There’s a lot packed into this title. What is on-chain? What is decentralized? What is the aim of regulation? Let’s unpack a bit, and remind ourselves that on the “how to regulate stablecoins” page the regulatory angle was argued to be around two parts:
- KYC and AML for transfers during the minting and redemption process
- Transparency requirements inspired by money market funds
On-chain implies that all the actions needed to offer a stablecoin is done on the blockchain where they run. If traditional fiat currency is used as collateral, this immediately breaks down, as this is off-chain. This still breaks down if other fiat backed stablecoins are used as collateral, as these come with off-chain risk. If some future CBDC is used as collateral, maybe, assuming this is offered fully on-chain, but this is unlikely as central banks will want to maintain their influence. Only on-chain cryptocurrencies fulfill this role currently.
Decentralized implies that this is a stablecoin run through the use of smart contracts deployed to the blockchain. All the logic is done through source code that is run in the open. But what if there are administrators involved? People who push parameter updates, to for example control interest rates on collateral used for minting? Is that centralized? We don’t have a clear picture on the interpretation of this.
We can imagine fully autonomous smart contracts to maintain this complete decentralized nature, with no administrator or special privilege role. But, what if a fully decentralized smart contract with on-chain collateral is used to provided a stablecoin pegged to the dollar? While there’s no actual fiat involved, an no traditional finance or banking connection needed, regulators would claim their role is around providing consumer or investor protection, helping maintain orderly markets. A highly utilized, fully decentralized stablecoin with on-chain assets would in that case still attract their attention. It probably doesn’t even matter if the stablecoin offers a stable value (compared to more volatile assets) not being pegged to a particular fiat currency, if its use represent a big enough impact to traditional markets.
If the aim of regulation is to ensure operational alignment, then on-chain decentralized stablecoins could offer all the tools and insights required. If the aim of regulation is to deny or limit access, then it doesn’t really matter how stablecoins are implemented. It is hard to imagine regulators, and authorities in general, letting stablecoins operate freely if they start having significant potential impact on their domains. But the interesting question is how they would regulate this, not if.
It is practically impossible to control, limit or deny what is done on-chain. Blockchains represent unstoppable systems, and there is no single point of failure available for attack or control. They are designed this way precisely to prohibit this outcome. And maybe you can argue what happens on-chain is outside the remit of these regulators. The more fruitful approach, for regulators and related entities, is to then approach the fiat on/off ramps (centralized exchanges), as these are the touch points.
This brings with it an interesting dynamic. Because the major public blockchains today are all open, with full transparency around their transactions, it could be argued that it is the responsibility of the exchanges to ensure they run sufficient analysis of this open system to capture irregularities and illegal activity. KYC, AML, and related monitoring is outsources to the centralized exchanges, much like a lot of this is today outsourced to the banks. And what we then have on-chain is a sandbox, with toys and tools, enabling a rapid, production grade, environment for experimentation, innovation and financial playfulness, with a controlled exposure to the rest of the financial systems.