The Dual Future of Stablecoins
Decentralize or Become An Extension of a Central Bank
TL;DR
The future is now clear, two types of Stablecoins will exist going forward. Those that are extensions of central banks or those that are fully decentralized, no middle ground is left. Three developments last week have made this obvious, first the recommendations by the Financial Stability Board, second the release of the 2.0 version of the Libra Whitepaper and third the announcement of China’s National Blockchain Committee.
In order to keep operating all centralized stablecoins will become highly regulated, their monetary polices controlled by individual nations and their baskets set by the IMF or similar global banking entity. The only alternative option is highly decentralized Stablecoins which have no custody of user funds, no company, no foundation, no operator & no validators involved.
For existing stablecoins they will need to rapidly move in one direction or another as these recommendations after July 15th will become finalized and then be implemented by member central banks. USDC and other existing regulated stablecoins are likely to double down on their centralized approach, perhaps even be pressured off tech stacks such as Ethereum onto Libra’s Blockchain or another similar chain that has all known validators.
For Tether’s USDT either becoming regulated or decentralized seems to be a difficult path as they lack any of the USDC type regulated DNA and their reserve model doesn’t lend it self easily to decentralization. For Maker’s Dai they recently added USDC to their collateral which may take them down the regulated path. And finally there are newer projects such as PegNet which are mining based, have no custodian, no operators, no validators, no company, no foundation and so forth, who are likely to pick up much of the market share for Stablecoins on the Decentralized side of the world.
The Financial Stability Board Recommendations
The Financial Stability Board is an independent group formed after the 2009 financial crisis by the G20 and is funded by the Bank of International Settlements based in Basil Switzerland. Last year the FSB was asked by the central banks and the G20 to make recommendations regarding “Global Stablecoins” following the announcement of Libra in June of 2019 which forced governments to take “stablecoins” seriously for the first time.
The following report released April 14th 2020 outlines the ten main recommendations by the FSB to the central banks who are its members, which include the top 24 economies in the world. Argentina, Australia, Brazil, Canada, China, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, South Korea, Spain, Switzerland, Turkey, United Kingdom, & United States.
The 10 Recommendations From The Report
1. Authorities should have and utilize the necessary powers and tools, and adequate resources, to comprehensively regulate, supervise, and oversee a GSC arrangement and its multi-functional activities, and enforce relevant laws and regulations effectively.
2. Authorities should apply regulatory requirements to GSC arrangements on a functional basis and proportionate to their risks.
3. Authorities should ensure that there is comprehensive regulation, supervision and oversight of the GSC arrangement across borders and sectors. Authorities should cooperate and coordinate with each other, both domestically and internationally, to foster efficient and effective communication and consultation in order to support each other in fulfilling their respective mandates and to facilitate comprehensive regulation, supervision, and oversight of a GSC arrangement across borders and sectors.
4. Authorities should ensure that GSC arrangements have in place a comprehensive governance framework with a clear allocation of accountability for the functions and activities within the GSC arrangement.
5. Authorities should ensure that GSC arrangements have effective risk management frameworks in place especially with regard to reserve management, operational resiliency, cyber security safeguards and AML/CFT measures, as well as ‘fit and proper’ requirements.
6. Authorities should ensure that GSC arrangements have in place robust systems for safeguarding, collecting, storing and managing data.
7. Authorities should ensure that GSC arrangements have appropriate recovery and resolution plans.
8. Authorities should ensure that GSC arrangements provide to users and relevant stakeholders comprehensive and transparent information necessary to understand the functioning of the GSC arrangement, including with respect to its stabilization mechanism.
9. Authorities should ensure that GSC arrangements provide legal clarity to users on the nature and enforceability of any redemption rights and the process for redemption, where applicable.
10. Authorities should ensure that GSC arrangements meet all applicable regulatory, supervisory and oversight requirements of a particular jurisdiction before commencing any operations in that jurisdiction, and construct systems and products that can adapt to new regulatory requirements as necessary.
In short, Global Stablecoins will need to comply with the banking standards that every major jurisdiction already imposes on financial institutions, custodians, and other regulated entities.
Enter Libra 2.0
After the release of the report by the Financial Stability Board, Libra released its version 2.0 of its Whitepaper.
The updated version directly reflects the compliance recommendations set by the FSB and the whitepaper even refers to Libra’s discussions with the FSB, IMF, World Bank, and other regulators as informing their decisions. Which result in four main changes to the original vision for Libra as presented last year in June 2019.
Summary of Changes to Libra
- Offering single-currency stablecoins in addition to the multi-currency coin.
- Enhancing the safety of the Libra payment system with a robust compliance framework.
- Forgoing the future transition to a permissionless system while maintaining its key economic properties.
- Building strong protections into the design of the Libra Reserve.
What these changes boil down to are that Libra users in four countries to start with will have single currency stablecoins (US, EU, UK, and Singapore) and the rest of the world’s users will use the Libra basket. As each country releases its Central Bank Digital Currency (CBDC) Libra will replace the currency they hold in reserve with the CBDC’s directly from that country’s central bank. The basket’s mix of assets will be limited to currencies (likely set by the IMF) and up to 90 day treasuries and other extremely conservative and short term government securities.
In addition Libra will introduce a “Financial Intelligence Function” that will handle KYC, AML, CTF and every other type of system wide tracking of user activity to meet the global standards.
Lastly Libra has given up on its path to “decentralization” meaning having community elected validators. Instead the government have made it clear to them that all validators must be known, regulated entities and the process of adding validators must consult with regulators.
There is still talk of “banking the unbanked” as part of the Libra mission, but frankly its hard to imagine how Libra can serve those who lack permeant addresses, or who don’t have government IDs or other blockers that prevent them from passing KYC in order to participate Libra, anymore than they can get a bank account today.
The Chinese Tech Stack & The National Blockchain Committee
While Libra has emerged as THE regulated “distributed ledger” for western banking the Chinese approach appears much more widely distributed among the major companies and players in the Chinese economy. Most of the major Chinese tech companies have built their own blockchains and the government is talking about a “Blockchain Services Network” that links them all together its tech being built on a fork of Hyper Ledger.
This is the Chinese National Blockchain Committee as it includes all the major tech companies and players that have built out the blockchains and conduct payments and other functions that the Chinese Central Bank Digital Currency will soon flow into. Already pictures are leaking of the testing cities and areas where China will first introduce their digital yuan.
So rather than join an effort such as Libra Chinese companies will be operating on a different tech stack entirely. Though it is similar in the sense that the validators and those involved are all known entities and implement many of the same requirements and standards.
The Stablecoin Landscape Moving Forward
The clock is now ticking for every Stablecoin project. Which direction will they take? This is a situation very similar to that of early 2017 when securities regulators starting taking an interest into the billions of dollars flowing into ICOs. As more and more recommendations became enforced later in 2017 and early 2018 it effectively forced every ICO project to either pivot to registering as a security or to launch their main nets and prove they were fully decentralized.
This was a difficult, complex and messy process to be sure. For those ICOs that went down the regulated path of being a security they found illiquid security token markets (due to a lack of broker dealers), regulators stalling on licenses and major jurisdictions unwilling to approve their filings (in the case of Reg A+) such as in the US.
On the other hand those that moved quickly and pushed out decentralized main nets were largely grandfathered in and either left alone entirely or got minor fines for their ICO baggage. Projects that took longer to launch such as Telegram effectively missed this grandfathering period and instead entered legal conflict with regulators that is still in April 2020 yet to be resolved.
Using this a recent history lesson it is likely that those that attempt to centralize will have a difficult path as much of the requirements are still ill defined and they must compete with an 800 pound gorilla in the form of Libra that has access to billions of users globally and the size required to work with institutions such as the Financial Stability Board, IMF, World Bank, and the world’s central banks directly. I expect those best positioned such as Coinbase’s / Circle’s USDC are likely to move toward the Libra Blockchain especially considering Coinbase is already a member of the Libra organization.
Tether’s USD is in a very difficult position as they are structured in a way that will be extremely difficult for them to comply with the new regulations, but it’s also hard to see a path for them as a private company with Bitfinex as their parent company to become decentralized. Maker Dai is also in a tough spot as they have a combination of centralized and decentralized elements. The more recent move to use USDC for backing of Dai may bring them down the path of centralization. They already have a foundation and the connections to try and be the Ethereum based regulated Stablecoins, however Ethereum’s lack of known validators will be an issue, so Dai may be forced to either operate on a private Ethereum Enterprise fork with known validators or join the Libra Blockchain.
Finally the recommendations do recognize a few limits to who has to comply with these new proposed rules for “global stablecoins”. Namely those who are not holding centralized reserves, not acting as custodial wallets, not involved in validation and other tasks. The first such project to exist is PegNet having launched its decentralized mining based stablecoin network in August of 2019. In the PegNet system the only actors are users and the protocol. Miners and arbitragers are completely decentralized functions in Pegnet with no intermediaries involved in confirming transactions or validating conversions of pegged assets in the network.
Conclusion
There are a few well positioned stablecoin projects that will benefit from these new recommendations namely USDC and Libra. Its a tough road ahead for Tether’s USDT that may well end up with it unwinding or having to significantly pivot from its current structure. Maker’s Dai will have to determine a path forward. Lastly I expect there to be massive growth in decentralized stablecoins such as PegNet as they compete for the market share of Tether and other stablecoins that are negatively impacted by these recommendations as they become implemented country by country.
