What the exit of Facebook’s Diem means for bank stablecoins | PaymentsSource

Meta’s ambitions to back a cryptocurrency appear finished for now after the sale of the Diem stablecoin’s assets, and the implications go beyond one company’s retreat from the market.

Meta, formerly Facebook, is a lightning rod for political controversy over how it handles data and privacy, as well as for how influential its social network has become. This made the company a focal point of discussions over how to regulate cryptocurrency — and those discussions will continue even after Meta steps out of the spotlight.

“Markets that [Facebook] enters that lack existing regulation eventually also face regulatory oversight,” said Tim Sloane, vice president of payments innovation at Mercator Advisory Group.

Diem has sold its technology assets to Silvergate Capital for $182 million. The assets include tools for operating a blockchain-based payment network that can support cross-border transactions. The tools are “critical to running a regulatory-compliant stablecoin network,” according to a press release published Monday afternoon.

“Through conversations with our customers, we identified a need for a U.S. dollar-backed stablecoin that is regulated and highly scalable to further enable them to move money without barriers,” Silvergate CEO Alan Lane said in the release. “It remains our intention to satisfy that need by launching a stablecoin in 2022, enabled by the assets we acquired today and our existing technology.”

The Wall Street Journal reported the sale followed signals that regulators were “uneasy” with the overall Diem plan.

“Despite giving us positive substantive feedback on the design of the network, it nevertheless became clear from our dialogue with federal regulators that the project could not move ahead,” Stuart Levey, Diem Networks’ U.S. chief executive, said in a prepared statement. “As a result, the best path forward was to sell the Diem Group’s assets.”

Even without the spectacle of Meta’s involvement, regulators have a genuine concern over how nonbank stablecoin issuers operate. Until these concerns are resolved, risk-averse nonbank issuers could stay on the sidelines, while heavily regulated banks carve out their share of the market.

For example, nonbanks don’t fall under Federal Deposit Insurance Corp. rules regarding reserves or liquidity protection, raising concerns about liquidity if consumers withdraw their funds en masse — a modern version of a “run on the bank.”

Clearing a regulatory hurdle

The federal government has signaled that it will likely require stablecoin issuers to be either chartered banks or regulated in a nearly identical manner. That places existing chartered banks, including Silvergate, in a potentially favorable position over nonbank stablecoin issuers.

“Silvergate is a regulated bank,” said Eric Grover, a principal at Intrepid Ventures in Minden, Nevada, adding that with stablecoins backed one-to-one by cash and short-term low-risk assets on its balance sheet, there will be far less regulatory pressure. “Regulators and politicians will have to relent. It would be unreasonable not to.”

Silvergate Capital is the parent of Silvergate Bank in San Diego, which specializes in blockchain technology and was slated to issue Diem as a partner in the project. Silvergate could still issue Diem, or a differently named stablecoin, without direct ties to Meta but could still benefit indirectly from Meta’s scale.

“With full control Silvergate can experiment developing different use cases. And, some of those use cases, I would think, can still serve and leverage Facebook platforms and billions of active daily users,” Grover said.

Formerly called Libra, the 3-year-old Diem stablecoin project was subject to nearly constant political and regulatory backlash. Though Facebook had signed on many well-known financial companies like PayPal, Stripe, eBay Visa and Mastercard, many of them dropped their support shortly after the project became public amid the regulatory pressure. The project later added Checkout.com as a partner in an attempt to offset the loss of payment expertise. “With [the sale], Silvergate will be well placed to take this vision forward,” Levey said. “Over the coming weeks, the Diem Association and its subsidiaries expect to begin the process of winding down, but we look forward to seeing the design choices, and the ideals, of Diem thrive.”

Silvergate did not return requests for comment. In an earlier interview, former Meta blockchain chief David Marcus, who has since resigned from the company, said Diem would not launch without full regulatory approval.

In time, the structure of the reserves backing the stablecoin were changed from a revolving basket of international currencies to a one-to-one backing by the U.S. dollar. Despite this change, final regulatory approval never came and Diem never launched. Novi, the Meta digital wallet designed to support Diem, has launched in pilot and is supporting other currencies.

And since Libra’s launch, nonbank stablecoins in general have become a source of controversy, with concerns ranging from privacy to the content of the assets backing the stablecoins. Regulators and members of Congress have expressed concerns that stablecoins present a threat to central bank monetary policy, and that some may not be fully backed by U.S. dollars or other safe assets, creating a risk to consumers.

The future of nonbank stablecoins

Even with Meta out of the conversation, regulators are poised to write rules for stablecoins, a task that’s taking on a greater urgency as stablecoin transactions soar, according to experts who specialize in blockchain and cryptocurrency. Congress is unlikely to pass a law governing nonbank stablecoins, leaving bank regulators largely responsible for stablecoin oversight.

Stablecoin transactions executed from one address to another on a public blockchain surpassed $5.5 trillion in 2021, according to Guidehouse and Messari. That’s up from $1.35 trillion in 2020 and $250 billion in 2019. That growth has fueled concerns among regulators that an economic crisis in the stablecoin sector could spread into other financial markets if the stablecoin issuers need to quickly cover losses in their investments.

“In the case of stablecoins, the issue becomes whether they are backed by highly liquid assets or not,” said Bill Nelson, executive vice president of the Bank Policy Institute in Washington. The BPI has contended that stablecoins are often backed by assets such as commercial paper that are “not completely safe and liquid assets with known value. … Commercial paper isn’t liquid and can be risky,” Nelson said.

Beyond relatively nonvolatile assets such as U.S. dollars or euros, some nonbank stablecoins have also backed the coins with short-term securities such as commercial paper, which is unsecured short-term debt that companies use to finance payroll and other near-term liabilities.

“Both Republicans and Democrats have publicly and privately expressed concerns with stablecoins having commercial paper in their reserves, especially if the commercial paper is from [politically risky] countries such as China,” said Ron Hammond, director of government relations at the Washington-based Blockchain Association, whose members include Ripple, Circle and several dozen other cryptocurrency or crypto-adjacent firms. Hammond contributed to the President’s Working Group report on stablecoins, which was issued in 2021 ahead of legislation or regulation for stablecoins.

Bank regulations treat commercial paper as debt instruments, which restricts banks’ investments in non-investment-grade debt. Also, certain commercial paper does not qualify as “highly liquified assets,” which means if banks do invest, it will count against the bank’s liquidity requirements.

Stablecoins are also often used to facilitate lending, trading and borrowing for distributed finance apps, which rely on software and blockchains to trigger financial transactions via smart contracts. That reduces reliance on traditional intermediaries, but the President’s Working Group report contends it also poses risks such as disruption to the digital asset trading platform that could threaten the stablecoin’s stability.

Sen. Elizabeth Warren, D-Mass., has called for strict regulation of stablecoins, saying stablecoins “prop up one of the shadiest parts of the crypto world, [distributed finance], where consumers are least protected.” Republicans, such as Sen. Pat Toomey of Pennsylvania, have called for Congress to pass a law governing stablecoins and have expressed opposition to direct agency regulation.

“The incentive is always going to be there to invest,” Nelson said, adding that the lack of clarity for disclosure allows nonbank stablecoin issuers to include commercial paper and short-term investments as assets backing the coins. “And the disclosures for [stablecoin issuers] are subject to interpretation.”