Decentralization detour: Regulated stablecoins hit unregulated exchanges

Three firms, which arguably played a critical role in popularizing bitcoin and other cryptocurrencies for the masses are now launching regulated stablecoins. But unlike bitcoin, whose most important value proposition is arguably censorship resistance, regulated stablecoins released by Circle, Gemini and Paxos are actually quite the opposite. If a user fails to pass know-your-customer requirements or if the stablecoins are simply suspected of being involved in illegal activity, they can be frozen, seized, forfeited or destroyed -- by the very governments bitcoin was built to work around.

Stablecoins are practical for traders that want to temporarily avoid price fluctuations or hedge against volatility. But volatility of cryptocurrencies has also introduced a bottleneck in the adoption of decentralized financial applications, especially in lending. There are many bitcoin and ether lending platforms but none have been able to accumulate a large user base, perhaps because of the uncertain environment for both the lender and the borrower.

Before the beginning of this year, there weren't many alternatives to Tether, an unregulated fiat-backed stablecoin that shares the same operators as Bitfinex. Even now, Tether records about 98% of all the stablecoin volumes and accounts for approximately 92% of all stablecoins in circulation. But as volatility of cryptocurrencies soared and Tether continued to raise doubts whether it actually holds the corresponding reserves, a whole bunch of new stablecoins started popping up. In fact, according to The Block’s findings, companies planning to launch a stablecoin raised more than $330M in venture capital. [related id=1]

On its website, Tether claims that the USD reserves are “subject to frequent professional audits." But details are mixed. In January, Tether dissolved its relationship with audit firm Friedman LLP and in July, Tether released a report by a law firm Freeh, Sporkin & Sullivan LLP attesting to USD reserves held on just a single day. Stuart Hoegner, Tether’s general counsel told Bloomberg: “The bottom line is an audit cannot be obtained. The big four firms are anathema to that level of risk.”

In the past month, three companies that are already regulated by New York Department of Financial Services (NYDFS) rushed to market to release their own regulated fiat-backed stablecoins - USD//Coin (USDC) by CENTRE and Circle; Gemini dollar by Gemini; and Paxos Standard by Paxos, operator of the itBit exchange. Unlike Tether, all three stablecoins didn’t have any problems with finding auditors to release monthly attestations from Grant Thornton, BPM and Withum (see the table below).

Tether and TrueUSD are registered with the Financial Crimes Enforcement Network, known as FinCEN, as an MSB. Circle is a registered MSB as well but also holds licenses in all states where they are required.  Thus far USDC has not been authorized by NYDFS. In September, New York did greenlight Gemini and Paxos to offer fiat-backed stablecoins. The approval was based on several requirements including:

• the stablecoin is fully exchangeable for USD
• Bank Secrecy Act, anti-money laundering, and Office of Foreign Assets Control controls to prevent criminal activity and terrorist financing
• risk-based controls to prevent illegal activity and market manipulation
• transaction monitoring and compliance with cybersecurity regulations

NYDFS also required Paxos and Gemini to warn its customers that their stablecoins may be frozen, seized, forfeited or destroyed if:

• the stablecoin has been or is being used for illegal activity
• there is a legal order or other legal process from a law enforcement agency

If Gemini or Paxos fail to comply with these requirements, the New York approval would be revoked. Therefore any regulated stablecoin will never be censorship-resistant. They will, however, provide nearly real-time global settlement as well as the ability to implement them in decentralized applications. Regulated stablecoins are also very useful for exchanges that don’t have banking because they make it possible to offload the legal and compliance responsibilities of fiat on ramps onto the third party.

Even though Binance is in the process of getting banking in Malta, it recently started listing Paxos Standard. Similarly, HitBTC implemented the Gemini dollar. Listing regulated stablecoins also gives exchanges a much larger reach than implementing their own banking. Binance CEO Changpeng "CZ" Zhao said: “Regulated stablecoins serve as a perfect middle ground where regulators maintain a large degree of control, but the currency also offers far more freedom than traditional fiat for users.”

While Paxos Standard and Gemini dollar are nearly identical in execution (apart from different auditors and banking partners), USDC uses a different governance model. CENTRE is a governed network and consortium, which lets any institution that satisfies the requirements to join and issue USDC as well. Circle, which acquired Poloniex in February, is the first of several members to launch USDC issuance. Other potential issuers are incentivized by earning fees. CIRCLE’s goal is to create a decentralized issuance model, which doesn’t rely on just one institution like Paxos and Gemini.

Two other regulated fiat-backed stablecoins are expected to hit the market in 2018 -- Stronghold USD, which will be launched in collaboration with IBM and will run on Stellar, and StableUSD, which will be available on both Ethereum and Stellar and support other blockchains in the future.

Update: This article has been updated to include the fact that Tether is registered with FinCEN (MSB #31000133402950).