Liu Xiaochun: What are the development paths after the legalization of stablecoins?

Article | Liu Xiaochun

The United States, Hong Kong, the European Union, and others are passing legislation related to stablecoins. Some voices believe that stablecoins have gained legal status and can now operate freely: first, as long as a license is obtained, stablecoins can be issued; second, stablecoins can be applied in all areas of payment circulation. This reasoning is flawed.

Having legislation does not mean that stablecoins are legal; having a license does not necessarily guarantee the successful issuance of stablecoins; stablecoins are not legal tender and cannot ensure acceptance in every payment domain; as one of many payment tools, stablecoins have specific application scenarios where they are particularly suited, but not every application scenario is suitable for the use of stablecoins.

The result of the legalization of stablecoins may not necessarily align with the outcomes desired by stablecoin issuers hoping for legalization.

Intermediaries of Currency Payments

Before the relevant stablecoin legislation was passed in the United States and Hong Kong, stablecoins had already been circulating in the market. These stablecoins were neither considered legal nor illegal. Now that the legislation has been passed and is entering the implementation phase, these stablecoins may become illegal. Therefore, Hong Kong has announced a series of detailed documents prior to the formal implementation of the legislation, providing existing stablecoin issuers with a transition period to meet the legal standards for issuing stablecoins during this period.

This also indicates that there are certain behaviors in some existing stablecoin applications that do not comply with legal regulations. The reason for legislating stablecoins is that they already exist and play a beneficial role in economic life, while also posing considerable risks and destructive effects on the economy and society, necessitating regulation and oversight through legislation.

Before analyzing the legitimate applications of stablecoins, it is necessary to clarify one issue. Stablecoins are not the real currency. The purpose of payment is to transfer currency, and both parties use stablecoins to ultimately achieve the payment of currency. Stablecoins are merely intermediaries for both parties to realize currency payment. Therefore, the proposition that stablecoins can achieve "payment equals settlement" is incorrect. As long as it is a scenario or time where legal currency facilitates payment, there is no need for people to use stablecoins as intermediaries to achieve currency payment. For issuers, stablecoins are a business; for users, they are a necessity.

Human society has many activities that thrive in a gray state, but once exposed to sunlight, they often become redundant.

For example, after the reform and opening up, the private economy in Wenzhou developed vigorously, giving rise to the famous "Wenzhou model." People analyze various reasons for the success of the Wenzhou model, and one important point is the developed and active private lending in Wenzhou. Because of this, the Wenzhou region generally adopts a tolerant attitude towards private lending, only taking appropriate measures to crack down or rectify when there are particularly large risks that affect social stability. In this process, various sectors have been calling for the transparency and legalization of private lending. In March 2012, the State Council decided to establish the Wenzhou Financial Comprehensive Reform Pilot Zone and approved the implementation of the "Overall Plan for the Wenzhou Financial Comprehensive Reform Pilot Zone in Zhejiang Province," one important content of which is to establish a registration and record-keeping system for private lending. Initially, there was some response to this system, but soon the number of registered private loans gradually decreased.

The transparency of private lending faces three issues: First, the purpose of the lending funds. In the early days of reform and opening up, according to national policy, banks and credit cooperatives could only lend to state-owned and collective enterprises. Individual businesses and private enterprises were considered gray or illegal activities, and banks and credit cooperatives could not provide loans. In this context, private lending played a crucial supportive role in promoting the development of individual businesses and private enterprises. As reform and opening up deepened, individual businesses and private enterprises were recognized as components of the socialist economy, no longer classified as gray or illegal activities, and private lending was therefore legitimized. However, the funding services of private lending do not only cater to individual businesses and private enterprises; there are also quite a few activities that are gray or illegal. For these activities, private lending operators are unwilling and hesitant to register and file.

Second is the source of borrowed funds. Most private lending in Wenzhou is not a temporary capital adjustment between individuals, but rather used for production and business activities and expanding reproduction, with larger loan amounts. Therefore, the source of borrowed funds is rarely the lender's own capital, but rather raised through methods such as "raising a meeting" and "shaking a meeting" (Chinese methods of private lending). This brings up a question: can private lending absorb deposits or raise funds? This is not easy for private lending operators to answer, and it is also a challenge for registration and filing institutions.

Thirdly, whether the interest income from private lending needs to be taxed. For all private lenders, the answer is clear: it does not need to be registered and filed.

Life needs sunlight, but not all life can survive in the sunlight.

Now let's look at third-party payments. In the early days of online trading platforms like Taobao, different banks' bank cards could not pay and settle with each other, and at the same time, the settlement rules of China's banking industry did not accept collection payments without signatures and authorization. At that time, there were no technical barriers to interbank online payment transfers; in fact, as long as the banks opened their system interfaces to each other, cross-bank card payment settlements could be realized. For various reasons, commercial banks did not do this at the time. Because bank cards could not make cross-bank payment settlements, it severely affected the activity and transaction volume of online transactions, leading to the emergence of third-party payments. Each bank opened its system interface to third-party payments, which completely followed the bank settlement method to provide customers with accounting settlements.

At the beginning of the emergence of third-party payment, it was actually in a gray area. Due to the fact that third-party payment services were a new type of online transaction, regulation took a considerable amount of time to observe and eventually recognized the beneficial effects of third-party payment on economic development, formulating relevant management measures and issuing licenses. After the legalization of third-party payment, it experienced faster and better development compared to the sunlighting of private lending in Wenzhou, and it also promoted the rise of financial technology. The fundamental reason for this is that third-party payment serves legitimate online and digital transactions with great development prospects, and there is no contradiction between its legalization and the services it provides.

Third-party payment institutions, before the regulatory rectification, had a profit model similar to that of current dollar stablecoin issuing institutions, mainly relying on depositing customer funds in banks to earn interest income, in addition to some income from remittances, withdrawals, and other fees.

Currently, the regulatory bills regarding stablecoins issued by various economies define stablecoins as payment tools. Payments exist for transactions, and without the demand for transactional scenarios, stablecoins are merely a redundant existence. Pure payment tools will not be hyped as collectibles like Bitcoin.

Four Strategies After Legalization

What will be the application scope after the legalization of stablecoins? Referring to the aforementioned cases of private lending in Wenzhou and third-party payments, there can be four strategies after the legalization of stablecoins: first, stabilize the existing territory and expand new territory; second, shrink the existing gray areas and expand mainstream payment scenarios; third, bring mainstream transactions on-chain to become payment scenarios for stablecoins; fourth, seek some special payment scenarios that temporarily do not require local currency payments, forming a state that runs parallel to and complements local currency payment space in terms of timing, but with limited scale.

Currently, there are mainly four types of use cases for stablecoins. The first is payments in the original virtual world. Only a small portion of these transactions have been legalized, while most are in a gray area and are awaiting legalization.

Secondly, it is to avoid certain cross-border transaction payments that are subject to U.S. sanctions. These transactions are considered illegal by the U.S. or certain Western countries, but are legal in most other countries. However, since fiat currency cannot be used directly and can only be transitioned through stablecoins, it still remains in a gray area. This part of the application has a clear regional concentration.

Thirdly, in some countries where the local currency is unstable and foreign exchange controls are strict, some individuals use USD stablecoins to combat local currency inflation and evade foreign exchange controls. This includes American technology companies paying outsourced developers in these countries. This type of payment brings benefits to individual users, but for these countries, it constitutes illegal behavior that disrupts the financial order. This application also shows a clear regional concentration.

Fourth, there are clear and recognized illegal activities, including money laundering, illegal cross-border asset transfers, etc. With the implementation of stablecoin legislation in countries like the United States, according to the requirements of these laws for KYC (know your customer) and anti-money laundering reviews, most of these stablecoin payments fall under illegal businesses, and issuing institutions need to withdraw from these business areas.

Therefore, after the legalization of stablecoins, the original market structure will be difficult to maintain, and the first strategy cannot be realized.

Therefore, entering mainstream payment scenarios is the main strategy after the legalization of stablecoins. The so-called mainstream payment scenarios mainly refer to retail payments, domestic trade payments, and cross-border trade payments.

There are two scenarios for retail payment. One is the general retail transaction scenario. In the narrative of stablecoins, one important aspect is inclusive finance, which states that stablecoins can provide account services for the poor who do not have bank accounts. An example is individuals in countries like Nigeria in Africa, who engage in small-scale export trade or accept outsourced coding jobs from American tech companies, receiving US dollar stablecoins. US dollar stablecoins must be exchanged for US dollars, so in countries like Africa, those who can obtain US dollar stablecoins must have the ability and opportunity to acquire US dollars. They accept US dollar stablecoins to circumvent their country's foreign exchange controls and to counteract the inflation of their local currency.

Regarding the personal use of stablecoins, apart from those engaging in virtual asset transactions in the virtual world, there is no large-scale phenomenon in developed economies. Poor people in the United States do not use dollar stablecoins because they can conveniently use dollars directly. Therefore, it can be said that in countries where the local currency is convenient to use and relatively stable in value, people do not use stablecoins pegged to their own currency in daily payments, nor do they accept foreign stablecoins such as dollar stablecoins. It should be noted that any country that issues sovereign currency will not allow payment instruments in foreign currencies to circulate in its domestic market, as this would disrupt the circulation of the sovereign currency and the order of the domestic market.

Another scenario for retail payments is the issuance of stablecoins by large merchants. These stablecoins are equivalent to gift cards issued by the merchants. For merchants, the benefits are twofold: first, it locks in revenue, and second, it allows them to utilize customers' cost-free funds. Merchants who issue stablecoins would certainly prefer their stablecoins to be widely accepted by other merchants. However, in reality, this is basically impossible. For example, if a holder of Walmart stablecoins tries to spend them at Amazon, Amazon will not accept them. This is because, for Amazon, Walmart is occupying the customer's cost-free funds, while they are receiving only items and not real money from the sales. For customers, purchasing gift cards usually comes with discounts, but stablecoins can only be exchanged at a 1:1 rate, and regulatory rules state that issuers cannot pay interest or profits.

Card organizations such as VISA, which are related to retail payments, also plan to issue stablecoins. For these card organizations, they serve as intermediaries for settlements between banks, individuals, and merchants. From the initial manual processes to the current electronic network settlements, they have continuously improved efficiency and enriched service offerings with technological advancements. Now, with blockchain and distributed ledger technology, they are certainly willing to experiment as long as it helps improve efficiency, reduce costs, and enrich service content. However, using blockchain and distributed ledger technology and issuing stablecoins are two different matters. Issuing stablecoins can indeed provide card organizations with cost-free funds and allow them to generate profits from these funds, but for cardholders and merchants, stablecoins are simply unnecessary and may even bring about exchange losses or exchange risks.

So, how about domestic trade payments and cross-border trade payments outside of retail payments in mainstream payment scenarios?

The narrative of blockchain technology being fast and low-cost in cross-border payments has been discussed for over a decade, and the narrative of stablecoins in cross-border payments mirrors this. For more than ten years, organizations like R3 (a blockchain industry alliance) and institutions like HSBC have conducted various explorations, successfully testing single transactions, but there has been no commercial application case. Seven years ago, JPMorgan Chase, the world's largest dollar clearing bank, launched a stablecoin – the JPM Coin, but it has not found any application scenarios in mainstream cross-border clearing. Even amidst the current popularity of stablecoins, their applications in cross-border payments still mainly focus on circumventing sanctions, avoiding foreign exchange controls, and money laundering, with few cases in mainstream cross-border payments.

In other words, stablecoins do not demonstrate substantial advantages in a legal cross-border payment environment. The fundamental reason is that the true purpose of the parties involved in cross-border payments is to exchange one currency for another and ultimately deposit the currency into a bank to generate benefits. Therefore, stablecoins have no advantages in legal cross-border trade payments, and they have even less advantage in domestic trade payments.

Therefore, under the same regulatory conditions, stablecoins have no place as long as there are no significant barriers to the use of fiat currency. In other words, stablecoins may only be useful in scenarios where it is inconvenient to use fiat currency or where it is temporarily possible to operate without fiat currency payments, which requires the third and fourth strategies.

First, one scenario is to put various assets on-chain for trading, such as the recently popular RWA (Real World Asset Tokenization). On-chain trading scenarios require compatible on-chain payment methods, which is logically valid. However, although on-chain payment methods can facilitate payments, it does not mean that these on-chain payment methods will necessarily be widely accepted.

There are some cases of financial assets being traded on-chain both domestically and internationally, such as the receivables on-chain in domestic supply chain finance, the digital green bonds issued by the Hong Kong Special Administrative Region government, and the recently traded renewable energy RWA products in Hong Kong, all of which did not use stablecoins for transactions. There are no stablecoins in circulation in mainland China, so of course, they won’t use stablecoins, but this does not hinder the use of so-called traditional fiat payment methods to achieve payment or financing for tokenized receivables. Hong Kong has stablecoins in circulation, but the issuers of bonds and RWAs are seeking to raise funds represented in fiat currency, and they can obtain the required funds, so there is fundamentally no need for stablecoins to be involved. The purpose for traders participating in the market for green bonds and RWAs is to earn returns represented in fiat currency; as long as they can trade directly with currency, they will not use stablecoins. Therefore, stablecoins can provide payment services for on-chain asset transactions, but they may not necessarily be widely accepted by traders.

The second type of scenario is e-commerce going on-chain, or stablecoins entering online trading scenarios. This requires building the blockchain into a new commodity trading infrastructure, with merchants moving from offline to online and then to on-chain, providing an application scenario for stablecoins. However, when e-commerce widely transitions from online to on-chain, banks and fiat currencies have no reason not to go on-chain. As long as banks and fiat currencies are on-chain, both parties to the transaction will definitely use fiat currency and bank transfer for payment. China is currently piloting the digital renminbi on a large scale, while banks are leveraging blockchain technology for various product and service innovations.

The third application scenario is for overseas enterprises to avoid foreign exchange controls. This may be the most effective and largest application scenario for stablecoins in a legal environment in the future. A tricky issue that overseas enterprises encounter is that different countries have different import and export trade management systems and foreign exchange management systems. In some countries, the value of the legal currency is very unstable, which severely affects the efficiency and effectiveness of fund inflows and outflows for overseas enterprises, and sometimes even raises issues of fund security. Large enterprises can set up a treasury in international financial centers to centrally manage and allocate funds within the group's enterprises in different countries, where stablecoins can be used as a transitional tool for certain payments and settlements in some countries. For some small and medium-sized overseas enterprises, a shared treasury can be established to provide similar services using stablecoins. This service does not violate the legal system of the host country and can also improve the speed of fund settlement and enhance the efficiency of fund usage for overseas enterprises.

Finally, there are some special closed-loop scenarios, such as casino chips and meal tickets in canteens, where stablecoins can be used for payments instead of legal tender within a certain range, with regular settlements in legal currency. This applies to scenarios like industrial chains, supply chains, and industrial clusters. Additionally, closed scenarios targeting end customers, similar to games, and offline prepaid card payment environments can also use stablecoins.

Tokenized bills are becoming more popular

It is quite perplexing that an "innovative financial product" requires people to painstakingly create legitimate application scenarios for it. The narratives surrounding stablecoins and previously cryptocurrencies, the metaverse, RWA, decentralized finance, and a series of others essentially revolve around whether technologies like blockchain can be more widely applied in the financial sector, or whether existing applications and innovative products can gain legal and regulatory recognition and enter the mainstream financial field. This question can also be asked in reverse: what requirements do technologies like blockchain and the innovative financial products based on these technologies need to meet in order to enter the mainstream?

Recently, the chairman of the U.S. SEC (Securities and Exchange Commission) proposed to have all financial assets traded on-chain. This is a realistic way to address the above issues, namely to apply blockchain and related technologies to build new infrastructure for financial markets, forming legitimate scenarios for the financial applications of technologies like blockchain. However, since it is a legitimate scenario, all financial products and transactions must be compliant, and the basic requirements are: good adaptability of technology to existing securities regulations; controllability of business, such as the ability to freeze, recover assets, and restore from operational errors; support for compliance controls related to identity and nationality, meeting KYC, AML (anti-money laundering, anti-terrorist financing reviews) requirements; confirmation of qualified investors, etc. This requires breaking the obsession with "decentralization." In a special context, "decentralization" means "supervising within the framework of legality." If this obsession cannot be broken, then the virtual economy will be like an underground economy, forever existing in a parallel world to the real one.

Trading financial products and related payments based on blockchain and distributed ledger technology can be done peer-to-peer, but many financial product transactions are not one-time buy-sell deliveries like general goods and services. For example, in stock trading, there is first the primary market fundraising, which requires roadshows, price inquiries, subscriptions, etc., and only then is there the delivery. Here, subscription and delivery are two payment settlement processes, not just peer-to-peer payments between buyers and sellers; secondly, there is the secondary market trading, which seems similar to general goods trading, but involves dividends, capital increases, and stock allocations, none of which can be resolved by simple peer-to-peer payments. For bonds, similarly, issuance requires roadshows, price inquiries, subscriptions, etc., interest must be paid before maturity, and upon maturity, the bond is redeemed. If a default occurs, different methods of resolution must be employed based on the situation, which also cannot be resolved by simple peer-to-peer payments. All of this requires a series of centralized legal, financial, and other processes.

Therefore, various financial transactions based on blockchain and distributed ledger technology require payment settlement tools and models that are compatible with the characteristics of the related transactions. Stablecoins are certainly not the only option, nor are they necessarily the optimal option.

Stablecoins are similar to bank notes, both are obtained by exchanging fiat currency. For the payer, there is not much difference between paying with currency and paying with stablecoins, as the real money has already been paid. However, for the payee, it is completely different; receiving stablecoins or bank notes is merely receiving a shadow of money, and whether they can obtain real currency depends on the issuer's credit.

If bills of exchange are tokenized, whether commercial bills or banker's acceptances, they are definitely more popular than stablecoins for the payer. This is because, when paying a bill of exchange, the payer is not actually paying currency; they are merely promising to pay currency in the future. Bills of exchange serve both payment and financing functions. Similarly, for the payee, they do not receive actual currency either, and whether they can receive currency depends on the credit of the issuer or acceptor. Therefore, in closed scenarios such as industrial chains, tokenized bills of exchange may be more applicable than stablecoins.

Currently, there are still proposals for deposit tokenization in the industry. The logic of deposit tokenization is exactly the same as that of existing debit cards, which is to put deposits on the blockchain, allowing the payer to make on-chain payments directly using bank deposits. The technical prerequisite for deposit tokenization is to replace the electronic technology used in the current bank account system with blockchain technology, which is akin to a fundamental infrastructure renovation that would involve having all stocks traded on the blockchain. If such a transformation is successful, tokenized deposits would definitely have advantages over stablecoins because they involve the actual currency, allowing both parties to seamlessly connect to their bank accounts before payment and after receipt, while also enjoying interest on deposits.

Central Bank Digital Currency (CBDC) is technically the same as stablecoins, but its nature is completely different due to the issuer. CBDC is the actual currency, so under the same scenarios and regulatory conditions, CBDC is absolutely superior to stablecoins. In the future of stablecoin legalization, one possible trend is that stablecoins will pave the way for the application of CBDCs. This is because private issuing institutions have more motivation and capability to explore application scenarios than central banks.

Furthermore, regarding the legislative intentions of the United States, an objective stance should be maintained without overly elevating its intentions. Some U.S. legislation implements national strategies, some maintains social and economic order, and some involves interest adjustment and redistribution, or in other words, interest transfer. While the U.S. is passing the stablecoin legislation, it is also passing legislation to prohibit central bank digital currencies, which on one hand strengthens regulation and maintains financial order, and on the other hand leaves room for profit in the cryptocurrency and blockchain sectors. In contrast, Hong Kong, China, while implementing the "Stablecoin Regulation," has announced that it is researching the plan to launch a digital Hong Kong dollar.

In summary, current stablecoins are a tool in the payment system and will maintain this attribute in the future, but they are unlikely to become mainstream payment tools. Whether they can have a larger legitimate application scale depends not only on the future demand for trading patterns of goods, services, and financial products, but also on the choice of regulatory approaches and the iterative progress of the technology itself. Additionally, if a stablecoin pegged to the Renminbi is issued, it is necessary to consider whether there are sufficient investable assets for its reserve.

(The author is the Deputy Director of the Shanghai New Financial Research Institute; Editors: Zhang Wei, Yuan Man)

Source: Finance Mayflower