Stablecoins

The quest for a viable “stablecoin” has been one of the recurring themes in the cryptocurrency world for a while now. Notably, Ethereum co-founder Vitalik Buterin wrote an article on the subject in Nov, 2014 (https://blog.ethereum.org/2014/11/11/search-stable-cryptocurrency/). Most recently, the stablecoin topic entered the zeitgeist around the Tether (non) scandal from late 2017/early 2018. To date, Tether is probably still the most recognized stablecoin, but major competitors are entering the space. We will discuss a few of the more prominent projects, but first: what is a stablecoin?

One of the challenges presented by the rampant volatility among all cryptocurrencies is their use as a medium of exchange or as a denominator for any non-instant transaction. Besides merchants who have strong fundamental convictions about the future of cryptocurrencies (e.g. Patrick Bryne & Overstock), the price volatility is generally a disincentive to accept crypto as payment for goods and services. Frequently, merchants who do accept crypto will charge a fee as a hedge against the currency risk which, in turn, disincentives the transaction. Why buy $100 chair for $112 worth of Bitcoin just for the privilege of transacting in Bitcoin? Well, we bought our entire set of office furniture with Bitcoin from Overstock, but it was December, 2017 and our USD basis in that $112 was single digit so it felt like a good deal. Counting on this type of consumer is hardly an economic model upon which anyone would build a retail business, though, it is not without precedent since its exactly this kind of currency arbitrage that underpins the outsourced labor model.

What if there was a coin that had a steady value? It would provide a consistent basis for product pricing and it could be the denominator for non-instant transactions. By non-instant, we are referring to transactions where some time passes between price determination and settlement. Real estate is a good example since, at least where financing is required, price is determined upon acceptance of a bid but funds don’t exchange hands until 30-60 days later. Pricing you home in Bitcoin would be a risky proposition. The home could be priced in USD and settled in Bitcoin but that is a different kind of transaction and not how currencies work.

To date, there are already a number of stablecoins either proposed or currently in circulation including Tether, TrueUSD, Basis and the Gemini Dollar. Tether is likely still the most recognized and transacted of all the stablecoins with a total supply of around $3bn which currently places it 8th in overall market cap. For a good portion of last year, the phrase “Tether FUD” (FUD is a colloquialism for fear, uncertainty & doubt) was the scapegoat for the end of the 2017 bull market since rumors circulated that Tether’s reserves were fractional and that their USDT tokens were not fully backed by USD. Tether was eventually vindicated by a 3rd party audit but the saga demonstrated that there was clearly a market for a better form of stablecoin and competitors were ready to pounce.

Before discussing a few of the projects, it’s worth considering the various methodologies for making a coin “stable”. The most obvious way to handle this is by pegging the coin to something already considered stable through the use of fully backed reserves. Without getting political about it, we could consider pegs like (some) individual fiat currencies like USD, EUR, JPY as a reasonable basis. A basket of currencies similar to the IMF’s use of five major currencies as a peg for their Special Drawing Rights (SDRs) has some merit as well and some projects have gone as far as to propose using a basket of other cryptocurrencies as backing. A crypto backed stable coin achieves the highest degree of decentralization but presents the greatest challenge from a stability standpoint. A basket of commodities might also work, similar to how we have the Consumer Price Index in the U.S. though the problem with any basket approach is that it will require periodic rebalancing which can be contentious. Another way to regulate the value of a token is through the structured regulation of token supply. To consider these various approaches to creating a stablecoin, let’s look at a few real-world examples.

We think pegging a cryptocurrency to a fiat currency is problematic since for it to be trusted, it needs to be fully backed. At a relatively small market cap like Tether’s $3bn or True USD’s $93m, having a fully backed coin is manageable, but we would argue that this model does not scale. The addressable market for stablecoins is massive. If they really are to fulfill the purposes for which they are marketed, (medium of exchange, stable trading pairs, financial instruments, settlement, etc.) a stablecoin would be competing for part of the total money supply market share. For argument’s sake, let’s just focus on M1 (physical currency & demand deposits i.e. the most liquid portions of the money supply) in the U.S., which is currently estimated at $3.7 trillion.

If a fully backed stablecoin wanted to capture just 5% of U.S. M1 that would require $185bn in non-fractional USD deposits. Furthermore, these deposits could not be rehypothecated and as such represent a highly inefficient use of capital. Both Tether and True USD are examples of fully backed, USD pegged tokens. While Tether is by far the more widely adopted of the two, we prefer the model proposed by True USD since it is fully redeemable for USD and offers regular, published, 3rd party, attestations of the USD holdings in escrow held by the TUSD Trust. Neither are scalable to meet market demand, however, so we think it is unlikely that either will come to dominate the stablecoin market.

The Gemini Dollar is the most recent addition to the fully backed stablecoin competition and while it suffers from some of the same scalability issues as Tether and TUSD, it has some improvements as well. Per their white paper (https://gemini.com/wp-content/themes/gemini/assets/img/dollar/gemini-dollar-whitepaper.pdf), the Gemini Dollar will be fully backed by USD reserves held in a trust, similar to TUSD. The Gemini Dollar goes a step further, to have their trust supervised and regulated by the New York Department of Financial Services and subject to New York Banking Law. Furthermore, the Gemini Dollar runs on the ERC20 protocol and transacts on Ethereum addresses. In so doing, the Gemini Dollar inherits ERC20’s own scalability and security issues but benefits from the compatibility of the Ethereum blockchain and will presumably accrue improvements from any implementations from the Ethereum development pipeline (e.g. Caspar, zkSnarks, etc.). Given the improvements discussed above and the advantage of being backed by the Gemini exchange, we think the Gemini Dollar is poised to be the leader in the fully backed sector of the stablecoin space.

The alternative to a fully backed, pegged, stablecoin is one whose value is maintained at a tight constant through algorithmic expansion & contraction of supply and demand. The most prominent example of this is Basis which received $133m in venture funding led by Bain Capital, a16z, and Google Ventures. Basis offers an unbacked stablecoin where token supply is governed by bonds which can be sold or redeemed to maintain steady value for the underlying token. There are merits to this algorithmic central bank model, but it does little to achieve decentralization and remains untested. For Basis to be successful, it will need to demonstrate that it can maintain steady value over a period of time enough to earn the market’s trust. We already have a notable example of failure in this space where Nubits, a supply/demand balanced stablecoin, slipped off its USD peg and traded as low as $.50. The advantages of an unbacked coin may prove to outweigh the challenges but the path to adoption will be cast with more doubt than that of the fully backed alternatives.

It is still too early to tell how the stablecoin marketplace will develop but as long as it is in its early days we offer three advantages of keeping the focus on Bitcoin. First, trading alt/BTC pairs presents some unique opportunities. If your goal is alpha and you denominate your portfolio in BTC, you can leverage BTC strength into altcoin positions in order to take advantage of cyclical altcoin volatility and vice versa. Second, and perhaps more obvious, is the implicit win-win scenario of trading alt/BTC pairs during a bull market given that either side of the trade holds a desirable asset. Lastly, Bitcoin may eventually obviate the stablecoin market entirely if it reaches a point of price maturity and market saturation such that the bulk of its volatility has already been absorbed. For now, and the foreseeable future, we at BTFD choose to denominate in BTC and believe the risk will be worth the reward.