Tokenized cash: A regulatory view of unlocking a digital financial market

Stablecoins

Fiat-backed stablecoins are essentially bearer instruments in which the holder of the instrument has a claim against the issuer of the coin for redemption from the pool of reserve assets. While stablecoins are currently the most prevalent form of digital cash instrument in the marketplace today, they are burdened by the potential of the credit risk of the issuer to destabilize their value, which challenges their ability to serve as “money” under the “singleness of money” concept.

In July 2023, the Financial Stability Board published a final report⁵ with recommendations for global regulators to consider in designing frameworks for the regulatory oversight and supervision of stablecoins in their jurisdictions. These recommendations included the need for comprehensive regulatory powers to supervise and oversee these arrangements, using a “same activity, same risk, same rules” approach, strong governance requirements, appropriate risk management frameworks, particularly as it relates to reserve management, operational resilience, anti-money laundering and cyber security safeguards, and comprehensive and transparent disclosure regarding the operation of the stablecoin arrangement, including legal clarity on redemption and enforceability of rights.⁶

While a number of jurisdictions have pursued or are pursuing legislative and regulatory frameworks consistent with these recommendations, their ability to enable stablecoins to serve as “money” under the “singleness of money” concept will be highly dependent on their implementation. The following describes specific regulatory approaches taken in Europe, Asia Pacific and North America.

Europe

In the European Union, the Markets in Crypto Assets Regulation (MiCA)⁷ adopted in June 2023 contains a comprehensive regulatory framework for stablecoins, referred to as either asset-referenced tokens, which seek to maintain a stable value by referencing multiple fiat currencies, commodities or other crypto assets, and electronic money (e-money) tokens, which seek to maintain a stable value by referencing a single fiat currency and which are likely to be the most relevant for the institutional tokenized asset marketplace. Algorithmic stablecoins are not permitted. MiCA obligates issuers of asset-referenced tokens and e-money tokens to maintain reserves to fully back the stablecoins, to properly manage the reserves in accordance with specified standards, including investment restrictions, segregation requirements and the requirement to hold the assets at a credit institution, and to maintain a separate buffer of highly liquid proprietary capital (referred to as “own funds”) based on the value of the coins in circulation.

In addition, these stablecoins must be redeemable at face value in the referenced currency at any time. Issuers of e-money tokens can only be credit institutions or authorized electronic money institutions, while issuers of asset-referenced tokens must be authorized to issue the coins prior to any issuance. Further heightened standards apply to stablecoins that are deemed “significant” by the European Banking Authority. The MiCA rules for e-money tokens and asset-referenced tokens began applying on June 30, 2024 (MiCA rules applicable to other types of crypto assets will come into force on December 30, 2024).

In the United Kingdom, the proposed stablecoin regulatory framework is described in three separate publications by each of the Bank of England,⁸ the Financial Conduct Authority⁹ (FCA) and the Prudential Regulation Authority¹⁰ (PRA), all of which were helpfully summarized in the Bank of England’s cross-authority roadmap published in November 2023. Viewed holistically, the proposed framework distinguishes between systemic and non-systemic stablecoins, with systemic stablecoin issuers regulated by the Bank of England for prudential matters and by the FCA for conduct matters, and non-systemic stablecoin issuers regulated by the FCA for both conduct and prudential matters. For all stablecoins, the framework includes provisions establishing reserve requirements, capital requirements, redemption requirements and remuneration requirements. Reserves must be highly liquid, high-quality instruments, with the Bank of England favoring the use of central bank deposits as reserves. Redemptions must be at par, with FCA rules requiring such payment to occur no later than the business day following the redemption request and the Bank of England rules requiring it to be same day. With respect to remuneration, both regimes would prohibit the payment of interest on stablecoin holdings.

Asia Pacific

Following a consultation started in 2022, the Monetary Authority of Singapore (MAS) finalized its framework for regulation of single-currency stablecoins (SCS).¹¹ Specific amendments to the Payment Services Act 2019 and related regulations to implement this framework are yet to be published by the MAS. The framework, similar to regimes in other jurisdictions, will require maintenance of highly liquid, high-quality reserves having a value that at all times is at least 100 percent of the value of outstanding SCS and timely satisfaction of redemption requests at par, which can be no later than five business days of the request. In addition, SCS issuers that are not banks will be required to hold a major payment institution license (or, for issuers with less than SGD 5 million in circulation, a standard payment institution license), to maintain a minimum amount of required capital and to constrain their activities within a limited scope of permissible activities.

In Japan, a regulatory framework for stablecoins became effective in June 2023. This framework requires that the stablecoins, referred to as electronic payment instruments in the regulations, be linked to a fiat currency, maintain reserves in demand deposits and guarantee redemption at par, and limits issuers to licensed banks, registered money transfer agents and trust companies that have registered as electronic payment instrument service providers (EPISP).¹² Although the framework has been effective for over a year, no company has yet been registered as an EPISP.¹³

North America

While there is no comprehensive stablecoin legislation in the United States, stablecoins are regulated at the state level as well as, for financial crimes purposes only, at the federal level. In most states, stablecoin issuers are required to register as money transmitters, while a few states have created more targeted and robust regulatory regimes for stablecoins, such as the BitLicense regime¹⁴ in New York. At the federal level, stablecoins qualify as convertible virtual currency under the rules and regulations of the Financial Crimes Enforcement Network (FinCEN) and are thus subject to relevant anti-money laundering requirements.

Recognizing that the current fractured state of stablecoin regulation in the US is not optimal, Congress has attempted to change that. In June 2023, the chairman of the United States House Financial Services Committee unveiled a draft stablecoin bill¹⁵ that gave oversight responsibilities to both federal and state regulators. While there is bipartisan support for stablecoin legislation, a key sticking point in the form of that legislation, however, involves the level of authority granted to state regulators. Recent statements by Rep. Waters, the ranking Democrat on the committee, indicate that she is looking to break that stalemate by seeking a “grand bargain” to finish the stablecoin bill this year.¹⁶

Additional progress is being made in the Senate; however, with Senators Lummis (R-WY) and Gillibrand (D-NY) introducing the Lummis-Gillibrand Payment Stablecoin Act in April 2024, which shares a number of similarities with Chairman McHenry’s draft 2023 House bill, although unlike the House bill, it would give the US Federal Reserve Board a level of responsibility over all stablecoins. The Lummis-Gillibrand bill would require stablecoin issuers to be either a federally regulated depository institution or, for stablecoins with an outstanding balance of less than US$10 billion, a state non-depository trust company that registers with the Federal Reserve Board.

In addition, stablecoin issuers must:

1. Maintain reserves equal to at least 100 percent of the nominal value of outstanding coins
2. Invest reserves only in limited, specified highly liquid assets
3. Prohibit rehypothecation of reserve assets, except as necessary to meet redemption requests
4. Honor redemption requests at par in legal tender within one day of the request
5. Produce mandatory reports regarding the stablecoin reserves, which reports must also be filed with the Chief Financial Officer of the issuer with the Federal Reserve Board under penalties of perjury
6. Comply with anti-money laundering, countering the financing of terrorism and sanctions rules as a financial institution under the Bank Secrecy Act

Other notable features of the bill are that, while stablecoins would not benefit from Federal Deposit Insurance Corporation (FDIC) insurance, the bill would create a conservator and receivership regime managed by the FDIC to help mitigate the risk of an issuer default.

Tokenized deposits

Tokenized deposits are created by a bank issuing a token to a customer representing a traditional deposit liability against the bank, and thus, are generally covered by the same regulatory framework as traditional deposits, maintaining their ability to serve as “money” under the “singleness of money” concept. While credit risk is mitigated given that they are issued by regulated deposit-taking financial institutions, they have more limited liquidity because they represent a direct claim between a bank and a specific depositor, and are thus not directly transferrable. In essence, the use of tokenized deposits mimics the existing intermediated financial model in place today, but could facilitate atomic (or near-atomic) settlement to the extent that the credit institutions are able to settle their wholesale payments with a CBDC or other instantaneous settlement service.

CBDCs

A CBDC is a digital form of a government-issued fiat currency. It is not backed by a specific commodity, but rather is backed by the full faith and credit of the government issuing the currency through its central bank. As such, it reflects a direct claim on the issuing government. Two commonly discussed models for implementing a CBDC are retail CBDCs and wholesale CBDCs. In a retail CBDC model, the CBDC would be directly available to retail consumers, either through an account held at the issuing central bank, such as in the case of DCash in the Eastern Caribbean Currency Union, or through a financial institution authorized by the central bank to maintain CBDC accounts for its customers, such as in the case of China’s e-CNY.¹⁷ Alternatively, in a wholesale CBDC model, the central bank would only issue CBDCs to, and hold accounts for, financial institutions where the purpose of the CBDC would be to facilitate interbank settlements.

According to the Central Bank Digital Currency Tracker published by the Atlantic Council,¹⁸ over 130 jurisdictions are either evaluating, conducting pilots (44) or have launched (3) CBDCs. Jurisdictions exploring CBDC pilots include numerous European jurisdictions, Australia, Japan, Turkey and all original BRICS jurisdictions – Brazil, Russia, India, China and South Africa. For more widely used currencies, the focus on wholesale CBDCs has been growing. BIS, along with a working group of six central banks,¹⁹ has noted that “compared with today’s central bank reserves, wholesale CBDC might enable programmability, composability and tokenization within the future financial system.”²⁰

Tokenized cash initiatives reimagining the financial infrastructure

In April 2024, the BIS announced the launch of Project Agora,²¹ a public-private collaboration between seven central banks and numerous private financial organizations, to explore how “tokenized commercial bank deposits can be seamlessly integrated with tokenized wholesale central bank money on a public-private programmable core financial platform with the goal of enhancing the functioning of cross-border payments.”

This project builds on the BIS unified ledger concept described above to explore how an integrated platform uniting both CBDCs and tokenized commercial bank deposits could “enhance the efficiency of business and regulatory processes in correspondent banking payment chains, thereby reducing transaction times and costs, enhancing payment transparency, and mitigating risks for banks involved in cross-border payments.” The central banks participating in Project Agora include the Bank of France, Swiss National Bank, Bank of Japan, Bank of Korea, Bank of Mexico, Bank of England and the Federal Reserve Bank of New York. Private institutions participating include major payments banks as well as Visa and Mastercard, among others. This project is scheduled to last until the end of 2025, at which point the consortium will release its findings, including identifying and analyzing potential legal and regulatory issues.

Private sector financial institutions are also leading initiatives seeking to develop commercial solutions to the digital cash conundrum while working closely with relevant financial system regulators. Fnality International, a consortium in which State Street is a minority investor, is one such example. Fnality is pursuing a global payments system comprised of a set of interlinked real-time wholesale gross settlement payment systems operating on Fnality distributed ledger technology. Each of the real-time gross settlement payment systems will be managed by a local Fnality entity and will operate through an appropriate account at the central bank for the relevant currency, resulting in a tokenized settlement asset that has the characteristics of central bank money, making it akin to a virtual CBDC. By interlinking settlement systems on a common platform, participants can simplify and expedite cross-currency payment flows, helping to increase efficiency and to mitigate risk across the financial system.

Consistent with the BIS unified ledger concept, the Fnality system is intended to be interoperable with externally built third-party technology platforms and applications facilitating activities such as securities settlement, exchange/clearing activities and cross-border payments, among others. Where these third-party systems are built on distributed ledger technology, the use of smart contracts across the platforms should help to facilitate the programmability of money and payment functions as envisaged by the BIS. According to Fnality, “[t]he practical effect of this is that participants are empowered to manage the entirety of their cash and collateral portfolio virtually, from a ‘single pool of liquidity’, rather than via the parking of capital across fragmented nostros, correspondents and domestic [Central Securities Depositories].”²²

Conclusion

Tokenization of financial instruments and financial market utilities is gaining increasing attention as having the potential to revolutionize and enhance the efficiency and reliability of our financial markets. A key to realizing these benefits at scale, however, is that the creation of a trusted, reliable digital cash instrument contains the necessary characteristics to satisfy the “singleness of money” concept.

While there are many efforts to build regulatory frameworks for stablecoins to help achieve this goal, it remains to be seen whether there is a regulatory and supervisory oversight model that can provide sufficient confidence in the safety of those assets for institutional transactions. Recent initiatives in digital cash involving public-private collaborations, however, may be the key to unlocking the full transformative power of tokenization of the financial infrastructure.