Imagine the following scenario: sometime in 2021, financial regulators declare that all stable coin owners need to be screened. What would happen to the cryptocurrency ecosystem?
Right now, much of the stablecoin usage is pseudonymous. That means you or I can keep Tether or USD coin stablecoins worth $ 20,000 in a non-hosted wallet (i.e. not on an exchange) without having to tell our identity to either Tether or Circle, the managers of these stablecoin platforms . We can send that $ 20,000 to other users who can pass the coins on, who in turn can pass them on and no one along this chain has to reveal themselves.
JP Koning, a CoinDesk columnist, worked as a stock researcher for a Canadian brokerage firm and as a financial writer for a major Canadian bank. He runs the popular moneyness blog.
The only point at which stablecoin users have to undergo a Tether or Circle Know-Your-Customer (KYC) process is to redeem stablecoins directly for traditional bank dollars. Or vice versa, to deposit dollars at Tether or Circle and receive freshly minted stable coins.
In a world where traditional non-blockchain financial institutions like PayPal, Chase, and Cell link all payments with names and addresses, stablecoin networks have become a rare privacy dig for digital payments. This has led to some pretty exotic uses for stablecoin.
In Moscow, Chinese clothing retailers are trading cash for cable in the gray market to repay profits, writes Anna Baydakova from CoinDesk. Ukrainian companies importing from Turkey use Tether to bypass exchange controls and a multi-million dollar Ponzi scheme relied on the Paxos Standard (PAX) for payments. In the world of decentralized finance (DeFi), unidentifiable computer programs conduct unregulated financial transactions running into billions of dollars in USD coins and other stable coins.
But will regulators allow this privacy gap to persist? What if, right now, officials from the Financial Crimes Enforcement Network (FinCEN), the Treasury Department’s money laundering watchdog, are planning how to contain stablecoin’s pseudonymity?
See also: What Are Stable Coins?
Let me speculate on what a possible reveal might look like.
FinCEN could now stipulate that everyone who wants to access Tether, USD coins or other official stablecoin (TrueUSD, Paxos-Standard, Gemini-Dollar, Binance USD, HUSD) must apply for a verified stablecoin account. This would mean providing photo ID, proof of address, and other information to Tether, Circle, or other issuers.
For many existing stable coin owners, this won’t be a big deal. Professional arbitrageurs who use stablecoins to move values from one central exchange to another are likely already KYC-enabled. And private customers who keep their stablecoins on an exchange like Binance would not see any changes because the exchange is already verifying their identity anyway.
Given that each transmission would have to have names and addresses associated with it, a revelation would certainly weigh on usage in the gray market like the Chinese traders in Moscow.
With stablecoins getting bigger by the day, regulators are unlikely to be able to ignore the problem of pseudonymity forever.
The issuers themselves would also be harassed. Building an infrastructure to collect and verify the identity of all users, not just the few who cash or deposit, is expensive. To recoup their costs, issuers like Tether and Circle may consider introducing fees. All of this could make stablecoins less accessible to people who only want to use them for occasional transfers.
In the world of DeFi, the effects of a stablecoin reveal were most felt. Real people who have stablecoins can be easily identified. In DeFi, however, stablecoins are often deposited in accounts that are controlled by autonomous code bits or intelligent contracts that have no underlying owner. It is not seen how a stable coin issuer can do KYC with a smart contract.
One of the most popular decentralized tools, Maker, holds $ 350 million worth of coins in various user-created vaults. This hoard of stable coins serves as security for dai, the decentralized stable coin from Maker. Another $ 130 million coin is in a smart contract for a manufacturer pen module. If all stable coin owners have to be identified, it is not clear who or which company would have to do a KYC check for this 130 million US dollar.
Another popular DeFi tool, Compound currently has $ 1.6 billion and $ 350 million worth of coins. Lenders can put their stablecoins in compound smart contracts and collect interest from borrowers who draw from the contracts.
Liquidity pools, smart contracts, which underlie decentralized exchanges like Uniswap and Curve, also contain large amounts of stable coins. Curve liquidity pools currently contain $ 1.25 billion worth of USD coins and $ 450 million worth of cables.
See also: JP Koning – What tether means when it says it’s “regulated”
In the strictest scenario, stablecoin issuers may be required to cut off any company that cannot provide a verified name or address. This means that Smart Curve, Maker and Compound contracts cannot get stable coins.
Given the ecosystem’s reliance on stable coins, this would almost break. Compound, Curve and Uniswap could try to adapt by replacing FinCEN-compliant stablecoins such as USD coins with decentralized ones, such as Maker’s Dai stablecoin. Since decentralized stable coins are not based on traditional banks, they are less committed to the FinCEN dictate.
But remember, Maker relies on USD coin collateral to add stability to the day. When makers like Compound and Curve can no longer hold USD coins, dai itself becomes less stable. And so the usability of Compound and other protocols based on dai would suffer.
If we imagine a more cautious scenario, FinCEN could allow for a smart contract exemption. As long as stablecoins are held in a smart contract rather than an externally controlled account, FinCEN would enable the stablecoin issuer to provide financial services for the smart contract. Much of DeFi could continue as before.
However, this option leaves a pretty big loophole for bad actors. The whole reason platforms need to verify accounts is to prevent them from moving illicit funds. If stablecoins held in smart contracts are exempted from KYC obligations, entrepreneurial individuals will move stablecoins to the smart contract layer, stimulating FinCEN controls.
See also: Questions about tether just don’t go away. Is the crypto market interested?
A mid-of-the-road scenario is for FinCEN to exempt smart contracts from stablecoin KYC, but only if the smart contract itself verifies the identity of all addresses that interact with the contract. In this case, Curve would need to set up a customer due diligence program to qualify for the use of stablecoins. The manufacturer would have to check all vault owners.
In this scenario we can imagine that DeFi is split into two parts. Purely decentralized protocols would avoid stable coins entirely to avoid exposing their users to KYC. Not-so-decentralized funding would start scrutinizing users to maintain access to stable coins.
There are many other possible scenarios. As you can see, this is a complex problem. If FinCEN is actually investigating the question of stablecoin’s pseudonymity, I don’t want to be the official trying to come up with an adequate answer. Too strict and DeFi may stop working. Too easy and DeFi will continue to pose a threat to money laundering.
But the clock is ticking. The combination of tether, USD coin, Paxos standard, Binance USD, TrueUSD, dai and HUSD regularly outperforms Bitcoin in terms of chain volume. In January 2021, these stablecoins were processing $ 308 billion worth of transactions, compared to $ 297 billion for Bitcoin. With stablecoins getting bigger by the day, regulators are unlikely to be able to ignore the problem of pseudonymity forever.
