Stablecoins as a Settlement Rail: What Clears, What Does Not, and Who Carries the Risk

The ledger may reflect a token transfer, but the settlement system still requires a legal and reserve-backed redemption.

Stablecoins promise to expedite settlement finality by eliminating the intermediary function of commercial banks, but a close examination shows that stablecoin issuers still carry substantial redemption responsibilities, and the risk of settlement interim transfer or reserves insufficiency can still land with the buyer or seller.

Settlement finality, in the context of stablecoins and redemption, is the point where a transaction is irrevocable and a stablecoin holder has the full legal right to claim USD in exchange, backed by a reserve asset. While public ledgers can quickly reflect token transfers, the real work of settlement still lies with the stablecoin issuer, and must reflect the principles established in the Bank for International Settlements standards for final settlement, in particular that settlement must be irrevocable and fail-free by the end of the value date. Whether the holder's reserve assets are segregated, whether the issuer can meet redemption requests, and whether a nail-in-the-joint finality leaves all parties whole - that is the legal context on which settlement rests.

Settlement Finality Versus Token Movement

While an on-chain stablecoin transfer leaves a public record, that transfer is not the same as end-of-day settlement, and does not meet the BIS benchmark for final settlement. In particular, under the law of the United States, stablecoin issuers bear the burden of backstopping the reserve assets and the redemption by USD, even as the token moves between buyers and sellers.

The U.S. House Office of the Law Revision Counsel sets forth provisions on this point. Under 12 U.S.C. §5903, a permitted payment stablecoin issuer must maintain identifiable reserves backing outstanding payment stablecoins on an at least 1-1 basis, and must establish clear and conspicuous procedures for the timely redemption of outstanding payment stablecoins. Further, under 12 U.S.C. §5906, these reserve assets may be used only for permitted purposes, including redemptions, and the issuers have a duty to back not only the circulating quantity of stablecoins, but any stablecoins issued and outstanding.

In Hong Kong, the Monetary Authority has also established reserve-backing rules, in particular, that licensees must provide stated stablecoin investors a right to redeem at par value, and give them a right to direct disposal of the reserve assets for redemption, as well as the right to claim on the licensee in the case of a shortfall. That means the buyer and seller are entitled, in the final settlement, to a direct claim on the reserve assets which are backing the transaction.

Together, U.S. and Hong Kong law make clear that, where a stablecoin is issued and redeemed in either jurisdiction, that redemption will be in USD, and in a quantity at least equal to the quantity of stablecoins which are issued, and there must be a clear backstop for claims in case the reserve assets are insufficient.

Reserves as the Backing Rail

The question of reserves, and whether stablecoins are truly backed by USD, is not simply an academic one. By definition, a dollar-that-circulates-on-public-ledgers must reflect a dollar that is on hand, or in overnight reserves, to back redemption. That is the rule in the United States, for U.S. dollar-backed stablecoins issued in that jurisdiction.

Under the New York State Department of Financial Services Guidance on U.S. Dollar-Backed Stablecoins, issued on June 8, 2022, the reserve assets must back the stablecoins on a 1-1 basis, and must be clearly segregated from the issuer's other assets Moreover, in accordance with the DFS's guidance, the market value of the reserve assets must be at least equal to the nominal value of all outstanding stablecoins as of the end of each business day. That means that under a stablecoin regime, the tokens may be issued, and ALSO redeemed, at the same rate as they are transacted, and the issuer must hold enough USD in reserve to ensure final settlement. This is the only legal way a stablecoin can make USD claims, and it cannot be circumvented by the quantity of on-chain transactions.

Under Hong Kong's HKMA Draft Guideline on Supervision of Licensed Stablecoin Issuers, licensed issuers that are 1-1 backed by their reserve assets must provide their holders the right to direct disposal of those reserve assets and the right to demand a USD claim in the case of a shortfall. This means the reserves must include at least enough USD to meet the full value of holders' outstanding units, and those reserves must be held in a segregated asset pool.

Redemption Mechanics and Timing

Most stablecoin networks provide the feature of a registry on a public ledger to verify the ledger entries and the reserve-backed indicia, such as. Some stablecoin issuers pay the full nominal value without corporate fees. But most stablecoins do carry a cost.

While some stablecoin issuers may advertise instant or one-click corporate redemption, the reality is more complex, particularly in the case of an issuer failure, or a redemptive run on reserves. In practice, stablecoin issuers have established redemption settlement that reflects a substantial quantity of transfer processing and USD availability.

Recent legal guidance from DFS spells out a clear rule: DFS defines timely redemption as "redemption not more than two full business days, T-2, after the business day on which the issuer receives a compliant redemption order." However, there is no consensus on the speed of available redemption in the absence of a priority claim on reserve assets -.

Deferral from a ledger to a bank account, to an incoming redemption request, means there is a real risk to the settlement system. Stablecoins that issue a "floating" claim on USD in a bank account, or in a reserve pool, without binding the redeemer's claim to a quantity of USD on hand from the moment of issue, allow future claims to "float," and leave a settlement risk that cannot be eliminated by an on-chain transaction and without the right to claim a segregated USD

Who Carries the Risk When Something Breaks

The stablecoin issuer, by law, has an obligation to back each stablecoin they issue with a reserve asset, such as a USD. There are several layers of risk to this settlement commitment, starting with the creation of a software network that issues a new financial instrument and puts it into circulation without a mechanism for backing. Even before a past collapse of a stablecoin network, the BIS established that there has to be an issuer of stablecoin which has the ability to back any redeemed USD. The BIS report entitled Application of the Principles for Financial Market Infrastructures spells out that the systemically important settlement system should provide clear and certain final settlement at a minimum by the end of the value date.

Under US law, under current law, a stablecoin issuer must maintain identifiable reserves backing for each outstanding payment stablecoin on an at least 1-1 basis. Each asset must be used only for permitted purposes, including backing the redeemed USD. This ensures that there is sufficient USD to provide a stablecoin holder a right to redeem, even if they exercise that right when the stablecoin is at the peak of its popularity.

The DFS clarifies that a stablecoin issuer must hold assets in an identifiable manner, and in a segregated asset pool. This means that, even in a credit rationing situation, the USD should be present and available for holders of U.S. dollar-backed stablecoins. However, even with these protections in place, stablecoins rely on centralized issuers, with the risk that a holder, particularly following a period of widespread token exchanges, cannot necessarily count on a directive claim on USD at the end-of-day value. While some would advertise instantaneous USD redemptions, enforcement actions have shown that this is not always possible, particularly in the absence of guarantees, or during a time of widespread claims. For example,

What Regulators Mean by "Safe"

When regulators assert that stablecoins are safe, they mean legal and regulatory backing against the risk of unstable value and the risk of insolvency. The stablecoin issuer must hold an identifiable and segregated pool, known to the regulators and the holders, to replace the USD issued. The need for segregation against issuer assets shows the risk of centralization and surprise, and the importance of regulatory backing. Additionally, it makes clear that the brick-and-mortar banking system is still part of the stablecoin settlement system, because the USD is the currency of redemption, and the bank would have to make it available. called on the BIS report on the Application of the Principles for Financial Market Infrastructures, to establish the benchmark for settlement readiness. According to BIS, systemically important settlement systems should provide clear and certain final settlement, at a minimum by the end of the value date. Final settlement doesn't change, and the PDF doesn't change, even if the stablecoin network is designed to wipe out the need to settle in the traditional way. At some point, the buyers and sellers need a real settlement, and a real bank account, and this requirement means that reserve assets, not just the software network, builds settlement.

The Practical Edge Cases

Despite the best legislative assurances, stablecoins are still advancing, without a clear timeline for enforceable rules. Stablecoins may fluctuate in their price, and may be subject to settlement windows, which means that "stabler" may not necessarily mean "instant." Moreover, even if there is a surplus of reserve assets, the issuer may still choose to apply a fee, a freeze, or other restrictions, and it is not clear that stablecoins are ultimately "money" in terms of legal status.

As stablecoins come to market, the definition remains fluid, and the claim on USD reserves fluid, so to speak. For example, have stated that the reserve operates with a "floating" USD claim, which means that there does not have to be a reserve to back each USD issued. The idea is to record a software entry, in the form of a USD entry, without the one-to-one backing, which means the USD claim is not settlement. Additionally, some stablecoin contracts require that the holder will be paid in stablecoins, without a USD right, which makes it unclear that the USD backing is more than a promise, and certainly not a clear and certain settlement.

At bottom, whether a stablecoin guarantees this or not, lies in this key piece: the promise at the point of redemption. Does the issuance of a stablecoin mean a USD backing? There is little guarantee of that, either in the law or in the goals of the issuers. In practice, this means that while the token may circulate, the issuance and circulation network does not always have the USD reserves, so the network does not guarantee the redemption of their claim on USD at a fixed rate. While corporations can advertise instant, redemption, coins should circulate with the caveat that there is no guarantee that USD will back each unit, let alone mint and circulate at the same rate.

Conclusion

While stablecoins offer fast inter-peer transfers, settlement systems still rely on USD redemptions, and rely on off-ramp banking. The Tokenization of USD does not take away the USD reserve requirement,, the USD backing, or the USD redemption rights of the stablecoin holders. Only the issuer has the ability to make sure that the USD reserve backing is present, and there is no guarantee that the reserve will back the USD stablecoin on issuance, let alone at the point of redemption