The problem with regulating stablecoin issuers like banks

One of my recent posts discussed the Report on Stablecoins published in November 2021 by the President’s Working Group on Financial Markets (PWG). While I fully supported the principle that similar types of economic activities should be subject to equivalent forms of regulation in order to avoid regulatory arbitrage, I also wrote that it was not obvious to me that bank regulation is the right answer for payment stablecoin issuance.

This speech by Governor Waller of the Fed neatly expresses one of the key problems with the recommendation that stablecoin issuance be restricted to depositary institutions (aka private banks). To be honest I was actually quite surprised the PWG arrived at this recommendation given the obvious implication that it would benefit the bank incumbents and impede innovation in the ways in which US consumers can access money payment services

“However, I disagree with the notion that stablecoin issuance can or should only be conducted by banks, simply because of the nature of the liability. I understand the attraction of forcing a new product into an old, familiar structure. But that approach and mindset would eliminate a key benefit of a stablecoin arrangement—that it serves as a viable competitor to banking organizations in their role as payment providers. The Federal Reserve and the Congress have long recognized the value in a vibrant, diverse payment system, which benefits from private-sector innovation. That innovation can come from outside the banking sector, and we should not be surprised when it crops up in a commercial context, particularly in Silicon Valley. When it does, we should give those innovations the chance to compete with other systems and providers—including banks—on a clear and level playing field”

“Reflections on stablecoins and Payments Innovations”, Governor Christopher J Waller, 17 November 2021

The future of payment stablecoins is, I believe, a regulated one but I suspect that the specific path of regulation proposed by the PWG Report recommendations will (and should) face a lot of pushback given its implications for competition and innovation in the financial payment rails that support economic activity.

I don’t agree with everything that Governor Waller argues in his speech. I am less convinced than he, for example, that anti trust regulation as it stands offers sufficient protection against big tech companies operating in this space using customer data in ways that are not fully aligned with the customers’ interests. That said, his core argument that preserving the capacity for competition and financial innovation in order to keep the incumbents honest and responsive to customer interests is fundamental to the long term health of the financial system rings very true to me.

For anyone interested in the question of why the United States appears to be lagging other countries in developing its payments infrastructure, I can recommend a paper by Catalini and Lilley (2021) that I linked to in this post. This post by JP Koning discussing what other countries (including Australia) have achieved with fast payment system initiatives also gives a useful sense of what is being done to enhance the existing infrastructure when the system is open to change.

Tony – From the Outside

Self regulation in DeFi

This article in Wired offers a useful summary of how some motivated individuals are attempting to use the transparency of the system to control bad actors.

It is short and worth reading in conjunction with this paper titled “Statement on DeFi Risks, Regulations, and Opportunities Commissioner Caroline A. Crenshaw that sets out a US regulator’s perspective on the question of how DeFi should be regulated. This extract from the paper covers the main thrust of her argument in favours of formal regulation

While DeFi has produced impressive alternative methods of composing, recording, and processing transactions, it has not rewritten all of economics or human nature. Certain truths apply with as much force in DeFi as they do in traditional finance:

– Unless required, there will be projects that do not invest in compliance or adequate internal controls;

– when the potential financial rewards are great enough, some individuals will victimize others, and the likelihood of this occurring tends to increase as the likelihood of getting caught and severity of potential sanctions decrease; and

– absent mandatory disclosure requirements,[10] information asymmetries will likely advantage rich investors and insiders at the expense of the smallest investors and those with the least access to information.

Accordingly, DeFi participants’ current “buyer beware” approach is not an adequate foundation on which to build reimagined financial markets. Without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries. Over time that reduces investor confidence and investor participation.

Conversely, well-regulated markets tend to flourish

“Statement of DeFi Risks, Regulations and Opportunities” by Commissioner Caroline A Crenshaw, The International Journal of Blockchain Law, Vol. 1, Nov. 2021.

Tony – From the Outside