Henry C. W. Price
Henry C. W. Price

The state of stability: Are Stablecoins the next frontier?

By Henry C. W. Price with additions from Hugh Lawson-Tancred, GCEX Research and Advisory Board

Stablecoins - the very name is strange, as coins in real money are completely stable, both physically and chemically. A gold coin is sometimes used as a metaphor for Bitcoin, for mining and its value proposition of scarcity. Proof of Work is inherent in a gold coin, although it can be counterfeited. Unlike Bitcoin, the coin you hold in your hand has to be extracted from raw materials, smelted, pressed into a form. It is Proof of Work. The work has been done so that one feels confident in using the coin as a store of value and indeed accepting it for goods and services. This began to change as the gold standard effectively reintroduced in the Bretton Woods system in 1944 was abolished in 1971 by President Nixon. No longer could entities exchange their dollars for gold; instead, the dollar would float freely. The word fiat comes from the Latin meaning “let it be done” in the sense of an order, decree.

Banknotes and other fiat currencies have no intrinsic value and were first introduced during the Tang dynasty (c.618–907). This trend of monetary innovation is continuing even now with the Chinese government's progression towards a central bank-issued digital currency, the furthest development of current Central Bank Digital Currency (CBDC) schemes. During testing in October, over 1 million dollars of the new cash was handed out to citizens1 in Shenzhen. China has been working on the project since at least 20162 under central bank governor Zhou Xiaochuan, most interestingly, not long after Bitcoin trading was banned in China. It is reported that Beijing has had an interest in digital currency since 2014.

The conundrum with Stablecoins is twofold. Firstly, the concept runs in direct defiance of the Bitcoin protocol, as the decentralised new money of the internet. Secondly, as a pointer to a real-world object, it is built on trust but as we describe above so is fiat itself. Stablecoins attempt to use recent innovation in blockchain technology and payment systems in parallel with existing payment systems and e-money. In general, public blockchains are much slower and provide little privacy compared to currency banking payment rails. So why are they becoming so popular?

Stablecoins
Exhibit 1: Mastercoin, later renamed Omni Layer.5

The search for stability

When describing Stablecoins, people cite “Mastercoin” as the first project, but this is not strictly correct. Mastercoin was the first ICO3, proposed according to Vitalik Buterin (Founder of Ethereum) on January 6, 2012 by J. R. Willett. The project formally launched in 2013, and then rebranded as the Omni Layer4 and is still in use today. 

At the time of writing the sale total raise was ~6673 BTC6, with a final balance of ~2.16 BTC, a far better result than expected in the initial fund raise. Approximately half a million dollars. After the raise many exciting possibilities could be explored with a second layer underpinned by the Bitcoin Blockchain, distinct from Tokens, secured by the underlying Ethereum Blockchain. 

Mastercoin was rebranded Omni and this token layer was used for the first Tether. Tether has subsequently also been issued as an ECR207 version, a standardized smart contract used for the issuance of token sales and made infamous in the 2017 ICO bubble. However, this second layer of tokens attached to an Ethereum address is now home to many assets and more well-known tokens than Omni. Some represent gold, fiat and, among the more exotic non-fungible assets, e.g., Crypto Kitties8. All kinds of assets can be represented on the blockchain and their ownership tokenized and exchanged on it via the signature scheme within it. 

In the original Mastercoin, self-stabilizing coins are also described where participants can bet on the price of any real-world asset, such as fiat, to mimic the observed price. Such a system requires enough participants to function. Much like a Contract for Difference (CFD), the price of the underlying could be replicated. This however appears never to have been implemented generally. 

Tether states that it is tied to reserves in a given bank or financial institution. The main concern has been verifying and auditing such funds held as collateral. Past incidents in the history of that particular currency have been problematic as Bitfinex and associated entities have been unable to obtain standard banking relationships. After Tether, USDC (Issued/redeemed by Coinbase and Circle) and other digital assets have introduced fully audited statements of collateralization of the token, usually in a regulated custodian bank. 

Tokens are the natural next step to reducing market friction. By their nature and construction, they cannot be counterfeited like banknotes or any certificates of ownership. The ledger entry serves as a binding record, and ownership of a tokenized security is transferred by a private-key signature scheme or other cryptographic methods. With other ledger and blockchain types, whether public, consortium or private, transactions may or may not be rolled back. On Ethereum, smart contracts may drive the development of programmable money, which, now with other blockchain features, starts to make Stablecoins have advantages over fiat and e-money. A private blockchain can reach comparable speeds to standard payment networks, making it a realistic option for latency-sensitive participants. 

Stablecoins

E-gold and Liberty Reserve  

Long before the inception of crypto currency as we know it today through the Genesis block of Bitcoin, in 1996, the concept of electronic transactions backed by real assets but not requiring the full paraphernalia and, crucially, identification of conventional bank accounts had already been launched by Douglas Jackson and Barry Downey in the form of E-gold. E-gold was definitely a transaction system rather than a token, still less currency, regime. Under E-gold it was possible to hold deposits of gold (and other precious metals) against which "spends" could be made. The spends were made in conventional fiat currency (the dollar) and did not create instruments which could themselves be traded. Effectively, this simply enabled anonymous asset-backed transactions. As such, it eventually became mired in allegations of money-laundering and was closed down in 2008 after regulator involvement. 

Whilst E-gold was not yet a genuine coin it became an important, albeit not complete, step in the direction eventually taken by Liberty Reserve. Set up in 2006, Liberty Reserve offered a system whereby clients (again with minimum identification) could hold funds in the form of tokens (LRs) which could be transferred to other holders within the system. These LRs, crucially, constituted individual assets which could be held, passed on and redeemed/converted in the same way as other currency units. The immediate convertibility into dollars (or euros) was what underwrote the entire system, but it was of course the anonymity of the transactions which made it attractive. It too, like E-gold before it, became a haven for the laundering of dark money, mostly the proceeds of cybercrime. It is controversial to what extent the operators of Liberty Reserve knew about, and indeed actively colluded in, the misuse of their system by criminals. Certainly, the alleged volume of funds lauded in this way ($6 billion) is an eye-watering indication of the extent to which such systems can produce a genuine worry for regulators.

Stablecoins
Exhibit 2: Price comparison of the closing price13 between exchanges

 

Stablecoins
Exhibit 3: Fractional ‘price premium’ between Bitfinex and Gemini, this has subsequently stabilised after June 2019

 

 

Stablecoins
Exhibit 4: Tether price observed on Kraken, with the ‘Price Premium’ shown in Exhibit 3

 

 

Comparison of Blockchains used for asset tokenisation 

 

Public Blockchains

  1. Decentralised consensus is slower due to its distributed nature 
  2. Max number of transactions much below PayPal or credit card methods.
  3. High-energy cost in Proof of Work setting.
  4. Mistakes cannot be corrected by any other party providing “immutability”.
  5. No single point of failure or manipulation, meaning your record or balance is secure. 
  6. Full record back to Genesis in a public ledger. Reduces opacity and makes corruption more difficult.
  7. “Code is Law” type contracts that force execution as written without further input from parties.

Private Blockchains

  1. Can establish a verifiable causal ordering of events.
  2. Can be useful in supply chains or back office post trade reconciliation and settlement.
  3. Can achieve fast implementations at scale. 
  4. Permissions required to transfer ownership of assets.
  5. Full record back to Genesis although private.

Consortium Blockchains

  1. Mixture of both types of chains with governance considerations.
  2. Trading some freedom and decentralization for some aspects of speed.

Blockchains provide atomic swaps and other advanced cryptographic options constituting programmable money. These properties set Stablecoins apart from standard e-money as it reduces need for a third party while reducing counterparty risk. Atomic swaps can verify that chains have been exchanged and reduce counterparty risk. This technology can also provide asset provenance and other transparency. Transaction analysis in a ledger to check sources of funds and detect suspicious activity, also called KYT, know your transaction analysis. It is up to the compliance officer to ascertain the potential threat. Multisignature and other approval schemes can be built into the protocol for management of asset transfers. 

Stablecoins have also found prominent place in DeFi markets and exchanges where parties need to exit a Bitcoin position without paying off-ramping fees to fiat. As a result, you could see Stablecoins as an alternative payments framework orphaned by traditional banks in the last few years of incredible growth. 

Stablecoins

Token backing? Who, what and where? 

Unlike cryptocurrencies, tokens and Stablecoins are a pointer of ownership to an outside asset. They fall readily into other security regulatory frameworks and the FCA9 asserts it is a technology neutral regulator, i.e., any ledger recording effectively a security is allowed under a framework. There are of course some regulatory and other risks using previously untested or proven technologies. 

Counterparty risk - Untethered 

For a while, Tether was processing US dollar transactions through Taiwanese banks which, in turn, sent the money through the bank Wells Fargo to allow the funds to move outside Taiwan. Tether announced that on April 18, 2017 these international transfers had been blocked. In early October 2018 Bitfinex was reported to be losing its banking relationship with HSBC10 and the Financial Times11 reports on how traders behaved due to the implied risk. Bitcoin trades broadly higher most likely due to investors perceived credit risk12.

After observing Exhibit 2 we define the following ratio which we call the ‘Price Premium’. After price differences stabilizing between exchanges when the New York Attorney General filed a suit accusing a cover up of $850 million in losses by Bitfinex in April 201914, a corresponding price difference is then observed between Bitfinex and other mainstream exchanges, see Exhibit 3.

It is interesting to place this ‘Price Premium’ in context with the USDT price. They are mostly fully anticorrelated as disentangling Bitfinex and Tether seems impossible. Tether may trade higher than one dollar if there is utility to holding a crypto fiat representative, i.e a fast exit or entry, since USDT can participate in the DeFi world where traditional fiat cannot. USDT in fact can raise a yield from its use in smart contract lending and other liquidity pools.

Baskets, old and new 

Increased stability could be achieved by a basket of different assets perhaps including some commodities. The most widely known basket is the Special Drawing Right, created in 1969 by the IMF. The ratios for Libra are defined in a letter responding to a question from German lawmaker Fabio De Masi15. The EU continues to be hostile to such a currency and there have been many regulatory hurdles to a launch. However, in more recent reincarnations of the currency, Libra has been considering single currency tokens much like existing Stablecoins and is hoping to launch in 2021.

Conclusions 

Stablecoins have positive properties, as they add technology and functionality to e-money and fiat. However, regulatory issues have mired this space along with counterparty risk on the underlying, untested and new technologies. Reducing market friction and allowing decreasing settlement times in FX are all possibilities. Algorithmically stabilised currencies can use inherent currencies such as Ethereum to replicate an underlying asset, and so far, this has worked. Decentralization comes with many trade-offs, including speed and some loss of privacy for participants; most likely hybrid systems will develop, or institutions will use non-public implementations of blockchain technology. However, Stablecoins certainly will hold a place for international transfers and other payment rails that are already in place, most likely reinforcing currency payment infrastructures, thus making transfers more transparent and cheaper for those using them.

  1. https://www.cnbc.com/2020/10/12/china-digital-currency-trial-over-1-million-handed-out-in-lottery.html
  2. https://www.coindesk.com/peoples-bank-of-china-discusses-plans-to-issue-digital-currency
  3. Buterin, V. and Buterin, V., 2020. Mastercoin: A Second-Generation Protocol on The Bitcoin Blockchain. Bitcoin Magazine. [Accessed 29 November 2020]
  4. https://www.omnilayer.org/
  5. Figure used under CC,  https://en.Bitcoinwiki.org/wiki/File:MSCscheme.jpg
  6. Today worth 123 Million Dollar 
  7. Ethereum Request for Comment 20 
  8. https://www.cryptokitties.co/
  9. https://www.fca.org.uk/publication/consultation/cp19-03.pdf
  10. Dudas, M., 2020. Bitfinex Appears to Be Banking With HSBC. The Block. [Accessed 29 November 2020]
  11. Kelly, Jemima (15 October 2018). “People are freaking out about Tether”. Financial Times. [Accessed 29 November 2020]
  12. Hankin, Aaron (15 October 2018). “Bitcoin jumps after credit scare”. Market Watch. [Accessed 29 November 2020]
  13. End of 23:59 UTC
  14.  Larson, Erik; Leising, Matthew; Kharif, Olga (26 April 2019). “Crypto Market Roiled by New Allegations Against Tether, Bitfinex”. Bloomberg. [Accessed 29 November 2020]
  15. Staff, R., 2020. U.S. Dollar To Be Main Currency Underpinning Facebook’s Libra: Spiegel. [online] U.S. [Accessed 1 December 2020]