1. History and Context for Stablecoins
1.1 History of Currencies
Long ago, trade was done by barter and, as a result, exchange rates were uncertain and dependent on the goods being traded. Over time, people found it easier to use specific forms of value to simplify trade (i.e. currencies). Goods were denominated in shells, stones, and eventually metal coins. Banks came into existence out of the need for a secure housing of currencies. Eventually, in order to make transactions easier and after significant trust (a recurring topic of importance in this paper) had been developed in banks, people began trading orders to transfer currency between accounts (banknotes). These banknotes established evidence for the negotiable settlement of debt—meaning verifiable documents which told the banks to transfer currency from one person to another. This is how much of the developed world operated until the Bretton Woods system —the beginning of global dominance for the US dollar (USD). Under the Bretton Woods system established in 1944, all currencies were indirectly backed by gold because they were convertible to USD (likewise, banknotes were convertible to gold). In 1971, however, US President Richard Nixon suspended the ability to convert USD to gold, thus decoupling much of the global system from gold and making the US dollar an unbacked, free floating, fiat currency. Relative stability remained despite no concrete peg or exchange rate for USD. After the end of the Bretton Woods system, global currencies have been mostly fiat (unbacked by anything other than a government’s agreement to recognize the value of a specific currency). 1.2. What is the Key Opportunity for Stablecoins?
Although not broken, the global currency market has room for improvement. Many regions in the world are experiencing hyperinflation, often resulting in the disappearance of wealth virtually overnight. Monetary policy tools are mostly indirect and their effects on the future are often debated. Cash transactions often come at a high cost. In short, technologists have created stable, digitally-native currencies which are built on top of the underpinnings of existing blockchain technology. Stablecoins help avoid the volatility associated with cryptocurrencies while retaining the benefits of full provenance (auditability) of transactions, programmability, and the capability to efficiently transact across borders. Hundreds of bright minds and vast amounts of capital are pushing for stablecoin adoption—both as a fiat currency alternative and as a new payment system. For example, top financial institutions and investors such as Goldman Sachs, Peter Thiel, Andreessen Horowitz, Bain Capital Ventures, Y Combinator, Facebook (specifically developing a stablecoin for remittances in India), and countless others have invested millions into projects in this space. For the first time in history, we could see the adoption of disintermediated value transfer systems; these systems are uncensorable, not dependent on any sovereign system, and act as a non-volatile store of value. Even governments are looking into ways they can improve their currencies. For example, the Russian Association of Cryptocurrency and Blockchain plans to release a “crypto-ruble” in 2019, and a fund backed by the government of the Chinese city Hangzhou is working with a Japanese bank to create a Yen-pegged stablecoin. The use cases for a government stablecoin include seeking means to track transactions, maintaining capital controls, implementing effective monetary policy, and avoiding sanctions. Many governments are also wary of the risks that decentralized stablecoins pose. These risks include undermining the effectiveness of monetary policy (depending on implementation), loss of seigniorage profits, money laundering, loss of government autonomy, and other threats. 1.3. The Meaning of Money
The qualities that make money usable are often taken for granted. According to the International Monetary Fund (IMF), in order for money to be successful, it must have these three functions: - Store of value: Its value does not depreciate (quickly). For example, vegetables are a poor store of value in that they rot and become worthless within only a few weeks. As a result, they are not a good asset for storing wealth. Compare this to USD, which hovers at ~1.5% depreciation per year.
- Medium of exchange: People must use it in transactions. For example, real estate stores value very well, but no one buys goods or services using their home as means of exchange due to the high costs associated with transferring ownership. Thus, these assets are not well-suited as a medium of exchange. Similarly, payment platforms, such as Stripe, have stopped accepting Bitcoin due to its transaction costs and high volatility, resulting in reduced value as a medium of exchange.
- Unit of account: The currency should exhibit the ability to be denominated in a useful manner. For example, gold may hold its value well and could be carried in a transportable manner (e.g. gold coins), but it would still be difficult to pay for goods and services using gold because most products and services are not denominated in it.
(Economists differentiate between currency and money—for the purposes of this paper, we will use the two terms interchangeably.)
All of the functions above are necessary for a currency to reach widespread adoption over time. So the question remains:
Why should anyone use stablecoins instead of fiat, such as USD? The answer is not so simple.
As a medium of exchange, fiat has the clear advantage of mainstream adoption. Cryptocurrencies, on the other hand, are generally not used in transactions, thus limiting their use as a medium of exchange. However, fiat can be slow and relies on antiquated technology and regulatory restrictions. On the other hand, cryptocurrencies offer instant settlement (barring current network limitations) and the potential for anonymity/pseudo-anonymity. Therefore, stablecoins hope to benefit from the foundations of cryptocurrency and act as a medium of exchange similar to traditional fiat.
As a store of value, fiat is at risk of centralized default. This means that one's money is only as safe as the depositors’ confidence in the centralized system and only up to the government’s insured amount. Most stablecoins in the market today, on the other hand, are built on a publicly distributed ledger that ensures trustless immutability and removes the need for a central party to “police” the ledger. In more complicated purchases (prone to error or arbitration), the immutability of cryptosystem logs actually becomes a shortcoming. Moreover, traditional cryptocurrencies suffer from extreme volatility, making them an unreliable store of value. Stablecoins carry the benefit of cryptosystems and solve the problem of volatility. As a unit of account, fiat has the advantage of being the default unit of account for purchasing goods and services. In the majority of stores, goods are priced in government fiat currencies. This is why the vast majority of current stablecoins are pegged to the value of a fiat currency. Some stablecoin projects, such as Reserve, seek to someday move away from this peg and become an independent unit of account.
In becoming a useful medium of exchange, store of value, and unit of account, currencies have changed much throughout history. One of the most critical factors developed over time is trust.
Before societies could make use of currencies like metal coins, people needed to trust that other people would find value in these coins. Before societies transitioned from precious metals to banknotes as currencies, people needed to trust that banks would be faithful in their promise to redeem the notes for precious metals. Otherwise, banknotes and metal coins would be a poor store of value.
Similar to how trust in the value of a coin or in the faithfulness of a bank was built up over many years, we can expect that trust in stablecoins as a unit of account, medium of exchange, and store of value will take time to develop. These qualities, however, will develop as iterations upon existing projects take stablecoins further in terms of technical functionality and public trust.
Currently, the combined market cap of the top stablecoins is almost $2.5 billion USD (about 2% of the market cap of all crypto projects combined). The majority of the stablecoin market cap is held by one project—Tether. Although Tether currently enjoys market dominance, there is an opportunity for second-movers to excel in specific use cases by employing new technology and business models. In Section 2 we will explore the history of Tether and outline the three main types of stablecoins.
2. The State of Stablecoins
2.1. The Tether Project
The current stablecoin ecosystem is mostly dominated by one player—Tether. Tether is a crypto asset built on top of both the Omnichain and Ethereum networks. At the time of writing, the project enjoys a $1.877 billion market capitalization which represents 75% of the whole stablecoin market. Tether claims to be collateralized by USD at a 1:1 ratio. In theory, this means each token is a promise to redeem one USD from a reserve, although in practice this has been difficult due to opaque agreements. Starting in August, Tether has fallen under scrutiny because of its relationship with the Hong Kong-based exchange, BitFinex. Journalists and researchers have alleged Bitcoin price-fixing schemes enacted on the Bitfinex exchange (the entry point for most Tether coins) by publishing critical articles such as “Is BitCoin Really Un-Tethered?”. Furthermore, both BitFinex and Tether share the same management team (CEO, Jan van der Velde, and Director/Chief Strategy Officer, Phil Potter), adding additional weight to the research-based indictments. These allegations have significantly undermined the public’s trust in Tether. As a result, the allegations of Tether fixing Bitcoin’s price has prompted the US Justice Department to open a probe. This has caused Tether’s price volatility (see chart below).