Circle Proposes New Capital-Risk Framework for Stablecoins

The rise of tokenized finance, particularly stablecoins and other stable value tokens, has introduced new dynamics and challenges for financial institutions in managing and assessing their capital needs. According to Circle's blog, three of Circle’s top financial leaders—Chief Economist Gordon Liao, Treasurer Dan Fishman, and Chief Financial Officer Jeremy Fox-Geen—have proposed a risk-based capital framework tailored to these digital assets.

Understanding the Token Capital Adequacy Framework (TCAF)

The proposed framework, named the Token Capital Adequacy Framework (TCAF), aims to adapt to the distinct characteristics and risks inherent in stable value tokens. The paper, titled 'Risk-based Capital for Stable Value Tokens,' demonstrates how a risk-based capital framework can establish a foundation for safety and soundness in tokenized finance.

Capital, fundamentally, is the difference between a financial institution’s assets and liabilities, serving as a buffer against potential losses. In traditional banking, capital adequacy is designed to help institutions weather financial shocks, maintain customer confidence, and prevent runs. Circle's executives argue that stablecoins and other stable value tokens require more specialized capital standards due to their tokenized nature, which presents unique characteristics.

Key Features of TCAF

The TCAF provides a robust methodology to assess, manage, and allocate capital for stable value tokens, enabling them to better withstand potential shocks and maintain stability. Unlike traditional banks, stable value tokens are transferred on programmable blockchains or distributed ledgers, creating unique financial and operational risk profiles that traditional Basel-style capital requirements cannot adequately address.

Moreover, existing capital frameworks that rely on fixed ratios do not account for the reserve differences with stable value tokens, nor do they cover risks such as susceptibility to coordinated runs and technology-driven operational risks.

TCAF Highlights

• Developed to assess and manage capital needs based on quantitative assessment of market, credit, and operational risks specific to tokenized assets.
• Designed to be adaptive; applicable to various token backings such as fiat, crypto assets, and synthetic assets; and to operate independently of reserve and liquidity standards.
• Emphasizes risk sensitivity and stress testing over fixed-ratio methods, such as those adopted in the European Union's Markets in Crypto-Assets (MiCA) regulatory framework.
• Requires internal stakeholder input in determining non-financial risk, helping to ensure accountability and better risk management.

Reshaping Operational Risk Frameworks

The TCAF can also be applied by banks to manage operational risks, such as losses from failed or inadequate internal processes or from external events like cybersecurity incidents. A risk-sensitive capital framework with sufficient internal accountability, as proposed by TCAF, provides a foundation for rewriting capital standards for operational risks more broadly for both banks and non-banks.

Recent cybersecurity events for financial firms underscore the need to re-evaluate operational risks and provide a stronger feedback loop between technology decisions and balance sheet allocations.

For a detailed understanding, read the full paper on [Circle's blog](https://www.circle.com/blog/beyond-basel-a-new-capital-risk-framework-for-stablecoins).