Could Stablecoin Regulation Be a Signal for the End of DeFi?

Since the concept of decentralized finance (DeFi) became popular in the crypto space in 2020, many argue that the field is not really decentralized as the name suggests.

One of the “centralized” features of DeFi that should be mentioned is that much of its economic activity is based on stablecoins.

To get a clearer picture of how important these centralized stablecoins are to DeFi, more than half of Uniswap’s trading volume over the past 24 hours can be seen in the UDC-ETH trading pair. About 94% of assets borrowed on Compound are USDC, USDT or DAI (a derivative of USDC at this time).

While most projects intend to build more decentralized stablecoins, in reality USDC, USDT, BUSD, DAI and other major stablecoins are now backed by assets held in financial institutions. traditional. In other words, governments can outlaw a large portion of the DeFi economy with the mere introduction of regulation.

Fed has the latest comment

In DC Fintech Week Last week, US Federal Reserve (FED) Vice President of Supervisors Michael Barr made various comments on the crypto industry. He said that while he does not feel that Bitcoin or other digital currency assets have a positive future, he believes in the potential of stablecoins.

Mr. Barr’s view partly emphasizes the high securitization of this dollar-pegged crypto asset. Interesting in the context of DeFi is Barr’s view that stablecoin issuers may not be able to track who is using their crypto dollars.

“As banks explore different ways to harness the potential of technology, it is important to identify and assess the new risks inherent in those models and whether those risks can be overcome or not,” Barr said.

“For example, with some models being explored, a bank may not be able to track who is holding its encrypted liability or whether its tokens are being used in operations. risky or illegal activity or not. While technical solutions are underway to manage these risks, it remains an open question whether banks can enter into such arrangements in a manner consistent with secure banking. and sane and compliant with relevant laws.

To answer such open questions, any bank that wants to experiment with blockchain technology should only do so in a controlled and limited manner. As banks test, I invite them to engage with their regulators early and often to discuss the benefits and risks associated with these new use cases, ensuring they are a good fit. with banking activities being conducted in a safe, sound and legally permissible manner. “

In fact, this is not the first time the issue of stablecoin usage has been raised or alluded to by a regulator or government official. In September 2020, the US Office of the Comptroller of the Currency (OCC) provided guidance (PDF) for banks looking to provide support to stablecoin issuers.

However, the comments from the OCC specifically did not address the issue of stablecoins being held in a non-custodial manner. “We do not currently address the authority to support stablecoin transactions involving non-hosted wallets,” reads the manual.

Recently, the White House announced that the Treasury Department will complete its illicit financial risk assessment for the DeFi sector by February 2023. In the same announcement, the White House noted that the development of CBDCs – Central bank-issued digital currency can help effectively support economic sanctions imposed by the US.

This is especially interesting in light of the recent surge in stablecoin usage in Russia (according to data from blockchain analytics firm Chainalysis), when the country is under economic sanctions for invading Ukraine.

While there is still a lot of regulatory uncertainty when it comes to stablecoins today, the current best practice method used by analysts is to collect personal information from users who create or redeem stablecoins through transfers. bank account. This leaves room for stablecoins to be used by name on the blockchain, but it’s important to remember that Chainalysis is always on the watch and users are almost always required to identify themselves as they interact with the banking world. traditional.

What will affect DeFi?

There are currently no plans to implement stricter Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations for stablecoins in the United States. This situation has fueled stablecoin regulation over the past year.

In terms of the impact on DeFi, stronger regulations on stablecoins would be huge. The main selling point of various DeFi applications is the ability to transact, borrow, lend and perform other financial activities without transferring personal information. This has the obvious benefits of ease of use and can also improve privacy for end users, but those selling points disappear in situations where stablecoin users have to identify themselves.

While it is true that stablecoin holders can still keep their own keys in a more regulated environment, the reality is that these are still IOU tokens that a traditional bank retains value. real.

Users will also need to consider the extractable value of miners and publish their finances, now tied directly to their real-world identity, on a public blockchain. It might make sense for many DeFi users to revert to the traditional, centralized exchange model at the time.

“If stablecoin transactions are subject to the Travel Rule, then centralized stablecoins will essentially become PayPal,” Sovryn contributor Yago said when commented. “DeFi will likely split under such a scenario with some protocols becoming licensed and others becoming more censorship resistant. However, licensed ‘DeFi’ is not something everyone needs. “

The Travel Rule that Yago refers to is the guidance of the Financial Action Task Force (FATF), the intergovernmental organization that fights money laundering. By following the Travel Rule, FATF says virtual asset service providers can help block terrorist financing, stop payments to entities subject to sanctions, and allow law enforcement to subpoena claim transaction records, detect suspicious financial activity reports, and prevent money laundering in the crypto space.

Of course, stablecoin issuers like Tether still have a role to play for their dollar-pegged tokens in a situation where regulation hammers the field.

“As Tether customers now, we see that USDT will continue to be the most widely used stablecoin in the market as a stable and efficient way to transfer dollars globally,” said Tether CTO Paolo Ardoino commented when asked about the value proposition of USDT if stricter KYC and AML regulations were implemented.

In an exclusive chat with CryptoSlate, Ardonio commented:

“Tether has many different use cases, especially in developing countries like Argentina, Brazil, Turkey and others. It can easily be transferred between exchanges or people, instead of going through a bank. It is easy to buy and sell and is available where you buy the cryptocurrency (exchange). Tether is often used as a way to hold funds on exchanges when traders feel the market is extremely volatile, and it has also found utility in emerging markets where citizens work to make money. against inflation and in a bustling e-commerce ecosystem. “

Regarding the potential effects of tighter stablecoin regulation on DeFi, Ardoino specifically avoided the topic of DeFi and instead pointed to the potential growth benefits of clearer regulation in space:

“Stablecoin regulation will provide much-needed clarity for larger corporations, financial institutions, and fintech companies entering the crypto market,” Ardoino said.

“A more regulated and secure crypto ecosystem benefits everyone involved, and we envision that regulation opening the gates for more products to enter the market. In our view, the fact that stablecoin regulation has been a hot topic of discussion among regulators today since we invented the coin in 2014, is extremely interesting. as it further validates the utility of stablecoins. If anything goes wrong, regulations will send a message that stablecoins and digital currencies are here to maintain economic freedom. “

It is unclear whether the potential division of the DeFi space into regulated and unregulated environments will take place at the stablecoin layer or on the underlying blockchain. Notably, there have been concerns regarding Ethereum’s regulatory grasp since the completion of the move to proof of stake (PoW). Yago added: “Unless the global regulatory regime changes dramatically, centralized stablecoins will become increasingly “PayPalized.”

While DeFi won’t go away completely with tighter KYC and AML enforcement on stablecoins, it will obviously cause the sector to shrink from what it is now, as much of DeFi’s utility will be. was wiped out when stablecoin regulation was enacted.