Recently, a research report by JP Morgan has drawn widespread attention. The report points out that with the increasing regulatory pressure, especially with the European MICA (European MiCA Regulation Comprehensive Report: In-Depth Analysis of the Far-Reaching Impacts on the Web3 Industry, DeFi, Stablecoins, and ICO Projects) regulation, stablecoin issuers like Tether may face significant challenges. This legislation requires that 60% of stablecoin reserves must be kept in banks in Europe. For Tether, meeting these stringent requirements may require a large-scale adjustment to its reserve management strategy. This involves not only the reallocation of funds but also potentially affecting Tether’s dominance in the market. If Tether cannot adapt to these new rules, its market share might be threatened, and it could face more regulatory pressure and market turmoil.

Meanwhile, last week, the bankruptcy liquidation of Swiss bank FlowBank triggered a chain reaction in the crypto industry. Anchored Coins AG, the issuer of the euro-pegged stablecoin AEUR, had deposited part of its reserve funds in this bank. When FlowBank entered liquidation, Anchored Coins’ funds were frozen, leading the company to suspend AEUR issuance and withdrawals. As the case develops, AEUR holders may face the risk of not being able to redeem their holdings in full. This event echoes concerns raised by Aiying last week in the article “From Crypto-Friendly Bank Customers Bank Under Federal Reserve Scrutiny, Viewing the Interwoven Impact of the Cryptocurrency Industry and Banking System.“ Currently, stablecoin issuers in regions such as Hong Kong, Singapore, and Europe must ensure sufficient reserve funds are held in bank accounts. If reserves are 100%, the risk lies entirely with the bank. If liquidity issues arise at the bank, it will also affect the stablecoin issuer. If reserves are less than 100%, stablecoin issuers act as “shadow banks,” adding another layer of leverage on top of the bank’s reserve ratio multiplier, thus amplifying the liquidity risk of the bank itself.

Due to the risk preferences of the banking system, they hold biases or aversions towards crypto institutions. Therefore, cash from these stablecoin issuers, OTC institutions, custodians, etc., is concentrated in a few accessible bank accounts, many of which are small, lesser-known banks. Thus, when a liquidity crisis occurs, these banks’ risk-bearing capabilities are very poor, making it highly likely that the stablecoin market could be thrown back to square one overnight.

Thus, to address the fact that what many perceive as an elite-controlled world is actually a shambles, rules must be established to counteract human weaknesses and balance the risks brought about by the rapid expansion of crypto assets. Circle recently released a white paper proposing a new solution called the “Token Capital Adequacy Framework” (TCAF). This framework is designed to address the unique risk issues faced by stablecoins in the market, such as market volatility, technical failures, and operational errors. Aiying considers this to be quite instructive. The following is a summary of the white paper’s content:

1. TCAF framework

Circle’s white paper introduces a new framework called the “Token Capital Adequacy Framework” (TCAF), suggesting that traditional banking regulatory frameworks, designed for conventional financial institutions, often rely on fixed risk ratios and predetermined risk weights. These methods may not fully reflect the actual risks faced by the stablecoin industry. TCAF aims to address these challenges with a more flexible and dynamic risk management approach tailored specifically for stablecoins and other digital assets.

1. Dynamic Risk Management

A key feature of TCAF is its dynamic risk management capability. Unlike traditional fixed standards, TCAF adjusts risk assessments based on real-time market conditions. For example, it uses stress tests to evaluate whether stablecoin reserves can withstand extreme market volatility. These stress tests simulate worst-case market scenarios to see if the issued stablecoin can maintain its value stability.

Additionally, TCAF adjusts capital requirements based on changing market environments. If market risks increase, such as during large-scale sell-offs or technical issues with blockchain networks, TCAF can quickly require issuers to increase capital reserves to ensure the stability of the stablecoin. This flexible adjustment mechanism allows TCAF to more effectively handle uncertain market conditions and sudden events, avoiding the rigidity and delay associated with fixed standards.

1. Comparison with Traditional Methods

Traditional banking regulatory frameworks generally use fixed risk ratios. For instance, banks are required to hold capital at a fixed ratio to cover potential risks. While this approach is straightforward, it lacks flexibility in rapidly changing market environments. Fixed standards may not promptly reflect new risks, especially in the digital asset space, where risks can emerge suddenly and in complex ways.

TCAF addresses these limitations by incorporating dynamic adjustments and stress tests. It can real-time adjust capital requirements based on actual risk situations, ensuring that stablecoin issuers maintain a safe capital level. This dynamic nature allows TCAF to better adapt to market changes and reduce the impact of risk accumulation and sudden events.

1. Technical and Operational Risk Management

Beyond market risks, TCAF also focuses on technical and operational risks. In the digital asset field, technical risks are significant, including blockchain network performance, cybersecurity issues, and smart contract vulnerabilities. If not properly managed, these risks can cause significant value fluctuations in stablecoins and affect overall market stability.

TCAF includes technical risks in its capital requirements. Issuers are required to regularly assess the performance and security of their blockchain networks and adjust capital reserves accordingly. If potential security vulnerabilities or performance bottlenecks are identified, TCAF mandates issuers to increase capital reserves to cover possible losses from technical issues.

Additionally, TCAF requires issuers to have strong operational risk management capabilities. Operational risks include issues ranging from management systems to human errors, such as data breaches and operational mistakes. By closely monitoring and managing these risks, TCAF helps issuers maintain the safety and reliability of stablecoins on both technical and operational levels.

2. Five goals of the TCAF framework

The design goal of the Token Capital Adequacy Framework (TCAF) is to help stablecoin issuers better manage risks while providing regulators with more effective supervisory tools. The framework has five major goals that cover key aspects of stablecoin risk management from different angles. Here are the five major goals of the TCAF framework:

1. Distinguish “Potential” from “Eliminated” Risks

The first goal of TCAF is to help issuers distinguish between “potential risks” that still exist and “eliminated risks” that have been effectively controlled through management measures. This distinction is important because it allows issuers to focus on managing risks that still pose a threat to the stablecoin, rather than wasting resources on issues that have already been resolved.

Specifically, TCAF uses continuous risk assessments and monitoring to identify risk points still present in market conditions, technical operations, and external threats. For these potential risks, TCAF requires issuers to take further measures, such as increasing capital reserves or improving technical systems. For risks that have been successfully eliminated, TCAF excludes them from further risk management actions, making the overall management process more efficient.

1. Assist Regulation and Simplify Processes

The second goal of TCAF is to help regulatory agencies better manage operational risks while keeping regulatory processes simple and efficient. Traditional banking regulatory frameworks often involve complex processes and extensive paperwork, which increases costs and may lead to inefficiencies.

TCAF simplifies reporting and introduces dynamic adjustment mechanisms, allowing regulators to more easily monitor issuers’ risk management status. For example, TCAF incorporates automated risk assessment tools that provide real-time data on issuers’ capital conditions to regulators. This streamlined process reduces regulatory complexity and enhances responsiveness, enabling regulators to quickly address market changes.

1. Standardized Approach for Different Regions and Institutions

Due to varying regulatory environments and market conditions across regions, the third goal of TCAF is to provide a standardized risk management approach applicable to different regions and institutions. Traditional regulatory frameworks often struggle to apply across borders because each country has different regulations and market practices.

TCAF offers a flexible set of standards that can be adjusted according to local conditions while maintaining consistent core principles. This standardized approach allows stablecoin issuers to maintain a uniform level of risk management globally and enables regulatory agencies to better coordinate and ensure the safety of cross-border capital flows.

1. Provide Incentives and Accountability Mechanisms

Finally, the fourth goal of TCAF is to encourage better risk management practices through incentive mechanisms and accountability systems. For issuers demonstrating excellence in risk management, TCAF may offer incentives such as reduced capital requirements or increased market access opportunities.

Conversely, issuers that fail to manage risks effectively are subject to stricter regulatory requirements and potential penalties. Through regular reviews and assessments, TCAF imposes more stringent requirements on these issuers and may impose sanctions. This dual approach of incentives and accountability aims to drive the industry toward greater regulation and safety.

White paper: https://www.circle.com/blog/beyond-basel-a-new-capital-risk-framework-for-stablecoins

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