Facebook-Backed Diem Explained

Now that everyone found out that the Diem Association plans to launch its pilot by the end of 2021, it got in the spotlight and caught the attention of a wider audience.

Recently, we covered the whole history of the Facebook-backed Diem, from the initial idea to the most recent news. If you missed that article for some reason, make sure to check it out here.

Today, however, we’ll talk about Diem itself, all the products and services that are to be released by the Diem Association, and regulations around them.

What is Diem?

Diem is a project introduced by Facebook in June 2019 under the name Libra. It is a whole ecosystem of digital products governed by the Diem Association. At the moment, on top of the cryptocurrency, it is designed to include the Diem payment system, Diem Blockchain, and Diem Reserve.

The general mission of the project is to enable a simple global payment system and financial infrastructure that empowers billions of people. The Diem Association wants to achieve this mission by cooperating with regulators, central bankers, elected officials, and various stakeholders around the world to determine the best way to integrate smoothly with local monetary and macroprudential policies.

The Association has set several goals to be achieved within the Diem project:

• Integrate blockchain technology into the everyday life of billions of people worldwide, providing them with access to safe and affordable financial services.
• Enhance traditional financial systems to become programmable, interoperable, and upgradeable.
• Build innovative but also safe and compliant financial applications that can serve everyone.
  

The Diem Association plans to achieve these goals with the help of the digital products we mentioned before, in the first place, the payment system supporting single-currency stablecoins and a multi-currency coin.

Is Libra Diem? Or is Diem Libra?

Even though the rebranding took place almost a year ago, many users still get confused by the former name of the project. So let’s clarify this issue once and for all.

In December 2020, Facebook-backed Libra completed a rebranding and became Diem in an attempt to distance itself from Facebook and ensure that the project meets regulatory expectations. This was mainly caused by the preceding concerns that such a powerful company as Facebook will get more influence on the global financial system.

Here’s a full overview of the history of Diem (formerly known as Libra).

If you want to learn more details, read our previous article covering the full history of Facebook-backed Diem.

What is the Diem Association, and why is it needed?

Diem Association is an independent membership organization overseeing Diem. It is responsible for the governance of the Diem network and the development of the Diem project.

It was decided to establish a whole association to govern the Diem project as this is the most reliable and secure way. Besides, it will be easier to bring the Diem mission to life by diverse and independent collaborators rather than one centralized party. This translates the overall principle of decentralization that Diem is built upon.

The main job of the Diem Association is to facilitate the operation of the Diem payment system; to coordinate the agreement among its stakeholders in their pursuit to promote, develop, and expand the network; to oversee the administration of the Diem Reserve; and to facilitate the provision of services in the Diem payment system in a safe and compliant manner.

The Diem Association consists of businesses and non-profit organizations from all over the world. At the moment, its members include Andreessen Horowitz, Blockchain Capital, Coinbase, Novi, Lyft, Shopify, Spotify, Uber, and others. However, the Association continues to accept new members that meet all the criteria and support the project’s mission.

The Association is governed by the Council comprised of one representative per each member organization. Major policy decisions are made with the consent of two-thirds of the Council representatives, the same supermajority of the network required in the Diem Byzantine Fault Tolerance consensus protocol.

What is the Diem payment system?

The Diem payment system is meant to be developed as a reliable and interoperable payment system that will help billions of people worldwide access financial services.

The payment system will support single-currency stablecoins (e.g., ≋USD, ≋EUR, ≋GBP, etc.) and a multi-currency coin (≋DIEM), which users will be able to hold and transfer all over the world.

To achieve accessibility and reliability of the tokens, each single-currency stablecoin will be backed 1:1 by the Diem Reserve, which will consist of cash or cash equivalents and very short-term government securities denominated in the relevant currency. Each Diem coin, being a composite of 1:1-backed single-currency stablecoins supported by the Diem network, will inherit the backing and stability of those stablecoins.

The Diem payment system will be built on the Diem Blockchain, which is completely open-source, meaning that anyone can access it and develop on it.

How does Diem blockchain work?

To ensure proper work of the Diem payment system, the Diem blockchain was developed from scratch to prioritize scalability, security, efficiency in storage and throughput, as well as future adaptability.

The Diem blockchain was built based on the following requirements:

• provide high scalability (high transaction throughput, low latency, high-capacity storage system);
• enable enhanced security;
• stay flexible to power future financial products and services.
  

It was decided that the Diem blockchain will use a combination of innovative approaches and well-understood tools, such as a Byzantine Fault Tolerant (BFT) consensus.

The biggest innovation implemented by the Diem Association was the Move language that was designed and perfected for the Diem blockchain. It was specially developed to implement custom transaction logic and “smart contracts” on the blockchain.

Move has several specific features inherent exclusively to this programming language:

• It decreases the risk of unintended bugs and security issues by building code that takes former security incidents into account.
• It prevents assets from being cloned by enabling “resource types” that constrain digital assets to the same properties as physical assets: a resource has a single owner, it can only be spent once, and the creation of new resources is restricted.
• It facilitates automatic proofs that transactions satisfy specific properties, such as the requirement that payment transactions only change the balances of the payer and receiver.
• It allows an easy and secure definition of the core elements of the Diem network, such as payment transfers and the management of validator nodes.
• It enables integrating compliance mechanisms into the Diem network.
  

Another essential component of the Diem blockchain is a Byzantine Fault Tolerant (BFT) consensus, which was adopted to facilitate agreement among all validator nodes on the ledger of transactions. It is used to build trust in the network, enable high transaction throughput, and facilitate clearly described transaction finality.

As the security of BFT depends on the quality of the validators, the Diem Association will perform due diligence on prospective validators. Besides, the software run by validators will also be strengthened by the network structure owing to different techniques (the separation of critical code, consensus algorithm testing, and careful management of dependencies).

Merkle tree structure will guarantee additional protection of the network by securely storing transaction data on the Diem blockchain and preventing any alterations. It turns the Diem blockchain into a single data structure that records the history of transactions and states over time.

Implementing such a structure will lead to the following results:

• Enable a unified framework simplifying the work of applications that access the blockchain.
• Bring public verifiability, meaning that anyone (validators, Diem Networks, Virtual Asset Service Providers , law enforcement, or any third party) can audit the accuracy of all operations.
• Allow signing transactions with cryptographic keys so that even if all validators are compromised, no falsified transactions from addresses with secure signature keys can be accepted as committed.
• Support a privacy approach that takes into account the variety of participants on the network.
  

You can find more technical information on the Diem Blockchain in the Technical Paper, the Move Language Paper, and the Diem BFT Paper.

Diem Coins: Diem stablecoins and multi-currency coin

The Diem payment system is designed to be a low-cost network that enables unlimited access to financial services to any user in the world. For this reason, single-currency stablecoins (e.g., ≋USD, ≋EUR, ≋GBP, etc.) are included to the network, as well as the multi-currency coin. This is believed to enable a range of domestic use cases empowering businesses and individuals all over the world.

Each single-currency stablecoin released by Diem will be supported by the Diem Reserve with cash or cash equivalents and very short-term government securities. They will only be minted and burned in response to market demand for that coin.

Such an approach will help the Diem Association lower costs and enable new functionality while giving maximum flexibility and control to central banks for how the Diem payment system is used in their countries.

When speaking about Diem stablecoins, it is important to differentiate them from central bank digital currencies (CBDCs). The Diem Association has clearly stated that Diem stablecoins are developed as a complement to, not a replacement for, domestic currencies, including CBDCs. This means that Diem does not aim to interfere with any country’s monetary sovereignty and monetary policy. On the contrary, the Association hopes that as central banks develop their CBDCs, they could be directly integrated with the Diem network.

The multi-currency Diem coin, on its part, is a fully backed basket of world currencies in the Reserve. It will operate as a settlement coin in cross-border transactions, serving as a neutral and low-volatility alternative and increasing financial inclusion. It is also supposed to serve as a simple solution for the places where there is no single currency coin yet.

The Diem coin will be implemented as a smart contract that aggregates single-currency stablecoins using fixed nominal weights (e.g., ≋USD 0.50, ≋EUR 0.18, ≋GBP 0.11, etc.). To limit any regulators’ concerns, the Diem Association offers regulators and international organizations to oversee the basket composition.

What is the Diem Reserve?

As we have mentioned above, Diem stablecoins will be fully backed by the Diem Reserve, consisting of high-quality liquid assets and supported by a network of resellers and exchanges buying and selling each coin.

The Reserve will hold, in cash or cash equivalents and very short-term government securities, an amount at least equal to the face value of each Diem Coin in circulation. Besides, it will mint and burn each single-currency stablecoin in response to market demand. Additionally, a smart contract will combine these specific single-currency stablecoins into a multi-currency coin based on specified fixed nominal weights.

The Reserve will consist of at least 80 percent very short-term (up to three months’ remaining maturity) government securities issued by sovereigns that have very low credit risk (e.g., A+ rating from S&P and A1 from Moody’s, or higher) and whose securities trade in highly liquid secondary markets. The remaining 20 percent will be held in cash, with overnight sweeps into money market funds that invest in short-term (up to one year’s remaining maturity) government securities with the same risk and liquidity profiles.

To protect the network and consumers, the Association is developing a regulatory capital framework to ensure it maintains an appropriately sized, loss-absorbing capital buffer. This is meant to mitigate any potential risks and losses within the framework.

The Diem Reserve will be transparently administered, regularly audited, and the results of such audits will be made publically available.

Compliance and regulations

In the world of decentralized finance, compliance is the most acute issue at times. And Diem has already drawn the attention of regulators, causing them to put the project on hold in 2019 and raise questions regarding Diem stablecoins. Thus, it is crucial for the Diem Association to create a legally compliant and safe network and engage regulators, central banks, and lawmakers to develop a consumer-friendly ecosystem.

The Diem Association and its subsidiaries will implement a compliance framework supported by the protocol-level controls and designed to ensure they meet regulatory obligations.

To develop a safe, compliant network, the Association will perform the following actions:

• create a comprehensive compliance program;
• set mandatory standards for unrestricted use of the Diem payment system;
• conduct due diligence on Association Members and Designated Dealers;
• distribute Diem Coins through regulated Designated Dealers;
• allow only Regulated or Certified VASPs to transact on the network without transaction and address balance limits;
• apply automated protocol-level compliance controls for all on-chain activity;
• develop an off-blockchain Travel Rule protocol;
• monitor Diem network activity and coordinate with participants;
• respond to identified potentially suspicious and sanctioned activity, including through reporting.
  

In the case of any potentially suspicious and sanctioned activity, the Diem Association will turn to the authorities according to applicable law.

Pontem contribution to Diem

Even though Diem is an ambitious project with huge potential, it has some bottlenecks. We’ve created Pontem Network to help Diem fulfill their original vision of financial inclusion through a safe and regulated permissionless system accessible to the world.

There are several ways Pontem can contribute to the Diem project:

• Pontem can facilitate the transfer of Diem stablecoins and the multi-currency coin with use cases for stablecoins.
• We can help provide proper instruments and product-market fit testing for compliance, including SaaS and business services.
• Pontem Network is the bridge to the permissionless system that already exists, which will enable the overall ecosystem improvement and help mitigate risks.
• We will be able to contribute to maintaining the system by providing liquidity from the permissionless ecosystem and complying with any necessary audits.
  

Pontem is already serving as an experimental network for Diem, providing users with multiple tools for testing their market hypothesis. Yet, we believe we can contribute to the network more as the pilot is released and beyond.