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The regulatory direction of the European Commission is to encourage the use of stablecoins as trading tools, rather than as a store of value.
Original title: “Analysis of the European Commission’s Stablecoin Regulatory Proposal”
Written by: Cui Chen, working at HashKey Capital Research
Audit: Zou Chuanwei, Chief Economist of Wanxiang Blockchain and PlatON
The European Commission’s proposal on crypto asset market regulations has improved the supervision of crypto assets related fields. As a special encrypted asset, stablecoins need to implement strict regulatory requirements. Only entities approved by the regulatory agency in the place of registration can issue stablecoins or provide corresponding services. Regulatory agencies are designated by each country, and the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) will also participate in relevant regulatory work. Regulators have put forward requirements for the information that issuers need to disclose, due obligations, and management of reserve assets. Encrypted asset service providers must be approved before they can provide services to users in the EU. The regulatory methods in the proposal can provide references for the formulation of regulatory policies in other countries.
On September 24, 2020, the European Commission (EC) issued a proposal on crypto-asset regulations, covering the parts that are not included in the existing EU Financial Services Act, and providing complete laws for the crypto-asset market in the EU frame. In addition to providing regulatory guidance for crypto-asset market participants, encouraging innovation is also one of the goals of the proposal, because existing regulations may hinder the use of distributed ledger technology. Take the current stable currency supervision scheme as an example. In the existing supervision system, define it as e-money and implement supervision policies related to payment services. But this scheme cannot cover all stable coins. Some stablecoins that are designed to store value or use other assets as reserves are not within the scope of supervision. There are also services related to crypto assets, such as crypto asset custody. Therefore, restricting the use of stablecoins seems to solve the financial risks caused by stablecoins, but if local users use stablecoins issued by third-party countries, such risks will still exist, so comprehensive and appropriate supervision is necessary.
Now some EU member states have implemented regulatory policies related to encrypted asset service providers, and more and more member states are considering the supervision of encrypted assets and encrypted asset service providers at the national level. These various bills will allow encrypted assets and services to adjust their products and business models in different regions, which will lead to high costs and cumbersome legal procedures, and limit their business expansion within the EU. In regions where legal certainty is lacking, users and investors face a lot of risks. In the proposal, the European Commission used “regulations” instead of “directives”. This is for unified regulatory considerations to facilitate the business of crypto asset issuers and service providers. If the proposal is passed, this will become the first EU-level pair Regulatory regulations for encrypted assets.
Another principle of the proposal is proportionality. Different services and activities and corresponding risks must be clearly distinguished to ensure that the administrative burden is proportional to the risk. Among all encrypted assets, stablecoins are easier to expand in use than other encrypted assets due to their particularities, which will cause greater risks to investors and the financial system, which will lead to financial stability and monetary sovereignty issues, and affect Monetary policy transmission, etc., so stablecoins are subject to stricter supervision.
This article analyzes the stablecoin part of the European Commission’s proposal for crypto asset market regulations, focusing on four aspects: definition, regulatory agencies, and requirements for stablecoins and related service providers. This proposal is in a leading position in the field of international regulation of stablecoins and will provide a reference for other countries’ regulatory programs.
The definition of stablecoins and the division of key points
Before understanding the specific regulatory laws, it is necessary to clarify the official definition of stablecoins. The stablecoin here is first of all an encrypted asset, which is a digital form of value or equity and uses distributed ledger or similar technology for electronic transfer and storage.
When used as a payment tool, stable currency and e-money have similar definitions. In the 2009/110/EC Directive, e-money users always have the creditor’s rights of the e-money issuer and can redeem e-money at face value at any time. However, some stablecoin users do not have such claims. Their redemption cycle will be limited or the redemption funds will not be equal to the reserve assets, which will affect the confidence of encrypted asset users and harm their interests. Therefore, in the proposal, this stable currency similar to e-money is clearly defined as an e-money token, and the issuer is also required to recognize the holder’s claims, and different regulatory measures will be taken for other types of stable currencies. Stablecoins that meet some specific conditions will also be classified as key stablecoins and need to follow stricter regulatory policies.
Asset-related token definition
An asset-related token is an encrypted asset that refers to multiple legal currencies, one or more commodities, one or more encrypted assets, or a combination of them to maintain its own value.
e-money token definition
e-money token is an encrypted asset that anchors a single legal currency to maintain its own value and is mainly used for trading.
Focus or not
EBA is responsible for judging whether stablecoins are key stablecoins. The standards are:
- The number of users, investors, and participating third-party entities is not less than two million;
- The total value or market value (if any) of the issued token is not less than one billion euros;
- The daily transfer amount is not less than 500,000 or the transfer amount is not less than 100 million euros;
- The value of reserve assets is not less than one billion euros;
- It is more important in cross-border activities, and the number of member states involved in the use of tokens as cross-border payments and transfers is not less than seven;
- Stablecoins and their issuers are considered to be related to the financial system.
As long as three of the above conditions are met, it can be determined by EBA as a key stable currency. In addition, the issuer can also actively apply to be classified as a key stablecoin project.
Responsibilities of regulatory agencies
Each member country shall appoint its own institutions to perform the functions of regulating stablecoins and notify the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA). If multiple regulatory agencies are involved, a point of contact for cross-border administrative collaboration must also be designated.
Regulators have sufficient regulatory powers over the issuance of stablecoins and encrypted asset service providers, including requiring the regulated party to provide additional information, delaying or prohibiting the issuance of stablecoins and trading permits or related applications by service providers. Regulators also have the power to punish violations and announce to the public the issuers of stablecoins that fail to fulfill their obligations.
EBA and ESMA, as highly professional institutions, will be responsible for the formulation of draft technical standards that do not involve policies. For example, the relevant standard format and process of the applicant for issuing asset-related tokens, the type of assets invested by the issuer, the calculation method of the issuer’s capital requirements, etc.
Regulation of key stablecoins
If a stablecoin is judged to be a key stablecoin according to the above criteria, its supervision will be handed over to the EBA. The EBA will establish a regulatory association with members including all key stablecoin-related entities and regulatory agencies related to encrypted asset service providers (for e-money token, the corresponding regulatory agency is the regulatory agency under the 2009/110/EC Directive). Information will be exchanged to promote cooperation. EBA will charge key stablecoin issuers to pay for expenses, and the fees are proportional to the size of the stablecoin’s reserve assets.
Specific requirements for stable currency issuance
For stablecoin issuers, the first principle to be followed is that they cannot be issued to the public within the EU or seek to trade on trading platforms before obtaining the authorization of the supervisory authority of the home country member state (that is, where the office is registered), and only Only legal entities established within the EU can be authorized. Before issuing to the public or seeking transactions, regulatory agencies need to be notified, and documents containing information to be disclosed, that is, white papers, must be published. The information must be presented in a fair, clear and non-misleading manner. For information provided by the public, stablecoin issuers and management agencies shall apply the civil liability management rules. According to the different definitions of stablecoins, regulators will have different requirements for their disclosure of information and obligations to the issuer.
Requirements for asset-related tokens
As mentioned above, before issuing asset-related tokens, the issuer needs to be authorized by the supervisory authority of the home country member state. The relevant application materials include the applicant’s information, white papers, descriptions of related businesses and obligations, etc. If the asset-related token is related to the currency in the EU, the regulator needs to consult the EBA, ESMA, the European Central Bank (ECB) and the central bank of the country that issued the currency before approving or rejecting it. When approved by regulatory agencies, this encrypted asset is valid throughout the EU and can also be traded on an encrypted asset platform.
Information to be disclosed
For encrypted assets, the basic information that needs to be disclosed includes: basic information of the issuer, project-related information, information about issuance to the public or platform transactions, rights and obligations related to encrypted assets, underlying technology, and risks. When it comes to asset-related tokens, the white paper also needs to add: the issuer’s management plan, token value stabilization mechanism, reserve asset investment strategy, reserve asset custody plan, etc. If the issuer does not provide direct claims or redemption rights to the holders of the reserve assets, the white paper should have a clear warning about this, and it should also be reminded in marketing.
There are also information disclosure requirements for the corresponding reserve assets, including the number of tokens in circulation and the value and composition of the reserve assets. The issuer needs to update the website at least once a month. Regardless of whether these encrypted assets are being traded, the issuer must disclose important events that may affect the value of the token or reserve assets.
The issuer of asset-related tokens must act honestly, fairly and professionally. The issuer must take the best interests of the token holder as the starting point and establish a transparent and efficient complaint handling process. The issuer must also formulate corresponding identification and management plans for conflicts of interest that may arise from the relationship between managers, shareholders, users and third-party service providers. The issuer should formulate an orderly gradual liquidation plan to ensure that the issuer protects the rights and interests of token holders during the process of suspension of operations or legal bankruptcy.
The issuer needs to formulate a robust management plan, including a clearly defined organizational structure, procedures for monitoring and reporting related risks, and a sound internal management mechanism. The requirement for the issuer’s own funds is at least 350,000 Euros and at least 2% of the average amount of reserve assets within six months. If it is defined as a key asset-related token, its own funds need to account for at least 3% of the reserve assets, and the issuer is required to pay more attention to risk management. The relevant management members of the issuer also need to have a good reputation and ability in terms of qualifications, experience and technology, and have the time and ability to perform their functions.
To maintain the stability of the value of the token, the issuer of asset-related tokens needs to ensure that there is sufficient asset reserves behind it. Issuers need to take prudent measures for the management of reserve assets to ensure that the creation and destruction of tokens correspond to the increase and decrease of reserve assets. The issuer should describe in detail the content related to the stability mechanism, especially the composition and distribution of reserve assets, the assessment of reserve asset risks, the process of token creation and destruction, the investment plan and investment principles of reserve assets, and the process of purchasing and redeeming tokens. The token issuer must ensure that the reserve assets are isolated from its own assets and can quickly access the reserve assets to satisfy the holder’s redemption request. Reserve assets should be kept by credit institutions and encrypted asset service providers. The issuer is responsible for selecting and appointing to ensure that the custodian has the necessary professional knowledge and good market reputation.
Reserve assets should be invested in safe and low-risk assets that can be liquidated with minimal price impact. All gains or losses arising from investment should be borne by the issuer. In order to ensure that asset-related tokens are mainly used for transactions rather than value storage tools, neither the issuer nor the encrypted asset service provider will distribute interest to users who hold the token.
For issuers of key asset-related tokens, they should formulate strict liquidity management strategies to ensure that the entire system can still operate normally under liquidity tight conditions.
Requirements for e-money token
Since the definition of e-money token is similar to e-money, the regulatory requirements for e-money token also draw on the relevant content of e-money.
Information to be disclosed
The white paper of the e-money token should include information about the issuer and project, relevant information for public offerings or transactions on the platform, e-money token-related rights and obligations, underlying technology, and risks. The white paper should clearly state that e-money token holders have the right to redeem e-money tokens at face value at any time.
The issuing institution of the e-money token should be a credit institution under the 2013/36/EU directive or an electronic money institution under the 2009/110/EC directive, and they should comply with the relevant operational requirements of the 2009/110/EC directive. The issuer should give the holder the right to redeem the token at the face value at any time, and the issuer can charge the redeemer during the redemption process. Similarly, neither the issuer of e-money token nor the encrypted asset service provider will distribute interest to users who hold the token. The issuer should invest the funds exchanged for the e-money token in the same currency as the e-money token to avoid cross-currency risks.
If it is defined as a key e-money token, the custody and investment rules of its reserve funds may not need to refer to the relevant content of Article 7 of the 2009/110/EC Directive, but refer to the requirements of key asset-related tokens, including the establishment of an orderly Gradual liquidation plan, etc.
Special circumstances where the above regulatory policies are not applicable
In order to reduce the administrative burden of small and medium-sized enterprises, the requirements for the issuance of stablecoins do not apply to the above circumstances when the following conditions are met: 1. In a 12-month period, the issuer’s average total debt does not exceed 5 million euros or other, etc. Value currency; 2. Tokens issued externally are only for qualified investors, and only qualified investors can hold them. The issuer still needs to provide the white paper and notify the relevant regulatory authorities.
Encrypted assets issued by the European Central Bank, European Investment Bank, central banks of member countries or other government agencies, public international organizations and services provided are not within this regulatory framework. This regulation also does not apply to encrypted asset services provided by individuals only for the parent company, subsidiary or other subsidiary of the parent company.
Requirements for service providers
This proposal also puts forward regulatory requirements for encrypted asset service providers, and the services provided by service providers are divided into two categories. The first category includes the operation of encrypted asset trading platforms, the use of one’s own account to participate in the transaction of encrypted assets with legal tender or other encrypted assets, and the custody of encrypted assets in the name of a third party. The second category includes the custody of encrypted assets, receiving or transmitting encrypted asset orders and executing orders on behalf of a third party, as well as providing consulting suggestions on encrypted assets.
Encrypted asset services within the EU can only be provided by legal entities that have registered offices in member states and have been authorized by the supervisory authority where the office is registered. If a person in the EU actively seeks encrypted asset services provided by a company located in a third country, then this company may not be regarded as providing services in the EU. However, if a company located in a third country wants to solicit users in the EU, it needs to obtain regulatory approval. At present, the scale of encryption service providers is relatively small, so the authorization is only determined by the supervisory authority of the member country where the registration is located, and the decision is valid throughout the EU.
Encrypted asset service providers should also act in an honest, fair and professional manner like the issuer of stablecoins to protect the best interests of users. Encrypted asset services should follow the relevant content of the 2002/65/EC directive as a “financial service”, such as the formulation of contracts. Encrypted asset service providers should provide users with clear, fair, and non-misleading information, and warn them about the risks associated with encrypted assets. Service providers should make their pricing rules public, establish a complaint handling system, and identify, prevent, manage, and disclose corresponding conflicts of interest. The requirements for managers and employees are the same as those for stablecoin issuers, and they all need to have sufficient knowledge and ability to perform corresponding duties. Service providers should set up sound internal control and risk assessment mechanisms to ensure the integrity of the received information, and also need to keep corresponding transfer orders and service records.
Services related to stablecoins mainly include the custody and trading of encrypted assets. When it comes to the custody of encrypted assets, the service provider needs to sign a contract with the user to protect the user. The service provider is responsible for the losses caused by network attacks, theft or system failure. When it comes to transaction-related services, the fee structure must be transparent and a non-discriminatory commercial policy must be implemented. Service providers also need to set corresponding rules to prohibit insider trading, illegal disclosure of internal information, and manipulation of encrypted assets.
Thinking and summary
From the starting point of the regulatory proposal, it can be seen that the European Commission encourages the innovation and development of distributed ledger technology and recognizes the value of distributed ledger technology in terms of efficient cross-border payment methods. The significance of this amendment is to encourage innovation and fair competition while protecting users and investors and ensuring financial stability. The content of the proposal also does not completely negate the previous supervision strategy. The supervision plan of the e-money token, which is similar in nature to the e-money, still refers to the previous e-money plan, and the supervision of the key e-money token is different.
The idea that runs through the entire regulatory program is consistency and proportionality. Consistency is reflected in the fact that once the relevant activities of encrypted assets are approved by the regulatory authorities, they can conduct business across the EU. Proportionality is reflected in the exemption of smaller stablecoins and increased supervision of key stablecoins. For SMEs, this can reduce compliance costs and ensure the stability of the financial system.
The current regulatory direction is to encourage the use of stablecoins as trading tools, rather than as a store of value. Any stablecoin issuer needs to register an office in the EU and meet the conditions to be authorized by the regulatory agency where it is registered before it can be issued in the EU. Stablecoins can be linked to the Euro or other currencies in the EU.
Unlike the issuance of stablecoins, related service providers can provide services from outside the EU to the EU without regulatory authorization, but the premise is that users in the EU actively use it. If service providers need to actively expand their businesses in the EU and recruit users in the EU, they need to register in China and accept the supervision of relevant agencies.
The proposal clearly states that stablecoins issued outside the EU can only be used within the EU after being registered and authorized within the EU. However, if stablecoins pass through an overseas encrypted asset service provider such as a trading platform, under the premise that users actively use it, they can still bypass authorization to reach users within the EU. In this way, the number of users who are exposed to unauthorized stablecoins will be relatively small, so there is no specific explanation in the proposal. In the future, it can be resolved through cooperation with regulatory agencies in other countries around the world.
The problems caused by encrypted assets and stablecoins are common problems in the world. This proposal provides a reference for the formulation of relevant regulatory laws in other countries. The issuer’s public information, reserve asset management plan, and the issuer’s obligations are all lessons learned, and this is also one of the significance of this proposal. Countries that are more open to encrypted assets can fully refer to such regulatory programs to reduce regulatory frictions for related companies and facilitate business development around the world.