Stablecoins and the Crypto Travel Rule: Are Stablecoin Issuers VASPs?

Stablecoins have become a critical part of the evolving cryptocurrency landscape. Given their significance, it's crucial to grasp their role concerning the Crypto Travel Rule.This final article in our three-part series compares perspectives from both the Financial Action Task Force (FATF) and the European Union's (EU) positions on decentralized finance (DeFi), Stablecoins, and non-fungible tokens (NFTs).

This article covers Stablecoins, the EU’s and FATF’s general stance on whether they are regulated virtual assets, if stablecoin issuers are regulated as VASPs, and covers noteworthy developments over 2022. 

What are Stablecoins?

Firstly, let's understand what stablecoins are. Stablecoins are a specialized type of cryptocurrency crafted to minimize price volatility. Unlike virtual currencies such as Bitcoin or Ethereum, which are known for their price fluctuations, stablecoins aim to maintain a consistent value. They achieve this stability by tying their value to a reserve asset, often a fiat currency like the US Dollar or the Euro, or other types of assets like gold. In essence, the value of a stablecoin is tied to the value of the underlying asset or group of assets to maintain a 1:1 ratio or another predetermined ratio.

Types of Stablecoins

Stablecoins can be categorized into three main types based on what backs them:

1. Fiat-Collateralized Stablecoins: These stablecoins are backed by a reserve of a specific fiat currency, kept in a bank or another regulated financial institution. In simple terms, for each stablecoin in circulation, an equivalent amount of fiat currency is held as a reserve.

2. Crypto-Collateralized Stablecoins: These are stablecoins that are backed by other cryptocurrencies. Given the volatile nature of cryptocurrencies, these stablecoins are typically over-collateralized to account for price swings.

3. Algorithmic Stablecoins: These stablecoins aren't backed by any collateral. They use smart contracts and other mechanisms to automatically tweak the stablecoin supply in reaction to demand changes, with the end goal of maintaining a stable price.

The primary uses of Stablecoins

Stablecoins serve multiple functions, including facilitating transactions, acting as a stable store of value within the cryptocurrency market, and forming a bridge between traditional fiat currencies and cryptocurrencies. Importantly, they are often used in DeFi applications for various financial activities like lending, borrowing, and earning interest on crypto assets.

The Rise and Scrutiny of Stablecoins in 2022

Stablecoin usage surged in early 2022 but faced scrutiny in the latter half of the year after the collapse of TerraUSD. TerraUSD was a popular algorithmic stablecoin whose dollar peg broke down due to massive concurrent withdrawals from Anchor and Curve crypto exchanges, causing a broader selloff that wiped off $200 billion from the market value of all crypto-assets.

The collapse of TerraUSD generated new concerns over stablecoins' safety, leading policymakers to impose rules on stablecoin issuers. Moreover, regulators and central banks became concerned about the rise of stablecoins eroding their monetary monopoly. Below we highlight relevant stablecoin events in 2022:

Stablecoin Legal & Regulatory Spotlight in 2022

• January 12, 2022 📋- The Hong Kong Monetary Authority (HKMA) released a discussion paper that provided insight into the HKMA’s plans for the future of stablecoin regulation in Hong Kong. 
• May 9, 2022 - UST's peg to USD broke, leading to the price of UST and its sister token LUNA crashing. This wiped $200 billion from the market value of all crypto assets.
• June 3, 2022 - Japan’s parliament passed a bill to ban stablecoin issuance by non-banking institutions.
• July 13, 2022 📋- The Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commission (IOSCO) affirmed that the Principles for Financial Market Infrastructures apply to ‘systemically important’ stablecoin arrangements and transfers. 
• July 19, 2022 - The UK Chancellor announced the planning of a bill that sets out how stablecoins may be used as a payment method.
• September 21, 2022 - Members of the U.S. Congress began working on legislation that would temporarily ban certain types of algorithmic stablecoins.
• October 5, 2022 📋- The EU’s MiCA laid out strict stipulations for stablecoin issuers due to their potential for mass adoption as a means of exchange as well as their associated market integrity risks.

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N.B. The dates that are accompanied by a clipboard icon indicate a document that was produced by a regulator.

How Does the Crypto Travel Rule Apply to Stablecoins?

Both the FATF and the EU have established significant stances regarding stablecoins. The FATF views stablecoins with concern due to their potential for anonymity, global reach, and potential misuse for illegal fund transfers. As such, it calls for a risk-based approach for identifying obliged entities. The EU's Markets in Crypto-assets (MiCA) regulation provides a more differentiated treatment, distinguishing stablecoins based on whether they qualify as significant asset-referenced or e-money tokens, each carrying distinct regulatory requirements. Notably, the FATF classifies stablecoins as securities or VAs, whereas the EU determines if a crypto-asset falls within the scope of MiCA depending on the nature of the token, including algorithmic stablecoins.

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FATF vs. EU: General Stance on Stablecoins

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FATF: Stablecoins rank high on the list of the FATF’s concerns “because of their potential for anonymity, global reach, and use to layer illicit funds.” The FATF also calls out their “greater potential for mass adoption” as stablecoins overcome the volatility issues associated with other crypto-assets and, therefore, constitute a more suitable option for payments. The FATF expects countries to “take a functional approach to identify obliged entities” and “mitigate the relevant risks based on a risk-based approach (RBA) regardless of institutional design and names.” ^[1]

EU: MiCA distinguishes the treatment of stablecoins depending on whether they qualify as significant asset-referenced tokens or significant e-money tokens, as these  “can pose greater risks to financial stability.” ^[2] Issuers of significant asset-referenced tokens or significant e-money tokens are subject to more stringent requirements including “higher capital requirements, to interoperability requirements and they should establish a liquidity management policy.” ^[3]

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FATF vs EU: Are Stablecoins considered Virtual Assets?

FATF: FATF classifies stablecoins as securities or VAs.

EU: Where a crypto-asset falls within the definition of an asset-referenced token or e-money token, it falls under MiCA’s scope, irrespective of how the issuer designed the crypto-asset, including the mechanism to maintain a stable value - this includes algorithmic stablecoins. ^[4]

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FATF vs. EU: Are Stablecoin issuers regulated as VASPs? 

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FATF: Entities involved in the governance of stablecoins, whether centralized or decentralized, could be categorized as VASPs depending on their position and the terms of the stablecoin arrangement. In situations where decentralized entities manage the stablecoin (e.g., MKR token holders who monitor Maker Protocol), it becomes more difficult to identify the entity responsible for AML/CTF. In these cases, entities that could fall within the scope for regulatory or supervisory action are the following: 

1. The initial driver of the development and launch of the arrangement that eventually becomes decentralized.
2. One that facilitates trading with stablecoins.
3. Custodial wallet services that support stablecoins. ^[1]

EU: Algorithmic stablecoins issuers that aim at maintaining a stable value in relation to an official currency of a country or to one or several assets, via protocols, are subject to the rules applicable to asset-referenced tokens or e-money issuers. Offerers or persons seeking admission to trading of algorithmic crypto-assets that do not aim at stabilizing the value of the crypto-assets by referencing one or several assets are, in any event, subject to the requirements applicable to the issuance of other crypto-assets (set in Title II of MiCA). ^[4] 

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FATF vs. EU: Noteworthy Stablecoin Developments

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FATF: In it’s Targeted Update, the FATF states, “As the liquidity of stablecoins increases in parallel with the growth of DeFi markets, FATF will continue to facilitate discussion between jurisdictions and other standard setting bodies on implementation issues.” ^[5]

EU: Stablecoin issuers should have a custody policy that ensures asset segregations, prevents tokens from being used as collateral, and provides holders with prompt access to their funds. Credit institutions, investment firms, or VASPs should custody the insulated reserves.  The credit institution, an investment firm, or a VASP that custodies the segregated reserve should be responsible for the loss of reserve assets. ^[6]

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In summary, the Crypto Travel Rule has far-reaching implications for stablecoins. Both the FATF and EU offer varied approaches in their regulations, primarily distinguishing stablecoins based on their nature, usage, and associated risks. As stablecoins continue to gain prominence in the crypto market, further evolution of regulatory stances is anticipated. Understanding these rules and how they apply to stablecoins will play a significant role in shaping the future trajectory of these digital assets.

Discover the link between the crypto Travel Rule and Stablecoins in Notabene's comprehensive 2023 State of Crypto Travel Rule Compliance Report.

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This article was initially produced when the "Markets in Crypto-Assets" document was still in draft form. However, the content has been updated to reflect the final regulation as published by the EU Parliament in 2023 [EU Parliament (2023). Markets in Crypto-Assets, various pages and paragraphs].