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August 16, 2022

Stablecoin regulation; Tornado Cash

Welcome to Swarm Markets’ media memo. This weekly update provides comments from Swarm Markets’ co-founders, Philipp Pieper and Timo Lehes, on key industry news that has caught our eye, plus our own developments. 

Comments available on the following news items:

  • Stablecoin regulation will make DeFi indispensable to TradFi
  • Tornado Cash arrest shows reach of global regulators

Stablecoin regulation will make it indispensable to TradFi

Decentralised infrastructure should be put to work in the context of TradFi to bring solutions to real world needs and problems. But only through regulation is that achievable. 

It’s essential that we get clarity on the status of stablecoins. Stablecoins are constructed to replicate the trust that already exists for currencies. You don’t want to suddenly introduce other risks that the user might not understand or be willing to tolerate.

The quicker we get to a place where users can have trust in the stablecoin market and infrastructure, and rely on it to build their processes and projects, the quicker that blockchain is going to move away from speculative crypto markets and trading. Knee-jerk reactions to some issues, such as systemic risk, consumer protection and contagion between the two, can have secondary effects that we didn’t want or anticipate.  

There is also a risk from a monetary policy perspective, which is one of the main thrusts for the EU to look at MiCa and stablecoin regulation. There is a desire from regulators to retain control over the money supply. If you create different currency reference values, then you’re creating new assets that have different collateralisation mechanisms. 

There are inflationary risks, and risks to the effectiveness of monetary policy, when the value of the stablecoin outweighs the value of the fiat currency it is pegged with. Stablecoins, if big enough, could begin to have an influence on the supply and demand of a currency.

As a starting point, regulators should look at the collateralisation of stablecoins – how are they backed? Banks have fractional reserves on their balance sheets, and stablecoins should be held to the same standards. That being said, those banks don’t have to hold 100% of consumer monetary claims as reserves.

Regulators need to decide if stablecoins are going to be regulated like banks, what is the threshold for their collateral? If not 1:1 then what? Further, what is the composition of assets that is acceptable? What kind of transparency for that is necessary? Who audits and reports on it? Globally speaking, we don’t have full clarity on where that should be. The sector needs clear policy goals and direction as soon as possible.

Stablecoins are needed for TradFi’s adoption of DeFi. DeFi is in ‘trial mode’ at the moment – playing with this infrastructure but doing so using crypto assets. 

The benefit of DeFi will bring about a system that allows users to hold their instruments, all of them, in one place without the use of intermediaries or middlemen. It will feel and smell like a traditional brokerage account, but it will all be underpinned by DeFi infrastructure and facilitated by stablecoins. For this to happen, the virtualisation of cash is essential. Trustworthy, regulated stablecoins will be critical to this.

The Tornado cash debacle show regulatory enforcement is becoming a reality

Regulatory enforcement – on a global level – is becoming a reality for the DeFi space. The arrest of a person allegedly involved with Tornado Cash, a crypto mixer service, is evidence that regulatory authorities and enforcement institutions are beginning to coalesce and cooperate. 

Tornado Cash flouted an array of financial regulations which led to the arrest, and had links to nefarious groups such as North Korean hackers. But while the service was proscribed in the US last month by the Treasury Department, it fell to Dutch authorities to track down one of the developers.

Tornado Cash sanctioned by the Department of Treasury’s OFAC list is remarkable, as the first piece of code—not a person—to be sanctioned. It is the latest event to provide impetus for developers and entrepreneurs to work with lawmakers on a regulatory framework for DeFi, and demonstrates the reach that regulators have, even into decentralized infrastructure. 

There is a clear global, coordinated approach developing and this is no bad thing. The time has come for DeFi service providers to adopt financial regulations in key regions and to cooperate fully with law enforcement when needed. Robust, transparent architecture is key to providing a trustworthy and safe platform for users and investors. 

Regulatory approval will serve to give confidence back to the DeFi sector at a critical time in its progression. Institutional players continue to adopt, invest and include DeFi in their future planning, but the transition toward that unified future will only proceed once the sector engages with regulation in a positive way.