Thinking | 1 August 2022
IOSCO and CPMI release guidance on the application of PFMI to stablecoin arrangements
By John Bassilios and Georgia Francis
In response to the volatility concerns associated with traditional forms of cryptocurrency, stablecoins have emerged in the market. A type of digital currency, stablecoins’ value is pegged to a reserve asset (eg fiat currency, commodities, reserves of other cryptocurrencies).
Stablecoin arrangements are payment systems, as they permit the transfer of value between stablecoin holders. This transfer function of a stablecoin is similar to the transfer function performed by other types of financial market infrastructures (FMI), and therefore carry similar liquidity, settlement, operational and cyber risks. As a result, a stablecoin arrangement that performs this transfer function are considered akin to a FMI.
Accordingly, the International Organisation of Securities Commissions (IOSCO) and the Committee on Payments and Market Infrastructure (CPMI), were called upon by the international regulatory community to provide guidance on how the existing Principles for Financial Market Infrastructures (PFMI), which apply to systematically important FMIs, could act as effective guidelines to stablecoin arrangements (given the transfer function similarities).
CPMI and IOSCO finalised their report in July 2022, which concluded that systematically important stablecoin arrangements would be expected to observe the PFMI. The report was intended for use by systemically important stablecoin arrangements and by regulatory, supervisory and oversight authorities as they carry out their respective responsibilities in the financial services market.
Determining systematic importance
In order to determine what is considered a systematically important stablecoin arrangement for the purposes of compliance with the PFMI, CPMI and IOSCO identified the following four key considerations.
- Size of the stablecoin arrangement, having regard to such factors as the number of stablecoin users, the number and value of transactions and value of stablecoins in circulation.
- Nature and risk profile of the stablecoin arrangement’s activity, taking into account the type of stablecoin users and transactions and the its reserve assets.
- The extent that the stablecoin arrangement is interconnected and interdependent with other market entities and systemically important FMIs.
- The availability of alternatives to using the stablecoin arrangement as a means of payment or settlement for time-critical services.
While CPMI and IOSCO note that a systemically important stablecoin arrangement should observe all relevant principles of the PFMI, while also acknowledging that there are unique features of stablecoin arrangements which may hinder straightforward compliance. Considering this, the report provides specific guidance in relation to four key principles, and how they intertwine with these unique features of stablecoin arrangements.
Principle 2 of the PFMI outlines the expectation that governance arrangements should promote stability and efficiency, and support the stability of the broader financial system. In this way, governance arrangements should provide for effective decision-making and support any procedures and rules.
CPMI and IOSCO have identified issues with neatly applying principle 2 to the operations of stablecoin arrangements, due to the fact their governance structures are decentralised in nature. For example, the transfer function can be set up on a permissionless public ledger as a smart contract and there may be no identifiable legal entities or persons that assume responsibility and/or accountability for this function. In this way, governance implemented exclusively through software may be inflexible in case of a changing regulatory landscape or where expert judgment and discretionary decision making are required.
Despite these intrinsic issues, a systemically important stablecoin arrangement will be expected to have appropriate governance arrangements in complying with principle 2. CPMI and IOSCO consider that this can be achieved by ensuring the ownership structure and operation of the stablecoin arrangement allows for clear and direct lines of responsibility and accountability, that can be ultimately traced back to natural persons to allow for timely human intervention.
Principle 3 provides that an FMI have a sound risk-management framework, procedures and policies in order to comprehensively manage legal, credit, liquidity, operational and other risks.
Stablecoin arrangements are structured quite differently from traditional FMIs, which may mean that adopting principle 3 will not be so straightforward. Specifically, stablecoin arrangements fulfil multiple functions that are usually operated independently and unconnected from one another, given the stablecoin arrangement is decentralised in nature. The net result of this is that it will be more difficult to comprehensively manage risks and identity responsible entities under a standard risk-management framework.
Nonetheless, systemically important stablecoin arrangements will be expected to develop appropriate risk-management frameworks and tools to identify and mitigate risks which are made apparent through regular wholistic reviews of the material risks that each stablecoin arrangement function poses to other functions and other entities it interacts with.
Principle 8 of the PFMI provides that rules and procedures should clearly define the point at which settlement finality takes place (the irrevocable and unconditional transfer of an asset or financial instrument, or the discharge of an obligation by the FMI or its participants in accordance with the terms of the underlying contract). Settlement finality is vital in mitigating risk that settlement in a funds transfer system will not take place as expected.
The report acknowledges one main issue that stablecoin arrangements may face in trying to comply with the settlement finality principle, that being a feature unique to blockchain technology called ‘probabilistic settlement’. This is the probability that a discrepancy between the state of the ledger and legal finality may occur. This situation may be exacerbated in the absence of a legal entity responsible for the stablecoin arrangement’s transfer function (as explained above), and therefore no simple way to enforce the legal conclusion of a transaction.
It follows that for systemically important stablecoin arrangement, in order to mitigate probabilistic settlement and comply with settlement finality principles, should:
- unambiguously define the point at which a transfer of a stablecoin through the operational settlement method used becomes irrevocable and unconditional;
- ensure that there is a clear legal basis that acknowledges and supports finality of a transfer; and
- have procedures in place for preventing any inconsistencies between the state of the ledger and legal finality.
Principle 9 of the PFMI states an FMI should conduct its money settlements in central bank money where practical and available. If central bank money is not used, and in any event, an FMI should any credit and liquidity risk arising from the use of commercial bank money.
A stablecoin is used as the settlement asset within the stablecoin arrangement, which means that the credit and liquidity risks associated with stablecoin arrangements are rooted in the stablecoin itself, the reserve assets backing the stablecoin, the issuer of the stablecoin and/or the settlement institution.
There is a risk of exposure to credit risk if the stablecoin loses value relative to the sovereign 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. Furthermore, there is also a liquidity risk in the event a stablecoin cannot promptly be converted into other liquid assets.
To mitigate the credit and liquidity risk outlined above, stablecoin arrangements should, according to the report:
- consider the sufficiency of the regulatory and supervisory framework that applies to the issuer, reserve manager and/or custodian of the reserve assets;
- ensure that stablecoin-backed assets are safeguarded and/or invested in a way that minimises the risk of loss on and delay in access to the reserve assets;
- assess the sufficiency of the stablecoin arrangement’s reserve assets to stabilise the value of the stock of stablecoins in circulation;
- consider whether the stablecoin enables those that hold it with a direct legal claim on the issuer and/or interest in the underlying reserve assets;
- determine the robustness and timeliness of the process for converting the stablecoin into other liquid assets in both normal and stressed circumstances.
What does this mean?
The application of existing market guidelines, such as the PMFI to stablecoin arrangements, leads the way for other emerging digital assets/currency and cryptocurrencies to be defined and regulated under existing laws and schemes both domestically and internationally.
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