CBDCs and Stablecoins: The Regulatory Battle to Come

With the increasing use of digital assets, especially in finance, we are going to enter a period of real competition between central bank digital currencies (CBDC) and their private counterparts, primarily stablecoins. This period will mark the beginning of segregation of digital assets into categories defined not only by functionality, but primarily by their regulatory appeal.

My thoughts on this below assume the following scenario for the next three to five years:

In the future I just outlined the tension between permissioned/public and censorship resistant/controlled is inevitable. With the help of cryptography and distributed infrastructure, it is relatively easy for individuals to opt out of the traditional financial system without any regard to applicable regulation.

The popularity of cryptocurrencies shows demand for internet-native financial services is growing. People want to transact in a borderless environment, put their money to work where it provides best yield and own exposure to assets from across the globe, not just what their local financial markets offer. Governments should not censor themselves out of this movement, which eventually makes the global financial system more efficient and thus is inevitable like any other form of progress.

I’m sure smart governments will lead the way in embracing and adopting decentralized finance (DeFi) and public blockchains, including non-financial applications like decentralized cloud services. But the struggle is still unavoidable. Other jurisdictions banning crypto will only suffer pains before having to give up. But for the reserve currency incumbents like the U.S., European Union and Japan, as well as powerful runner-ups like China, the fight may be very much justified.

For this reason, the new stablecoin projects should offer strong differentiation to their CBDC opponents, both government-run (e.g., China’s DCEP) or private, but government-regulated (potentially all U.S. dollar-backed stablecoins, e.g., USDC or diem). 

Decentralization

Truly decentralized mechanics are based on algorithms that need minimal human intervention. The reason for this is humans are trackable, whether public or pseudonymous. One may make an argument that it is impossible to stop an app once it’s deployed to a platform like Ethereum. But it is still very much possible to hamper all of its development and maintenance if governments want to go after founders, operators and most-active community members. 

Even the previous head of the Office of the Comptroller of the Currency, Brian Brooks, (a very crypto-friendly, pro small-government kind of regulator) made straightforward comments along those lines. With the role of reserve currency governments expanding on the backend of the COVID-19 crisis, such arguments will only strengthen. 

That is why projects built/lead/governed by teams based in, for example, the U.S. (like Maker DAO and the newer projects Frax, Fei and Reflexer) are at risk. I’m not implying governments will go after them, but they might exercise certain control over their founders/teams and the “decentralized community” counterargument may turn out pretty weak in the face of real pushback.

A stablecoin needs to be unstoppable by being as independent as possible from human intervention. Pseudonymity of the leading team is a secondary but relevant factor here because it keeps the focus on the tech. Governance-minimized approaches taken by teams at Lien, Gambit and (eventually) Basis Cash are all interesting experiments in this direction. 

Non fiat-based stability

The majority of stablecoins today are pegged to the value of the U.S. dollar one way or another. This is not critical if those are algorithmic or collateral based (in the sense that governments might control, sanction or freeze assets). But for assets that are backed by USD (or other fiat) directly or indirectly (e.g., backed by other USD-backed stablecoins) this becomes a vulnerability. For one, the U.S. Federal Reserve effectively controls any USD-denominated bank account. 

Also, in a scenario of a change in value of USD (which may happen momentarily or in a series of drastic steps, according to both history and macroeconomic theory) those assets may not appear as stable as they currently seem. That is why a crypto-native stablecoin makes much more sense in the long run. Fei, Reflexer, Lien, Float and Liquity are all backed by ETH (a decentralized asset), with Reflexer and Float also abandoning a strict peg to the USD, striving instead to keep the purchasing power of their respective tokens. 

Algo coins like basis cash and empty set dollar (ESD) are formally pegged to USD but can actually be re-pegged to any other unit of account. The same goes with DAI, which was originally envisioned to transition into an SDR-like instrument, backed by a crypto basket. Meanwhile, a project called Shell, which creates “shell” tokens carrying multiple similar assets inside (e.g., all USD-pegged or BTC-pegged tokens), without any overcollateralization, is minimizing the risks of any one stablecoin within a shell’s composition, but doesn’t (yet) solve a problem of dependency on a USD peg.

True community support

Real liquidity is not measured in circulating supply but in the number of wallets that hold it. There is no use in a stablecoin that is printed in hundreds of millions of units but held only by a relatively small group of speculators (e.g., ESD). Yet, it is too early to say which of those newer breed of stablecoins actually gets a wide enough distribution to catch on. The way to gauge potential future utility, which may drive wider distribution, is to evaluate a project’s expected positioning and compare it with how passionate is the community behind it. 

By “positioning” I mean whether it is naturally resistant to a scenario where regulators, say in the U.S., make it obligatory for the holders of stablecoins to adhere to strict know your customer/anti-money laundering rules, enforced through the admin of a smart contract (e.g., USDT).

The pushback on seigniorage algo stablecoin projects like Basis Cash or Float is usually that they are based on so-called “ponzinomics” – i.e., the implicit need for a constant inflow of capital-bearing entrants. But I’d argue in a scenario where strict KYC requirements are placed on protocol developers, you won’t need incentives other than the ability to transact freely outside of the surveilled and restricted world of government-controlled stablecoins.

The most recent proposals by the Financial Action Task Force (FATF) – a global super body that pushes for regulations in the KYC/AML space – may be interpreted as forcing protocol/dapp creators and maintainers (i.e., the team) to implement some form of KYC rules on the base technology level.

As you can tell, my criteria clearly favors algorithmic, anon-team lead, sometimes very experimental projects. This is a murky path, but through trial and error I’m sure the winner emerges from this space rather than anywhere else. Current experiments seem interesting, but I’d watch them with caution. As I’ve mentioned earlier: Basis Cash, Float, Lien (the stablecoin is IDOL) and Gambit are the ones I’m personally watching closely. Out of the non-anonymous projects, Shell and Liquity are the most interesting ones.

These musings are based on a rather long-term view, not necessarily current or even three to five years from now dynamics. Obviously centralized dollar-backed coins have proven to be the go-to-source of liquidity in the space and will remain to be for some foreseeable future. But as CBDC/private stablecoin tensions heat up (i.e., as the space becomes big enough to provide a real alternative to government-controlled financial systems), we could see state actors exploit the fiat dependencies of dollar-backed projects. 

In my view this is inevitable, so I’d like to prepare and participate in those alternative experiments rather than wait on the sidelines. This is the biggest sector of DeFi in terms of size and impact. Smart investors are watching these projects closely, without being too much distracted by hot topics of the day. So, expect capital to pour into those systems and may the most resilient ones win.