ETFs Rule, Stablecoins Drool: How to Make Cryptocurrencies go Mainstream
If it were possible to create a “stablecoin” that had a fixed value with respect to fiat currencies, it would relieve a great deal of the public’s concern and anxiety about using cryptocurrencies. Hundreds of articles have been published since on the subject of stablecoins. Rather than recap all of this interesting analysis, let me start with the central point. There are three main approaches to stable coins. Only one works, except, it doesn’t.
The Three Approaches to Stablecoins
Non-collateralized monetary policies: Coins backed by the selling of bonds to reduce money supply when token value drops or a policy that taxes or burns outstanding tokens held by users to reduce money supply, that use seigniorage shares and other forms of derivatives to prop-up token value, and so on.
Crypto-collateralized stablecoins: Coins that are issued only when ETH, or some other cryptocurrency, is put into escrow in a smart contract to serve as collateral.
Fiat-collateralized stablecoins: Tokens that can be redeemed for dollars, euros, or even gold, on demand by some mechanism.
I’m not going to name names here. Have a look at this excellent piece by Nathan Sexer if you are curious about where your favorite stablecoin fits.
There are three main approaches to stable coins. Only one works, except, it doesn’t.
Money for Nothing
Non-collateralized stablecoins are an economic impossibility. Effectively, the value of the coin depends upon trust in the value of the coin. For example, suppose I issued a stablecoin that I wanted to peg at a value of exactly $1. Unfortunately, the market price of my coin on exchanges drops to $.90. In response, I offer to sell a bond for one coin that will pay you 1.1 coins when the the coin’s value goes back up to $1. Whoopee! you cry. Free money!
All you would have to do buy is a bond today with a coin worth $.90 and you will get back 1.1 coins later worth $1, a pure profit of $.20 for each bond you buy. If enough people believe this, then enough tokens are taken out of circulation (since the platform holds the tokens used to buy these bonds) and the wondrous forces of supply and demand drive the price of the stablecoin back up to $1. Notice what I slipped in there: “if enough people believe it”. If they don’t, then not enough bonds are purchased, the price stays below $1, and the bonds can never be paid off. A stablecoin that has broken its value promise is not one that inspires confidence. It is likely to fall even further in value and quickly enter a death spiral. No matter what approach is used, in the end, it always comes down to some version of this story: the value of the token depends on people believing in the value of the token. Larry Eichengreen summarizes this nicely in his recent Guardian article.
Non-collateralized stablecoins are an economic impossibility.
Stability Built on Shaky Ground
Crypto-collateralized stablecoins would certainly work if you wanted to peg the value of one token to the value of another token, but what would be the point in that? You could simply use the original token. Using cryptocurrency to collateralize a peg of a token’s value to a fiat currency, on the other hand, is quite tricky. To begin with, there are a raft of practical concerns such as whether the smart contract is bug free and the cryptocurrency collateral store is secure. There is also a more fundamental problem resulting from the volatility of whatever cryptocurrency is being used to back the value of the stablecoin.
To understand this, suppose I put $100 worth of ETH in escrow in exchange for $100 worth of stablecoin. Obviously, if the value of ETH falls, there is not enough value in escrow to redeem the stablecoins that were issued at their stated value. Over-collateralization is needed to protect against this possibility. So, suppose instead that in May of 2018, I deposited one ETH worth $800 to be held in reserve against $400 worth of a stablecoin. As we all know, the ETH dollar price dropped from $800 in May to $200 in September. As a result, only half of the required collateral would be on hand to redeem the stablecoin. Of course, one could require a four to one, or a ten to one, deposit of ETH for each stablecoin, but this does not solve the fundamental problem of volatility in the value of the currency used for collateral.
An even more more serious problem is that stablecoins do not protect the original purchaser from volatility in ETH price. Let me make this clearer: a stablecoin purchaser who deposits one ETH in May gives up something worth $800 in exchange for a stablecoin which is only worth $200 in September. By buying the stablecoin in May and holding it until September instead of cashing out into dollar bills (which are remarkably stable with respect to the value of a dollar), the purchaser loses $600. In effect, the original purchaser who funds the escrow is taking all of the volatility risk upon himself to make a coin that has a stable value for subsequent users (always provided the value of the escrow does not fall too much). This is a very generous act, but it is hard to see it as a foundation for sustainable monetary system. Again, there are many variations on this basic approach, but all are subject to similar problems. See the following by Preston Byrne or Izak Fritz for further discussion and additional details.
Crypto-collateralized stablecoins do not provide a foundation for sustainable monetary system.
Is Stability Even Possible?
This brings us to fiat-collateralized tokens. The good news is that these could actually work, at least in theory. The bad news is that it is extremely difficult and costly to do so in practice. Let’s begin by looking at some real world examples.
When you deposit money into your checking account, what you get in exchange is an addition to your balance in the bank’s database. In effect, this is an electronic IOU recorded in a private ledger. Why should you trust that the bank will actually give you back your dollars when you ask for them? If you think the bank manager looks like an embezzler or that the bank might be insolvent, you would be well advised to go to the nearest ATM and withdraw all you can before the bank is out of money. (This is called a bank run.) As is well known, banks do not keep one dollar in a vault for each dollar on deposit. Deposits are only fractionally collateralized. The rest is lent out and so is illiquid. Some loans may even have gone bad and the bank may not have enough assets, liquid or illiquid, to pay back all its depositors. To prevent the bank runs that might result, the FDIC was set up to serve as a guarantor of bank deposits. (They are from the government and are here to help.) The FDIC promises to give you dollars in exchange for electronic bank balances on demand if the bank cannot. As long as we believe this, our deposits are fully collateralized by the printing presses of the US Federal Reserve.
This is an example of a fully fiat-collateralized token (electronic bank balances) that works. A dollar in our accounts can always be redeemed for a dollar in fiat no matter what the condition of the bank. If the FDIC or Federal Reserve do happen to fail, it will most likely be because of a zombie apocalypse or some larger catastrophe. Pieces of paper with dead presidents on them are not likely to be high on our list of concerns in this event.
The good news is that fiat-collateralized tokens. could actually work, at least in theory. The bad news is that it is extremely difficult and costly to do so in practice.
A somewhat less successful set of examples are gold (or other commodity) standards that attempt to peg dollars or other fiat currencies to a fixed amount of metal. If a 100% gold reserve were kept on hand and everyone trusted the government to honor its redemption promise, this would work just fine. The problem is, some wiseguy, usually an economist, points out that all that gold is just sitting there doing nothing. Why not lend it out, build some roads, feed the hungry, pay for economic think tanks, and fund other key governmental functions? After all, how likely is it that everyone is going to want to get their gold back at once? Let’s just keep half of it on reserve, I mean a third, or perhaps a tenth . . . The inevitable result is that someone mounts a speculative attack, sells dollars short, and demands gold until the government gives up or runs out. The value of the dollar plummets, and the currency speculator walks away with a nice profit from his short position.
An even less successful example was England’s attempt to maintain a 2.7 mark/pound exchange rate as part of its effort to support the European Exchange Rate Mechanism in the early 1990s. George Soros and other currency speculators shorted the pound forcing the Bank of England to raise interest rates and commit large parts of its foreign exchange reserves to buying back the pound on the open market. This became increasingly difficult as the Bank of England’s reserves dwindled. Ultimately, England was forced to give up and let the exchange rate float. There are too many other examples of failed attempts to support under-collateralized fixed pegs to count. They litter economic history like so many beer cans on the side of the road.
The underlying economics here is that the one and only way to support a fixed exchange rate is to have a 100% reserve of the other currency. For example, suppose Venezuela issued 100 billion Bolivars and wished to maintain a ten to one exchange rate with the US dollar. The Venezuelan central bank would need to have 10 billion dollars on reserve in order to credibly claim that it would be able to defend this exchange rate, come what may. The same thing is true of commodity backed currencies, as we pointed out above. There simply is no free lunch.
The one and only way to support a fixed exchange rate or stablecoin is to keep a 100% reserve of the other currency.
This leaves us in a bind. Anyone who wants a make a stablecoin must put 100% of the revenue received from selling the coin into a reserve account. None of the revenues from the sale of the stablecoins can be used to fund the building of the platform! Economists refer to such a situation as a “major bummer”. Given this, why would anyone want to make a stablecoin? What is in it for the platform that does so? On might guess that the platform could live off the interest it receives from the money deposited in the reserve account. A problem here is that these reserves must be completely safe and immediately available or else the platform risks the kind of bank run mentioned above. Of course, nothing is completely safe and liquid, but the closest thing is lending at the “London InterBank Offered Rate” (LIBOR). This is a money market between large banks for terms as short as one day. Banks borrow here to meet the reserve requirements imposed by their regulators for the most part. Unfortunately, interest rates are low and so this is a pretty slim source of support for a platform on an ongoing basis. As an example, on September 19, 2018, the US dollar overnight LIBOR rate was a bit under 2% while the euro overnight LIBOR rate was about –.5%. (This is not a typo; the interest rate was negative!)
On the cost side, stablecoins by their very nature must be strongly connected to the conventional banking sector. Brokers must be paid to move money into and out of LIBOR loans or other money markets, and transaction and service fees must be paid to banks to move money to and from crypto-exchanges and the accounts of users wishing to cash out their stablecoins (which involves ACH, SWIFT or other wire fees). In addition, safeguarding the reserves on deposit, meeting accounting, disclosure. user AML/KYC, other regulatory requirments, paying the network of validators on the stablecoin’s blockchain, paying crypto-exchanges for their services, and on, and on, all cost money. Ultimately all of this has to be paid for by users if the stablecoin platform is to be a trustworthy and sustainable business. What this means is that, at best, stablecoin platforms will need to charge transaction and account fees similar to what a conventional bank does, as well as follow similar compliance, reporting, and regulatory oversight rules.
The final piece of bad news is that we cannot have a 100% fiat-collateralized stablecoin without trust in the platform, the technical implementation of a new technology, and confidence that governments will continue to allow the platform to function and keep its promises. Fiat-collateralized stablecoins will never offer a decentralized, trustless, uncensorable, inexpensive, privacy protecting, alternative to conventional banks. In fact, the level of risk exposure and the degree of trust needed to keep a dollar in a stablecoin is considerable and probably greater than what a dollar on deposit in a conventional bank requires.
Fiat-collateralized stablecoins will never offer a decentralized, trustless, uncensorable, inexpensive, privacy protecting, alternative to conventional banks.
Do We Even Want a Stable Coin?
To summarize, the only path to a sustainable stablecoin involves:
- Fees similar to, or greater than, conventional banks
- A central point of failure and trust at the stablecoin platform-real banking sector nexus
- No real gain in privacy over conventional banks due to KYC/AML and other regulations
- Additional risk from software, fraud, and regulatory uncertainty
Let’s suppose we somehow overcame all of these hurdles. What value would a stablecoin such as this provide? It is unlikely merchants would see much advantage in this stablecoin over cash or debit and credit cards. Stablecoin merchant fees are likely to be similar to (or greater than) what they are for credit cards. Even if transactions costs for stablecoins were zero, the savings would be on the order of 2% or so. Nice, but not compelling. Stablecoins cannot give either merchants or users privacy and anonymity like ETH, BTC, and other cryptocurrencies that do not need to interact with the banking sector. Finally, such a stablecoin is neither decentralized nor trustless, and in fact, requires that trust be placed in new technologies and platform founders rather than well-established technologies, banks, and other financial institutions.
Although it is hard to see stablecoins as a killer app, they do facilitate one new and valuable service on blockchain. Remember that blockchains can only control things that are native to the blockchain. An Ethereum smart contract can move ETH from one account to another in a trustless, decentralized, and immutable way. It cannot, however, move dollars from one bank account to another, transfer the ownership of a car, or make someone fulfill a legal obligation in the real world. A stablecoin, on the other hand, moves tokens that represent real dollars on the blockchain and so can control them in the same way. Provided that the platform is trustworthy and the real banking sector and government regulators permit, recognize, and enforce these tokenized transfers of dollars in the real word, stablecoins offer something new.
Oh My God I Hate Economists!
Hey, don’t blame me, I’m just the messenger.
Does this mean we should give up? Are stablecoins a pipe dream? Should we simply forget about monetary policy on blockchains? Is there no viable solution to the problem of cryptocurrency volatility?
Yes. Yes. No. and No.
The only path to a true stablecoin on blockchain is too costly and involves compromises that make it not very worthwhile in the end. Monetary policy by itself, no matter how clever, will never lead to a viable stablecoin. Instead, monetary policy should be refocused on supporting the interests of a platform’s users in ways that are feasible and produce tangible results. This is a very interesting topic on its own, but one for another day.
What is the Solution Then?
Is there a way to solve the problem of price volatility in cryptocurrencies without a stablecoin? The answer lies in ETFs for cryptocurrencies and includes completely conventional derivative instruments built on this foundation.
Suppose I wanted to take an escrowed payment in ETH, or write a contract specifying a price to be paid each month in BTC, or I simply wanted to hold a cryptocurrency as a store of value. None of these things are possible unless I am also willing to bear the risk of how much the cryptocurrency I get in the future might be worth. This makes it impractical to use cryptocurrencies in these and most other contexts, and is the major reason that a stablecoin on blockchain is seen as so important.
Farmers have long sold futures to protect themselves from the risk that crop prices might fall between the the time they are planted and harvested. Suppose we did the same thing for cryptocurrencies. For example, suppose that ETH is worth $500 today and I signed a smart contract with someone which paid out one ETH in six months. Instead of holding this contract myself, I could try to sell it to someone else for cash today. How much would someone be willing to pay me for such a contract on the open market? Obviously, this depends on what the market (on average) thinks one ETH will be worth in six months. So how can we figure out what the market predicts?
This may surprise you, but the market must think (at least approximately) that the price of ETH in six moths will be the same as it is today. This is a result of something called “Efficient Market Theory” (You might have a look at another Medium piece I wrote on estimating future cryptocurrency prices for a more complete explanation.) The short version is that if the market expected that ETH will be worth, say $700, in six months, people would buy it today and drive the price up to $700. This is simply an arbitrage opportunity. On the other hand, if the average market expectation was that ETH would be worth $300 in six months, no one would be willing to buy it for $500 today. In fact, no one would be willing hold to ETH until the price dropped to $300. In other words, today’s price of ETH must reflect the market’s average expectation of its future price. This does not mean that the market will be correct, only that self-interested arbitragers will drive today’s prices to equal this future expected value.
Going back to our original question, this implies that a fair price for your escrowed ETH is exactly $500. If you offered to sell your contract for $400 you would create an arbitrage opportunity given the current expectation of the ETH price in six months. If you offered it at $600, you would find no buyers.
Before you all go accusing me of believing in perfect, frictionless markets, let me admit that the last paragraph is not quite true. In fact, you would probably get a bit less than $500. This is due to factors such as interest rates, risk premiums, transactions costs, and so on. How big a wedge this puts between the market and “fair” value of the escrowed ETH depends on how efficient the markets that are created to sell ETFs, futures, and other derivatives turn out to be. Given that these derivative products will be created on the blockchain, enforced automatically by smart contacts, and use instruments that are well-understood by financial markets and the brokerage industry, there is good reason to believe that crypto ETF/derivative markets will be quite efficient indeed.
The answer lies in ETFs for cryptocurrencies and includes completely conventional derivative instruments built on this foundation.
Are Crypto ETFs and Derivatives Really a Better Solution than Stablecoins?
Let’s compare the stablecoin solution to the derivative solution:
Fees: Probably comparable. Banking and transactions fees for a really well-run, fully fiat-collateralized stablecoin are likely to be around a few percent. Brokerage fees for derivatives in an automated, immutable, smart contract protected, blockchain marketplace should be in the same range.
Central points of failure: A stablecoin must connect to the real banking sector at the platform level, and the platform must authorize and stand behind the redemption of coins for fiat. In contrast, a blockchain futures and derivatives approach is a two-sided market with many brokers, dealers, banks, and consumers on each side. The level of trust needed is no greater than we currently have for these financial actors. If Bank of America or Merrill Lynch is trusted with our money and investments in the real world, they should be at least as trustworthy when their obligations are recorded on an immutable blockchain.
Privacy and regulation: There is no getting away from the fact that all interactions with the real banking sector remove any meaningful privacy. Any derivative contract that is settled for cash will be connected to you through your bank account (and visible at least to the financial company that makes the transfer, your bank, and the government). However, there is no reason that this needs to be tied to your activities in the cryptocurrency world. You might simply buy a derivative contract as speculative investment. Purchasing such a contract in no way implies that you must be trying to hedge against risk for a cryptocurrency position you hold. What happens on blockchain, stays on blockchain.
Risk: With a stablecoin, all kinds of things could fail catastrophically and unpredictably. The smart contract could have bugs, the key vault could be hacked, a government could confiscate the fiat reserve, and so on. With derivatives, you only have the exposure you choose, you are working with established financial agents using standard and well-tested financial instruments in a settled regulatory environment. Of course there is always risk, but it is of a much lower magnitude.
My view is that the quest for a stablecoin is difficult and ultimately pointless. Making a viable, sustainable, and useful stablecoin is almost impossible. At best it would embed high costs, require high levels of trust in a central authority, include new and unpredictable types of risk and offer very little in return. On the other hand, futures and other derivatives are a tried and tested way to hedge against risk from price volatility and every other kind of future uncertainty. While derivatives are not a purely on-chain solution, neither are stablecoins. On the other hand, derivatives don’t have the other problems that stablecoins do. When the SEC eventually decides to allow these markets to open, blockchain itself will make it possible to access them cheaply and universally. In turn, this will make existing cryptocurrencies a viable choice for everyday transactions.
When the SEC eventually decides to allow these Crypto ETF and derivative markets to open cryptocurrencies will at last become a viable choice for everyday transactions.