Gemini and Paxos announced regulated dollar-backed stablecoins last week. You might be thinking that the industry needs more stablecoins like it needs more Ethereum giveaway twitter scam accounts, but these two projects1 are unique in at least one way: regulatory approval from the New York Department of Financial Services–historically one of the more conservative regulators of crypto businesses.

Like it or not, regulation plays a large role in the adoption of crypto. In this piece, I’d like to reflect on the role of stablecoins in the industry today and take a look at why a company like Gemini would decide to make a regulated one.

## The product-market fit of Tether

Today, crypto is mostly used for speculation. This is not a controversial statement and I’ve made it before in my post on blockchain adoption. The biggest winners of the last year power speculation: centralized exchanges like Coinbase and Binance, token issuers like all of the projects that did an ICO, and investors that raised capital for funds.

Less well understood is the astounding success of Tether’s stablecoin, USDT. USDT makes up for nearly 2% of the cryptoasset marketcap and more importantly, over 20% of its volume. It is supported by virtually every major exchange and is a invaluable tool for major players in the market like OTC desks and market makers.

As Hasufly and Sylvain Ribes wrote in their great piece on Tether’s role in the cryptomarket “Tether’s hold on Bitcoin’s liquidity: A risk assessment”2:

The story of Tether to date has been one of success. Within two years it has grown from storing less than $10M to almost$2.8B in value. Being listed on virtually every exchange, it enjoys massive network effects and the market trust in its convertibility has remained quasi absolute throughout its history. Which demonstrates two things:

1. There is a strong natural demand for storing and moving stable value on the blockchain
2. People are willing to take on the involved centralization risks in return for convenience

Exchanges, OTC brokers and arbitrage shops, who all provide valuable liquidity to the cryptocurrency ecosystem, are Tether’s main customers.

Unlike products relying on crypto-anarchic visions of alternative, uncensorable financial systems, USDTs have product-market fit right now.

Unlike USDT or the Gemini Dollar (GUSD), most stablecoin projects want to introduce a stable cryptoasset uncontrollable by a single company or government. Projects like Basis and Terra (who raised $125M and 30M respectively) want to do this with algorithmic designs, and others like MakerDAO3 have created censorship-resistant networks that collateralize their stablecoin45. While these projects would like to see their stablecoins used in the cryptocurrency trading ecosystem, their dreams are bigger: to compete with fiat currencies. As I write this, countries like Venezuela, Turkey, and Iran are all experiencing currency hyperinflation. Citizens of these countries might not care about the ideals of cryptocurrencies, but do care about a more stable currency. In the short term, it may not matter whether that stable currency is censorship-resistant or not–US Dollars are desirable despite censorability in nations experiencing hyperinflation. But over time, the theory goes, people will prefer a store of value that cannot be seized or tampered with. If that day comes, censorship-resistant stablecoins won’t just appeal to victims of currency crises, they’ll appeal to all users of money. ## Is regulation a competitive advantage? If stablecoins either compete against USDT as a reserve currency for trading or with fiat as a censorship-resistant store-of-value, what role does regulation play? As I mentioned in my post on competitive moats, crypto projects can benefit from intangible assets like regulatory approvals. Intangible assets (e.g. patents, brands, trade secrets): when a company holds intangible assets like patents or brands that lead to monopolies or pricing power in the market. But what does regulation even mean for a stablecoin? For Gemini (and Paxos) to receive regulatory approval, they needed to design their stablecoins to comply with a set of fairly stringent rules. From the DFS press release: The approvals are based on stringent requirements for these products, and already required of both Gemini and Paxos, including requirements to: • Ensure that authorized stablecoins are fully exchangeable for a U.S. dollar, with conditions to ensure monitoring and recordkeeping. • Implement, monitor and update effective risk-based controls and appropriate BSA/AML and OFAC controls to prevent the Gemini Dollar or Paxos Standard Token from being used in connection with money laundering or terrorist financing. • Implement, monitor and update effective risk-based controls to prevent and respond to any potential or actual wrongful use of stablecoin, including but not limited to its use in illegal activity, market manipulation, or other similar misconduct, as required by DFS’s February 7, 2018, “Guidance on Prevention of Market Manipulation and Other Wrongful Activity”. • Compliance with DFS’s transaction monitoring and cybersecurity regulations. • Post terms and conditions in a prominent location on both Gemini’s and Paxos’s respective websites, and in any other form or manner required by DFS, that warns consumers that: ** Any stablecoin and/or the fiat currency available upon redemption of any stablecoin may be forfeited if the stablecoin has been, or is being used for, illegal activity ** Any stablecoin may be subject to forfeiture to, or seizure by, a law enforcement agency in the event that there is a legal order or other legal process ** Any stablecoin or fiat currency available upon exchange of stablecoin that has been subject to freezing, forfeiture to or seizure by a law enforcement agency, and/or subject to any similar limitation on its use, may be wholly and permanently unrecoverable and unusable and may, in appropriate circumstances, be destroyed • Maintain policies and procedures for consumer protection and to promptly address and resolve customer complaints. The two most important themes are that users have strong guarantees that their stablecoins are backed and exchangeable for fiat and that the issuers will comply with any government requests, including seizing a user’s assets. As described in the Gemini dollar whitepaper: As a regulated issuer, we need a technical design and implementation that gives us the ability to upgrade the Gemini dollar token so we can […] Pause, block, or reverse token transfers in response to a security incident (i.e., catastrophic event) or if legally obligated or compelled to do so by a court of law or other governmental body. From a technical perspective, this is achieved through upgradeable smart contracts. In concept, the Gemini team could pause, block, or reverse transactions by updating the contracts as needed6. On the one hand, these features seem awful. If censorship-resistance matters at all, a regulated stablecoin issued by corporation is your worst nightmare. You inherit the unsound monetary policy and censorship of fiat money and you take on the potential censorship of the issuing corporation. This makes a regulated stablecoin a poor competitor for the “censorship-resistant store of value” market. On the other hand, if regulatory approval is a hard requirement to participate in the trading of cryptocurrencies, then compliance with these regulations might be an advantage. In particular, the same properties that make a regulated stablecoin unfit as a censorship-resistant SoV could make it a great fiat on-ramp. In addition to regulators simply blocking the use of unregulated stablecoins as fiat-onramps, it’s believable that new retail and institutional investors would feel more comfortable knowing that the stablecoin they buy is “protected” by the government. After all, Gemini’s objective is to build trust around their exchange to better attract investors and traders. As a next step in our mission, we must improve the linkage between these worlds by giving fiat currency the same desirable technological qualities of cryptocurrencies. Regulation isn’t strictly better for traders, however. For example, Binance, one of the largest users of USDTs, operates in a legal gray area in many jurisdictions. It’s hard to imagine Binance or traders on Binance wanting to subject their “reserve currency for trading” to the censorship of the US Government or a company like Gemini. Altogether, more regulated stablecoins are probably a net positive for crypto. They offer regulatory clarity and increased trust for new retail and institutional investors. Discourse around these regulated stablecoins might also highlight the cost of regulation–freezing or seizing funds, pausing and reversing transactions–and strengthen the argument for censorship-resistant money. Still, the regulatory approval of GUSD has to make you wonder: if regulatory compliance requires removing the most important feature from a cryptocurrency, is it a cryptocurrency at all7? Or is it more like existing, non-crypto financial instruments? Even if these censorable stablecoins help introduce more people to crypto, is there a hidden risk? Crypto requires its users to “do their own research” (e.g. which coins to buy, how to keep them safe) yet suffers from widespread misinformation and misuse of key phrases even amongst insiders8. I worry for a generation of crypto users whose first cryptocurrency is a regulated stablecoin. But I guess mitigating that risk is up to us. Thanks Haseeb Qureshi and Myles Snider for their input on this piece And just for fun: 1. The 28th and 29th stablecoin to be announced over the last couple years, according to stablecoinindex 2. Their point–that Tether’s risk in the Bitcoin markets is overstated–is out of scope for my piece but worth noting here. They conclude that, “In spite of the neverending hubbub surrounding Tether’s emission and unclear backing, it is these authors’ opinion that the threat it poses is vastly offset by the services it renders. Its solvency appears to no longer be in question, and while the public and the media are right to contemplate the possibility of authorities bringing USDT trading to a halt, they should not dread the long term aftermath.”” 3. Maker’s Dai, which is collateralized by Ethereum, has shown impressive stability through a huge market correction in ETH from$1400+ to \$170. A great recap can be found here

4. The design-space for stablecoins is out of scope for this piece, but I may cover it in a later one. This piece by Haseeb Qureshi is a great starting point.

5. Disclosure: I am an investor in Reserve Protocol.

6. I was amused to see a wave of outrage on twitter in response to this code audit of GUSD. Perhaps the title of the article was baiting the outrage, but even a two minute skim of the GUSD whitepaper or the regulatory requirements would make it obvious that this feature was part of GUSD.

7. I would be remiss if I did not mention stablecoin skeptic Preston Byrne’s thoughtful post on the GUSD. Two points worth highlighting. First, he characterizes GUSD as a “coupon redeemable 1:1 for an actual deposit” which is similar to “existing interbank solutions.” In other words, it’s explicitly much more like a legacy financial instrument than a cryptocurrency. Second, his musings on the public vs permissioned blockchains as architectures for such stablecoins is interesting: “So while Gemini is running this stuff on an ERC20 now, as Gemini wants to increase the complexity of the applications it is running – say, to run a financial instrument over the public internet – it may choose to simply deploy its own blockchains – permissioned, but publicly viewable – in future.”

8. See my posts on “rent-seeking”, “governance”, and “decentralized”