How Regulation of Centralized Stablecoins Will Change the Market
Recent government noise, both in the US and abroad, have led people to an expectation of incoming regulation. Centralized stablecoins and their issuing parties, as well as the broader DeFi ecosystem and the protocols within it, have come under increased scrutiny as the Web3 economy matures. Regulation and its effects on centralized stablecoins may lead to decentralized stablecoins becoming the new hinge of value upon which crypto rests.
The Importance of Stablecoins
Stablecoins are essential to the functioning of the crypto economy. Without them, the inherent volatility of digital assets would be too much for even the most risk-hungry trader, granted they are used to settle trades in many spot and derivative markets across many prominent exchanges. Before 2014, when Tether was first minted, the crypto market was extremely unsophisticated, as there was no central locus point to build a scaffold of agreed value.
Commonly pegged to the US Dollar, stablecoins give a digital ‘safe haven’ for value without having to off-ramp into traditional fiat currencies, encouraging money to stay in the Web3 economy without being yanked out. This has propelled growth in the market as a whole. What’s more, stablecoins and DeFi are intimately linked, as yields can be earned in a currency whose underlying value is not subject to change.
One could argue that stablecoins enhance the dominance of existing currencies because they democratize access to finance for the unbanked. Granted that currency access becomes easier, people worldwide can freely make payments, access credit markets, and earn yields, helping strengthen the currency itself.
How Stablecoins Work — Centralized and Decentralized
Most large stablecoins are reserve-backed, meaning that the issuing entity holds an equivalent value of non-digital assets (bonds, fiat, stocks, etc.) to guarantee the tokens value. These are centralized stablecoins, a distinction that is important to understand. Other stablecoins are backed by protocols that use crypto-collateral, or they are algorithmically maintained. These coins are decentralized, as they are validated by a decentralized ledger.
Concerns Around Stablecoins
Currently, the combined market cap of stablecoins is over $160 billion dollars, with no signs of slowing down. The vast majority of them are centralized, and reserve-backed. Stablecoin issuers are minting coins at a rate of knots, fuelling the growth of the market as a whole. Large actors like Coinbase and Binance have launched their own stablecoins, as have a myriad of smaller providers. 75% of all crypto transactions occur between a stablecoin and another crypto asset, and 5% of all tokens currently on the market are stablecoins.
With this, concerns are being raised that these reserve-backed stablecoins are not fundamentally backed by ‘real’ assets (such as stocks, bonds, or cash) like they are claimed to be, and Tether — the largest by market cap — has come under increasing scrutiny as to whether it can truly guarantee its token on a 1:1 basis, or whether it runs a fractional, perhaps too fractional, reserve.
This possible powder keg is just one of the reasons the US congress, and other governments around the world, are keeping a close on their development. The EU wants to introduce law that demands stablecoins are backed 1:1 by ‘real’ (i,e, national) money and that the reserves are audited, with French finance minister Bruno Le Maire stating “The central bank, I mean the ECB, is the only one to be allowed to issue a currency.”
Currency and Power
When it comes to stablecoins, the term ‘license to print money’ has never been so aptly applied. For that is exactly what stablecoin issuers are currently doing. Throughout history, governments have taken — shall we say — a dim view of private entities printing their own currency.
In 17th Century Britain, a huge array of ingenious token currencies were employed to oil the wheels of trade between various sectors of the economy in the absence of a reliable supply of silver and gold coinage. This boisterous trade, although effective at spurring economic growth, did not last long, with a proclamation from the King of England in 1672 stating ‘no person or persons should for the future make, coin, exchange or use any farthings or tokens except as should be coined in his Majesty’s mint.”
Today, China’s repeated banning of crypto is seen as an attempt to defuse the possibility of alternate power systems taking root in the country. The reasoning is perhaps obvious. Money is power. By controlling the money supply and its use, you control society’s perception of value. History is littered with examples of such crackdowns, ranging from a benign cease and desist to full-scale repression.
The Importance of Protections
It’s not just the government flexing their muscles in a desire for power, though. It’s far too simplistic an argument to make. Governments do have a responsibility to their citizens. Although arguments against crypto that include money laundering, ‘criminal activities’ and ‘protecting investors’ are often a laughing stock in crypto circles, the fact remains that cryptocurrency is plagued with a surfeit of bad actors, and that novice investors can and do get duped by the malfeasance of operators who create and sell tokens with little oversight.
Regulation would severely dampen the crypto markets as a whole as it struggled to adapt to this new set of laws and, with prominent voices in the US saying that the government should not ‘scare away’ this new technology and the wealth it is creating. Cynthia Lumis, a bitcoin advocate and senator in the US congress, states that onerous legislation would be harmful to the ‘financial innovation’ that cryptocurrency is enabling.
Recent Indications of Regulation
Nevertheless, legislative efforts around stablecoins are gathering pace. A recent U.S treasury report on stablecoins has called for regulation, citing the widespread move from both retail and institution into stablecoins creating a concentration of economic power that is unacceptable.
The PWG report also says ‘In addition to market integrity, investor protection, and illicit finance concerns, the potential for the increased use of stablecoins as a means of payment raises a range of prudential concerns’. Meaning that, should a significant number of redemptions on the underlying value of the token all at once, the knock on effects on the wider crypto economy could be devastating as poorly regulated or unaudited providers scramble to liquidate their assets to meet demand.
Furthermore, it says the specter of settlement risk is more apparent the more that payment services are integrated: “If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system”.
Since we are entering a phase of mass adoption, where the ‘crypto economy’ and Web3 becomes more analogous to just ‘the economy’, the more the government is worried that such a ‘bank run’ event could cause significant damage to the general markets as a whole. This is particularly crucial at a stage where institutions are becoming more and more invested in crypto.
It is these institutions who in particular seek regulatory clarity as they seek to onboard their assets in Web3. “The regulatory framework is one of the major hurdles to wider scale adoption for a lot of investment managers,” says Joe McCarney, the global blockchain assurance leader at EY, who recently published a report on hedge-funds’ appetite for crypto.
Securities Law and Cryptocurrency
Also pertinent is the SEC’s ongoing discussion about whether cryptocurrencies, including stablecoins, qualify as securities. This is a big deal as, should they rule that cryptocurrencies are securities, they would then fall under the purview of US securities law. This would subject trades to a wide range of legal requirements, such as registering with the SEC and being subject to the US Securities Act.
To be a security, a financial instrument is subjected to the Howey test, which determines whether it qualifies as an ‘investment contract’. The Supreme Court states the test is whether there is an ‘‘investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.’
When it comes to crypto, this law is still somewhat unclear, with plenty of myths being peddled on social and mainstream media.
Security laws are here to protect consumers, and there are still means of compliantly building projects and launching tokens.
In the US, securities laws should be interpreted alongside utility token laws. Thus, a cryptocurrency may be classed as a security if passively holding it brings an expectation of profit. However, a crypto is not a security if it respects the utility token laws, meaning that a token should be immediately deployable to fulfill use cases.
Such is the case with Onomy Protocol. The NOM token provides immediate utility and users can actively participate in the network from day one by ensuring network security by validating or participating in governance decisions. Projects like Onomy are therefore building entire decentralized ecosystems before the token is available on public markets, in line with the current regulations. This also necessitates having a network of fully-decentralized validators and contributors, alongside a DAO to govern everything, to the point where project treasuries may also be DAO-governed, meaning that core team members do not hold the keys to the protocol’s financial resources.
How Decentralization is the Key
The key to all this is, as many in the crypto community would fervently agree with, centralisation. Gary Gensler has pointed out that DeFi is not as decentralized, in many cases, as it ought to be. “These platforms facilitate something that might be decentralized in some aspects but highly centralized in other aspects.”
A truly decentralized stablecoin, which isn’t reserve-backed, but rather capitalized by a crypto-asset, would escape even the most hawkish regulator. The implication is that as long as there is no central authority, then there is nothing to regulate. Regulation exists to protect people, and systems, from entities that have levers of control. If no one controls the levers, no one needs to be protected from anyone.
Enter Onomy’s Decentralized Denoms
Onomy Protocol is closely following the regulatory trend, doing everything possible to ensure that our stablecoins remain fully compliant, and thus, usable for trading, payments, settlement, and more. Instead of opting to collateralize via real-world assets, using algorithmic mechanisms that are prone to failure, or relying on price oracles subject to manipulation, Denoms will be fully decentralized, collateralized by the native NOM protocol coin, and perhaps most importantly, will have price points determined by the ONEX’s order book.
The Onomy Reserve will leverage a hybrid collateral mechanism to be unveiled at a later date that ensures fiat-pegged stablecoins keep their peg intact, no matter which national currency is moved on-chain.
Together, these components assure regulatory compliance as well as the infrastructure required to onboard billions, if not trillions of dollars, into Web3, further opening the decentralized economy to institutions, traders, and retail users worldwide looking for better opportunities in DeFi.
It is likely that regulation is coming. Yet it’s important to remember that regulation, particularly of stablecoins, mainly impacts custodial actors. In a truly decentralized world then we, the people, make our own rules.