for 44%, 33% and 13% of the market, respectively.10 Similarly, the top 1% of investors hold approximately 90% or more of the total supply of the major fiat-referenced cryptoassets (Chart 5).11 The highly concentrated nature of these markets and holdings implies outsized impacts if major parties are affected by cyberattacks or a loss of confidence.

Consumer and investor protection risks

Due to lack of adequate regulation and disclosure, consumers and investors of fiat-referenced cryptoassets may be at increased risk of fraud or investment scams. For example, without consumer protection and market conduct regulations, these holders may not be aware of their rights and responsibilities. Moreover, consumers and investors may be led to believe that these cryptoassets are risk free. For instance, the misnomer of stablecoins can leave the impression that the price will not deviate from its peg, both in normal times and during stress events. Claims that these cryptoassets have the backing of reserve assets could lead holders to believe that they have a secure claim on reserve assets with no redemption restrictions. If fiat-referenced cryptoassets were to become widely adopted, these risks could have implications for financial stability.

Other risks

In addition to the above risks, fiat-referenced cryptoassets present many risks that are similar to those posed by other types of cryptoassets. These may be:

• new operational and governance risks, including from the use of novel technologies such as DLT
• accountability risks with no entities or individuals responsible for comprehensive, end-to-end risk management if the arrangement is decentralized and uses a public blockchain
• national security and financial crimes risks

Wider adoption of these assets could also cause structural changes to the Canadian financial sector by diverting funds from stable retail bank deposits to wholesale deposits. Such diversion potentially increases lending costs. Whether these risks would materialize in practice depends on many factors that require further research.

Regulatory response

In light of the potential benefits of and risks posed by fiat-referenced cryptoassets, authorities in major jurisdictions are developing and implementing regulatory approaches. These authorities have a dual objective of promoting innovation while mitigating risks. The FSB and international standard-setting bodies have also published specific guidance, including:

• recommendations for regulating, supervising and overseeing global stablecoin arrangements, cryptoassets and markets (FSB 2020 and 2022)
• application of the Principles for Financial Market Infrastructures to stablecoin arrangements (CPMI–International Organization of Securities Commissions 2021)
• prudential treatment of the exposure of banks to cryptoassets and stablecoins (Basel Committee on Banking Supervision 2022)
• anti–money laundering and counter-terrorist financing measures (Financial Action Task Force 2021 and 2022)

A well-designed fiat-referenced cryptoasset that adequately manages risks should have a reserve of high-quality liquid assets denominated in the reference currency and separated from the issuer’s own funds (Financial Stability Board 2022). Furthermore, holders of these assets should have the legal right to redeem them at any time, subject to any clearly disclosed redemption restrictions.12

The FSB’s central recommendation to follow the principle of “same activity, same risk, same regulation” is behind the development of national regulatory approaches. In practice, this implies that issuers of fiat-referenced cryptoassets should be regulated prudentially and meet capital and liquidity requirements, given they are as exposed to run risk as commercial banks are (Financial Stability Board 2022). Some jurisdictions are applying or considering these prudential requirements for issuers through their current banking or payments regimes, while others are developing new custom-made regulatory regimes. Most jurisdictions are regulating or proposing to regulate cryptoasset exchanges and trading platforms under securities regimes and wallet providers under e-money or retail payment regimes. These regimes will deliver the same level of protection to cryptoasset consumers and investors as they do to consumers and investors in the traditional financial system.

National authorities are at different stages of developing and implementing their regulatory approaches. This work is necessary because most existing regulatory regimes, in Canada and abroad, are not presently fit for purpose. They were not designed for the unique features of fiat-referenced cryptoassets and the networks of entities and activities involved in their creation, distribution and use. For instance, the cross-border and online nature of these assets and associated activities can create legal uncertainty about how to apply some existing regimes and make enforcement action challenging. Using DLT can further complicate enforcement by making it hard to identify individuals to hold accountable for certain activities. Given these unique features, activity-based regulatory regimes (i.e., ones where regulations apply to the activity, no matter the type of entity performing it) are better suited. However, some existing regulatory frameworks in Canada and other jurisdictions are entity-based (i.e., they apply only to specific types of entities, such as banks), creating challenges.

At the time of writing, Japan and the European Union are finalizing their regulatory frameworks, which are expected to come into force in 2023 and 2024, respectively (Amaya 2022; Council of the European Union 2022). Meanwhile, Singapore’s framework is already in place (Monetary Authority of Singapore 2022). The United Kingdom, the United States and Hong Kong have also proposed regulatory frameworks (HM Treasury 2021; US Department of the Treasury 2021; Hong Kong Monetary Authority 2022).

In Canada, the Canadian Securities Administrators (CSA) has published a framework to regulate and oversee cryptoasset trading platforms (CSA 2020). Also, such cryptoassets are considered virtual currencies under Canada’s anti–money laundering and anti-terrorist financing regime (Proceeds of Crime [Money Laundering] and Terrorist Financing Act). Businesses that deal in virtual currencies—such as for providing exchange or value transfer services—are considered money services businesses under this regime and are subject to compliance and reporting requirements. Earlier this year in its Budget 2022, the federal government announced a financial sector legislative review focused on the digitalization of money (Department of Finance Canada 2022). In the first phase, the focus will be on digital currencies including cryptoassets. More recently, in line with guidance from the Basel Committee on Banking Supervision, the Office of the Superintendent of Financial Institutions (OSFI) has announced an interim approach to the exposure of banks and insurers to cryptoassets (OSFI 2022a). The interim approach determines the regulatory requirements that banks and insurers must meet for holding cryptoassets. It categorizes cryptoassets into two groups and outlines the respective capital and liquidity treatment of each group as well as limits. OSFI has also proposed a Digital Innovation Roadmap, which outlines its workplan including developing prudential regulation for fiat-referenced cryptoasset arrangements (OSFI 2022b).

Conclusion

Fiat-referenced cryptoassets have seen tremendous growth in recent years. Since these types of cryptoassets have the potential to perform many of the functions of money, they could become more widely used to pay for everyday goods and services. Fiat-referenced cryptoassets could make payments faster and more efficient due to features of the novel technology they are built on. However, they could also pose financial stability risks, some of which were illustrated in the market turmoil of May and November 2022, highlighting the need for adequate regulation and supervision. Work is underway, domestically and internationally, to develop a robust regulatory framework to mitigate the risks these types of cryptoassets can pose to holders, the financial system and the economy. A timely and comprehensive regulatory approach in Canada will ensure that fiat-referenced cryptoassets can deliver potential benefits without posing unnecessary risks.

Endnotes

References

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