HashKey: Detailed explanation of the direction and significance of the European Commission's stablecoin regulatory proposal

Original title: "Analysis of the European Commission's Stablecoin Regulatory Proposal"
Written by: Cui Chen, works at HashKey Capital Research
Reviewer: Zou Chuanwei, Chief Economist of Wanxiang Blockchain and PlatON

The proposal on crypto asset market regulations issued by the European Commission has improved the supervision of crypto asset related fields. As a special crypto asset, stablecoins need to implement strict regulatory requirements. Only entities approved by the regulatory authorities of the place of registration can issue stablecoins or provide corresponding services. Regulatory agencies are appointed by each country, and the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) will also participate in related regulatory work. The regulatory authorities have put forward requirements for the information that issuers need to disclose, the obligations they should fulfill, and the management of reserve assets. Crypto asset service providers must be approved before they can provide services to users in the EU. The regulatory approach in the proposal can provide a reference for the formulation of regulatory policies in other countries.

On September 24, 2020, the European Commission (EC) published a proposal for crypto-asset regulations, covering parts not included in the existing EU Financial Services Act, and providing a complete legal framework for the crypto-asset market in the EU. In addition to providing regulatory guidance for crypto-asset market participants, encouraging innovation is also one of the goals of the proposal, as existing regulations may hinder the use of distributed ledger technology. Take the current regulatory scheme for stablecoins as an example. In the existing regulatory system, it is defined as e-money and regulatory policies related to payment services are implemented. However, this scheme cannot cover all stablecoins. Some stablecoins that are used for the purpose of value storage or are reserved by other assets are not within the scope of regulation. The same is true for crypto-asset-related services, such as crypto-asset custody. Therefore, restricting the use of stablecoins seems to solve the financial risk problems brought by stablecoins, but if local users use stablecoins issued by third countries, such risks will still exist, so comprehensive and appropriate supervision is necessary.

Some EU member states have now implemented regulatory policies on crypto asset service providers, and more and more member states are considering regulating crypto assets and crypto asset service providers at the national level. These bills with different contents will require crypto assets and services to adjust their products and business models in different regions, which will lead to high costs and cumbersome legal procedures, limiting their business expansion within the EU. In areas where there is a lack of legal certainty, users and investors face a lot of risks. In the proposal, the European Commission used "regulations" instead of "directives" for the sake of unified supervision and to facilitate the business of crypto asset issuers and service providers. If the proposal is passed, it will become the first EU-level regulatory regulation on crypto assets.

Another principle of the proposal is proportionality, which requires a clear distinction between different services and activities and their corresponding risks to ensure that the administrative burden is commensurate with the risk. Among all crypto assets, stablecoins are easier to expand in scale due to their particularity than other crypto assets, which poses greater risks to investors and the financial system, leads to financial stability and monetary sovereignty issues, and affects monetary policy transmission. Therefore, 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 plans.

The definition of stablecoins and the classification of whether they are important or not

Before understanding the specific regulatory bills, it is necessary to clarify the official definition of stablecoins. Stablecoins here are first of all a kind of crypto asset, which is a digital form of value or equity and uses distributed ledgers or similar technologies for electronic transfer and storage.

When used as a payment tool, stablecoins and e-money have similar definitions. Directive 2009/110/EC stipulates that users of e-money always have a claim on the e-money issuer and can redeem e-money at face value at any time. However, some stablecoin users do not have such a claim, and their redemption cycle will be restricted or the redemption funds will not be equal to the reserve assets, which will affect the confidence of crypto asset users and harm their interests. Therefore, in the proposal, this stablecoin similar to e-money is clearly defined as an e-money token, and the issuer is also required to recognize the holder's claim. Different regulatory measures will be taken for other types of stablecoins. Stablecoins that meet certain 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 a crypto asset that references multiple fiat currencies, one or more commodities, one or more crypto assets, or a combination of them to maintain the stability of its own value.

e-money token definition

E-money token is a crypto asset that is anchored to a single legal currency to maintain its own value stability and is mainly used for transactions.

Focus or not

The EBA is responsible for determining whether a stablecoin is a key stablecoin. The criteria are: 1. The number of users, investors and participating third-party entities is not less than two million; 2. The total value or market value (if any) of the issued token is not less than 1 billion euros; 3. The number of daily transfers is not less than 500,000 or the amount of transfers is not less than 100 million euros; 4. The value of reserve assets is not less than 1 billion euros; 5. It is of great importance in cross-border activities, and the number of member states involved in the use of tokens for cross-border payments and transfers is not less than seven; 6. Stablecoins and their issuers are considered to be interconnected with the financial system. As long as three of the above conditions are met, it can be determined by the EBA as a key stablecoin. In addition, the issuer can also actively apply to be classified as a key stablecoin project.

Responsibilities of the regulatory body

Scope of the regulator’s powers

Each member state needs to appoint its own regulatory body for stablecoins and notify the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA). If multiple regulatory agencies are involved, a contact point for cross-border administrative cooperation must also be designated.

Regulators have sufficient supervisory power over stablecoin issuers and crypto asset service providers, including requiring the regulated party to provide additional information, delaying or prohibiting the issuance and trading licenses of stablecoins or related applications of service providers. Regulators also have the power to punish violations and make public stablecoin issuers that fail to fulfill their obligations.

As highly professional institutions, EBA and ESMA will be responsible for the formulation of draft technical standards that do not involve policies, such as the relevant standard formats and processes for applicants of asset-related tokens, the types of assets invested by issuers, and the calculation methods of issuers’ capital requirements.

Regulation of key stablecoins

If a stablecoin is determined to be a key stablecoin according to the above criteria, its supervision will be handed over to the EBA. The EBA will set up a supervisory association, whose members include all entities related to key stablecoins and regulators related to crypto asset service providers (for e-money tokens, the corresponding regulators are regulators under Directive 2009/110/EC), and they will exchange information to promote cooperation. The EBA will charge fees to key stablecoin issuers to cover expenses, and the fees are proportional to the size of the stablecoin's reserve assets.

Specific requirements for stablecoin issuance

For stablecoin issuers, the first principle to be followed is that before obtaining authorization from the regulator of the home member state (i.e. the place where the office is registered), they cannot issue to the public within the EU or seek to trade on the trading platform, and only legal entities established within the EU can be authorized. Before issuing to the public or seeking to trade, it is necessary to notify the regulator and publish a document containing the information that needs to be disclosed, that is, a white paper. The information should be presented in a fair, clear and non-misleading manner. For the information provided to the public, the issuer and the management agency of the stablecoin should apply the civil liability management rules. Depending on the definition of stablecoins, the requirements of regulators for its disclosure of information and the obligations of issuers will also be different.

Requirements for asset-related tokens

As mentioned above, before issuing asset-related tokens, the issuer must obtain authorization from the regulator of the home member state. The relevant application materials include information about the applicant, white papers, descriptions of related businesses and obligations, etc. If the asset-related token is related to a currency within 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. Once approved by the regulator, the crypto asset is valid throughout the EU and can also be traded on the crypto asset platform.

Information to be disclosed

For crypto assets, the basic information that needs to be disclosed includes: basic information of the issuer, relevant information of the project, relevant information of issuance to the public or platform trading, rights and obligations related to crypto assets, underlying technology and risks, etc. When it comes to asset-related tokens, the white paper also needs to supplement: 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 holders on reserve assets, the white paper should have a clear warning about this, and there should also be reminders in marketing.

There are also requirements for disclosure of information on the corresponding reserve assets, including the number of tokens in circulation and the value and composition of the reserve assets, which the issuer needs to update on the website at least once a month. Regardless of whether these crypto assets are being traded, the issuer must disclose important events that may affect the value of tokens or reserve assets.

Issuer Obligations

Issuers of asset-related tokens should act honestly, fairly and professionally. Issuers should establish a transparent and efficient complaint handling process based on the best interests of token holders. Issuers should also develop corresponding identification and management plans for conflicts of interest that may arise from the relationship between managers, shareholders, users and third-party service providers. Issuers should develop an orderly and gradual liquidation plan to ensure that the rights and interests of token holders are protected during the process of the issuer ceasing operations or going bankrupt according to law.

The issuer needs to develop a strong management plan, including an organizational structure with clear responsibilities, a process for monitoring and reporting related risks, and a sound internal management mechanism. The issuer's own funds are required to be 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, the 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 duties.

Reserve Assets

In order to maintain the stability of the token value, the issuer of asset-related tokens needs to ensure that there are sufficient asset reserves behind them. The issuer needs to take prudent measures to manage the reserve assets to ensure that the creation and destruction of tokens correspond to the growth and decrease of reserve assets. The issuer should describe in detail the content related to the stabilization mechanism, especially the composition and allocation of reserve assets, the assessment of reserve asset risks, the token creation and destruction process, 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 meet the redemption requests of holders. The reserve assets should be kept by credit institutions and crypto asset service providers, and the issuer is responsible for selecting and appointing them to ensure that the custodian has the necessary expertise 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 from the 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 crypto asset service provider will distribute interest to users holding tokens.

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 tight liquidity conditions.

Requirements for e-money tokens

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 e-money token should include information about the issuer and project, relevant information about issuance to the public or trading on the platform, rights and obligations related to e-money token, 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.

Issuer Obligations

The issuers of e-money tokens should be credit institutions under Directive 2013/36/EU or electronic money institutions under Directive 2009/110/EC, and they should comply with the relevant operational requirements of Directive 2009/110/EC. The issuer should give holders the right to redeem tokens at face value at any time, and the issuer may charge fees to the redeemer during the redemption process. Similarly, neither the issuer of e-money tokens nor the crypto asset service provider will distribute interest to users holding tokens. The issuer should invest the funds obtained through e-money tokens in the same currency as the e-money tokens to avoid cross-currency risks.

If it is defined as a key e-money token, the custody and investment rules of its reserve funds do not need to refer to the relevant content of Article 7 of Directive 2009/110/EC, but instead refer to the requirements for key asset-related tokens, including the establishment of an orderly gradual liquidation plan.

Special circumstances where the above regulatory policies do not apply

In order to reduce the administrative burden on small and medium-sized enterprises, the issuance requirements for stablecoins do not apply to the above situation when the following conditions are met: 1. The average total debt of the issuer does not exceed 5 million euros or other equivalent currencies within a 12-month period; 2. The tokens issued to the outside are only for qualified investors and can only be held by qualified investors. The issuer still needs to provide a white paper and notify the relevant regulatory authorities.

Crypto assets issued by the European Central Bank, the European Investment Bank, central banks of member states or other government agencies, public international organizations and the services they provide are not covered by this regulatory framework. This regulation also does not apply to crypto asset services provided by individuals only for the parent company, subsidiaries or other subsidiaries of the parent company.

Requirements for service providers

The proposal also imposes regulatory requirements on crypto asset service providers, which provide services in two categories. The first category includes the operation of crypto asset trading platforms, using one’s own account to participate in the trading of crypto assets with legal currency or other crypto assets, and the custody of crypto assets in the name of a third party. The second category includes the custody of crypto assets, receiving or transmitting crypto asset orders and executing orders on behalf of third parties, and providing consulting advice on crypto assets.

Crypto asset services within the EU can only be provided by legal entities with offices registered in member states and authorized by the regulatory authorities of the office registration place. If a person in the EU actively seeks crypto asset services provided by a company located in a third country, then the company may not be considered to provide services within the EU. However, if a company located in a third country wants to recruit users within the EU, it needs to obtain approval from the regulatory authorities. At present, the scale of crypto service providers is relatively small, so the authorization is only decided by the regulatory authorities of the member state where the registration is located, and the decision is valid throughout the EU.

Cryptoasset service providers should also act in an honest, fair and professional manner to safeguard the best interests of users, just like stablecoin issuers. Cryptoasset services should follow the relevant content of Directive 2002/65/EC as "financial services", such as the drafting of contracts. Cryptoasset service providers should provide users with clear, fair and non-misleading information and warn them about the risks associated with cryptoassets. Service providers should make their pricing rules public, establish a complaint handling system, and identify, prevent, manage and disclose relevant conflicts of interest. The requirements for managers and employees are the same as those for stablecoin issuers, and they need to have sufficient knowledge and ability to perform their respective duties. Service providers should set up sound internal control and risk assessment mechanisms to ensure the integrity of the information received, and they also need to keep relevant transfer orders and service records.

The services related to stablecoins mainly include custody and trading of crypto assets. When it comes to custody of crypto assets, service providers need to sign a contract with users to protect them, and the service providers are responsible for losses caused by cyber attacks, theft or system failures. When it comes to trading-related services, the fee structure should be transparent and a non-discriminatory business policy should be implemented. Service providers also need to set corresponding rules to prohibit insider trading, illegal disclosure of internal information and manipulation of crypto assets.

Thoughts and Conclusions

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 improved bill is to encourage innovation and fair competition while protecting users and investors and ensuring financial stability. The content of the proposal does not completely negate the previous regulatory strategy. The regulatory scheme for e-money tokens, which are similar in nature to e-money, still refers to the previous e-money scheme, but is different in the regulation of key e-money tokens.

The idea throughout the entire regulatory scheme is consistency and proportionality. Consistency is reflected in the fact that once the relevant activities of crypto assets are approved by the regulator, they can be carried out throughout the EU. Proportionality is reflected in the exemption of smaller stablecoins and the increased supervision of key stablecoins. For small and medium-sized enterprises, 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 for value storage. Any stablecoin issuer needs to register an office in the EU and meet the conditions to obtain authorization from the regulatory authority in the place of registration before it can be issued in the EU. Stablecoins can be pegged to the euro or other currencies in the EU.

Unlike the issuance of stablecoins, relevant 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 them. If service providers need to actively expand their business in the EU and recruit users in the EU, they need to register in the country and accept supervision from relevant institutions.

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 are used by overseas crypto asset service providers such as trading platforms, they can still bypass authorization and reach users within the EU under the premise of active use by users. The scale of users who are exposed to unauthorized stablecoins in this way will be relatively small, so the proposal does not specify it in detail. In the future, it can be solved through cooperation with regulators in other countries around the world.

The problems brought about by crypto assets and stablecoins are common problems around the world. This proposal provides a reference for the formulation of relevant regulatory bills in other countries. The requirements for the issuer to disclose information, the management plan for reserve assets, and the obligations of the issuer are all experiences that can be learned from, which is also one of the significances of this proposal. Countries that are more open to crypto assets can fully refer to such regulatory plans to reduce regulatory friction for related companies and facilitate global business.