Yesterday, the Chairman of the US central bank (FED), Jerome Powell, said he believes it is now necessary to regulate cryptocurrencies and stablecoins.
According to the FED, stablecoins need regulation
Yesterday marked a difficult day for the crypto markets as well, with the price of Bitcoin falling from $20,200 to $18,900. Although the descent occurred a few hours after Powell‘s words, thus not caused by these statements, it is possible that the Fed Chairman’s remarks contributed to the selling pressure.
Speaking at a panel discussion on digital finance hosted by Banque de France, Powell said that DeFi suffers from significant structural problems, but that this situation will not persist indefinitely. He added:
“There’s a real need for more appropriate regulation, so that as DeFi expands and starts to touch more retail customers and that sort of thing, so that appropriate regulation is in place.”
Given that the meeting of Banque de France, which is France’s central bank, was specifically about the new digital finance, Powell did not just talk about DeFi.
He also spoke about stablecoins, saying that in his view these also need regulation, particularly to ensure that they have sufficient reserves to match 1:1 redemptions.
He also added that the Fed is still deciding on whether to develop its own digital currency, but that they do not anticipate a decision on that for some time to come.
Thus the possible digital dollar seems momentarily shelved, while issues related to DeFi and stablecoins are topical.
After all, during 2022 the main problems to the crypto sector were caused precisely by stablecoins and DeFi, especially due to the implosion of the Terra ecosystem.
Curiously, but not coincidentally, Powell said nothing yesterday about whether to regulate the use of cryptocurrencies such as Bitcoin or Ethereum as means of payment, perhaps because he does not consider this an urgent issue.
In contrast, the “real need” to regulate DeFi that the Fed Chairman alluded to seems like an urgency, probably because the risk of other similar situations is considered possible.
Traditional finance is not completely free of these risks, but over the decades many laws and regulations have been issued that greatly limit such risks. In particular, efforts have been made to prevent investment offers being made in the market without knowing in advance who would be responsible in case of problems or failure.
Regulating DeFi will be a problem
In contrast, it is the opposite in DeFi, meaning that it is often difficult to really know who is behind a decentralized protocol that offers returns. Moreover, even in cases like Terra, where the identity of the founder was well known, it is not easy to know in advance what responsibilities those offering returns have before the law.
By now, probably even at the institutional level, the difference between payment tokens, such as BTC, and tokens that promise returns is beginning to emerge and be well understood. It is worth pointing out, however, that ETH has recently moved from payment tokens to tokens that allow returns by staking, so it has become borderline in this respect.
It certainly seems that the regulation Powell referred to does not address the common use of cryptocurrencies such as Bitcoin as means of payment at all, but instead has strictly to do with crypto investments that promise gains or returns. Bitcoin, on the other hand, promises nothing.
At this point, the focus shifts to how it will actually be decided to regulate these new types of investments, and especially what can actually and concretely be done, given that on decentralized P2P protocols it is very difficult for a state to intervene.
It is worth mentioning that in the US, as well as in the vast majority of developed states, it is illegal to offer investments in unregistered securities to retail customers. There are several cryptocurrencies that could fall under this definition, because the famous Howey test by which investment contracts, i.e., securities, are identified defines them as investments of money with a reasonable expectation of making a profit through the efforts of others.
Even those who entrust their ETH to the node operator in order for the operator to stake them could fall under this case of investing money for cash gains from the efforts of others.
This logic could also apply to a great many DeFi protocols that promise financial returns to those who simply deposit funds on a smart contract hoping that other users or the smart contract itself will bring them gains.
So the issue of regulating DeFi, but also staking, seems really critical to the future of the crypto industry, especially if a giant like the US were to decide to move in that direction.
The Fed does not seem to have the qualifications to legislate on the matter, while Congress seems intent on leaving control of the market to the SEC and CFTC, the former for securities, the latter for commodities. Cryptocurrencies such as Bitcoin fall under commodities, and apparently so does ETH, but for instance as far as staking is concerned, at this time it is still not entirely clear.
With regard to stablecoins, on the other hand, Powell only said that it would be necessary to mandate by law that they be 100% collateralized so that they would be exchangeable with the underlying at any time in a 1:1 ratio.
So with respect to stablecoins, the situation seems less complex and perhaps easier to regulate. Furthermore, to be frank, it seems that regulation along these lines could be positive only if it were limited to that.
Stablecoins without proper hedging, i.e., algorithmic ones, at this point could exist only as a result of the activity of truly decentralized smart contracts, i.e., those that do not involve there being an issuing entity in addition to the smart contract itself. A stablecoin such as UST, with the Luna Foundation Guard behind it run by a team of people, might no longer be in compliance with the law should it be set this way.
The eventual regulation of DeFi, on the other hand, would be much more difficult and complex, insomuch that frankly it seems that so far no one has yet attempted it. It is easy for Powell and the Fed to demand that it be regulated, because they are not the ones who have to do it.
It is up to the government to set the rules
In the US it will be up to the government or Congress to determine how, if at all, to regulate this complex apparatus made up often of smart contracts that are not operated by registered firms or people whose identities are known. Moreover, over the past few years many US politicians, as well as foreign ones, have shown that they still do not have a good understanding of how these new technologies really work, so it is rather rare to find politicians who are able to legislate in this regard.
One concrete attempt has already been made, namely the Responsible Financial Innovation Act by Senators Lummis and Gillibrand, but as good as Lummis and Gillibrand are in their knowledge of the crypto sector, it does not concern DeFi.
So regardless of Powell’s request, which denotes a certain urgency, at present, it is hard to imagine that the government or the US Congress could really take action on this issue any time soon. They might do so with regard to stablecoins, since US policy has been discussing for some time now the need to make them legally obligated to be covered, but with regard to DeFi they seem to be really up in the air.