Bank of Canada calls for comprehensive stablecoin regulation

Welcome to Kitco News’ 2023 Outlook Series. Uncertainty continues to dominate financial markets as central bank monetary policies push the global economy into a recession to cool down inflation. Stay tuned to Kitco News to learn from the experts on how to navigate turbulent financial markets in 2023.

(Kitco News) – The Bank of Canada has released a new report titled “Potential benefits and key risks of fiat-referenced cryptoassets” in which the central bank emphasized the need to develop clear regulations around stablecoins.

The bank highlighted the fact that since the beginning of 2020, the global market value of fiat-referenced cryptoassets has increased more than thirtyfold to reach $161 billion in value by the middle of 2022, indicating a rising interest in the asset class.

“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,” the report said. “If well designed and appropriately regulated, these cryptoassets could bring efficiencies and greater competition to payment services, especially in a more digitalized economy.”

But the bank also warned that without safeguards, stablecoins could pose a significant risk to the stability of the financial system.

Currently, stablecoins are mainly used as a medium of exchange and store of value on centralized crypto exchanges and decentralized finance platforms, which the Bank of Canada says offers several benefits, including the ability to provide distributed ledger technology-based financial services.

Additional benefits of transacting in blockchain-based stablecoins include the fact that blockchains operate continuously as opposed to many fiat payment systems that are limited to banking business hours, and crypto blockchain transactions can settle faster than fiat currency transactions.

“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,” the bank said. “These cryptoassets could therefore play a significant role in the financial system in the future.”

The report also highlighted the capabilities of smart contracts, which “allow automatic payments based on specific, pre-defined conditions, supporting the notion of ‘programmable money.’” A well-referenced example of such a use case includes the transfer of funds for a house purchase that triggers once an inspection report has been received and confirmed.

When it comes to the main risks that stablecoins pose to holders, the financial system, and the economy, the Bank of Canada highlighted run risk, contagion risk, concentration risk, and consumer and investor protection risks.

Run risk refers to the possibility of a “bank run” being triggered if stablecoin holders no longer believe they will be able to redeem their tokens at par with the reference currency. “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,” the report said.

Contagion risk has emerged due to the fact that stablecoins now account for roughly 50% of the total cryptoasset trading volumes, which means that if there is a run on these assets, “this larger presence can cause disruptions in cryptoasset markets and their affiliated services.”

“The turmoil in cryptoasset markets in 2022 illustrates the interconnectedness and resulting contagion within the crypto ecosystem,” the bank said, referring to the collapse of the stablecoin Terra USD earlier in the year. “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 is tied to the fact that the top three fiat-referenced cryptoassets – Tether (USDT), USD Coin (USDC) and Binance USD (BUSD) – have 90% of the total fiat-referenced cryptoasset market while the top 1% of investors hold approximately 90% or more of the total supply of the major fiat-referenced cryptoassets.

“The highly concentrated nature of these markets and holdings implies outsized impacts if major parties are affected by cyberattacks or a loss of confidence,” the report warned.

On the consumer and investor protection front, the main risk comes from the lack of adequate regulation and disclosure, which opens these parties to an increased risk of fraud or investment scams.

Other risks noted by the bank include new operational and governance risks, accountability risks that arise from having no entities or individuals responsible for comprehensive risk management, and 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,” the bank warned. “Such diversion potentially increases lending costs.”

Due to the outlined risks, the Bank of Canada has called for a comprehensive regulatory approach for stablecoins similar to what is being developed by the Financial Stability Board.

“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,” the report said.

“A timely and comprehensive regulatory approach in Canada will ensure that fiat-referenced cryptoassets can deliver potential benefits without posing unnecessary risks,” the report concluded.

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.