In the previous parts of this series, we’ve been looking at the regulation needed in order to encourage the adoption of stablecoins for retail payments (read Part 1 and Part 2 here).  

Notwithstanding the similarities between bank deposits and stablecoins, there are some notable differences. For instance, a stablecoin issuer can allow the stablecoin to be listed on (crypto) exchanges and trading venues. In contrast to stablecoins, bank deposits are not tradable, i.e. there is no secondary market for bank deposits. In practice, issuers of the stablecoins are also operating the exchanges where their stablecoins are traded alongside other cryptoassets. But stablecoins can also be listed on exchanges that are operated by a legal entity that is different from its issuer.  

If a stablecoin is traded electronically, the price of the stablecoin will no longer be pegged to the underlying asset, but it will fluctuate according to supply and demand among the participants of the exchange. Any matched trade is a contract between buyer and seller and does not involve the issuer of the stablecoin. There is no direct link between the on- exchange price of a stablecoin and the obligation of the issuer to redeem at par. But there are indirect spillovers. For instance, doubts about the solvency of a crypto exchange where customer assets including deposits in fiat currency are held, can easily lead to fire sales of stablecoin on the exchange, which can then trigger a run on the stablecoin issuer. The recent collapse of the second largest crypto exchange FTX and the repercussions this sent to crypto and stablecoin markets is a case in point.  

Obviously, exchanges that offer trading of stablecoins (and other crypto assets) should be regulated like other electronic exchanges (e.g., trading rules, prevention of price manipulation, monitoring, and access requirements). Moreover, crypto exchanges perform functions that are not typically performed by trading venues, and that those functions are similar to the ones performed by other intermediaries (e.g. on-boarding retail investors, providing custody of participant assets or clearing and settlement of trades). [1] More specifically, crypto exchanges are different from conventional exchanges in two ways. First, they are open to retail clients and not just regulated entities. The large client base can lead to operational challenges, in particular with respect to on and off ramping of fiat currency. Second, crypto exchanges typically require trades to be pre-funded on both the cash (fiat) side and the token (crypto) side.most clients hold some cash balances (deposits) at the crypto exchanges.  

 In times of stress, clients are likely to withdraw these deposits in the very same way as they run on a bank or stablecoin issuer.  Thus, crypto exchanges should be subject to bank-like operational, capital and liquidity requirements. Additional requirements would also have to include that all risks arising from links between the stablecoin issuer and the operator of the crypto exchange are managed and controlled properly.   

Token wrapping: a forgotten topic 

Any stablecoin is originally issued on a particular blockchain (let’s call it ‘BC-A’). It can be used to make payments only among users connected to BC-A, i.e. payor and payee need to be addressable on the same blockchain. This property severely limits the usefulness of a stablecoin as it can only be used in applications that are built on the same blockchain. In the traditional financial system, this would be equivalent to a world in which electronic payments can only be made among customers of the same bank.  

In order to overcome this limitation, processes called ‘token wrapping’ or ‘cross-chain bridges’ were invented. [2] Token wrapping allows a stablecoin to be sent from one blockchain (e.g. BC-A) to another blockchain (e.g. BC-B). This enhances the attractiveness of a particular stablecoin as it enables payments among users of different blockchains and trading on multiple crypto exchanges.  

The concept of ‘token wrapping’ is relatively simple. A user sends tokens issued on BC-A to a custodian (in blockchain parlance a ‘smart contract’) who then issues a token representing the original token on BC-B. The wrapped token can then be used to settle transactions on BC-B. In other words, the custodian serves as the ‘bridge’ between two different blockchains. Similarly, the wrapped token can be converted back into the original token, if the custodian is requested to do so by a user. ‘Wrapped tokens’ are like American Depository Receipts (ADRs) in the world of traditional securities market infrastructures. ADRs are used to make securities tradable on foreign exchanges.  

Wrapped tokens or cross-chain bridges have turned out to be a key vulnerability of the token universe. There have been numerous hacks on cross-chain bridges leading to significant losses of assets. One of the largest happened just a few weeks ago. Moreover, it is reported that cross-chain bridges have been used in money laundering attempts. Such vulnerabilities can easily undermine confidence in the stablecoin arrangement and lead to a run on the stablecoin. Thus, regulators should pay a great deal of attention to the safety of cross-chain bridges.  While it is not a priori clear which entity of a stablecoin ecosystem should be held accountable for the safety of cross-chain bridges, the case could be made that it is the duty of the operator of the payment function of the stablecoin arrangement (see my blog on making payments with stablecoins). 

Tokenisation is happening fast. New means of payment and new financial players are moving at a speedy pace, and adherence to new regulatory standards will enable them to scale fast too. While stablecoins will serve the retail market, Fnality Payment Systems will serve the wholesale financial industry, providing a network of fully-regulated on-chain payment rails, interoperable with both legacy and novel technologies, and secure by design via decentralization and the distribution of accountability across the system. 

If you haven’t read the first two blog posts of this series, you can find them linked here

Part 1: Regulating the Issuance and Redemption of Stablecoins

Part 2: Regulating payments with Stablecoins

We’d be interested in hearing your thoughts on what other regulations stablecoins and novel payments might need as well as any of your worries when trusting your money, or your companies on these systems. 

[1] Regulatory considerations on crypto asset trading platforms were issued by IOSCO, a global standard setting body, in 2020. 

[2] A more detailed discussion can be found, for instance, in Stevens (2022).