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Improving the Stablecoin: A Zero-Trust Decentralized Reserve

Abstract: This paper proposes improvements to the stable coin concept, by reducing or removing requirements for trust, and removing the paramount sources of risk, through the use of a decentralized natural commodity reserve, distributed to users:

  1. eliminating the necessity of a currency peg
  2. eliminating the central authority entrusted to manage the reserve
  3. eliminating the custodian entrusted to hold the reserve
  4. eliminating the auditor entrusted to confirm the reserve
  5. eliminating the reliance on any specific blockchain implementation
  6. utilizing a tri-token architecture: asset, equity and utility
  7. integrating the reserve asset to a liquid commodity market
Who’s minding your stablecoin?

1. Stablecoin Background

What is a currency?

A currency, whether fiat or digital, must provide three functions: serve as a medium of exchange, provide a reliable store of value, and act as the unit of account. The store of value is the challenge. U.S. Dollars are a store of value, because their purchasing power has been proven over centuries. They are the only currency accepted for U.S. taxes, and they are broadly accepted in most global economies. To build the foundation for this utility, U.S. dollars were backed by gold from 1790s to the 1970s. The World Bank president suggested that leading economies should readopt the gold standard.

What is a cryptocurrency?

An new definition was added to the Merriam-Webster dictionary in 2018: “Cryptocurrency: any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions.”

Cryptocurrencies just aren’t currencies, yet.

Until their purchasing power can be proven for decades (or perhaps if the U.S., E.U., or the IMF accepts them for all debts, public and private), no crypto-currency can truthfully claim to be a store of value. Some are surely a store of utility, assuming they can be reliably used for a valuable future service. But the reality is that most crypto-currencies are merely a store of hope — that a future buyer will demand that token for a greater price than today. They simply cannot fulfill the role of a currency, today.

With no store of value, cryptocurrencies are inherently volatile, and more often than not, short lived. High volatility and risk of obsolescence certainly limits their adoption. Few consumers can bear the risk of accepting payment in a currency that may lose 30% of its value in a month, or might be useless next year.

Enter the stablecoin

The goal of a stablecoin is create a store of value, by representing another asset that actually is a store of value. Ideally, this would result in a low volatility true currency, with all of the benefits of a distributed ledger. Presumably, if such an alternative exists, user adoption will be rapid, and the economic and social benefits will be substantial.

Fiat collateralized stablecoins seek to provide the store of value of a fiat currency, and inherit its lower volatility. One issue is that by pegging to a fiat currency, the tokens also inherit that currency’s existing risks — such as monetary policy and potential for economic devaluation.

The currency peg

To tether a digital currency to a fiat currency, a central authority enforces the ratio of the value (the peg) between the two currencies. Contemporary examples include the Hong Kong dollar, which is managed by the territory’s monetary authority, the HKMA, and is pegged at HK$7.80 to US$1.00. Presuming the availability of capital reserves, the HKMA purchases U.S. dollars at HK$7.75, and sells them for HK$7.85, at any volume necessary to maintain the peg.

With international trade imbalances, and local differences in inflation and economic growth, over time, currencies naturally diverge in value. Hong Kong has managed a peg since 1939, originally to the pound sterling. But in 1967, the British government devalued the pound. HKMA attempted to adjust the peg, but ultimately abandoned the pound, pegging to the U.S. Dollar in 1972. The USD peg has been adjusted three times since, most recently in 2005, and floated freely between 1974 to 1983. To maintain the peg, HKMA maintains a massive reserve, US$361 billion as of March 2016.

Without a sufficient reserve, a currency peg can fail. Arbitrageurs hope so — they try to “break the bank,” taking positions that will profit from a forced peg adjustment. They bet that the central authority, or bank, cannot maintain the peg, and make trades that deplete the reserve, to force the central authority to abandon or adjust the peg.

In 1990, the United Kingdom joined the European Exchange Rate Mechanism (ERM), agreeing to maintain a peg of £1 to DM 2.95, obligating itself to purchase unlimited pounds sterling for 2.773 Deutschmarks. But German inflation, under the strain of reunification, was much lower than the United Kingdom’s — the value of the Deutschmark fell relative to the pound. The central authority was pushed over the limit by George Soros, and many other speculators, who massively shorted the pound.

The reserve & maintaining the currency peg

To peg the value of a crypto currency to a fiat currency such as U.S. Dollars, the central authority (or the stablecoin issuer) holds a reserve of the fiat currency. When necessary, they use the reserve to purchase their own currency at the peg price, and maintain the value ratio. During the advent of globalization in the 1800s, currencies were asset backed by gold. No peg or currency reserve was required, because each currency floated relative to a common universal commodity asset.

For the last century, countries employing a peg have attempted to maintain it by using a fractional reserve. The most widely-used standard for reserve adequacy, for “market-access” countries (participants in the International Monetary Fund, capable of issuing liquid treasury debt) is the “Greenspan-Guidotti” rule, whereby 100 percent of short term debt, outstanding or to be issued in 12 months, is held in reserve.

2. Risk Factors: Fiat Collateralized Stablecoins

In addition to the risks inherent to cryptocurrencies, such as losing encryption keys, theft by hackers, volatility, and obsolescence, fiat collateralized stablecoins add the risks inherent to the underlying fiat currency, such as government manipulation, seizure, and policy changes. And fiat collateralized stablecoins introduce vast new risks, outlined below.

I am your central authority.

The central authority (the stablecoin issuer)

Recall the Merriam-Webster definition of cryptocurrency: they have “no central issuing or regulating authority.” With a fiat collateralized stablecoin, you now have both. Rather than reducing government control, that government’s fiat currency is used as the actual value, and a new, private company, acting as the issuing and regulating authority is added on top, trusted to manage the peg and the reserve.

It becomes the responsibility of the token issuer, the central authority behind the stablecoin, to maintain the peg, by holding and deploying substantial reserve when necessary. To gain user confidence, recent stablecoin issuers claim to hold a reserve equal to all of their outstanding currency. If that is the case, how they actually generate a profit and run sustainable system, is an obvious question.

More likely, stablecoin issuers are attempting to mimic the peg and reserve process of countries (or in this case, territories) like Hong Kong — even adopting the idea of a fractional reserve, all the while generating a profit.

But a lightly regulated, profit seeking company is not the equivalent of an established government. Hong Kong is a large economy, a participant in the IMF, and can issue reliable bonds (US$74 billion in 2017). The HKMA is part of a legislative and judicial system that provides regulation, monitoring and enforcement.

Given the risks, it is likely that no amount of reserve can truly mitigate the risk of a private centralized authority issuing stablecoins.

Central Authority Risks:

The central authority could

  1. mismanage the peg
  2. hold insufficient reserve
  3. fail under attempts to “break the bank”
  4. falsify, or not report reserve assets
  5. embezzle token sale proceeds
  6. embezzle reserve assets
  7. issue more tokens than assets
  8. go bankrupt or be acquired
  9. suffer external/internal hacking
  10. be subject to global litigation, regulation, and enforcement

The custodian of the reserve

To protect the reserve, a central authority can hire a custodian to hold the reserve, whether a bank to hold funds, or a depository to hold assets like gold.

Custodian Risks:

The Reserve Custodian could

  1. embezzle reserve assets
  2. be bribed to falsify reserve holdings
  3. be robbed, attacked or hacked
  4. be subject to local regulation, litigation and enforcement
  5. go bankrupt or be acquired

The Auditor of the Reserve

To assure users that the reserve exists and is protected, the central authority will surely hire an auditor (and in the case of precious metals, also an assayer) to periodically inspect, account and attest to the reserve.

Auditor Risks:

The Auditor could

  1. be bribed to falsify reserve holdings
  2. be hacked or attacked
  3. be subject to local and professional regulation
  4. be subject to litigation & enforcement
  5. go bankrupt or be acquired

Risk Summary: Each of the currency peg, the central authority, the custodian and the auditor, is a single point of failure, and focus for attack. The risks are simply insurmountable.

3. A Proposal for a Decentralized Reserve Stablecoin

A decentralized reserve of the assets backing a stablecoin is offered as a solution to the risks outlines above. A decentralized reserve removes the trust factors, and eliminates the paramount source of risk — a centralized authority responsible for a peg and a reserve. The decentralized reserve, which is essentially distributed to the users or their proxies, will be comprised of a physical natural commodity as the asset, providing a low volatility, growth constrained, universal store of value. The proposal is essentially to adopt a modern version of the gold standard, independent of fiat currency risks and machinations. To leverage the power of decentralization, as the tokens are purchased by users, the asset of the reserve, the actual commodity, is simply delivered to the owners. The network is the custodian and auditor.

The commodity we propose are natural certified diamonds, aggregated by an optimization process into a fungible commodity set. Using modern packaging and wireless technology, the diamond asset will feature integrated authentication, and wireless audit and blockchain features. With this technology, the physical assets are constantly audited, and the owners control the token, attaching the value of the asset to smart contracts, or liens via distributed blockchain transactions.

Economics of the reserve asset

As a natural commodity, upon the creation of each token, the underlying asset, a commodity set of certified diamonds, will be purchased from a global commodity market, at a current market price, and delivered to the token buyer. The economic supply curve of the commodity, where an increase in demand results in a higher price — and a higher price results in more supply, will provide a counterbalance to the supply and demand of the linked stablecoin.

Rather than relying on the actions of a central authority to manage a peg, the currency reflects the current value of the commodity and the utility of the token, and floats freely. The dynamic market provides liquidity. Commodities have several natural buyers: consumers of the commodity, and investors in the commodity, whether direct holders or through futures contracts and exchange traded funds. And now, a new buyer is added: crypto asset users.

As a result, owners of the stablecoin have three sources of demand when they want to sell their stablecoin and the physical commodity it represents: other stablecoin users, commodity users, and commodity investors.

Tri-token structure

To support this decentralized reserve stablecoin, a tri-token structure is ideal:

Stable, so you can learn the fundamentals.
  • Asset Token — representing ownership, enabling crypto transactions, and constantly auditing the physical asset
  • Equity Token — to capitalize and govern the commodity and token ecosystem, and receive dividends
  • Utility Token — ecosystem currency, accounting for costs and value creation

Token distribution (open api)

Rather than launching a new token on an existing blockchain platform, exposed to potential technological obsolescence, the asset tokens will be distributed to owners as a token attached to the cryptocurrency platform of their choice.

A simple public blockchain ledger will record the creation and issuance of each asset token to various blockchain platforms over time. An open API will be offered, allowing developers to attach the asset token to new platforms and applications, where a stablecoin feature is required. Owners can change asset token platforms at will.

Decentralized Custodians

To enable the asset token to be attached to a smart contract, or for a lien to be placed against the asset, it must be held by a trusted third party. To ensure that the asset reserve is decentralized, the custodians, and the ability to transact the asset, are both decentralized. Custodians hold the assets, but cannot transact the digital token, which is held by the owner. The integrated auditing of the asset prevents custodian fraud, so no auditor is required.

When a new asset token is created, the diamond commodity is acquired from the commodity market. The token owner has the option to take delivery of the token and the physical asset, or the owner may elect for the physical asset (but not the token) to be delivered to the custodian of their choice. Custodians hold the asset in an online smart cabinet. The smart cabinet wirelessly communicates with the encryption chip embedded in the tamperproof packaging containing the commodity. The network is the auditor, and hundreds of custodians around the globe, approved by vote of the network, will receive a small daily fee for holding the assets.

Auditing and token transactions

While the physical asset and token is held by an individual owner (as opposed to those held by the owner’s custodian) the asset is offline. Because the asset has been delivered, the owner can independently verify the authenticity of the commodity.

The owner can still sell the token and asset to a buyer, face to face. Each party authenticates the asset with a smartphone which interacts with the integrated authentication chip. They can then complete an online transaction of currency for asset token and physical asset. Otherwise the asset token is frozen for all other transactions, because the network cannot communicate with the asset, and a trusted third party cannot deliver it.

For the physical assets held by a custodians in an online smart contract, the owner retains control of the token, and the online asset reserve is audited daily. The network pings each asset with an encryption challenge. Assets that are online (and can be authenticated by the network) are available to their token owner for online transactions. These include selling the asset and token, attaching the token to a smart contract, or allowing a lien against the value of the token (and the physical asset).

Fiduciaries welcome

Because there is a market traded physical asset to custody, there is a much greater potential for fiduciaries (banks, brokerages, asset managers, investment funds) to support clients who wish to use a decentralized reserve stablecoin. Fiduciaries will likely provide custodian services, holding the physical asset for their clients.

Property rights & benefits

As physical property, the commodity asset backing the proposed stablecoin will benefit from all the protections available to consumers in their local courts. This includes benefits like the adjudication of disputes and inheritance proceedings. If the token is stolen by a hacker, the physical asset can still be recovered. If the physical asset is stolen, the diamonds are lost, but the thief cannot benefit from the digital asset.

Access to justice is a good thing.

Market operations

The entity that will purchases the diamonds to assemble into a fungible commodity, and which issues the asset token, is building an electronic diamond market. The Equity Tokens that are funding the development of the ecosystem own the commodity exchange, and earn revenue from the exchange fees. These Equity Tokens govern the diamond commodity and the stablecoin ecosystem. The members of the diamond exchange are the largest diamond manufacturers, and the largest diamond buyers.

The asset token issuer is a market maker on the diamond exchange, offering a daily bid for all diamond types that are compatible with the diamond commodity. But it is the market which determines the daily price for individual natural diamonds, and for the diamond commodity that is used for the universal crypto asset. This diamond exchange will dramatically increase the efficiency of the diamond supply chain, benefitting consumers, crypto asset users, and the diamond industry.

4. Conclusion

A better stablecoin is possible, building upon the decentralized structure of the blockchain ledger, by incorporating a decentralized reserve. The reserve is distributed to the owners, or their custodian, as fungible physical commodity, with integrated auditing, authentication and blockchain technology, and delivered with a cryptocurrency token.

The need for a currency peg is eliminated by tethering the stable coin to a natural, growth constrained, physical commodity. A global commodity is impervious to risks conveyed by fiat currency. Accordingly, early global currencies were all secured by such commodities, such as gold.

Tamperproof packaging encases the commodity, embedding a wireless encryption chip and security features. These enable easy physical and digital authentication, and digital auditing. The chip will hold half of a blockchain token, with the key held by the owner.

Zero-trust is achieved by decentralizing the reserve, by delivering the physical commodity and the token to the owners. Owners may also select from dozens of global custodians to hold their commodity, but not their key to the token.

Assets are audited daily by the network, by querying the encryption chips. The custodians cannot falsify their holdings, or transact the token without the owner’s key.

When held online by a custodian, owners will remotely transact the economic value of the asset, in any currency, through a smart contract or lien. Tokens attached to offline assets are frozen, and cannot be digitally transacted (by lien or online sale). But using a smart phone to authenticate the commodity and attach to the network, individuals can effect a sale in person.

With no currency peg or reserve to manage, there is no need for a risky central authority or repository. Because the asset is delivered to the owner and directly authenticated, the producer of the asset need not be trusted. The reserve is distributed, and the network is the custodian and auditor.

Finally, rather than issuing yet another currency backed by a commodity, the asset token will be deployed via a token on any crypto platform.

The proposed system uses a tri-token structure: an asset token that can be moved between blockchains, an equity token to fund, govern, and earn dividends from the asset ecosystem, and a currency token used inside the ecosystem.

Logically, the ideal commodity to asset back this stablecoin, which can held in a decentralized reserve, are natural certified diamonds. Diamonds are the most value dense commodity on earth. Using blockchain technology, a liquid commodity market is being created, bringing substantial efficiency to a notoriously opaque and inefficient market.

A diamond commodity, modern packaging technology, a new, liquid diamond commodity market, and blockchain technology will combine to create the universal crypto asset.

Note: From a posting originally appearing on BitCoin Forum, April 11, 2018