Wednesday, November 6, 2019

From unknown wallet to unknown wallet

Antony Lewis recently published a useful article on stablecoins. In it he describes something called "permissioned pseudonymity". In traditional payments systems, people only get to access to payments services after opening an account. This requires that they provide suitable identification. So these systems are not pseudonymous. Usage and personal identity are linked.

Stablecoins operators, on the other hand, sever this link. Users can transfer stablecoins to other users without providing personal information. John Doe can pay Jane Doe, no questions asked. Antony calls this permissioned pseudonymity because regulators permit pseudonymous usage of stablecoin networks.

The above payment is an example of permissioned pseudonymity. It is a $30 million transfer between two unknown wallets along the USD Coin stablecoin network. The operator of this network, Centre, may have no idea who did this transfer.

I do wonder how long regulators will allow pseudonymous usage of stablecoins to continue. Most of the rules surrounding payments emanate from the Financial Action Task Force (FATF), a global committee of regulators that meets together every once in a while to determine how to fight ghoulies like money laundering and terrorist financing. The FATF guidelines are in turn applied by local regulators in each country with some modifications, and monitored by FATF for compliance.

FATF regulations are supposed to be technology-neutral. In short, the same principles apply to new technologies and incumbent technologies alike. This makes sense. We probably don't want regulators to picking winners and losers by setting one set of requirements for companies A-E and another set for F-J. The competition for market dominance only begins after they've complied with the same rulebook.

So far FATF hasn't had much to say on stablecoins. But you can be sure that something is in the works, and it isn't likely to be good for stablecoin operators. The problem is that granting permissioned-pseudonymity to stablecoin operators contradict technology-neutrality. It sets one set of standards for bank accounts and another for stablecoins.

Banks are already obliged to collect the personal information of all their account holders. If two people transfer $30 million along the bank payments network, you can be sure that the banks who manage these accounts have already gone through the costly process of collecting personal information. 

Why should stablecoins like USDC and PAX be exempt from this obligation?

Antony suggests that stablecoins qualify for an exemption because they meet regulatory concerns through other sensible means. Because stablecoins use blockchains, and blockchains record transactions, the information trails left by pseudonymous stablecoin users can be traced and monitored for suspicious activity. The stablecoin issuer can then toggle a kill switch and freeze potentially dangerous addresses.

This makes sense. But if stablecoin issuers can avoid identifying its customers by implementing a process of monitoring and freezing, it seems to me that the incumbent technology, the bank account, should also be granted the same opportunity. After all, account-based systems can do kill switches and tracing just as well as stablecoins can.

For instance, say that Citibank were to set up its own pseudonymous account payments network, call it Citibank HushAccounts. Customers can open a HushAccount without providing personal information. They can then use the HushAccount network to trade balances pseudonomously to other account holders. Citibank bankers monitor HushAccount transactional patterns and freeze anything that looks odd. Personal information only needs to be provided when a user wants to cash out of the HushAccounts system.

Of course, we already know that Citibank can't implement HushAccounts. It's illegal. Which underlines my point about technology-neutrality. Why can a stablecoin like USD Coin get away with pseudonymity but Citibank can't?

Let me put it differently. If stablecoin issuers can get away with not collecting user ID, then expect to see Citibank make a few cosmetic changes to its traditional account-based system so that it qualifies as some sort of stablecoin blockchain thingy. And now that it needn't collect as much information about its customers, it can fire a bunch of its compliance staff. Other banks would copy it. Soon we'd get hyper-stablecoinization. Every bank account would be converted into a stablecoin. But FATF rules aren't supposed to favour any one technology.

So for the sake of maintaining neutrality, I wouldn't be surprised to see regulators put an end to pseudonymous stablecoin usage. Stablecoin issuers will only be able to give out addresses to people who have passed through some sort of know-your-customer process.

There's a second possibility. As Antony points out, there is one notable regulatory exception to universal identification in payments. In many parts of the world, people can buy prepaid debit cards (or in Europe, e-money) without providing any ID. This provides the card owner with pseudonymous access to the Visa or MasterCard networks. I've written about these cards before (in fact, it's one of the most popular posts I've ever written). You can also trek over to my article at Sound Money Project on the topic.

Stablecoins, like prepaid debit cards, might be granted their own exemption.

There is a caveat to pseudonymous prepaid access. Regulators have set a very low ceiling for the amount of pseudonymous value that prepaid cards or e-money wallets can hold. In the case of the U.S. it's just $1,000. (In Europe, it's just 150 euros). Anything above that and a prepaid card holder must submit identification. There are other limits too. In the U.S. the cards must be non-reloadable, and people can't use them for person-to-person payments, at ATMs, or for international purchases. This makes for an extremely constricted payments product.

Regulators believe that by keeping the pseudonymous prepaid ceiling low and reducing the features that a card offers, they achieve two things. The risk of money laundering and terrorist financing are minimized. At the same time the unbanked and those without ID still get access to the retail payments system.

If FATF were to allow stablecoins to offer a limited amount of pseudonymity, the ceiling for it would probably be quite low, much like prepaid debit cards. No more $30 million person-to-person payments, just $20-$2000 ones. After all, it's hard to make an argument for why genuinely needy folks without IDs would need to make million dollar stablecoin transactions. 

I should point out here that I'm not saying that I'm a fan of FATF and its mission to unveil every single transaction. I've written many times about the benefits of financial anonymity. And a lot of smart people that I read think that the cost of enforcing anti-money laundering rules far outweighs any benefits that it provides. All I am saying is that I suspect that permissioned pseudonymity for stablecoins isn't going to last very long, in its current form. It'll either be banned altogether, or a very low ceiling will be set on it.

P.S. If I had to predict, I'd go with a ban. It's easy to get around a ceiling. If the ceiling is set at $1000, then users can set up 1000 pseudonymous accounts in order to get $1 million in pseudonymity.


  1. How much of this applies to a decentralized stablecoin (e.g. MakerDAO's DAI)?

    1. I am going to guess that either MakerDAO has to register with FinCEN and do AML, or it will be obligated to ensure the CDPs that use it are registered and in compliance.

  2. This is about stablecoins where regulators can possibly impose rules but what about privacy coins like Monero where even the blockchain won't reveal anything and there is no central operator to regulate? Even if these get banned from exchanges, there is nothing to stop such coins operating on peer to peer exchanges or offshore / darknet exchanges.

  3. Reading this, I am curious about the powers in play and their incentives for each of your options that are explained. I see three possibilities about the future of pseudonymous moneys described in your article. I see 4 powers at play all option: Those currently in the pseudonymous moneys market, competitors to those in the pseudonymous money market, regulators, and citizens not involved in the pseudonymous money market.

    Option 1: Regulators continue to allow pseudonymous money online.
    Option 2: A complete ban of pseudonymous moneys.
    Option 3: A ceiling for online pseudonymous moneys.

    Looking at option 1, it seems this would be the optimal option for individuals utilizing this market and/or hoping to utilize this market. Therefore, the current organizations and individuals currently utilizing this market would have an incentive to promote option 1. This power being in favor of option 1 furthers the likelihood it is chosen. You also mention Citibank because it is likely if option 1 were chosen, that they would also want to get into this market and that this market could potentially save them money in the sense that they could reduce a lot of the compliance work they currently pay for. Yet, with the value growth of data as a commodity, it is likely that current competitors to the pseudonymous money market players such as Citibank would not desire option 1. Option 1 would mean that their value of financial data would decrease, even more so if they joined the pseudonymous money market. Thus it is possible that the competitors would lose if option 1 is chosen even if the competitors later joined the market. Saying that, further research would need to be done to determine if the value gained from joining this market and cutting compliance resources would outweigh the value of financial data gathered from the current market. Saying that, for now we could consider the power of the competitors to those in the pseudonymous money market to be a wash. Option 1 seems to be the least optimal option in the eyes of regulators. This option would likely lead to the most laundering/corruption out of the 3 options and this option does not fall in line with their desire to have technological unbiasedness. Thus from the perspective of the regulators the incentive would be to stop/regress option 1. As far as the citizens not involved in the pseudonymous money market, we would likely see four schools of thought. Some people would likely not care about the dilemma at all. Others would likely believe most that people have a right to financial privacy and freedom of choice. Others would likely believe most that it is sketchy and would prefer all laundering stopped. The last school of thought would likely oppose option 1 in fear of change. Based on no scientific evidence, and purely on personal speculation of people, I would guess that the majority of the citizens would fall into the school of thought of opposing option 1. For the reasons stated above, I think option 1 is an unlikely scenario as there is only one power that is for certain in favor of option 1 and in my opinion, it is the least strong power of them all: those already in the pseudonymous money market and those looking to enter the pseudonymous money market. I believe regulators power and citizens power is the strongest of the powers I mentioned, both of which would likely oppose option 1, barring further findings. On top of that, competitors which I find to be of equal power as those in the market (for discussion sake) would also oppose option 1, furthering the unlikeliness of this option.

    1. Next let's look at option 2. It seems as though this would be the optimal option for eliminating as much laundering as possible, but it is the least desired option by those utilizing the market or hoping to utilize the market. Thus those involved in this market or looking to enter this market would strongly oppose this option. Competitors to the pseudonymous money market would likely be in favor of option 2. Although you spoke about Citibank having the option to enter this market, they would likely see it as less risky to take full advantage of their already dominant resources by increasing the value of financial data (outlawing a lack of data would likely grow the market of bankable individuals and the market for financial data). The power of regulators would favor option 2 as well as it would limit laundering more than any other option. Yet, there is an issue with this, as you again run into the problem of equality since prepaid debit cards would still be allowed as pseudonymous money. Regulators could then decide whether to outlaw these forms of pseudonymous money or to create a more complex regulation that would allow these but outlaw the stablecoins or similar options. This creation of a more complex regulation would likely lead to loopholes in the future and ways that another stablecoin like product would emerge within the regulation standards. Therefore, although regulators would be in favor of option 1, this factor of legal complexities in regard to the current standards on prepaid cards would likely lower the incentive of regulators for this option. Utilizing a similar 4 option school of thought for citizens not involved in pseudonymous money, I would assume the majority of opinion would be in favor of this option as it limits laundering and does not change the current banking system from their perspective. Yet, the further litigations in regards to prepaid cards could throw a curveball in this, as we would have to assess the powers in regard to prepaid card legality as a completely separate topic. Therefore option 2 leaves us with a strong incentive against option 2 from a weaker power of those involved in the pseudonymous money market. It also leaves us with a strong incentive in favor of option 2 from the competitors, regulators, and citizens. The caveat to those in favor of this decision is how the regulators react to prepaid debit cards, which could completely change the incentives of regulators, competitors, and the citizens.

    2. Option 3 is the in between option. I see the power of those within the pseudonymous money market to be strongly against this option as it slows down their current market. The competitors would likely be in favor of this option in comparison with some of the other options. This would allow competitors like Citibank to utilize online pseudonymous money market options without losing a large share of their overall banking market or financial data market. Given their current resources, they would likely compete within this market with ease. Regulators would also likely be in favor of this option as it limits the laundering that they see and leaves less need for future litigation. We would likely still see laundering as we do with prepaid cards, but it would require more energy and resources to do so, thus it would be less likely to occur. Yet, the fact that the ceiling is a similar law as the current law on prepaid debit cards, it means that there would not be a need to adapt the current law on prepaid debit cards (thus less pushback from those powers), creating an incentive to option 2 for its future ease. Lastly, citizens would likely be in favor of this option as well. It would be new to them, thus they would have distrust for change, but the small scale of it will not worry them severely. On top of that, if more professional competitors, such as Citibank, enter the market it would likely just be seen as a new way to transfer money and not so much as a sketchy online money scheme. All the while, those citizens who believe in freedom of choice and privacy would likely favor it to an extent as it is at least a compromise to the options available. Thus option 3 presents us with nobody strongly against with the most strongly opposed power being a weaker one in that of those already in the market/those looking to enter the market. The strongest of the powers, regulators and citizens, would likely advocate for option 3 as it provides them ease, transition, and freedoms while limiting the current state of laundering and corruption.

      Looking at it this way makes me believe that the option you present about creating a ceiling system and similar regulation to those currently on prepaid debit cards is the most likely option to occur in the future.Of course it still leaves room for laundering and corruption, but what does not? This is obviously not a scientific approach and there is massive room for error when simply guessing the motives of the powers involved, but it made me wonder why you think the most likely option will be a ban? Is it because of its simplicity?

      --Thank you

    3. Wow, quite the reply. Thanks Chase.

      "... but it made me wonder why you think the most likely option will be a ban? Is it because of its simplicity?"

      Yes, the simplicity. It's very difficult to put a ceiling on anonymous money. People will just get around the ceiling by opening multiple accounts.

      The same criticism can be levelled at prepaid cards, of course. If the ceiling on prepaid anonymity is $500, then with three cards someone can reach $1500. This is somewhat mitigated by the fact that cards can only be used where retailers accept Visa/Mastercard, and not in p2p transactions. This limits their usability. Also, regulators can simply tell stores (or the card networks) to disallow the usage of multiple gift cards to make one transaction.