Governments are warily watching the growth of stablecoins, a form of digital asset with the potential to replace national currencies. How they are regulated may provide valuable pointers about possible future treatment of the wider cryptocurrency space, says NZS Capital co-founder and investor Brad Slingerlend.

Bitcoin and other cryptocurrencies fell in value after the People’s Bank of China re-iterated on 22nd September that all activities related to them, such as mining, trading, token issuance and payments, are illegal.

But there wasn’t much new in the announcement, which largely reinforced China’s years long resistance to cryptocurrencies, based on a perception that they can harm national security, along with social and financial stability.

Of more concern could be the potential for US regulators to introduce rules that stifle innovation and growth in the space. At her confirmation hearing in February, US Treasury Secretary Janet Yellen urged lawmakers to “curtail” the use of cryptocurrencies over concern that they are “mainly” used for illegal activities.

“We need to make sure that our methods for dealing with these matters, with terrorist financing, change along with changing technology,” Yellen said.¹

“Cryptocurrencies are a particular concern. I think many are used — at least in a transaction sense — mainly for illicit financing.

“We really need to examine ways in which we can curtail their use and make sure that money laundering doesn’t occur through those channels.”

One reason for concern is that ransomware attackers often demand payment in cryptocurrencies. But research by blockchain software provider Chainalysis ² found that, while ransomware accounted for 7% of all funds received by criminal addresses in 2020 – a 311% increase from the prior year to a value of almost $350 million worth of cryptocurrency – overall, the illicit share of all cryptocurrency activity last year was just 0.34%, or $10 billion in transaction volume, down from about 2.1% or $21.4 billion worth of transfers in 2019. Total cryptocurrency assets are estimated to be about $2 trillion.

Which suggests Yellen’s worries are overblown. Yet it is the kind of rhetoric that lawmakers are increasing using in an effort to justify greater oversight of the sector. A key target appears to be stablecoins, which peg their value at par to a currency such as the US dollar in a bid to avoid the volatility that characterizes cryptocurrencies such as bitcoin.

On one level, regulatory scrutiny is surprising, since it tends to significantly lag innovation. Take for example Google, Amazon and Facebook. It wasn’t until they achieved global dominance that governments in developed markets began to carp about their power and influence. This is typically how it goes – innovators create a “tech tornado” and governments, initially seized by a kind of paralysis, eventually emerge from their nap and set about ramping up oversight.

But compared with the mega platforms, stablecoins are insignificant – indeed, for many readers this may be the first time they’ve even heard the term. While stablecoin issuance has surged about four times in 2021, it’s only about $125 billion³ ,according to Coin Metrics and The Block.

So why are governments so concerned? Unlike the big platforms, which primarily exert power over consumers, stablecoins have the potential to limit, or even eliminate, governmental control over money supply.

According to the Institute of Electrical and Electronic Engineers ⁴, 86% of central banks globally are exploring the possibility of introducing digital currencies. Motivators include keeping a currency’s reserve status and tackling money laundering, tax avoidance and other financial shenanigans.

Digital sovereign currencies could also make it easier to implement deeply negative interest-rate policies. Negative rates drive asset prices up and incentivize hoarding physical money (which isn’t subject to rate deductions). So if cash gives way to digital currency, deeply negative rates could motivate people to invest, pushing asset prices up still further, which could exacerbate wealth inequality.

So policymakers are fretful that stablecoins such as Tether and USDC could one day effectively replace national currencies, and when there is a government power grab to be had, the competing alternatives are likely to face regulation, or even be declared illegal. So, right on schedule, US President Joe Biden’s administration has signalled that stablecoins such as Facebook’s Diem could “undermine the stability of the financial system.” ⁵

The argument is that assets that back stablecoins may not always be cash equivalents such as US Treasuries. If reserves take the form of preferred stock, loans, commercial paper, real estate or other less liquid assets, regulators argue issuers may not be able to redeem those securities quickly during a period of turmoil.

Governments therefore want to ensure that issuers hold enough liquid assets to reflect the value of the currency they have in circulation, while having robust and secure networks to handle a surge in transactions from customers seeking to cash out.

This level of regulation would increase the risk of regulatory capture, which translates into significantly higher costs for issuers, favouring established players over newcomers. Overreach could therefore lead to the creation of a powerful digital currency in an emerging market.

As Facebook’s head of payments David Marcus said on a recent Protocol interview: “If the U.S. misses the boat on innovation, and talent and companies flee to other jurisdictions that have more innovation-friendly environments, and with clearer regulation, we have a lot to lose.

“I’m hopeful that we land in a good place soon, and that we can stay in a leadership position in what is undoubtedly going to be one of the greatest areas of innovation in the next decade.”

Investors with an interest in digital assets should therefore watch how scrutiny of stablecoins develops for potentially valuable clues about the direction oversight might take in the wider cryptocurrency market.

Brad Slingerlend is co-founder and an investor at Denver-based NZS Capital, which manages more than $1 billion in assets and focuses on innovative companies that create more value for all their constituents – including investors, employees, vendors, the communities they operate in and the planet as a whole – than they take for themselves. NZS Capital has a strategic partnership with Jupiter Asset Management.

¹ US Treasury Secretary nominee Janet Yellen attacks cryptocurrencies | Currency.com
² https://go.chainalysis.com/rs/503-FAP-074/images/Chainalysis-Crypto-Crime-2021.pdf
³ https://www.theblockcrypto.com/data/decentralized-finance/stablecoins
⁴ Digital Currency and Trade Systems Are Tearing up the Rules (ieee.org)
⁵ Facebook, Biden officials poised for clash on cryptocurrency – The Washington Post