Stablecoins: Why we need to bring traditional finance to crypto


Antique photograph: Bank of England, London

In the fast-moving world of crypto, there is always the latest thing. Over the past 18 months, we have seen the proliferation of stablecoins: tokens that are pegged to and backed by assets, like a fiat currency, gold, or other types including those where an algorithm regulates the supply of the token based on demand. There are over 50 projects in late development or live, with many more on their way, and you may have heard of some of the most prominent of those; the likes of Tether, the Winklevoss twins’ Gemini dollar, MakerDAO, and Circle’s USD Coin.

Let’s just recap the fundamental question around Stablecoins: why are they useful? Stablecoins are a reaction to the fluctuations and volatility we see in cryptocurrencies with the benefits of cryptocurrency and blockchain. They offer investors – and users – the prospect of a safe haven when markets are volatile. I.e. if someone does not want to hold their wealth in fiat currency, and wants to stay within the crypto ecosystem, but needs more price stability, a stablecoin can be useful. They also offer a quick way to enter or exit highly volatile assets. Crucially, these tokens offer access to the crypto ecosystem built on the stability and endurance of the existing financial system.

And often, to help guarantee stability, Stablecoins really are collateralised by another asset or coin. I.e., as an investor, you might get $100 of a stablecoin in return for $200 of ether (or just $200). The idea here is to mimic full-reserve banking, where an institution holds the equivalent to what it lends, meaning you could never have a run on a bank, because those depositing their money could withdraw at any time.

But here, we are using words not usually associated with currencies, but with financial instruments – ‘tracked’, ‘collateralised’. What is a stablecoin, really, and why could they be valuable? The intention is for them to be currencies, yet, to date, they have been conceived of, built and used like financial instruments. It is vital that we find an answer to this question, because as long as it is unanswered, stablecoins cannot be effectively regulated. And, if they are not appropriately regulated, investors, the wider crypto community and the traditional banking sector are either going to steer clear, or fall foul.

When talking about stablecoins, it is worth recalling the hype around Initial Coin Offerings (ICOs) last year. The crypto world needs to be very careful around over-egging products and services, because doing so usually results in damage to the consumer (last year, $6bn was lost to failed ICOs). And it is not difficult to imagine the scope for bad actors: using stablecoins like a deposit-taking mechanism, or even in a ponzi scheme fashion.

Instead, we must return to the same questions we apply across the financial system: who is the operator, and how do they operate? While the community, and world more widely, thrashes out an answer to what constitutes a stablecoin, I would like to suggest a framework investors and users could follow when approaching this unregulated space.

First, have a look at the team behind the project. Who are they? What experience do they bring to the table? Big names and financial institutions are green flags.

Second, what country are they operating from, are they registered, and are they operating under a licence? Is that licence connected to them, or are they working through a third party? Third parties should not automatically set off alarm bells, but make sure you’ve bottomed out the chain of responsibility.

Third, how does the project talk about regulation and responsibility? Do they adhere to certain frameworks and standards of their own volition? What industry bodies are they part of? Fourth, what does their literature say around the offering itself? If the project is promising 1:1 parity, how is that being achieved? Can you ensure it’s true? What customer protections do they offer? Fifth, who do they work with? What payment processors do they use, for example? Digging into their banking relationships is crucial: how does custody work, and are they insured? Finally, are there signs that anti-money laundering checks and other compliance measures are in place? These checks should be required alongside a licence, so make sure they are mentioned.

There are standard-setters in this emerging market. The Bank of Tokyo-Mitsubishi UFJ, the banking arm of MUFG, is reportedly looking to trial its in-house cryptocurrency next year. This is a project the bank has been working on for years. They have taken their time to create a token that will allow their 100,000 retail banking customers to do things like make payments at restaurants and shops in MUFG coins, where each coin will be equivalent to and redeemable for one yen.

Well-executed and delivered stablecoins will make a huge difference to consumers. Cross-border transactions, P2P and micro-payments will suddenly be far easier, and cheaper. But while we should expect regulators and governments to continue looking closely at stablecoins and, in time, for a smart regulatory regime to hopefully emerge, in the meantime, the onus falls on individuals to make smart decisions around which stablecoins to invest in, and then use.

I expect that the winners in the market will be large financial incumbents who take time self-regulating and putting the consumer front and centre. These organisations must now put their efforts into building and using the right infrastructure, and developing robust levels of trust across the board, from their banking relationships to their compliance. This will determine how well they maintain their peg amid economic difficulty – as well as the ability to explore further use cases, specific areas of utility, and broader adoption.

Moreover, it is these emerging examples that will pave the way to regulation that can capture the mercurial nature of these tokens. To my mind, we will likely see different rules for different stablecoins. A stablecoin pegged to the Nasdaq should be treated like a tracker fund; one that is backed by local community assets could come under social enterprise or localism legislation. If a company is issuing a stablecoin and deposit-taking in order to back that coin, it needs to be treated like a bank.

While many of us are excited to see how things play out, we know that hype and over-excitement does not pan out well in this space. Time and care need to be taken, for the sake of the consumer, and the sake of the future of the crypto space.

 



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