The Financial Conduct Authority has finalised its rules for issuing stablecoins in the UK. The regime is rightly being recognised as sophisticated and balanced. As a stablecoin issuer, Agant is excited to have a framework to build towards. Nonetheless, it imposes some interesting and consequential departures from the traditional business model of a stablecoin issuer.
The ‘own funds’ requirement
One such departure is an issuance-linked ‘own funds’ capital requirement. The FCA will require issuers to meet an ‘own funds’ requirement of 1% of issuance (known as the K-SII requirement). The FCA is not alone in this – the Markets in Crypto-Assets regulation requires 2% for European Union issuers – and the FCA reduced its proposal to 1% from 2% following consultation. But is this prudential tool, originally developed for banks and investment firms, capable of having the intended effect when applied to the unique business model of stablecoin issuers? Perhaps more importantly, will it have any unintended consequences?
To answer that, it is worth recalling that own funds requirements are about managing the company’s financing structure rather than the assets it holds (which are dealt with under the extensive backing assets and liquidity requirements).
At the fundamental level, ‘own funds’ rules are about debt versus equity. Debt financing puts pressure on the solvency of the company. The debt must be repaid even if the value of the company’s assets falls. With equity, the company does not have to make repayments. If assets perform badly or the company faces unexpected costs, the company’s solvency is unaffected because there is nothing to repay. This is why equity (and retained profits) are called ‘own funds’; the company does not need to repay them.
Importantly, own funds requirements do not dictate what the company does with the funding. As the Bank of England explains (in relation to banks): ‘It can be misleading to think of capital as ‘held’ or ‘set aside’ by banks; capital is not an asset. Rather, it is a form of funding — one that can absorb losses that could otherwise threaten a bank’s solvency.
Stablecoin solvency differs from
For stablecoins, the solvency of assets compared to liabilities is a key regulatory concern. However, the nature of the risk, and the structure through which issuers manage it, are categorically different from the banking business model. As a result, own funds requirements do not have the same effect.
The own funds requirement makes the issuer’s own financing structure safer by reducing its repayable liabilities in favour of equity, but this has little bearing on the stablecoin’s solvency for two reasons.
First, the stablecoin’s solvency rests on the integrity and liquidity of the off-balance-sheet backing assets. Regulators have rightly imposed extremely strict requirements on the quality and liquidity of the backing assets (and additional liquid asset buffers). The assets are held on trust, segregated from the issuer’s balance sheet. These assets are therefore insulated from any debt financing the issuer may have taken on.
Second, while the own funds requirement may reduce repayable liabilities as a portion of the capital on the issuer’s balance sheet, it does not reduce repayable liabilities in relation to the stablecoin or its backing assets – all stablecoins continue to represent a potential redemption. The own funds requirement does not replace these claims with a non-redeemable instrument in the same way it forces banks to replace deposit claims with non-repayable equity financing. Therefore, making the issuer’s capital structure safer has little effect on the assets and liabilities of the stablecoin.
Do own funds address operational risks?
The primary purpose of own funds requirements is to force equity investors to ‘absorb losses’, as both a going and gone concern. However, in relation to the K-SII for stablecoin issuers, the FCA suggests that the requirement aims at operational risk:
‘In deciding the new metric, we have considered what operational risks are present. These largely relate to failures in systems, processes and controls associated with the safeguarding of backing assets. There are also additional risks arising from the need to use third parties and the demands on governance.’
It is common practice to use own funds requirements to manage operational risks. These include system failures and third-party defaults. Growing the balance sheet while reducing the portion of repayable funding frees up the issuer to deploy assets towards operational costs without risking insolvency. In effect, the operational costs are losses that are absorbed by the own funds requirement.
However, for stablecoin issuers specifically, there are two major concerns with this focus on operational risks.
First, is it not clear that an own funds requirement linked to issuance levels actually improves issuers’ ability to cover operational costs. Issuers already have relatively small and low-risk balance sheets. Unlike banks, which are funded by repayable customer deposits, stablecoin issuers have limited inherent solvency risk to reduce. Growing and rebalancing the balance sheet towards the safest (and most expensive) capital is not necessary if there is limited repayable funding, and therefore limited pressure on the balance sheet in the first place. Stablecoin issuers can, of course, take on debt financing, but it is not a core part of their funding as it is for banks or e-money institutions whose balance sheets are funded primarily by repayable customer funds. The positive effect of an operational own funds requirement is therefore limited.
In addition, own funds do not equate to assets that can be readily deployed to cover operational costs. The money raised as own funds will not sit idle. For commercial and competitive reasons, it will be put towards improving operations, for example more staff, improved office space, new technology or even client entertainment, none of which would be easy to liquidate. Without the liquid resources with which to pay the operational costs, own funds requirements play only a limited role in supporting operating expenditure.
The second concern is that 1% of issuance risks being wildly disproportionate. The appropriate analogy here is to consider regulators’ approach to fund managers. Fund managers, like stablecoin issuers, manage off-balance-sheet assets that vastly exceed the value of their own balance sheets. The own funds requirements aimed at fund managers’ operational risks are orders of magnitude smaller than 1% of assets under management and are subject to caps.
While it is true that the operational risks stablecoin issuers face grow with issuance, they do not grow linearly. Issuing more stablecoins does not lead to more claims on the issuer’s balance sheet (and if it did, 1% would not be nearly enough). Nor does the increased issuance necessarily lead to more operational costs. The technology and operations, and their associated risks, need not differ significantly between issuance of £1m stablecoins and issuance of £1bn.
Would other tools be more effective?
For the stablecoin issuer, it may make more sense to link the operational own funds requirement to the size of the balance sheet, the potential scale of the operational loss or the income of the business, rather than the amount of issuance. This would be consistent with the other components of the FCA’s cryptoasset own funds requirements, such as the fixed overheads requirement, which is based on the issuer’s operating costs.
The risks associated with issuance and redemption are already addressed by a suite of strict requirements, including: the requirement for issuers to maintain full 1:1 backing; substantial liquid asset buffers; a statutory trust over the backing assets; reconciliation requirements; and safeguarding rules in CASS 16, including diversification of custodians. Meanwhile operational risks are addressed by general risk management duties, operational resilience standards, and systems and controls requirements including due diligence and oversight of service providers. If the FCA deems these tools insufficient, they can be adjusted, but an issuance-linked own funds requirement is not an efficient way of protecting holders.
To some extent the FCA recognises that other tools may be more effective. It acknowledges the proportionality concern where it states: ‘A higher coefficient is likely to conflate the operational risk K‑SII covers with: the liquidity and market risks addressed by the issuer liquid asset requirement [and] the backing asset requirements set out in our stablecoin issuance Policy.’
Practical consequences: destabilising the stablecoin
Setting aside whether it hits its target, the major consequence for issuers is a potentially destabilising effect on the stablecoin’s stability.
If issuance runs up against the limit set by the own funds, issuance will need to be paused so the issuer can raise more tier-1 equity. Raising tier-1 equity financing is not cheap, straightforward or quick.
By preventing the issuer from supplying more stablecoin to meet growing demand, the own funds requirement creates an artificial shortage. This could quickly force users either to bid up the secondary market price of the stablecoin above its peg as they try to source it from distributors, none of whom are able to rely on supply from the issuer, or, in response to the shortage and volatile price, to dump the stablecoin as it is no longer seen as a reliable settlement asset for their on-chain activities. The end result is destabilising pressure on the stablecoin’s peg.
Ultimately, as an issuer, our concern is that the unique business model of a stablecoin means an issuance-linked own funds requirement is ineffective as a tool for addressing stability and operational risks, and significantly increases risks by preventing supply from meeting demand in the secondary market.
Tom Rhodes is Chief Legal Officer at Agant.
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