US Stablecoin Regulation Could Lead to Geopolitical Competition

Cryptocurrencies were created to become an independent financial system to counter the monopoly of nation-states. Trends such as decentralized finance (DeFi) have emerged as robust new offshoots to an industry that, until only two years ago, mainly offered only trading, investing and transacting. There are now a range of utilities around payments, digitally native financial services and financial inclusion that are moving from the abstract to very real in the crypto space. With the current fiat system of currency, underpinned by the Federal Reserve and the United States dollar, cryptocurrencies have started to separate state and money.

However, recent regulatory developments could push stablecoins closer to the existing fiat system, unleashing a competition among countries for control over a lifeblood of the crypto industry.

The current market cap of stablecoins has surpassed $108 billion as of July, representing ~7% of the total cryptocurrency market cap. Stablecoin providers are going beyond the utility of cryptocurrency trading. Their main benefits – namely, faster transaction speed, borderless payments, generally lower fees and eventually programmable money – already enable a multitude of other use cases today: remittances, micropayments, commercial payments, bank deposits and withdrawals, payroll, escrow, store of value, settlement, lending, wealth management, foreign exchange trading and powering decentralized applications. Being central to the development of DeFi, reserve-backed stablecoins such as tether and USDC currently dominate in most decentralized exchange (DEX) trading pairs and lending markets. Besides DEXs, lending platforms and other DeFi applications rely on stablecoins like dai and USDC to mitigate volatility in crypto markets and attract more investors. 

The significance that stablecoins hold in the crypto economy cannot be underscored enough. If some stablecoin investments begin to lose their financial stability or value, that could cause considerable damage to the greater cryptocurrency market. We don't know if stablecoins would be able to liquidate enough investments rapidly to meet the unfavorable demand if a big group of stablecoin holders suddenly wanted to sell their tokens. A sudden lack of faith in stablecoins and issuers could cause the cryptocurrency market to experience a catastrophic liquidity shock.

Regulatory activity around stablecoins has intensified. In 2020, the Financial Action Task Force (FATF) said stablecoins share the same potential money laundering and terrorist financing risks as other cryptocurrencies and called for revised AML/CFT standards. Later in 2020, the STABLE Act was introduced in the U.S. Congress, requiring stablecoin issuers and institutions to become licensed members of the Federal Reserve system and follow the appropriate banking regulations. The President’s Working Group on Financial Markets (PWG) also met this month to discuss stablecoins – including their recent rapid growth, potential uses as a form of payment, and potential risks to end-users, the financial system, and U.S. national security, culminating with Treasury secretary Janet Yellen urging regulators to “act quickly” on regulating stablecoins.

The policy measures being considered for such regulation will bring stablecoins firmly under the monetary control of the Federal Reserve. Earlier this month, the Federal Reserve co-authored a paper with Yale University proposing two major ways to regulate stablecoins. The first was to convert them into the equivalent of public money by either issuing them via FDIC-insured U.S. banks or backing them 1:1 with U.S. Treasury bonds. This is a similar system of oversight as with U.S. bank deposits. The other alternative suggested in the paper was to introduce an American central bank digital currency and taxing stablecoins, so called “private money” out of existence. This could essentially make a government-issued CBDC the de facto stablecoin of the cryptocurrency world. 

Both these measures constitute a de facto “dollarization” of the stablecoins, especially the non-algorithmic coins such as tether and USDC, which dominate the space. Although stablecoins have always been measured in dollars, pegging reserves and compliances to the Federal Reserve will effectively tie down these global instruments to U.S. monetary oversight. This could reduce the cryptocurrency ecosystem to a shadow of the global fiat system today. Algorithmic stablecoins and DeFi might stay out of the regulatory loop for sometime but not forever. Whether they will be able to earn the trust of the average retail consumer remains to be seen. The collapse in pegs of algorithmic coins such as fei and iron have created doubts in recent times.

Stablecoins might also not reduce to a monopoly of the Fed, if other countries retaliate. China, Russia and the European Union have all taken steps or voiced concerns to move past the dollar-dominant financial system. All three countries have also actively experimented with and regulated cryptocurrencies or built their own digital currency. It is very likely that if U.S.-bank or Treasurys-backed stablecoins emerge, these countries will issue stablecoins backed by their own currencies into the wider cryptocurrency market. Both CBDCs and private and public-private stablecoins denominated in different currencies could emerge as a counter to U.S.-centered regulation of stablecoins.

A critical component of the cryptocurrency ecosystem could, hence, either become a shadow of the existing system or a battleground of intense geopolitical currency wars. In either case, in remaining a pillar of an independent financial cryptocurrency-based system, stablecoins face a considerable challenge.