Can regulatory systems come to terms with Facebook’s stablecoin?

Facebook’s ambition to create a transferable global digital coin between users on the social media giant’s messaging platforms WhatsApp and Messenger has been controversial from the outset. Perhaps not surprisingly, the backlash from regulators around the world was substantial from day one. The world’s leading economies were less than enthusiastic of the possibility of a cryptocurrency – a global stablecoin – issued by a social media giant, rivalling their sovereign currencies and disrupting the established monetary policies, monetary sovereignty, and financial stability both locally and globally.

The concerns outlined by international and government heads included: privacy, money laundering and financial terrorism, consumer protection, data security, network stability, competition, and taxation. The lawmakers had to have a united international regulatory response to Libra – now Diem – to prevent arbitrage opportunities. They had to establish how to regulate the currency, manage the Reserve backing the currency, and how the global financial infrastructure would be affected. To monitor payment chain information and exchange listings of the coin, its wallets, validators and providers, the regulators also required full access to the Association’s system.

The latest revisions to the proposed system

Registered in Geneva in May 2019, the Libra Association has persisted in its efforts to bring the stablecoin project to life and has tweaked its design several times to meet regulatory concerns. After many months of government hearings and investigations, Libra rebranded to Diem Association in December 2020 and published the latest version of its white paper on its payment system design. The regulatory concerns deserving specific attention, have been addressed in four fundamental changes:

1. Offering single currency stablecoins in addition to the multi-currency coin. This decision addresses the regulators’ view that a multi-currency coin would interfere with monetary sovereignty and monetary policy, should the network reach significant scale. 

Each coin will be supported by “a reserve of cash or cash-equivalents and very short-term government securities denominated in that currency and issued by the home country of that currency”. The Association will start with single stablecoins on the USD, EUR, and GBP and expand over time. The organisation would continue to work with financial regulators worldwide to expand the collection of single currency coins offered.

As central banks develop their own digital currencies (CBDC), Libra would like to integrate these into its network directly, removing the need for a Reserve and reducing credit and custody risk. This addresses the regulators’ competition concerns that the planned digital payment system could unfairly lock out competitors.

Under this change, the original multi-currency Libra coin will be a digital composite of some of the single currency Libra coins available on its network. The implementation of a smart contract would aggregate the single currency coins using fixed nominal weights. Oversight and control of the composed currency basket and their respective weights could be done by a group of regulators or an international organisation under the guidance of the Swiss Financial Market Supervisory Authority, FINMA, as the main regulator of the Association. Libra could act as a settlement coin in cross-border transactions and countries that do not have a single currency coin.

• Enhancing the safety of the Libra payment system with a robust compliance framework. To help support and uphold operating standards for network participants, the Association established a Financial Intelligence Unit (FIU) function. The FIU incorporates current lawmakers’ feedback and continues to develop its framework for financial compliance with existing standards for Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT), sanctions compliance, and the prevention of illicit activities.

Initially, the network will only be accessible to Designated Dealers and Regulated Virtual Asset Service Providers (VASPs). When all relevant compliance frameworks have been finalized and approved by regulators other VASPs and other individuals and entities (Unhosted Wallets) seeking to transact or provide services through the Libra network would be included, subject to balance and transaction limits.

• Forgoing the future transition to a permissionless system while maintaining its key economic properties. This is in response to the regulators’ concerns that unknown network participants might take control of the system and remove key compliance provisions. In a permissionless blockchain, the developer effectively relinquishes control of the purposes and means of personal data processing. The regulators fear this will undermine data and network security as well as consumer protection. In the private/permissioned network, the administrator determines the purposes and means of personal data processing on the blockchain. The Association will try to replicate some of the permissionless system’s economic benefits combined with the governance and due diligence inherent in a permissioned system.
• Building strong protections into the design of the Libra Reserve. This change responds to the regulators’ concerns about the impact of extreme situations or stressed scenarios.  The assets held in the Reserve will have short-term maturities, and its amount will be equal to the face value of each Libra coin in circulation. At least 80% will be government securities with up to three months’ remaining maturity and credit ratings of  A+ (S&P) and A1 (Moody’s), or higher. The outstanding 20% will be held in cash, with overnight sweeps into money market funds that invest in government securities with up to one year’s remaining maturity and the same risk and liquidity profiles. According to A regulatory and financial stability perspective on global stablecoins issued by the European Central Bank (ECB), the currency reserve for the euro stablecoin could become the leading money market fund in Europe and be systemically important. Thus, if the Association is to operate in the European market, it should be subject to the current regulations for money market funds or a new set of rules that address the specific requirements of stablecoins.

Since losses cannot be wholly excluded and, following supervisors’ advice, a capital buffer whose size is to be determined by a regulatory capital framework will additionally support the Reserve.

The Reserve will be transparent and regularly audited by independent auditors, while the audit results will be publicly available. Furthermore, the Association will publish on its website “on a daily basis the then-current composition of the Reserve and the then-current market value of the assets”.

The modifications above represent a change of direction in the Association’s original vision; a clear sign of a willingness and readiness to comply with regulators’ requirements. Recent high profile hires also showcase an intent to please the regulators: Stuart Levey as CEO, former Chief Legal Officer of HSBC and Under Secretary of the Treasury for Terrorism and Financial Intelligence during the Bush and Obama Administrations, and Steve Bunnell as Chief Legal Officer, former General Counsel of the US Department of Homeland Security, and a former Chief of the Criminal Division of the US Attorney’s Office for DC.

In April 2020 the Association formally applied for a payment system licensing with FINMA, potentially heralding the launch of the first single currency stablecoin, which would be backed one-for-one by the USD. It is unclear whether and when a licence will be granted and if FINMA would impose further amendments to the payment system. Plus as much as the Diem Association tries to distance itself from Facebook, we can’t overlook the fact that Novi Financial, Inc., the company which built and will operate the Diem wallet, belongs to Facebook. The social media company’s poor track record on data privacy remains an ongoing concern for regulators.

The white paper Stablecoins: risks, potential and regulation, which was published by the Bank for International Settlements (BIS) in November 2020, argues that while global stablecoins offer great potential, the benefits may be achieved more effectively in many cases with Central Bank Digital Currencies (CBDCs) and other initiatives such as fast payment systems. And while the Central Banks do not have to issue fiat currency-based stablecoins – a strictly political decision – they are also obviously uncomfortable with the idea that a private company with three billion users can do so. Hence, we already have the digital yuan, while the digital euro and digital yen are in the pipeline.

The obvious need for a more efficient and financially inclusive payment system, combined with the already existing technology for its support, makes the arrival of a fiat-backed global stablecoin and the development of a regulatory framework to host it inevitable. While there is still a long way to go, the system is finally awake, and the process of establishing proper legislation has commenced.

As the regulatory framework progresses, further analysis on the consequences of global stablecoins on the economic and business environment will be vital as we prepare for a new digital currency era.