If Stablecoins are causing instability, regulators themselves are to blame

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With the stable coin market hitting $ 100 billion last month, the debate over how to regulate these new financial products is intensifying.

Last week, Federal Reserve Chairman Jerome Powell warned that stablecoins “are growing incredibly fast but without proper regulation.” This week, the president’s financial markets task force, made up of key U.S. financial regulators, will discuss stablecoins.

Regulators fear the explosive growth in the stable coin market could create financial stability issues. It may be, but if it is, it is the regulator’s fault.

One of the main drivers of the popularity of stable coins is their pseudonym. People do not have to provide ID to use them. By failing to close this pseudonym loophole early on, the regulators themselves have sponsored the “incredibly rapid” growth that now worries them so much. If they continue to ignore the pseudonym problem, their job will only get more complicated.

There are two types of stablecoin regulations

There are two types of financial regulations: anti-money laundering rules and financial stability rules.

In the first case, financial institutions such as stablecoins are required to do due diligence with their customers to weed out bad players. Stability encompasses concerns such as: “Does stablecoin contain assets that are safe enough to ensure that it is truly stable?” “

Related: How $ 33 Billion Robinhood Ended Up To Be Worth Less Than Coinbase

The heightened concerns about stablecoins relate to the second type of regulation, financial stability. “We have a tradition in this country where public money is held in what is supposed to be a very safe asset,” Powell said last week, highlighting regulatory frameworks for bank deposits and money market funds. “There is no such thing as stable coins.”

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This lack of security, combined with the “incredibly rapid” growth in the market, has scared America’s biggest banker.

Pseudo digital dollar

Regulators fear this rapidly growing segment of the financial industry. But the growth of stablecoins has been caused by the regulators themselves. Specifically, it is the early failure of regulators to properly articulate how anti-money laundering rules apply to stablecoins that has supported the incredible growth of the market.

For several years now, stablecoins have provided a highly demanded financial service, but no other US financial institution is licensed to provide: non-KYC (know your customer) access to digital US dollars.

You or I can hold $ 100,000 in a PayPal account or a bank like Wells Fargo, but only after going through the due diligence processes of those institutions. This is not the case with stable coins, however. We can hold $ 100,000 worth of tether or USD coins without having to provide any identifying information to Tether or Circle, the owners of these stablecoin platforms.

We can then send that $ 100,000 to other users, who can transfer the stablecoins, who in turn can transfer them, and no one along that daisy chain needs to go through a know the customer process. .

The only users that stablecoin issuers bother to identify are those who wish to convert stablecoins back to real dollars, or those who wish to deposit dollars with the stablecoin issuer in exchange for stablecoins. But that’s a tiny minority of stablecoin users.

Given that anti-money laundering requirements have become more stringent over decades, it is mind-boggling that stablecoin issuers have been allowed to continue providing this level of pseudonym. But not a single US regulator has done anything to stop it.

There have been indications of regulators’ dissatisfaction with the pseudonym stablecoin. Last December, for example, the president’s task force (the same one that met this week) suggested that stablecoins should “have the ability to obtain and verify the identity of all parties. to the transaction, including those that use non-hosted wallets “.

A hosted stablecoin wallet refers to balances of tether or USD coins held on an exchange like Coinbase, which performs KYC on all of its customers. An unhosted stablecoin wallet is when a user keeps their stablecoin balances on their own. For the most part, stablecoins currently make no effort to identify unhosted users.

Another indication of what US regulators actually think of the pseudonym stablecoin comes from the Office of the Comptroller of the Currency (OCC), one of the main US banking regulators. Last year, the OCC granted federal banks the power to support stable transactions, but only if they involve hosted wallets. Since all major stablecoin issuers allow tons of unhosted activity, banks regulated by the OCC are likely off limits to them.

So, the best dog regulators don’t like pseudonyms. Even then, stablecoin platforms continue to offer it. Since the PWG meeting in December, the stablecoins market has grown by an astonishing $ 75 billion to $ 110 billion in stablecoins in circulation, largely due to the demand for a digital dollar pseudonym.

Who are the users of the pseudonym stablecoin?

The pseudonym Stablecoin is the key to decentralized finance, or DeFi. DeFi tools are automated smart contracts running on Ethereum, Binance Smart Chain, or Tron that provide various financial services such as banking, lending, or trading.

The financial services offered on DeFi are strictly regulated in the United States. But the operators of these decentralized tools have for the most part avoided chartering or licensing, generally after having cited their anonymity, their automated nature and their lack of centralization. And with the exception of a few cases like EtherDelta, a decentralized exchange, regulators haven’t shut down these tools.

Gray market financial institutions would normally not have access to the accounts of US financial institutions. But the flaw in the pseudonym stablecoin allows these DeFi tools to do just that – ingest huge amounts of safe digital dollars.

One of them, MakerDAO, held just over $ 350 million in USDC as of December. He now holds nearly $ 3.5 billion! Maker is just one of many pseudonymous stablecoin users.

The Stablecoin pseudonym is also useful for outright illegal activities. Ponzi schemes and High Yield Income Programs (HYIPs) would normally be prevented from accessing dollar payments. They are illegal and therefore the banks cannot serve them. But there are many cases of Ponzis and HYIP using stablecoins for payouts and payouts, thanks to KYC stablecoin ‘light touch’.

If US regulators had required stablecoins to KYC on all their users from the start, gray market DeFi tools wouldn’t be able to access stablecoins, and neither could operators Ponzis and HYIP. DeFi would be much smaller than it is now. And stablecoins would never have grown into a $ 110 billion market.

But regulators let the pseudonym continue, so stablecoins became important. And now these regulators find themselves in a mess of their own making. As the market becomes important, they now find themselves preoccupied with issues such as systemic risk, financial interdependencies and cascading failures.

A minimum of regulation

Powell is unhappy with the state of stablecoin regulators, but it should be borne in mind that U.S. stablecoin issuers already operate within a financial regulatory framework.

The New York Department of Financial Services, or NYDFS, has authorized state trust companies to issue stablecoins. Three stablecoins – Gemini Dollar, Paxos Standard, and BUSD – are already operating under the NYDFS regulatory framework. Circle, the issuer of the USD Coin stablecoin, took a different route to regulation. He obtained 44 state fund transfer licenses. This is the same regulatory route taken by PayPal and Western Union.

As long as stablecoins remained small, these niche regulatory frameworks were probably sufficient to ensure the financial security of stablecoins. But Tether and USDC are now bigger than many U.S. banks and money market mutual funds, which are held to stricter rules than fund issuers.

To complicate matters, the entire DeFi ecosystem has grown around the assumption of pseudonymous access to stablecoin. By removing the pseudonym as late in the game as it started, regulators will be forcing big changes on these decentralized tools.

Regulators are late and have a long way to go. They worry about the financial stability issues surrounding stablecoins, but finding the pseudonym loophole will be a big part of their job. I don’t envy them.

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