VIRTUAL CURRENCIES—CFTC advisory committee delves into stablecoins - 10 March 2020

Officials from two traditional banks as well as a DAO (decentralized autonomous organization) described their organizations’ stablecoins, including functioning, benefits, and regulatory oversight.

A recent meeting of the CFTC Technology Advisory Committee (TAC) took an in-depth look at the particular form of virtual currency known as "stablecoins." Chaired by Commissioner Brian Quintenz, who sponsors the TAC, the panel received an overview from an IMF official and heard from several groups with stablecoins currently in the works, including Paxos, JPMorgan, and MakerDAO.

What are stablecoins? Commissioner Quintenz gave the following definition of stablecoins:

A class of virtual currencies that seek to offer price stability against another asset, frequently by being "backed" by that asset in reserve, like fiat currency(ies) or certain physical commodities (e.g., precious metals). Stablecoins have the potential, through tokenization, to function as viable, liquid mediums of exchange and serve as powerful enablers of smart contracts.

Putting this in context, Tommaso Mancini-Griffoli, deputy division chief in the Monetary and Capital Markets Department at the International Monetary Fund (IMF), offered the use case of paying for a cup of coffee. If the coffee costs $1, the consumer wants to be able to pull out that amount to pay for it. In turn, vendors like to be paid a stable amount, because they don’t want to have to transfer what they receive immediately into another type of asset. Both consumers and vendors want a stable store of value.

A stable store of value has two facets: price stability and exchange stability. Coffee has a price, expressed in a unit of account, say $1. Mancini-Griffoli explained that the fact that $1 allows us to pay for a cup of coffee today and tomorrow and hopefully next year represents price stability. The fact that having $1 in our bank account allows us to pay for coffee that costs $1 represents exchange stability.

Store of value can be affected by the dimensions of denomination, exchange pledge, backstop, settlement technology, and backing assets. These dimensions differ between bank money and e-money. Mancini-Griffoli compared bank money to e-money as follows:

Bank money is denominated in the domestic unit of account, e.g. dollars, and can be redeemed or exchanged at fixed face value. For example, if you have $10 in your bank account, you can redeem it for a $10 bill. You can rely on being able to make that exchange because there is a government backstop: deposit insurance, lender of last resort, emergency liquidity, supervision, etc. The government plays an important role in making that exchange pledge credible, said Mancini-Griffoli. Settlement is centralized; when money is transferred from account to account, your identity and ownership is verified. The bank can hold a mix of assets against the claim because of the government backstop.

E-money varies tremendously, and there is no single stablecoin that is the same across all the dimensions. For example, a type of e-money called eCBDC or "e-central bank digital currency" has a high degree of exchange stability and is the same as banks on the dimensions of denomination and exchange pledge. However, the backstop is private, settlement is mixed, and the backing asset is central bank reserves. In contrast, coins, or e-money that is token-based, use decentralized settlement instead of centralized, and use "safe and liquid" reserves rather than central bank reserves. Somewhere in between the two is another type of e-money called "closed loop" systems, such as Alipay and WeChat Pay.

Finally, there is investment money, a type of liability that is issued in its own denomination. Redemption is not fixed at face value, but rather is variable at market value. In other words, you get back your collateral at market value whenever you decide to redeem, said Mancini-Griffoli. Like coins, the settlement technology is decentralized, but the assets that back the claim are not necessarily "safe and liquid," but rather are mixed.

According to Mancini-Griffoli, stablecoins pose several concerns for monetary authorities. First, there are potential consumer protection concerns. Stablecoins are issued by private companies with private backing, with no government backstop, which raises issues about the solidity of the exchange pledge as well as default and market risks. In turn, these issues raise public policy concerns about broader financial stability, in the case of very large-scale redemptions of stablecoins or movements of capital out of countries into stablecoins, particularly out of the currencies of weak countries. Stablecoins might also undermine monetary policy control in countries with weak institutions and high inflation where there is already partial dollarization. Finally, there are concerns about data privacy and confidentiality, interoperability, competition and efficiency, and financial integrity in terms of KYC and FATF standards.

Paxos. Charles Cascarilla, CEO and co-founder of Paxos, described how the Paxos stablecoin works, as well as regulatory oversight and benefits.

Paxos’s customers are institutional in nature, and Paxos is generally an institutional platform, Cascarilla said. Assets are sent to Paxos and are held in bankruptcy-remote, fully segregated reserve accounts. The assets are generally held in T-bills or over-collateralized repo of T-bills that are returning in a day or less than a week. Therefore, there is no duration risk or credit risk. Paxos is simply holding dollars in a reserve account, and those equal and map one-to-one with a token, which is always redeemable for $1. Currently the token is issued on Ethereum, but Paxos will likely add other chains over time, said Cascarilla.

In terms of regulatory status, Cascarilla said that Paxos created a Trust Company in the state of New York in May of 2015 and was the first firm to be approved to operate in the blockchain and crypto space as a Trust Company. That status offers a foundation that allows Paxos to hold custody assets and then to be able to tokenize them. Trust company status has also facilitated other approvals and access, including full SWIFT access and Federal Reserve National Settlement Service (NSS) vault around the world. Paxos is also in the process of applying for 30 agency registration with the SEC. Paxos has both internal and external auditors that make sure that the dollars equal the number of tokens at all times. In addition, because Paxos is incorporated under New York banking law, chartered under New York banking law, it follows all the practices for anti-money laundering/Know Your Customer (AML KYC) and has a Bank Secrecy Act (BSA) officer.

Some of the benefits of tokenized dollars are 24/7 instantaneous movement and lower cost, said Cascarilla. In the case of Ethereum, it costs about three cents to five cents to do a transaction, which is two or three orders of magnitude less than a bank wire. In addition, tokenized dollars create access. If you have a smart wallet, you can now have access to digital U.S. dollars, which is important for global use of the dollar and important for unbanked and underbanked consumers. Finally, this financial market infrastructure can be utilized by many different firms, said Cascarilla.

J.P. Morgan. According to Eddie Wen, global head of digital markets at J.P. Morgan, the most viable applications of stablecoin technology lie within either the payment space or the settlement of transactions. The JPM coin, which is currently in prototype form, is built on top of the forum protocol- based blockchain network, but it can be adapted to interoperate with other protocols subject to client demand.

Similar to Paxos, the product is only available to JPMorgan customers who have gone through the KYC process, and it is based on a permissioned blockchain and is not available for retail use. Wen further explained that the coin is not money per se and not legal tender. Rather, it is a digital representation of clients’ money at JPMorgan Chase, it always has the value equivalent to US dollars, and it is backed by the full faith and credit of JPMorgan Chase.

In terms of use cases, the JPMorgan coin is not an attempt to replace the global payment system, but a mechanism designed to improve it, said Wen. The bank has its eye on the future, with the coin providing infrastructure for the bank to build the next generation of digital applications and services.

"If we are successful in making ubiquitous deployment of JPMC coin internally within the bank, a lot of the applications and system systems that we build in JPMorgan could be substantially simplified," said Wen.

Maker DAO. In contrast to Paxos and J.P. Morgan, which use permissioned blockchain, Maker DAO uses a decentralized network to issue its stablecoin, Dai. According to Steven Becker, president and CEO of Maker DAO Foundation, centralized and decentralized stablecoins are complementary, and as many centralized as decentralized projects as possible are needed. That said, Becker gave the view that decentralized finance or DeFi can help bring the unbanked and underbanked onto blockchain. According to the Center for Financial Inclusion, 68 million Americans are currently underserved, meaning that 20 percent of the population cannot afford to be a part of the financial system. DeFi can help change that, said Becker.

What about criticisms that decentralization is unmanageable and not capable of being regulated? Becker gave the analogy of an ocean.

"If you imagine for a second decentralization as an ocean, it is really impossible to try and regulate the ocean. But you can certainly regulate the ports, the harbors, the ships and the shipping lanes," said Becker. "Instead of trying to control for the ocean, why don't we try and control for how we interact with and engage with it? It really comes down to looking at the control of the activity, not the entire structure."

Questions. Committee member Gary DeWaal of Katten Muchin asked what is the use case for a stablecoin backed by another digital asset that has tremendous volatility? Becker responded that the use cases are working capital, capital structuring, general trading, and really anything in terms of finance and insurance. He said that potentially any collateral type could be used, which makes it important to have decentralized chains at the intersection between the decentralized space and the traditional economy. For example, with something like debt factoring, you could tokenize invoices and get your financing from a decentralized space a lot quicker and potentially with better terms than from a traditional space. There is currently an organization called DexFreight that is doing this for truckers, said Becker.

Thomas Chippas, CEO of ErisX, asked if reserve assets earn interest and if coin holders receive that interest. Cascarilla said the assets do earn interest, but coin holders do not receive that interest. If interest were paid, it might begin to look like a financial instrument, which could raise potential securities issues. By having it tied one-to-one and not having any interest rate component, the value does not fluctuate, versus a physical currency dollar. As to the impact to a coin holder of a negative interest rate environment, Cascarilla thinks the mechanism used to manage that would be transaction fees. Wen said that for J.P. Morgan, the stablecoin represents the money the client has in the bank, so it would be handled the same way as traditional money.

CFTC Commissioner Dan Berkowitz asked why a particular J.P. Morgan stablecoin was needed, versus just using dollars. Wen replied that a lot of it is technology-driven, because most activity on payment rails cannot operate on a real-time basis. Some people think of coins as software architecture to maintain existing systems and make them more agile, said Wen.

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