A Bridge to New Money
Chesterton’s Fence, skeuomorphism, and growing nuance in crypto regulation
Regulations and crypto are meeting in the middle, and the first stage of that is stablecoins and money on regulated networks. The way that regulations are developing is a guide to the way that regulators work, and the nuance that is developing around stablecoin regulation is a positive sign. We need regulations that are appropriate to the risks of crypto; stablecoins are the first step in that process, and a good starting point for future development.
There is a concept known as Chesterton’s fence. Similar expressions of the same idea relate to second order thinking, throwing the baby out with the bath water, and so on. Chesterton put it like this:
“There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, ‘I don’t see the use of this; let us clear it away.’ To which the more intelligent type of reformer will do well to answer: ‘If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.’”
- ‘The Thing’, GK Chesterton, 1929
The reason that this is a recurring theme through history is that the zeal of the reformer is also recurrent. When we see something is wrong, we want to change it. The problem is that we all tend to operate from a narrow perspective. I am a product of my background, culture, upbringing, schooling, professional experience, and so on. These things helped to shape my opinions, political views, social outlook, and generally the way that I see the world. To understand the fence, I need to understand a different set of perspectives and experience.
From a crypto perspective, the reformers are enthusiasts who – stereotypically – see no need for anti money laundering legislation because everything is transparent and on chain. There is no need for currency control because it is impossible to enforce on personal wallets. There is no need for banks because I can manage my own keys and be my own bank. Let me say that even the most extreme crypto maximalist tends to have a more nuanced view than this, but the general principle holds.
 When I say “crypto” I mean crypto currencies, DeFi, and all that stuff. The nuance comes later.
Seek first to understand
The corollary of Chesterton’s fence is regulation by skeuomorphism. Skeuomorphism doesn’t appear in my 1982 copy of the Concise Oxford Dictionary, but with software design in particular, we have come to understand it as the practice of creating something so that it looks a bit like the old thing. This helps people to recognise and understand it, and makes them more comfortable adopting it. Thus we have a save icon that looks like a 3.5” floppy disk, lamps that look like candlesticks, and so on. It is a way of providing a bridge to the new thing from the old thing, and is the first approach regulators around the world took to crypto. They started out by treating it like forex, or a commodity asset, or an orange farm. It’s a kind of backwards skeuomorphism – crypto was designed to replace the old way of doing things, but when it comes to understanding it, we look for an analogy. The problem with this approach is that there are key aspects of crypto that are different, and so require some new rules. Analogy is a great way to understand things, but it’s a rotten way to regulate new technology.
In the developed world of finance (outside the US in other words), this approach is falling away, and we have seen a progressively growing understanding reflected in the regulation of crypto. The meta view is that regulators seem to have developed the most detailed understanding when it comes to the form of crypto that is closest to the money they already know: stablecoins.
Skip this paragraph if you know this, but a stablecoin is a crypto asset that is designed to be stable with reference to some fiat currency, usually the US dollar. They are used in about 90% of crypto transactions. This is because most transactions are made by traders, and they want to come back into dollars (or whatever) when they close a trade. You don’t sell your Tesla shares for Amazon shares, you sell them for cash. It’s the same in crypto, but you don’t want to have to deal with the banking system, so you stay in a crypto asset that mimics cash: a stablecoin. The two biggest are Tether (USDT) and US Dollar Coin (USDC). There are several ways of achieving stability, using code or collateral, and I will look at these later to illustrate my points below.
And then to be understood
Let me first say this: crypto needs regulation. There may always be an unregulated parallel system, but if we want to change the world, then we need to include people who don’t care why bitcoin is so cool, and who can’t even spell Ethereum. We are building a new, decentralised, financial services infrastructure. It’s going to feel like a compromise to bitcoin maximalists, but it’s going to make a difference, and it will need regulation. Regulations are imperfect, but they provide a degree of protection from things like Terra/Luna and FTX. They also provide a certainty to the builders, who need to know what the rules are so that they can innovate, without the risks of their project being fenced off.
The shift from the world’s regulators has been initially in recognising that this change is inevitable, then in learning, and then in planning and regulating. What is interesting to me is that the learning is visible in the regulations. You can see the trajectory in the development of different approaches, and if you can see the trajectory, then you can predict where it lands.
Initially, the response from regulators to stablecoins was nervous and defensive. Libra in particular was a trigger for a regulatory response that illustrated the challenges of trying to do too much too soon. Libra, later rebranded as Diem, was proposed as a global stablecoin based on a basket of currencies, leveraging Facebook’s users as a ready-made customer base. It raised questions of licensing, tax, money laundering, operational risk, monetary policy, and not least data protection. Facebook’s recent history included the Cambridge Analytica scandal, and so allowing a global business with a questionable privacy record to run global money was always a long shot. Libra was probably a factor in accelerating the exploration of central bank digital currency (CBDC) around the world.
The CBDC work done by about 90% of the world’s central banks resulted in a large pool of bankers thinking harder about money, what it was, who created it and how it worked. This was already a rite of passage that anyone who tried to understand bitcoin had been through. This stage of exploring the fundamentals is a crucial stage in unpacking something new, and Libra forced many people who hadn’t considered the impacts of global money to do so for the first time.
Libra was a very ambitious idea, and an attempt to jump to an endpoint of a global form of money. At the moment, central bank money is created – by fiat – by governments, and then commercial bank money is created by the banks that they regulate. To expect governments everywhere to simultaneously pass the legislation, or grant the licences, that Libra would have needed was optimistic to say the least. The members of the Libra Foundation gradually recognised this, and dropped out of the programme. Libra / Diem was eventually shut down in February 2022.
Regulations that deal with stablecoins are now emerging around the world. There are common themes, which is entirely to be expected, since regulators receive guidance from international organisations and standard setting bodies. This guidance is pretty consistent, and consistency is good, or we end up with regulatory arbitrage. The interesting thing is how regulators are thinking about stablecoins, and the nuances in dealing with them. Some of this is still regulation by analogy, but most is the creation of important distinctions between different types of stablecoin and different issuers. What is also clear is the enlightened self interest of regulators. This itself has variances depending on the body; regulating the EU for example, is much harder than dealing with a single financially advanced nation.
You can think of stablecoins as algorithm based or asset backed. The first rely on a game theoretic mechanism to ensure that the stablecoin retains its fiat peg, by manipulating the supply and/or price of a second linked token. This is what Terra did, and the approach is most charitably described as unproven. Regulators tend to steer clear of this, lumping these coins with other crypto as a part of the system that is not yet worthy of being treated seriously, other than as a speculative asset.
The second group, asset backed stablecoins, splits into other sub categories. This is where the regulatory treatments start to get more thoughtful. We can more or less eliminate crypto collateralised coins like DAI. In this case, crypto assets are staked, and a percentage of their value created as a stablecoin. Regulators generally put these in the same category as riskier crypto described above.
Now we come to stablecoins that are backed by “conventional” assets. These assets might be a single currency, a basket of currencies, a commodity or basket thereof, or other financial assets like equities or debentures. Regulators are starting to make distinctions based on these, and treating them in different ways. When they do, they are tending to go back to analogy, which makes sense. Analogy is a way of saying “same activity, same risk, same rules”. Fiat backed stablecoins are the closest thing to money, so are most familiar to regulators, and can therefore be regulated by analogy. Other instruments will require more work, but this is where we are starting.
The world’s regulators are unpacking stablecoins. The Monetary authority of Singapore has proposed rules that only allow single currency stablecoins, that must be issued from Singapore, and that must be issued against Singapore dollars or a G10 currency.
In Japan, stablecoin legislation was passed in June 2022 and will become law in June 2023. Stablecoins may be issued by banks, trust companies, and some money transfer authorities, i.e. financial institutions that are already within the Japanese licensing regime. The legality of overseas issuers is unclear.
The MiCA (Markets in Crypto Assets) legislation in Europe differentiates between ‘e-money tokens’, backed by a single fiat currency, and ‘asset referenced tokens’, backed by multiple currencies or other assets. For e-money tokens – closest to cash – issuers must be credit institutions or e-money institutions, i.e. entities that already create forms of money.
The UK’s response is (whisper it) similar to the EU, in that it proposes to bring fiat referenced stablecoins under the same regulatory oversight as e-money and similar payment methods. Same activity, same risk, same rules.
The nuance is reassuring to see: asset vs algorithm; fiat vs basket; even different types of fiat. We can hope that future regulations in the turbulent wake of Terra/Luna and FTX are similarly considered and nuanced. What is clear, though is that there is an openness to fiat backed instruments that look like money and are issued by the same institutions who currently issue forms of money. Hold that thought.
Commercial Banks have always played a critical role in bringing financial innovation to the market, collaborating to create the Financial Market Infrastructure on top of which they compete for customers. We are starting to see these role players do the same in stablecoins, pushing the conversation forward, launching proofs of concept, and taking the lead in creating new decentralised financial market infrastructure on top of which stablecoin based payments and transactions will operate. Without practical applications championed by commercial banks, regulations can only be abstract – tangible examples create better discussions.
One example of this was launched in mid November by a consortium including the New York Fed, Swift, Mastercard, Citibank, HSBC, Wells Fargo, and others. The plan is for a “Regulated Liability Network” - a DLT that will support “regulated liabilities”, i.e. forms of money, issued by a central bank, commercial banks and non-bank issuers. This to me is a clear indicator of what the near future looks like, at the convergence of regulations and technology, showing what is currently feasible and allowable. The logic is that the DLT is just a new technology being applied to forms of money that are already regulated. The instrument hasn’t changed its legal form; it is just on a new platform. A platform that, incidentally, offers the possibility of much more: innovation with programmable money, and the addition of other asset types. The stablecoins described by pending legislation will be some of the first things added to this kind of system, shortly followed by other tokenised assets and even forms of crypto.
Regulated liability networks like this are the first step toward regulated blockchains at national and international level. This is what the National Blockchains that we have been building will start as, and programmes like the one from the NY Fed will feed into this process. With a growing understanding and an evolving consensus around regulation, the way forward for digital money is currently much clearer than it has ever been.