Stablecoins have emerged as one of the larger distributed ledger conversation topics since late 2017 and into 2018. Over the course of the year, the conversation has put to question whether stablecoins are a viable model and, if so, which type of stablecoin model?
It was pure ignorance, derived from the distaste of the Tether fiasco, that up until a few minutes ago, I was about to write something resembling a hit piece on the viability of stablecoins. But before I decided to go further with the piece, I wanted to look into the article I had glanced at recently, that detailed the different stablecoins that Huobi had recently brought onto their exchange. It was at this point that I realized that “the” conversation is changing (evolving) to focus on cryptoassets rather than currencies. Nobody wants to transact on a volatile currency, although I believe there are models for speculative currency & assets (as I’ve addressed in the speculative token section of a previous piece).
I see parallels within the real world today to the forecasted long-run world within an article that I drew up a few days ago, where the cryptoassets are becoming some of the first foundational tokens and stablecoins are becoming the transactional tokens.
What I had originally imagined was that transactional tokens would emerge in a hard-power fashion, with regulators facilitating the implementation of rules behind digital currencies from top-down, but now I’m starting to see things differently. The origination of historic currencies in the beginnings of days was very much a grass-roots effort, so there’s a very real possibility that the US government — understanding that they may want to maintain a policy of non-intervention so as to not stymie innovation — may be willing to overlook the quasi-multicurrency violation of US law, in favor of creating ubiquity in trading digital assets. In this way, digital currencies will rise in a “soft power” fashion rather than the hard power way that I had initially imagined (ie top-down legislation & enforcement).
Based on this article, there are three models behind stablecoins:
(1) Fiat-collateralized (centralized)
Backed by fiat currencies, these centralized stablecoins rely on a single actor to issue IOUs redeemable at a 1:1 ratio for the underlying asset, with reliable convertibility of the IOU helping to maintain the 1:1 peg.
(2) Crypto-collateralized (decentralized)
Backed by crypto assets, these decentralized stablecoins rely on trustless issuance, also referred to as on-chain issuance, and maintain their 1:1 peg against assets via overcollateralization, incentives, and other methods
(3) Non-collateralized (algorithmic)
Algorithmic stablecoins, also referred to as Seigniorage Shares and Future Growth-Backed stablecoins, are algorithmically-backed with expansion and reduction of coin supply mathematically determined. There is NO collateral backing issuance. Ironically, central banks typically maintain the stability and supply of their fiat currencies through similar mechanics.
Based on the author’s line of reasoning and some thought of my own, the only model that seems to work would be the first one (ie fiat-collateralized tokens). The difference between the fiat collateralized model and the other two models is that the risk can be mitigated for the fiat-collateralized model while the other two have no checks in place. Let’s run through the worst case scenarios for each.
For fiat-collateralized, the risk is counterparty risk (ie that the central institution won’t pay). Suppose I spend $100 at an exchange and get 100 X coins that trade at $1/pc. In an unregulated arrangement without laws, there’s nothing stopping the exchange from hyperinflating the currency by mass-producing the supply, and then when I go to exchange one of my tokens for $1, I am told that my currency is only worth $0.13. In this situation, the exchange is effectively a liar, and made off with the $0.87 from each dollar that I deposited.
For crypto-collateralized, the risk is underlying volatility of the value of the collateral. Suppose Y coins are tied to a number of digital assets across industries: real estate-backed tokens, vehicles, machinery etc. These assets can then be staked for coins. However, if misreporting on the assets occur or one of the markets backing the coin plummets, then the debt holder may decide not to pay back the loan.
For non-collateralized, the risk is lack of growth. This currency functions by creating a new stablecoin whenever there is increased demand, and by issuing shares when there is a decreased demand (which you can only get through 1:1 exchange of your stablecoin for a share). Assuming that the currency has a poor outlook, speculators likely would have no interest in buying shares (where they are promised a small amount of interest when the coin market price increases supply). As a result, the price of the coin maintains a low price and people will soon rush to offload their coins into assets to retain value.
In the first type of stablecoin arrangement (ie fiat-collateralized), if there is a money supply which is validated and secured by regulatory checks, watchdog agencies, and 3rd party auditors (as well as visibility available to the world at large), then the risk is mitigated. The Fed will release reports every quarter about interest rates and quantity supplies, while a circle of auditors corroborate that information. The second type of stablecoin arrangement (ie crypto-collateralized) doesn’t make sense. Essentially, the currency is based on debt, and nobody in their right mind would be willing to give up an equivalent amount of currency for a staked house, if there is no information about the house or that that future outlooks for the housing market look grim. As well, we’re brought back to the barter system in the event of default (eg someone wanted to buy groceries, couldn’t pay me back, and now I have a piece of furniture). I feel that the third type of stablecoin arrangement (ie non-collateralized) needs to be explored further, but my gut reaction tells me that this doesn’t sound good in practice. I have to wonder if the algorithmic arrangement propels economic downturns and is susceptible to foreign manipulation tactics.
In effect, while there may be value in taking another stab at the third model at some point in the future, I say why don’t we take things slow for the moment and keep economics in a way that everyone can understand: transparency, accountability, and government regulation. For this reason, the first model (ie fiat-collateralized) seems to make the most sense.
The Contenders
Huobi’s recent addition of four stablecoins to its market is significant in that — should one or multiple of the stablecoins acquire a trusted reputation over time — companies may decide to build tokenized assets off of these stablecoins. Let’s go through these coins, but first refer to this article that covers them well.
Gemini Dollar (GUSD)
Created by Winklevoss brothers
Regulated by New York State Department of Financial Services
The equivalent amount of circulating GUSD tokens will be deposited into the official Gemini Dollar bank account at the State Street Bank and Trust Company
A monthly audit by BPM, LLP will take place to guarantee its 1:1 peg
ERC-20 token that can be transferred on the Ethereum network
Gemini dollars are created at the time of withdrawal, and burned at the time of deposit
Ensuring their technical design encompasses the ability to “Pause, block, or reverse token transfers in response to a security incident or if legally obligated or compelled to do so by a court of law or other governmental body.”
Paxos Standard Token (PAX)
Created by the team at PAXOS
Approved and regulated by the New York State Department of Financial Services
The entire supply of PAX is collateralized by USD in dedicated omnibus cash accounts at FDIC-insured banks
Monthly audits performed by Withum accounting firm
Always able to redeem PAX for USD within one business day
Support team included for larger accounts
Company established as a trust company rather than a bank (ie fiduciary that custodies customer deposits and therefore will always keep customer funds completely segregated)
Smart contract code audited by Nomic Labs
TrueUSD
Created by the team at Trust Token
First stablecoin regulated by the US Government
Audits performed by Cohen & Co
ERC20 stablecoin that is fully collateralized, legally protected, and transparently verified by third-party attestations
The token uses multiple escrow accounts to reduce counterparty risk, and to provide token-holders with legal protections against misappropriation
The team has a code of ethics
The token dovetails with Trust Token, which is the parent platform that allows for the creation of asset-backed tokens
USD Coins
Created by the team at Circle, Coinbase
Coins are issued by regulated and licensed financial institutions
Audited by Grant Thorton, LLP
Contracts manage the minting and the redemption/burning of stablecoins
ERC-20 token creating possibilities in payments, lending, investment, trading, and trade finance
Circle team was the first team to receive a BitLicense, and is a registered money services business (MSB) in US and has an E-Money Issuer license from the Financial Conduct Authority in the UK
Forging the Path Ahead
There are some considerations that need to be had before we get too far ahead in the stablecoin realm.
The first is about the legal fiduciary duties of the companies hosting the token ecosystem. What are the legal responsibilities that these stablecoin providers have to guarantee your funds? Do you have the law on your side for when you want to withdraw your money at a 1:1 ratio, or can these stablecoin providers theoretically change-up the ratio at which you get your money back? In the event of a company shutdown, are you protected under law to withdraw your money?
The second consideration is around individual privacy rights. What are the legal responsibilities for these stablecoin providers to provide coin metadata to the government? What knowledge about chain-of-custody is kept private? How do the laws behind forced transfers & account-freezing come into play with stablecoins?
The third consideration is around the longevity of the Ethereum platform. What will happen if the Ethereum platform can no longer function organically? If newer, better decentralized networks emerge, is there a transition plan to take the token over to another network? If such a move were in order, do investors in the stablecoin have the ability to remove their funds prior?
The final consideration is around digital asset viability. What is necessary in order for digital assets to be linked to the stablecoin? Is it at the discretion of the stablecoin providers to accept or deny applications for digital asset tokens to be tethered to the stablecoins? Will the stablecoin providers vet the companies of the digital assets? Will the stablecoin providers produce and release regular reports on the quality grade of the different assets tied to the stablecoin?
While this is new, exciting territory for all of us, I have reservations over how the coin being married to the Ethereum network will weigh in on regulatory oversight and economic behavior. I look forward to seeing how this area of the ecosystem develops in the coming months.
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While this article is posted here, it’s posted elsewhere as well. In an effort to create a cross-platform discussion, I invite you to expand on any thoughts you have here in the comments as well as over on treadie, which is very much a microcommunity twitter. The reason I use treadie is because (1) it’s free, signup only with Facebook or Twitter; (2) you don’t get the walled garden of only one platform comment section, instead combining everyone for discussion. Link: https://ssp.treadie.com/
