Regulations are like glaciers. Because of their incredible weight, these massive bodies move slowly but shape the terrain underneath. The fjords, lakes and valleys carved as the ice sheets advanced or receded have sculpted the landscapes upon which the global economy was erected. Even in the world’s freest markets, statutes and standards have similarly profound effects. Government protocols provide the topography that we navigate while maximizing our various objective functions. Glaciers and policymakers are typically unrushed, but environmental changes can quicken their pace.
As our lives are increasingly spent online, supervision has transcended into the digital realm. Laws regarding data collection, content moderation and rights management have been introduced to protect users, while trying to foster an environment where innovation can thrive. The advent of bitcoin introduced the idea of web-native money, which has the potential of undoing what Marc Andreessen calls the internet’s original sin. Borne out of a frustration towards a financial system deemed corrupt with regulatory capture and greed, the supply of this digital currency relies on cryptography and algorithms to manage supply. Demand is, like the modern monetary system, based on belief.
Humanity’s story has been moulded by glacial forces and the digital asset markets have been marred by regulation.
In the early days, purchasing BTC occurred via P2P mechanisms like PayPal. As scammers entered to take advantage of the market’s opacity, the earliest exchanges were borne. Unfortunately, the pioneer venues like Mt. Gox were still subject to criminal activity as frequent hacks drained accounts. Litigation was commonplace too because authorities deemed the businesses to be in violation of money transmission or laundering laws. Many failures came to pass. The heightened oversight made it difficult for exchanges and other crypto-related firms to open bank accounts, so capital flowed to friendly jurisdictions. Constraints associated with these new domiciles required creative funding operations, but ingenuity found a way to accept fiat transfers. Motivations like avarice and frustration towards the traditional financial system upheld demand for bitcoin, which drove prices higher and spawned innovations. New blockchains, like Ethereum, were developed. The smart contract set off an explosion of controversial Initial Coin Offerings, providing capital for projects of sometimes questionable or abject quality.
More speculators entered the market to pursue these Alt Coins. When exiting their holdings, traders would often rotate into BTC because it was the least volatile cryptocurrency and many exchanges either did not allow fiat on the platform or took a large fee from the transfer into traditional currency. Out of this grew a need for an on-chain asset that could serve as cash. These early crypto holders longed for a safe haven in the event of a market decline or crash. If the price of bitcoin began to drop rapidly, a holder wanted to convert their holdings to some cash-like asset on a single platform to avoid potentially massive losses. In 2014, the first of these stable tokens was released as Realcoin and shortly renamed as Tether (USDT).
Despite having to contend with numerous legal challenges, USDT enjoyed its first-mover advantage for several years. Interestingly, while digital asset markets have been founded on the principle of decentralization, Tether remains a closely-held entity whose disclosure has, to-date, been selective. USDT was initially plugged into the American financial system through Taiwanese banks, but eventually their transfers were blocked, forcing the group to domicile in kinder jurisdictions. Tether’s been hit with numerous lawsuits and fines nearing $100M in total. Among the charges are allegations of misrepresenting its reserves. As a result of this controversy, new challengers have emerged to serve as steady assets in an otherwise tumultuous marketplace.
The name “stablecoin” is somewhat self-explanatory, but what does it really mean and how does it work? It turns out that the intrepid spirit we’ve witnessed across the internet has also taken interest in these seemingly boring assets, whose price is intended to be fixed. Let’s dive in.
Fiat-backed stablecoins are supported to maintain a 1:1 ratio, meaning that one stablecoin is equal to one unit of currency; typically, the USD. As such, for each stablecoin that exists, there is (theoretically) an equivalent balance of fiat held in a bank account. Often, token issuers have a mechanism to permit the exchange of the digital asset for hard currency. Of course, such a transaction would be subject to compliance with the necessary KYC/AML legislation. When someone wants to redeem for cash, the entity managing the stablecoin will transfer the necessary amount of fiat into the client’s bank account. The equivalent number of stablecoins are then “burned” or permanently removed from circulation.
- The principal advantage of this approach is that it’s relatively easy to understand. Most consumers today have more of a digital relationship with money and this is hardly a departure from that.
- On the other hand, holders must place a great deal of trust in the issuer with respect to the promise that their tokens are actually funded by a commensurate balance of fiat. As mentioned, Tether has come under scrutiny in the past regarding the opacity of their reserve disclosure and recently hedge funds have placed bets that the assets backing the tokens are worth less than $1.
- Others have favored a more transparent approach, publishing audited assurance of the 1:1 ratio and willingly engaging with regulators. Among them is Circle, which issues USDC in partnership with Coinbase and has been approved for settlement on the Visa network. In contrast, Tether famously didn’t send any representation to the US Congress’ Financial Service Committee’s hearing on stablecoins.
- Other fiat-based stablecoins are in circulation, but USDT and USDC dominate the landscape. Their combined capitalization is greater than the rest of the market combined.
Some groups have elected to create other asset-backed offerings pegged to the value of real-world goods. Digix Gold (DGX) is built on the Ethereum network but suspended operations earlier this year. The token was secured by physical gold, where one DGX represented one gram of the yellow metal, though holders were required to be in Singapore to carry out an exchange. Tether, Paxos and others have similar tokens. Alternatively, SwissRealCoin (SRC) is backed by a portfolio of Swiss real estate and permits owners to vote on the investment decisions of the fund.
A few years after Tether’s ground-breaking introduction, MakerDAO launched the first crypto-backed stablecoin – Dai. Previously this was a more centralized endeavour, but the governance now rests solely with the DAO. Because you can see the wallet holdings on blockscans, the reserves for crypto-backed stablecoins provide an improved level of transparency. However, due to the inherent volatility in most digital assets, to maintain a 1:1 peg, the backing requires overcollateralization of 1.5:1 - 2:1 to provide adequate assurance. Users who deposit Ether (or other tokens accepted as collateral) can borrow against the value of their deposits and receive newly generated Dai. This is relatively capital intensive and can still result in de-pegging. On Black Thursday in March 2020, a tail-risk event caused a momentary increase in the DAI price (triggered by an ETH price crash and a clogged Ethereum network) which led to $8M worth of liquidations. Following a governance change, subsequent de-pegging will see Maker’s governance token MKR minted and sold on the open market to raise collateral. It’s worth noting that, while decentralization provides some benefits, DAOs have governance issues of their own.
An emerging alternative that is rapidly gaining adoption is the algorithmic stablecoin. Instead of using cash or crypto reserves, this controversial model uses codified rules and an associated reserve token to peg a stablecoin; most often, to USD. These tokens are considered the most decentralized, as they do not rely on a single entity to maintain the collateral. For the non-quantitative, these coins are the least transparent because the algorithms are difficult to decipher. Terra’s UST is the leading “seignorage” stablecoin. Through the Chai network/app, millions of Koreans transact in TerraKRW (KRT), which is accepted as payment at thousands of real-world merchants. Recently, UST has surged to be the #3 stablecoin by market cap. The popularity has largely been fueled by lending rates on the affiliated Anchor Protocol, which (until recently) has provided APYs of ~20%. However, many question the sustainability of this model. While the UST/LUNA pair have survived several market routs, other algo-pegged projects haven’t been so lucky. There have been numerous exploits and capital flights which resulted in significant losses. Notably, the Iron/Titan Finance debacle from last year:
Trust is an essential component of any financial system. A traditional bank is often levered 8x – 10x, which effectively means that for every dollar their clients deposit the financial institution will issue $8 - $10 of loans. Should depositors begin to fear that the credit book is experiencing losses, then they’ll ask to receive their savings in cash, sparking a “run on the bank.” In the extreme, a situation can arise where the lender cannot satisfy the withdrawals and if they’re unable to raise equity capital, they fail. This happens more frequently than you might think.
Holders of UST can redeem their tokens for a dollar-equivalent balance of Luna. If heard mentality takes over and people look to redeem large amounts of UST all at once, then significant supply of Luna will flood the market and drive the price down. As the rush for the exits continues then ever-increasing Luna tokens will be minted, resulting in what’s called a “death spiral.” This is what happened in the Titan picture above and is explained here as well:
Recently, there’s been some innovation regarding the reserve pools securing the peg of algocoins. By diversifying the collateral to other digital assets or even ESG-related goods like carbon credits, the intention is to provide additional trust. Despite some directional improvements, the reflexivity of these mechanisms has many traditional financiers wondering about systemic risk. DeFi continues to expand its popularity and the number of new stablecoins is also on the rise. For example, NEAR and TRON announced algorithmic offerings this week and there are countless Olympus DAO forks. Like fiat currencies, these protocols are all meant to be steady, and they compete for liquidity on a battlefield of trust and interest rates. As the fight for capital heats up, a levered system means that a confidence breach could break one or many of these codified tokens, leading to drastic spillover effects.
Regulations have a part to play in all of this. If stablecoins were to take market share too quickly, this could pose liquidity concerns in the traditional banking system. While it’s legally difficult for policymakers to challenge an algorithm backed by a decentralized token, a corporation that houses cash (or its equivalents) while issuing tokens starts to look more like a conventional financial institution, and this brings it under the purview of the established watchdogs. Leaders, like Circle, claim that they’re willing to play by the rules, but a lack of clarity means that it’s difficult to make significant investments for future growth and innovation:
The looming threat of an advancing glacier is creating incentives that (when combined with some decentralization maximalism) are pushing innovation to replicate the trust placed in the currencies of nation states. Ironically, this may lead to the destabilization of the digital economy or, if successful, it could rock the real-world system. However, despite the headwinds, some legacy financial houses continue to invest in a comingled future. Blackrock inked a strategic partnership with Circle that will see the world’s largest asset manager take primary stewardship of USDC’s cash reserves and explore “capital markets applications” for the token. Fidelity, which announced that clients can now hold bitcoin in their 401(k)s, also participated in the round.
Central bankers have taken note and there are digital currency initiatives being explored around the world:
The Bank of International Settlements hosted a conference on DeFi and the monetary system a few weeks ago. Panelists were unanimous in their perspective that the digital economy is an unstoppable force. They believe that its regulation will require policymakers to step outside their conservative comfort zones and create rules for what the future might look like. The pace of change is too fast for the old approach. Legislation drafted with the present in focus will be off the mark by the time it’s passed. Perhaps the best course of action is to collaborate:
DeFi wouldn’t exist without stablecoins.
They’re the foundational layer that’s allowed the digital economy to flourish. As such, these tokens can be considered the most interesting part of the cryptoasset market. They’re not about “number go up” but rather serve as the foundation upon which creatives can adapt elements of the financial system in code. However, as the world of internet money collides more frequently with the traditional system, there will have to be some harmonization. While the icecaps in the physical world are receding, the regulatory reach of monetary politicians is encroaching on the digital landscape with glacial force, and this is influencing the behavior of technologists and speculators. New business models are being created and the balance of power is shifting. It’s likely that inequality will persist, but the distribution in web3 is different.
Huge waves are formed when glaciers break off into the sea. Sometimes a select group of elite surfers in wetsuits risk their lives by hanging out at the edge of the ice cliff for a chance to ride the whitecaps. It’s a beautiful thing when they’re successful.
We can draw an analogy to the digital economy. Negotiating the elements in the face of a giant that creeps and then moves suddenly requires courage, skill and maybe a little craziness. The innovators who continue to build while consulting with lawmakers share these traits and will be the ones to ride the wave of success. Let’s hope the rules don’t “fall flat”.