The United States is accelerating the regulation of stablecoins. What should China do?

Since 2020, stablecoins have become a key "infrastructure" of the crypto market, with a huge potential impact. According to Forbes' forecast, stablecoins will become mainstream in 2022. According to the report of the US President's Working Group, the utilization of stablecoins increased by 500% between October 2020 and October 2021, and this rate of adoption does not seem to be decreasing. The author has previously conducted an in-depth analysis of the various risks of stablecoins. This article will discuss two issues: first, the United States is accelerating its efforts to regulate stablecoins; second, how should Chinese regulators respond?

1. The “foreplay” of US regulatory policy: intensive inquiries, reports and hearings

After the U.S. Financial Stability Oversight Council released a report on stablecoins in November 2021, Deputy Treasury Secretary Nellie Liang said recently that "if Congress does not enact legislation, regulators will try to use the powers they have." Regulators claim that an investor run on stablecoins could be destructive to the market, and if such a run occurs, the sheer scale of the market collapse could disrupt traditional financial markets.

Also in November 2021, the Congressional Banking Committee sent letters to several stablecoin issuers, including Coinbase, Gemini, Circle, Paxos, TrustToken, Centre, Binance US and Tether. In the letter, the committee asked the issuers to provide stablecoin purchases, minting processes, restrictions, and issuance and redemption data, and summarize their own company's redemption mechanism (including its conversion into US dollars).

In December 2021, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on stablecoins, chaired by Committee Chairman Sherrod Brown and Senator Patrick J. Toomey, titled “Stablecoins: How Do They Work, How Are They Used, and What Are Their Risks?”.

At the hearing, Brown revealed that the responses from stablecoin issuers were not very clear, which made lawmakers unable to believe that most ordinary customers could get more protection after purchasing stablecoins. Senator Patrick J. Toomey agreed that stablecoins need a new regulatory system, "Stablecoin regulation should be strictly customized and coordinated in the United States and around the world. In addition, regulation should seek to maintain the international competitiveness of the United States. Regulators should recognize that privately issued stablecoins will not undermine the international status of the US dollar, but well-managed stablecoins can actually support it. Finally, regulation should allow stablecoins to interoperate with the current financial system."

Prior to the hearing, Toomey published the principles for stablecoin regulation on the Banking Commission website. Toomey proposed the following principles, which will influence his upcoming stablecoin legislative framework:

Stablecoin issuance should not be limited to insured depository institutions.

First, the business model of stablecoin issuers is different from that of traditional banks.

Second, requiring all stablecoin issuers to become banks would stifle innovation.

Third, regulation of payment activities should create a level playing field.

Stablecoin issuers will choose from at least three regulatory regimes depending on their business model: (1) operate under a traditional bank charter; (2) obtain a special purpose bank charter designed specifically for stablecoin providers under new legislation; (3) register as a money transmitter under existing state regimes and as a money services business under FinCEN's federal regime. (4) All stablecoin issuers should adopt clear redemption policies, disclose requirements regarding the assets that support stablecoins, and may meet liquidity and asset quality requirements. (5) Commercial entities should be eligible to issue stablecoins as long as they comply with these regimes. (6) Non-interest-bearing stablecoins do not necessarily have to be regulated like securities. (7) Regulation should protect the privacy, security, and confidentiality of individuals using stablecoins, including allowing customers to choose not to share any information with third parties. (8) In light of emerging technologies such as stablecoins, financial supervision requirements under the Bank Secrecy Act should be modernized, including requirements for existing financial institutions.

At this hearing, Dispater and Massari of Circle (issuer of stablecoin USDC) jointly proposed a stablecoin regulatory framework that would limit the types of reserve assets that stablecoin issuers can hold and establish a universal system for minting and redeeming stablecoins. It is worth noting that Tether, the stablecoin issuer recognized by the industry as having the greatest risk and the largest market value, did not attend this stablecoin hearing. Currently, USDT is still the dominant stablecoin.

On December 21, Fitch Ratings of the United States released a report stating that improved supervision may ease the credit risk of stablecoins. Fitch believes that the US regulatory approach is particularly important for the medium-term development of the industry, because the vast majority of major stablecoins currently traded are pegged to the US dollar, and this situation is expected to remain unchanged in the medium term.

In summary, the U.S. Congress has had a relatively detailed and in-depth discussion on stablecoins, as well as its connotations and risks. Some regulatory guidelines have been roughly formed, which will directly shape the stablecoin market in the next one or two years. It will then rely on its strong financial regulatory capabilities and “long-arm jurisdiction” mechanism to regulate the crypto market. This cannot but attract the attention of Chinese regulators.

In addition, some leaders of the U.S. financial regulatory authorities believe that it is not necessary to vigorously promote digital legal tender and issue digital dollars like China. Most stablecoins are pegged to the U.S. dollar. For ordinary people, their functions and payment convenience are almost exactly the same as digital legal tender, and they even play a huge role in expanding the international influence of the U.S. dollar. In addition, Chinese investors actually hold a huge amount of stablecoins. At the same time, China's financial regulatory authorities have not issued detailed reports and regulatory guidelines on the risks of stablecoins. The author believes that this area is extremely worthy of attention and would like to propose the following policy recommendations:

2. Limitations of China’s Current Stablecoin Regulation

Compared with the investigation and prosecution of USDT by the US procuratorate, China's judicial institutions are deficient in the following aspects: First, the scope of China's judicial prosecution is limited and the supervision initiative is insufficient. According to Article 18 of the Criminal Procedure Law of the People's Republic of China, the cases directly investigated by the procuratorate do not include economic and financial crimes such as fraud; second, China's judicial jurisdiction is limited. Tether's place of registration and operation are both overseas, and my country's judicial authorities lack effective jurisdiction over USDT issuers, custodian banks and cryptocurrency exchanges.

At the same time, compared with the United States' exploration of stablecoin regulation, China's regulation faces many difficulties: First, regulators have insufficient understanding of stablecoins such as USDT, and the legal characterization is unclear. The "Notice on Preventing Bitcoin Risks" issued by the People's Bank of China and five other ministries in 2013 only pointed out that Bitcoin is a specific virtual commodity; the "Announcement on Preventing Token Issuance and Financing Risks" issued by seven ministries in 2017 aims to completely ban illegal token financing and issuance activities. None of these normative documents mention the regulatory intention, legal definition and risk warning for USDT. In November 2020, the "China Financial Stability Report (2020)" mentioned stablecoins for the first time (Financial Stability Analysis Group of the People's Bank of China, 2020), and the "White Paper on the Research and Development Progress of China's Digital RMB" in July 2021 pointed out that some commercial institutions plan to launch global stablecoins, which will bring many risks and challenges to the international monetary system, payment and clearing system, monetary policy, cross-border capital flow management, etc. (Digital RMB Research and Development Working Group of the People's Bank of China, 2021). This shows that my country's financial regulators are gradually paying attention to the risks of stablecoins, but currently they are mainly at the risk warning stage.

Secondly, my country lacks relatively clear regulatory objectives and frameworks for stablecoins, and corresponding regulatory principles and standards have yet to be issued. Taking major international financial organizations as an example, the Financial Stability Board advocates the concept of "same risks, same activities, same supervision" to penetrate and characterize stable assets, and puts forward more than ten high-level recommendations such as establishing effective risk prevention and control, reserve management, transparency, and anti-money laundering; the International Organization of Securities Commissions recommends in the "Global Stablecoin Initiative Report" that stable assets with payment functions be included in the CPMI-IOSCO Financial Market Infrastructure Principles; the Basel Banking Committee includes stablecoins in the macro-prudential capital adequacy regulatory framework and applies the most stringent regulatory requirements. The above-mentioned international financial organizations all attach great importance to the risks of stablecoins and have proposed a relatively clear regulatory framework. In contrast, the incompleteness of my country's blockchain financial regulatory principles and frameworks such as stablecoins has brought troubles to the resolution of law enforcement and judicial disputes.

Finally, my country's regulatory authorities lack effective regulatory tools, and it is difficult to monitor, identify, and deal with USDT risks. First, under the territorial principle, regulatory agencies lack effective law enforcement measures against overseas issuers and exchange entities such as Tether and Bitfinex; second, the existing financial anti-money laundering and foreign exchange monitoring systems have blind spots and loopholes in monitoring USDT. A large number of USDT over-the-counter transactions occur at home and abroad, and funds flow point-to-point through bank accounts and third-party payment channels, which are difficult to monitor. Faced with the regulatory dilemma of blockchain finance, traditional models are mostly limited to the declaration of prohibiting cryptocurrency or stablecoin transactions, and the effectiveness of regulation remains to be explored.

III. Regulatory Countermeasures

First, the legal attributes of USDT should be clarified. It should be noted that stablecoins cannot be equated with independent monetary systems because they do not have the two characteristics of a robust value anchor and centralization (Wang Huaqing and Li Liangsong, 2019). Stablecoins are not recognized by sovereign states or given unlimited legal sovereign credit by social recognition. Private institutions monopolize the issuance of stablecoins and act as credit intermediaries. This private cryptocurrency is a new form of the "digital age", which has changed the subject and credit method of currency issuance and forced the old financial regulatory measures and monetary policy measures based on traditional physical currency to undergo new changes (Zheng Yu, 2020). Stablecoins have greater compliance risks, which will weaken the credit basis of stablecoins and do not have a stable value anchor. The circulation of different types of stablecoins in a single market is likely to lead to currency conflicts and confusion, increase transaction costs, and is not conducive to the formation of a centralized monetary system. Therefore, although stablecoins have the economic attributes of currency, they cannot become the legal tender or standard currency of a sovereign state and do not have the same legal status as legal tender. Investors use stablecoins such as USDT to exchange fiat currencies and trade currencies. In essence, they rely on the US dollar credit behind USDT to trade with other fiat currencies or cryptocurrencies, which can be seen as an extension of US dollar credit on a global scale.

The author believes that USDT is a payment tool supported by the real purchasing power represented by US dollar assets, which can be characterized as a foreign currency bill. After the user invests 1 US dollar, Tether deposits the user's 1 US dollar into the custodial bank or trust company account as a reserve. The user and Tether, Tether and the custodian institution respectively constitute a creditor-debtor relationship. Tether is indebted to the user and has a deposit claim to the custodian institution. USDT is the certificate of the creditor-debtor relationship between the user and Tether denominated in US dollars. For foreign countries (such as China), the USDT in circulation represents a certain amount of foreign currency assets, that is, foreign currency bills. In this regard, my country can include USDT in the scope of broad foreign currency and foreign exchange assets, use foreign exchange, anti-money laundering and other regulatory frameworks to combat USDT speculation, and prudently strengthen supervision of USDT circulating in China.

Secondly, the active regulatory role of the judiciary should be fully exerted at the procedural and substantive levels. At the procedural level, the Chinese procuratorate should actively strive for jurisdiction over USDT-related entities. According to the principle of attribution of commercial activities, the issuer of USDT, the actual controller of the exchange and the place where the infringement occurred are the core of the judicial authorities to establish jurisdiction. The judicial authorities can penetrate the personality appearance and confirm the actual controller of the issuer and the trading platform based on the appearance of the behavior. Specifically, in the field of infringement disputes, according to Article 28 of the Civil Procedure Law, investors can file a lawsuit against Bitfinex and Tether for market manipulation, fraud or data privacy leakage based on the place where the infringement was committed and the place where the infringement occurred; in terms of cybercrime, the Opinions on Several Issues Concerning the Application of Criminal Procedure in Handling Cybercrime Cases enumerates the crime locations of cybercrime cases, that is, the public security and other law enforcement agencies can file a case against Tether at the location of the Tether server, the location of the computer information system used by the victim, the location of the victim when the victim was infringed, and the place where the victim's property suffered losses, and the procuratorate can initiate public prosecution. At the same time, judicial authorities can apply for judicial assistance from judicial authorities in Hong Kong, China, where Tether’s headquarters is located, or where the server is located, such as joint investigation, judicial evidence collection, execution of judgments, and freezing of USDT using the “blacklist” mechanism. In the process of investigating, combating crime, and recovering property, the intermediate and high courts with jurisdiction over the case can also require the issuer to fulfill its fiduciary obligation to disclose funds, or require relevant exchanges to provide necessary assistance, expanding the scope and strength of judicial activism.

At the entity level, judicial guidance can be used to provide useful exploration for courts facing the problem of "unable to handle justice" when hearing USDT-related cases. In the judgment, the court can summarize the facts, controversial points, and key points of the USDT case, and refer the cases with unified legal application and rule guidance to higher-level courts or specialized courts (such as financial courts) for trial, so as to exert the binding force of individual case guidance. In addition, judges are encouraged to conduct useful exploration within the legal framework, consider the political, legal, and social effects of judicial judgments based on factors such as financial supervision and financial justice, public interests and individual private interests, and weigh the consequences of such new or difficult cases. In the criminal field, strengthen the criminal law regulation of stablecoins and combat the instrumentalization tendency of USDT in crimes such as theft, fraud, and money laundering; in the civil field, the effectiveness of relevant behaviors can be determined under the principle of respecting autonomy of will and protecting legitimate property. By giving full play to the rule of supplementary rules of judicial decisions, reference can be provided for legislation and supervision.

In addition, regulators should speed up the construction of a stable asset supervision system. my country can learn from the experience of the United States and international organizations, penetrate USDT trading activities based on the concepts of inclusive prudence and ex ante regulation, and formulate regulatory measures in terms of market access, anti-money laundering, foreign exchange management and cross-border collaborative supervision in accordance with the idea of ​​"same risks, same functions, same supervision".

In terms of market access, my country's regulatory authorities can formulate access standards by category: in terms of subject regulation, for stablecoin issuers that are not registered in China but actually provide services to Chinese users, regulatory authorities can require issuers, managers and actual controllers of cryptocurrency exchanges, and over-the-counter USDT exchangers (OTC) to fulfill anti-money laundering filing and transaction reporting obligations in accordance with the principle of territorial supervision. In terms of behavioral content regulation, the payment function supervision of stablecoins such as USDT can be strengthened, requiring stablecoin issuers, cryptocurrency exchanges, and payment institutions and individual merchants using stablecoins to apply for prepaid card licenses or online payment licenses similar to third-party payments, or to launch "crypto asset payment" licenses. In the future, we can try to introduce stablecoins into regular exchange transactions, strengthen the first-line supervision and node management of exchanges and payment institutions, and standardize the access and business activities of stablecoin payment businesses.

In terms of anti-money laundering, regulators should eliminate anti-money laundering monitoring blind spots and include stablecoins such as USDT in the existing anti-money laundering legal framework: First, they should promote the formulation of stablecoin anti-money laundering regulatory technical standards, define the subject, object, behavior and other elements of stablecoin money laundering in a typological manner, and improve the pertinence and operability of anti-money laundering supervision; second, in terms of customer identity identification, issuers, exchanges and exchangers should be required to strictly implement KYC processes such as real-name authentication, weaken the anti-censorship properties of USDT, and promote cross-verification and related sharing of off-chain and on-chain transaction data; third, strengthen bank account monitoring and management. Public security organs and commercial banks should strengthen the full-chain monitoring of funds laundered using USDT, strengthen the identification of funds of unknown origin and abnormal bank accounts, and take measures such as marking, inquiry, transfer limit and freezing. At the same time, they should focus on strengthening the identification and monitoring of USDT over-the-counter exchangers, regularly check the flow of funds, and hold exchangers who "knowingly" and "negligently" accept the stolen money criminally liable. Fourth, financial regulatory authorities can use the idea of ​​"embedded supervision" to embed smart contracts on public chains such as Ethereum and Tron, dynamically track USDT addresses and blocks in China, and embed anti-money laundering regulatory requirements into the stablecoin system; at the same time, regulatory authorities can contact and establish cooperation with issuers Tether and cryptocurrency exchanges, draw on the "Fund Travel Rule" to strengthen monitoring of large and abnormal funds, and, if necessary, require cryptocurrency exchanges and Tether to assist regulatory authorities in blacklisting specific USDT addresses and taking stablecoin freezing measures.

In terms of foreign exchange management, foreign exchange regulatory agencies should first track the development trend of USDT at home and abroad, strengthen research on USDT issuance, circulation mechanism and application scenarios, and improve the professionalism and foresight of regulatory personnel; second, try to include stablecoins such as USDT in my country's foreign exchange regulatory framework and balance of payments, establish a two-way exchange and settlement and sale approval registration and filing management system for stablecoins such as USDT and RMB, strengthen the position management of domestic RMB accounts and foreign currency accounts of individuals or enterprises, and identify suspicious transactions; third, strengthen technical supervision, use regulatory technology such as blockchain, big data, and artificial intelligence to improve foreign exchange supervision capabilities, collect suspicious account node information, and guide cryptocurrency exchanges, stablecoin exchangers and issuers to assist in combating USDT-related foreign exchange speculation based on the principle of risk neutrality. If necessary, it can be explicitly prohibited to use stablecoins such as USDT in domestic trading scenarios.

In terms of cross-border coordinated supervision and collaborative governance, my country's regulatory authorities should actively cooperate with foreign judicial and law enforcement agencies to deepen their understanding of the risks of stablecoins, jointly explore innovative mechanisms for cross-border stablecoin supervision, and promote the formulation of international regulatory standards for stablecoins and the implementation of regulatory frameworks. At the same time, the central bank can lead the establishment of a "cross-border regulatory sandbox" as a pilot for collaborative supervision, and include stable assets such as USDT in the sandbox observation test. Article 22 of the "People's Bank of China Law of the People's Republic of China (Draft for Comments on the Revised Draft)" promulgated in October 2020 stipulates that "no unit or individual may produce or issue token tickets and digital tokens to replace the circulation of RMB in the market." This prohibition may be adjusted to a flexible authorization license in the future, that is, "Without the permission of the People's Bank of China, no unit or individual may produce or issue token tickets and digital tokens to replace the circulation of RMB in the market." Based on this, regulators may authorize compliant and technically capable financial technology institutions to issue stablecoins anchored to the RMB for use in specific scopes and scenarios in the future, and use them as a supplementary means of payment, which can be included in the category of electronic currency. Together with the digital RMB, they will promote the construction of digital infrastructure, resist the erosion of the RMB ecosystem by stablecoins such as USDT, and open up application scenarios at home and abroad.

IV. Conclusion

As an extremely important "passport" in the cryptocurrency market, USDT has become increasingly popular with the rise of the entire private cryptocurrency and the investment needs of Chinese investors. As stablecoins gradually spread to the traditional financial market, they will pose a great challenge to the current financial regulatory and legal system. In the absence of legal rules to provide definitive guidance, China needs to be guided by financial risk prevention and investor rights protection, assess the risks of USDT through economic substance based on a prudent framework, track and judge its trends in a timely manner, and formulate response strategies for legal currency-collateralized stablecoins such as USDT. By timely incorporating the new blockchain financial innovation format of USDT stablecoin into the regulatory vision and legal framework, and updating the regulatory concepts and methods, regulators have important practical significance for enhancing the international competitiveness of the RMB, protecting the rights of investors, and maintaining the financial security and stability of my country.