A recurring refrain from the champions of cryptocurrency is that global regulators simply “don’t get it.” However, regulators have allocated significant resources to their assessment of the ever-evolving cryptocurrency landscape and to date have shown deep technical understanding as well as an open mind in their deliberations within this debate. The latest paper from the European Central Bank (ECB) takes a deep dive into one significant sub-set of the cryptocurrency ecosystem and shows a thorough comprehension of both the purported benefits and the challenges with mass adoption of this new currency type.
A stablecoin is a type of cryptocurrency that pegs its value to the underlying value of another asset or basket of assets, such as the US dollar or a gram of gold. Stablecoins were created in direct response to one of the most commonly cited criticisms of cryptocurrency: price volatility. Even the most successful cryptocurrencies in the market such as Bitcoin or Ethereum have experienced erratic short-term price swings throughout their lifecycle. Overly volatile currencies tend to be difficult to use as a well-trusted medium of exchange since it is hard to gauge the relative value of the currency against assets you may wish to purchase.
Facebook brings stablecoins into the spotlight
In June, Facebook announced it planned to introduce its own cryptocurrency, dubbed Libra, which would be backed by a basket of currencies including the US dollar, Japanese Yen, and Euro as well as a basket of assets such as Treasury bills. Facebook hoped to enable its billions of existing users to send and receive money from across the globe, potentially disrupting the remittances market.
However, the Libra announcement was met with political and regulatory resistance, so much so that Facebook slowed down the project significantly. Regardless, others have similar stablecoin launches under construction. Japan, for example, has taken a more agreeable stance toward crypto and appears to be seeking a way to regulate stablecoins. In particular, Tokyo believes stablecoins have great potential to make global foreign payments faster and cheaper. Walmart, one of the world’s biggest retailers, also wants to get in on the action. A patent filing suggests that, like Facebook, Walmart wants to develop a digital currency backed by the US dollar that could be used to store wealth and be redeemed and converted into cash at retailers.
ECB deep dive
While a number of regulators such as the US Securities and Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA) have weighed in on cryptocurrencies, primarily to educate and forewarn consumers, the ECB's report on stablecoins is the first effort by a regulator responsible for issuing a major fiat currency, in this case the Euro, to tease out what makes digital currencies tick and examine the hurdles that they must overcome.
The ECB paper stands out for several reasons. First, its sentiments are certainly not anti-crypto. Much of the cryptocurrency community believes that regulators and banks either don't understand digital currencies or don't want them to succeed, or both. The ECB paper maintains a neutral stance on the concept and offers a clinical assessment and taxonomy about stablecoins. This indicates that regulators want to establish a common vernacular around digital currencies before moving further into detailed rulemaking. The paper reveals a deep level of understanding about the nuances of the various coins.
The ECB paper considers four types of stablecoins:
- Coin linked to fiat currencies
- Coin linked to basket of commodities
- Coin linked to a basket of cryptocurrencies
- Coin using an algorithm to keep value within a specified band
The first two types require an issuer to hold the underlying assets as a custodian and issue a token against them. As we outlined previously, there remain many uncertainties about digital assets and whether or not regulators will impose custody rules upon them. The latter two types are not backed by financial assets which are capable of being safekept in a traditional sense and exist solely on a distributed ledger known as a blockchain. As such, these methods lack a specific set of laws and regulation to govern them at this point in time. The so-called algorithmic stablecoin holds its value steady by issuing and removing coins from circulation, much like a central bank does with fiat money, however it lacks the transparency of a fiat currency.
Nonetheless, the main takeaway is that the ECB is not likely to start writing bespoke regulations for cryptocurrencies anytime soon. Existing payment providers are faced with a raft of regulations that protect both the market and investors. All signs indicate that if stablecoins are to proliferate it will be either through digital issuances from the traditional governments, central banks, and already regulated financial institutions or global payment providers each respecting the already very robust existing legal and regulatory frameworks. Made to measure global cryptocurrency rules are unlikely in the immediate future.
Regulators do not appear to see digital currencies as a new paradigm, but rather an extension of an already complex and well-governed international ecosystem and it is within those parameters that stakeholders must plan. The traditional banking or fiat issued currency model is unlikely to disappear, rather there will be a new method of global payments and remittances co-existing to evolve and enrich options for customers across the globe.
Also, as many legal minds have already pointed out, if a stablecoin issuer takes deposits and issues tokens against fiat currencies or commodities like gold, aren't they already acting like banks or asset managers? Shouldn't they be audited to show they are holding the assets they say they are? Shouldn’t they pay into investor insurance schemes to protect their customers? Shouldn’t they hold adequate levels of capital on their balance sheets for the same reasons?
The future of cryptocurrencies
As the ECB paper illustrates, there are three basic problems that cryptocurrencies need to overcome. The first is that in the last couple of decades, global authorities have introduced a sheaf of know-your-customer laws to protect against money laundering and tax evasion. That regulators would allow crypto issuers to undermine this progress by permitting basically anonymous transactions is unlikely.
The second problem is that governments want to control their own money supply for a number of reasons, such as reducing inflation when it gets out of hand. They don't want to see private entities having their hands on those important levers.
Lastly, there is concern about counterparty risk. There exists a mature network of well-capitalized and carefully audited banks in the developed world that are considered sound counterparties for financial transactions. If a bank fails, there is an existing infrastructure, such as deposit insurance, that immediately gets activated. When it comes to the systemic upheaval, we saw in 2008, regulators are unlikely to entrust counterparty risk to private and often anonymous counterparties. Just recall the recent death of the CEO of a Canadian cybercurrency exchange, taking to the grave the password controlling about $190 million of customer crypto deposits.
In order for the future to bring mass adoption of stablecoin, it needs strengthened regulations to better protect cryptocurrency investors through increased transparency and confidence. While the SEC is still weighing its response, the ECB seems to be saying that stablecoins, at this juncture, may be a hammer in want of a nail. In practice, non-governmental stablecoins may not be able to compete with legacy currencies on a level playing field because of the enormous costs involved in complying with existing regulation. It's now up to the disrupters to show how they can make it happen and still stay within the existing rules.