Is Diem doomed?

Rare was the occasion when President Trump and Rep. Maxine Waters could agree on anything, but Facebook has a knack of bringing people together. The matter at hand was Libra, a new digital currency designed for use on the social network. In a statement on June 2019, the left-leaning chair of the House Financial Services Committee argued that Facebook had a poor record of data protection for its users, and the project shouldn’t expect consent from Congress until it clarified its intentions. Trump was sharper. Comparing Libra to other cryptocurrencies such as Bitcoin, which the president tweeted were “not money” and “based on thin air,” the president argued that if Facebook wanted to become a bank, it should be regulated like one.

It was a PR disaster for Facebook. In the preceding year, the company had been quietly recruiting dozens of international companies to embark on the Libra project, an attempt to create the first cryptocurrency with truly global reach. A type of ‘stablecoin,’ Libra was designed to avoid the volatility of Bitcoin or Ethereum by mirroring the value of a basket of global currencies. Through specially designed digital wallets, Facebook’s billion and a half users would be able to use it to buy and sell services on the platform, transforming it from a social network into a financial powerhouse.

For lawmakers, regulators and the public at large, however, the timing of the announcement couldn’t have been worse. Facebook had been embroiled in a series of crises – from data privacy scandals to a putative role in Russian election manipulation – that made a foray into finance unappealing. Even after Mark Zuckerberg himself strenuously denied that the currency would be run by Facebook alone in testimony to Waters’ committee, sponsors began deserting the project in droves.

Beating a hasty retreat, the Libra Association’s executives began to re-evaluate the currency’s ambitions in light of public expectations. By the end of 2020, they came up with several solutions, starting with a promise that the project wouldn’t advance until it obtained approval to operate from the necessary financial watchdogs. Moreover, instead of pegging the stablecoin against a basket of global currencies, it would be linked to the dollar alone, while its operational headquarters were moved from Switzerland – hardly known for its financial transparency – to the US. The name was also changed, from ‘Libra’ to ‘Diem’ to demonstrate its “organisational independence” from Facebook, according to a press release.

While Libra foundered, another stablecoin seized the limelight. Founded in 2014, Tether also promises a one-to-one exchange rate with the dollar and has issued an estimated $71.19bn-worth of tokens to date. The question of whether those tokens are sufficiently collateralised, however, has sufficiently worried financial watchdogs to the point of contemplating new and rigorous regulatory frameworks for how stablecoins should operate.

The threat posed by stablecoins like Tether to the integrity of financial markets is very real, says Timothy Massad, senior fellow at Harvard’s Kennedy School of Government. That shouldn’t detract from their promise, he says – everything from smoother transactions to financial inclusion for the unbanked. “Living up to that promise, though, requires, I think, a robust regulatory framework to make sure that the risks vis-à-vis financial stability, as well as investor protections, are addressed,” explains Massad. That can only come through new national and international legal frameworks, he says, above and beyond the patchwork of state-level licenses currently governing these products. The trouble is, “we don’t have that today”.

Mirror universe

Stablecoins are not a new idea. In the 19^th century, state laws in the US allowed regional banks to issue their own form of private currency, provided it could be exchanged one-on-one with state bonds. But this rule was only enforceable inside the state where the note had been issued. According to economic historians Gary B. Gorton and Jeffery Y. Zhang, ‘a note issued by a bank in Tennessee might circulate at a 20% discount in Philadelphia,’ leading to constant haggling and an inefficient system of transactions.

These proto-stablecoins were eventually rendered extinct by the National Banking Act of 1863, which placed heavy taxes on notes issued by private banks. The invention of Bitcoin almost a century and a half later, however, saw the emergence of a new, parallel universe of cryptocurrencies. Created as a means of achieving an alternative financial system outside the reach of big banks and national governments, these tokens were subject to wild fluctuations in price and couldn’t be redeemed easily with real-world fiat currencies. Additionally, “many crypto exchanges and other platforms…had trouble obtaining bank accounts in the traditional financial system,” explains Dr Garrick Hileman, head of research at cryptocurrency exchange Blockchain.com.

For many, Tether (USDT) was an ideal solution to this problem. Pegged to the US dollar, it afforded cryptocurrency users a safe way of redeeming their earnings from Bitcoin or Ether by converting it first into USDT, and then into dollars. As such, stablecoins are “really only used in the crypto sector today,” says Massad, “but they do have potentially broader applicability.” By virtue of being a purely digital currency, stablecoins such as Tether are more easily included in blockchain-enabled smart contracts than their fiat equivalents. Additionally, supporters argue, these tokens provide an alternative architecture for digital payments – one that’s notably more efficient and cheaper than the current structure overseen by payment giants like Mastercard and Visa.

This, essentially, is also the premise underlying Diem. According to its original white paper, the association’s mission ‘is to enable a simple global payment system’ by ‘enabling new functionality, drastically reducing costs, and fostering financial inclusion’. In time, the paper goes on, the sheer weight of users being introduced to Diem could see the entry of millions of previously unbanked citizens entering the economy ‘who may not have access to a Regulated or Certified VASP, many of which will not find it commercially feasible to service these groups.’

There’s also a healthy dose of self-interest in a platform like Facebook supporting the creation of a new stablecoin, says Hileman. “This is one of the major markets that could move the needle for a big company, in terms of the hundreds of billions of potential revenue,” he explains. “Not to mention the fact that, you know, payments and money are very social.”

For [Facebook] to have something of that nature would really be a boon of cosmic proportions. Essentially, virtual life becomes real life.
Alexander Lipton, Sila

Diem, in short, could constitute an entirely new profit centre for Facebook, whose long-term future is in doubt after recurrent data protection scandals and a perception among younger users that the platform is passé. Making the social network an easy place to conduct financial transactions is likely to see it retain more users, and attract millions more, explains Professor Alexander Lipton. “For them to have something of that nature would really be a boon of cosmic proportions,” says the MIT fellow and chief technology officer at fintech firm and stablecoin issuer Sila. “Essentially, virtual life becomes real life.”

Managed expectations

So far, Diem has made only small steps toward fulfilling that promise. While an official launch for the currency was trailed for later this year, Facebook has so far confined itself to facilitating digital payments via its Novi wallet. Even then, only a select number of users living in the US and Guatemala are permitted to do so, with all transactions being made using the Paxos stablecoin and not Diem, as many anticipated. In the meantime, the association issued a statement welcoming Congressional scrutiny while stressing its independence from its social network patron (‘Diem is not Facebook’) and its receptiveness to regulatory feedback.

This may be an especially shrewd position in the current moment. Recent months have seen financial watchdogs grow increasingly anxious that the stablecoin market is much less sound than its name suggests. Stablecoins like Tether “have grown so much, so quickly,” says Massad, without sufficient proof that there is enough fiat currency to back them up – underscored by a recent $41m fine issued by the US Commodity Futures Trading Commission against Tether for failing to maintain sufficient monetary reserves between 2016 and 2018.

Indeed, a recent investigation by Bloomberg found that the portion of Tether’s reserves it could trace were tied up in Chinese commercial paper and crypto-backed loans (a short-seller has recently issued a $1m bounty for information on where the rest of them were). Aside from lingering questions about whether these assets constituted sufficient reserves to back up $69bn of USDT in the case of a run on the stablecoin, the decision to invest in commercial paper markets outside of (the highly rated) US jurisdiction makes Massad nervous. Ideally, those reserves “need to be invested in safe assets, such as bank deposits [or] treasuries.”

That’s not the only thing worrying financial regulators. Another issue is the technical resilience of stablecoins, most of which operate on decentralised blockchains. “You want to make sure that the code is sound and the smart contracts are sound,” says Massad, “in the sense that they aren’t at risk of having an outage or a hack.” Regulators also need to know who holds the administrative keys, what protections are in place for investors, and what safeguards prevent the use of stablecoins in money laundering or other forms of illicit activity.

These bulwarks against fraud and mismanagement are few and far between in the world of stablecoins, says Massad. As such, the risk of a run on Tether or other stablecoins is very real. Under those circumstances, “you could have a spike in demand for redemption and exchange,” says Massad, one that could not only lead to a major crash in cryptocurrency markets but a cascading effect across credit markets and beyond.

The future of Diem

Unsurprisingly, financial watchdogs around the world have become increasingly vocal about instituting a clear legal framework for stablecoin operations. On 6 October, the International Organization of Securities Commissions announced that stablecoins should have “little or no credit or liquidity risk” and should be regulated in the same way as any other form of financial market infrastructure.

Does this mean that Diem is doomed to suffer the same fate as its Victorian antecedents? Not necessarily, says Massad. “Regulators are very nervous that, because of Facebook’s customer base, this could become just very important, very quickly,” he concedes. “On the other hand, Diem has said they would comply” with what regulators require of it – a plausible promise, considering the immense amount of criticism generated by the currency’s initial announcement in 2019.

Lipton remains sceptical. “I think they’re misguided,” he says, arguing that the sheer weight of public disquiet about Facebook’s size and power is enough to prevent it from launching anything resembling a successful stablecoin (Lipton has also accused the then-Libra Association of plagiarising a white paper he co-wrote on stablecoins.) That doesn’t necessarily mean, however, that the concept per se is doomed by this greater regulatory interest. On the contrary, “robust and reasonable regulation is something which is really beneficial” for innovation to continue in the world of cryptocurrencies, says Lipton.

Where this regulatory interest will lead is anyone’s guess. Some speculate that regulating stablecoins will mark the start of a much wider intervention by financial watchdogs into cryptocurrencies generally. Others, meanwhile, wonder whether stablecoins can coexist with government experiments with central bank digital currencies (CBDCs.)

“There is a potential clash, most definitely,” says Lipton, especially if CBDCs are built on blockchains and become direct competitors to the functionality of stablecoins. On a more basic level, the existence of stablecoins challenges the monopoly rights of nation-states in the issuance of currency, a challenge that could become intolerable if these tokens continue to grow.

For Hileman, these discussions allude to a much larger debate about the functionality of money itself, triggered by the dawn of cryptocurrencies in the late 2000s. Both stablecoins and CBDCs offer unprecedented opportunities for the state and private companies alike to institute safeguards against money laundering and other financial crimes. Accompanying that is a “great risk of a loss in privacy that could have all sorts of negative knock-on effects, in my opinion, for freedom and independent political discourse”. Attempts to thrash out the appropriate line between oversight and privacy will continue to inform the debate around stablecoins for decades to come.