How to regulate stablecoins
When trading cryptocurrencies the process typically starts with exchanging these from fiat currencies. While there are OTC P2P options available, also for individuals, the convenient approach is to do this through a centralized exchange with traditional banking connections. An exchange with traditional banking connections will need to have sufficient KYC and AML procedures in place for the local market it is serving, otherwise its partnering banks might also get in trouble.
The same will also apply for stablecoins, during their minting and redemption process. Hence, if you do, and the stablecoin you’re interacting with is a centralized fiat backed stablecoin, you’ll need to involve traditional bank transfers as part of this. It then makes sense to expect these stablecoins to follow the same KYC and AML procedures as when using a centralized exchange.
The wast majority of stablecoin users never directly themselves mint or redeem these for the underlying, instead only trading these on secondary markets. What sort of regulation should we expect on secondary markets? This is not clear, and we also need to keep in mind the decentralized nature of blockchains. While centralized exchanges and centralized stablecoins have connections to the traditional finance system, decentralized exchanges and decentralized stablecoins do not.
For decentralized operations, we find smart contracts, with whom anyone can interact according to the logic of the stablecoin. Note that some of these decentralized options do have active administrators, i.e., organizations or other entities, helping to manage some part of the day to day functioning of these. Does that make them less decentralized? Others might be fully decentralized with no administrator functionality at all.
The above is pointing towards a complex regulatory picture. Rushing in regulation on an evolving landscape without a clear understanding might not be helpful. But doing nothing is also not helpful if blockchains, cryptocurrencies, DeFi, and stablecoins are to participate in the broader financial world.
It’s also very beneficial to anyone wanting to use stablecoins to understand completely what is the underlying asset. As a derivative, the value of the stablecoin is predominantly driven by its underlying. If there’s no clarity on what is backing a stablecoin, how can you be sure it’s worth what it claims? This is where we can likely find much regulatory inspiration from money market funds. There’s no good excuse, as a centralized stablecoin operator, to not want full transparency on its underlying.
If regulators are to enforce such transparency, decentralized stablecoins with on-chain collateral could be seen as the perfect end goal, as these give full insight into their current state on a block by block basis. Centralized stablecoins will likely struggle to match this, even with great eager and willingness, simply because on-chain transparency is absolute. The trade off is technical risk, as fully on-chain decentralized stablecoins often need to be far more complex from a smart contract coding point of view. Should regulators then somehow enforce technical audits on smart contract code?
There are a lot of questions above, questions that aren’t yet fully answered. We can likely find existing regulatory frameworks around KYC and AML with regards to money transfers, and we’ll likely find much reuse in how money market funds are handled. Decentralization and smart contracts do bring novelty, and within these there’s a gradient at play with regards to how operationally contact free these are.