The future of payments in a decentralized world

Written by Kapronasia || May 04 2023

This commentary was written in collaboration with Banking Circle.

Given the hype around the nascent decentralized third iteration of the internet, it is common these days to read or hear that “Web3 is the future of payments.” But is it?

That depends.

Decentralized virtual currencies, a key Web3 building block, have been used as payments since at least 2009, but they have failed to penetrate mainstream financial services for two main reasons. One, cryptocurrencies like bitcoin are too volatile to be a reliable payment system. Their prices fluctuate wildly. Second, the crypto payment user experience is often poor compared to traditional finance, especially when factors like the complexity of multiple chains and high blockchain transaction fees are considered.

Some crypto diehards insist that bitcoin will prevail for payments. They say that the desire of an increasing number of people to pay for goods and services with bitcoin will incentivize entrepreneurs and investors to build the infrastructure to facilitate bitcoin payments globally. They cite the Lightning Network, a layer-2 payment solution (a secondary protocol) built on top of the bitcoin blockchain.

Don't bet the farm on it. The biggest bitcoin boosters have a deep-seated financial stake in endlessly promoting it, ensuring its value rises as high as possible, irrespective of its utility for payments.

The stablecoin value proposition

A more realistic alternative to crypto assets like bitcoin and ethereum would be stablecoins. A stablecoin is a crypto asset that aims to resolve the volatility problem by maintaining a stable value relative to a specified asset. It is pegged to one of three types of assets: a fiat currency like the US dollar, a commodity like gold, or a crypto asset.

A centralized institution ensures “stability” in stablecoins by issuing and redeeming these crypto assets. A custodian must hold corresponding reserves, usually fiat currency issued by governments, that back each unit of stablecoin that is issued.

According to Venture Beat, “trusted stablecoins are essentially a digital version of a dollar — fully reserved by physical U.S. dollars in bank accounts, redeemable 1:1 for cash and available for use on blockchains.”

Stablecoins could improve on existing payment systems by reducing costs, improving security, and increasing the speed of transactions while avoiding the volatility of cryptocurrencies without a peg. Stablecoins could potentially boost financial inclusion by speedily bringing the unbanked into the financial system and improving the access of the underbanked to financial services.

There is some evidence that both consumers and merchants are willing to adopt stablecoins expeditiously. According to a survey Deloitte published in June 2022, about 75% of surveyed merchants plan to accept digital asset payments by 2024, and 83% expect consumer interest in digital assets to increase in the near future.

When stablecoins are unstable

Despite the promise of stablecoins, they could fail to live up to their name without a robust regulatory framework and corresponding financial industry infrastructure – which at this point does not exist.

The most infamous example of a failed stablecoin is UST, which imploded suddenly in May 2022 along with its sister coin Luna over roughly a week’s time when it lost its peg to the dollar, deep-sixing a US$60 billion crypto payments ecosystem.

In February 2023, the U.S. Securities and Exchange Commission charged UST creator Terraform Labs and its CEO, Do Kwon, with fraud, alleging that they masterminded a multibillion-dollar crypto asset securities fraud. Terraform Labs promoted UST to investors as a “yield-bearing” coin, offering to pay interest of up to 20%, the SEC said.

Unlike asset-backed stablecoins, TerraUSD was algorithmic, aiming to maintain stability through algorithms and smart contracts that manage token supply. Following Terra’s failure, the decision was made in March to fully back the FRAX stablecoin with U.S. dollar equivalents, likely marking the end of the algorithmic stablecoin experiment.

The impact of MiCA

The European Union’s Markets in Cryptoassets (MiCA) directive could be a game-changer for Web3 payments. MiCA will regulate the cryptocurrency sector with common rules across all 27 member states, including those specific to stablecoins. MiCA is part of a broader push by the EU to regulate digital finance more like it does the traditional financial services sector.

When it comes to stablecoins, MiCA mandates that they are sufficiently backed, have capital requirements for issuers, and have issuance limits, with a focus on transparency. Though some crypto fundamentalists are griping about the regulations being overly restrictive, they probably will lead to much wider stablecoin adoption in the EU.

With the passage of MiCA reducing regulatory uncertainty, “I expect major European banks will roll out crypto-asset services in the next 48 months, be it custody, exchange, or the issuance of e-money tokens or asset-referenced tokens, colloquially referred to as stablecoins,” Patrick Hansen, Director, EU Strategy & Policy at Circle, wrote in March.

The Japanese approach

In addition to the EU’s MiCA, Japan’s stablecoin regulations are also worth watching carefully. In December 2022, the country’s ruling Liberal Democratic Party (LDP) released an interim proposal on Web3 policies signaling Japan’s interest in developing related businesses. The proposal’s key recommendations include revisions to the tax code and the policies of regulatory bodies in charge of digital assets, as well as establishing audit guidelines for Web3 companies and promoting stablecoins.

Additionally, Japan's Financial Services Agency is reportedly seeking feedback on new regulations that would allow stablecoins issued outside the country to be listed on local exchanges. Under the draft regulation which is expected to be finalized by June, local distributors will be allowed to handle payments-focused stablecoins. If this draft regulation is enacted, it will likely reverse a ban on the local distribution of foreign stablecoins.

There is a caveat, however. A spokesperson for Japan's FSA said in a statement to Cointelegraph: “This does not mean that all foreign products of so-called ‘stablecoins’ will be allowed without any restriction,” adding that the agency would only allow stablecoins that pass specific safety checks – without specifying the criteria.

Japan’s private sector has also shown a keen interest in stablecoins. In March, the Japanese banks Tokyo Kiraboshi Financial Group, Minna no Bank and Shikoku Bank announced that they would experiment with stablecoin payments using a system developed by Web3 infrastructure company system GU Technologies on the public blockchain Japan Open Chain.

The jury is still out

For Web3 payments to live up to their promise, the role of volatile cryptocurrencies like bitcoin and ethereum must be minimized, and stablecoins with reliable pegs must become the industry standard. For this to be possible, more comprehensive regulations and financial infrastructure must be put in place. Otherwise, it will only be a matter of time until the next UST incident.

Some jurisdictions like the EU and Japan are leading the way on stablecoins, and should they be successful, it could pave the way for a wider adoption of Web3 payments globally. But regulatory harmonization will take time.

Ultimately, it will be important for major economies that have yet to espouse clear stances on Web3 payments and stablecoins to do so, namely the United States, China and India. The U.S. delayed broad consideration of stablecoin regulation in July 2022. China has been generally opposed to use of crypto in its financial system though recently it has signaled a possible subtle shift in direction. For its part, the Reserve Bank of India has raised concerns any crypto asset pegged to the US dollar or any other global currency could destabilize the Indian rupee.

Given the economic clout of these three countries, without their active participation, it is hard to imagine Web3 will be the future of payments.

This commentary was written in collaboration with Banking Circle and originally appeared on Banking Circle