‘Reserves’ backing 3P Stablecoin Pegs
Talking about the differences between ‘Actual Reserve’ and ‘Implied Reserve’.
If you don’t know the difference between 3P, 2P, & 1P Stablecoins, read this.
I first heard about the distinctions between ‘reserves’ by listening to a Hidden Forces Podcast with Nevin Freeman of Reserve Protocol, and the distinctions made a lot of sense in my Brain.
It was great because it was the first time I had heard the Ideas of…
- Size of Actual Reserve/Size of the Implied Reserve
- What is the ‘Credibility of the Promise’ to spend those reserves maintaining the peg?
…in-depth.
Here’s what Nevin says about ‘reserves’ backing a Stablecoin. (This is the cliff notes of the important things he said on the podcast, my Opinion will be after all of it):
‘Having enough assets in reserve, of the currency you’re pegging to, so you can always make good on the promise to repurchase your currency for the rate that you’ve promised.’
‘Will you always be willing to make that trade- to give the person a dollar for a Demetri Coin?’
Pegs Breaking: 2 things
- Body maintaining the peg runs out of that foreign currency & they can no longer hold that peg.
- They don’t run out of money, but decide not to spend the money on keeping the peg. They spend it on something else (political favors, social good, etc).
Issue: Defending a peg in a Depreciating environment. You can always print of your currency to buy up foreign exchange, but you can’t just create dollars.
Framework for Stablecoin Designs:
- Size of Actual Reserve or the Size of the Implied Reserve? (Can always take a Stablecoin Design and translate it into thinking about the Implied Reserve)
- What is the ‘Credibility of the Promise’ to spend those reserves maintaining the peg?
If you have sufficient reserve size/implied reserve size, and a highly credible promise, then you have a pretty good currency peg. You can make the ‘Credibility of the Promise’ easier or harder to assess, depending on the design.
USDT
People have trouble trusting Tether because it’s hard to tell if the reserve is there.
What is size of USDT reserve? If we assume there is 1:1 backing, then it is sufficient.
What is the ‘Credibility of the Promise’ to spend the dollars maintaining the peg? Difficult for crypto audience to assess whether or not Tether or Bitfinex will choose to spend those dollars maintaining the peg. Up until now, they probably have, but there’s always the Q of whether that will continue- and that’s difficult to assess.
As long as Tether is a cash machine, Bitfinex should have no problem in maintaining the Tether peg.
MakerDAO
Deposit collateral in smart contract. They can take out some token against that collateral, as a loan.
Collateral acts as the ‘reserve’ for a specific Stablecoin. Collateral all belongs to some person. It’s collateral specific to each individual, it’s not all in 1 big bucket. Doesn’t permit you to spend that collateral to defend a currency peg in a direct way.
If price of stabletoken diverges from pegged price for a long period of time, Global Settlement . GS is a process that allows you trade these stabletokens for a dollar worth of that collateral.
Job in assessing what the Reserve is, is a little bit more complicated. If price of Stablecoin is below $1, speculators might want to buy that token, bc they believe 1 of 2 things:
- Either, price returns back to $1 by market forces.
- Or if that doesn’t happen, a Global Settlement occurs and they can trade the Stablecoin for $1 worth of collateral
What is the capital out there that is actually available on a moment-to-moment basis to provide the buy-wall for the Stable currency?
Answer: It’s the capital held by all of those diverse individual speculators who will make the choice whether they want to buy the Stablecoin when it’s worth 90 cents or 40 cents or whatever.
There’s no central reserve account.
The amount in reserve is equal to: How much capital do I believe the crowd is holding that they would be willing to spend on this particular financial proposition?
Will those speculators want to spend the capital on this, vs. some other financial proposition, at the moment that the price needs to be supported for the stablecoin?
The implied reserve size is opaque.
‘Credibility of the Promise’ to spend those assets maintaining the peg? There’s no central body, or piece of code, to decide to spend those assets to maintain the peg. Instead, there will be 100k+ people deciding whether or not they should ‘buy the dip’ in expectation that everyone else does as well.
Not an easy currency peg to assess or trust.
Demetri: “You can’t control people’s subjective perception of value. And if that’s what you’re relying on to maintain the peg, that’s not enough.”
Seignorage Shares.
Size of implied reserve?: The # of dollars worth of share tokens you can mint and sell at any given time before people stop wanting to buy them anymore.
‘Credibility of the Promise’ to spend those reserves?: If that currency has ‘caught on’ then the market will probably want to buy those share tokens. If the currency is new, then the market will not know whether this type of currency will catch on, and there may be times where nobody wants to buy share tokens at all.
Reserve Protocol
- Have sufficient assets in reserve.
- Highly credible promise.
Lockup a portfolio of different cryptoassets into a smart contract (called The Vault), and then deterministically spend those assets in order to defend the peg.
“We’ve thought through a way to make sure that we have enough assets held in that Vault, that we never end up not having enough to defend the peg.”
And because it’s just a smart contract, people can just look at the code & see ‘Ok any time the price of the Stablecoin is less than the pegged price, this contract will deterministically repurchase tokens to support that peg.’
End of Cliff Notes
My Comments
Re: “We’ve thought through a way to make sure that we have enough assets held in that Vault, that we never end up not having enough to defend the peg.”
Hmmm. I wonder what their plan is to do that. The Hong Kong Monetary Authority has been able to maintain the HKD peg to the USD since 1983. They are top-10 in the World for Forex Reserves, with $430B available for either investing (to grow their reserve account), or for maintaining the peg. “The total foreign currency reserve assets of US$431.9 billion represent about seven times the currency in circulation…” Since the HKD has been at the weak-end of its 7.75–7.85/USD pegged-range for the last few months, the HKMA will probably have to start using some of its reserve to start buying up HKD. Just like with any peg, the HKD can only last until the HKMA reserve backing it dries up, and if speculators smell blood in the water & see a chance to profit from forcing the peg to fail, they will all gladly pile on.
I don’t think the 7:1 reserve ratio actually matters. I think it is only the ‘nominal value’ of the reserve, relative to the ‘nominal value’ of shorts a few big players could levy on the peg, that matters. The ‘nominal value’ of the reserves just has to be big enough to survive shorts by a few combined big players. If it can survive shorts by a few colluding big players, then those big players probably won’t event try to collude in the first place, meaning the peg will not be threatened until the ‘nominal value’ of the reserve starts to decrease to where the speculators can be in striking range of the peg with their shorts. For example, if Bridgewater ($118B AUM), Soros ($28B AUM), and DE Shaw ($27B AUM) all wanted to combine forces with all their money to do a massive short to break the HKD peg, they couldn’t do it. Their total AUM is only $173B, only about 40% of the HKMA Reserves. So a large ‘nominal value’ of a reserve is actually more for defending against manipulations by nefarious actors, rather than normal market occurrences.
(For the Bridgewater, Soros, and DE Shaw example above, you should have noticed that there are actually only $61B of HKD currency in circulation [since the $430B reserve is backing the currency at a 7:1 ratio], so $61B HKD is the max they could borrow and short sell. I think it’s impossible to get everyone in a country to allow you to borrow all their currency for a short, so the max they could get their hands on would only be some % of the $61B. The type of short that I’m concerned with is repeatedly buying and selling massive quantities of the currency, enough to really cause the prices to fluctuate up and down in the market, and get people to leave that currency for having no trust in the peg. An example of that is 2 paragraphs down with the ‘$1000 in circulation and $7000 in reserve’ economy.)
Shorting in Forex is different from Shorting a Stock because there are 2 currencies involved in every transaction: A short on USDT/USD is equivalent to a long on USD/USDT. To ‘short’ USDT relative to the USD, you would get a large amount of USDT from another trade, and then use your massive USDT pile to sell into the USDT/USD order book, effectively pushing down the price of USDT/USD, which is equivalent to raising the price of USD/USDT.
Thought: If there is a Stable Currency with $1000 in circulation and there is $7000 in reserve to back that peg, an adversary with a large nominal AUM (relative to ‘nominal reserve’) can repeatedly buy/sell that currency in circulation to destroy the trust that users’ have in that peg, therefore bringing the market price of that Stablecoin down, as well as the confidence of the market looking to possibly buy that Stablecoin back up to its peg. As this is done more times, more and more users of that Stablecoin leave, which means the ‘possible money to support the peg’ leaves as well.
New Scenario: Same Reserve Size of $430B, but Hong Kong is the King of the World. All countries have the same purchasing power as today, but the reserve ratio of HKMA is now 30% instead of 700%. The Reserve is at it’s same nominal value of $430B (now backing $1433B currency in circulation instead of $61B in circulation). In this scenario, I think the ‘Strength of the Peg’ stays the same. And I think that because the adversaries against the peg still have the same purchasing power as power as before- Bridgewater ($118B AUM), Soros ($28B AUM), and DE Shaw ($27B AUM)- and now they can actually borrow up the $173B to short sell, as there is enough in circulation to reach that amount, but they still will not defeat the HKMA reserve of $430B, and the HKD will remain pegged just fine. (And the reserve would use <$173B to support the peg because there will be speculator liquidity in the market that is the first line of defense before the HKMA has to jump in to ‘right the ship’.)
Re: Size of Actual Reserve/Size of Implied Reserve
I think we can use the Size of Actual Reserve/Size of Implied Reserve ideas to create a Mathematical Equation for how ‘good’ a 3P Stablecoin is.
Stablecoin Score Equation =
(Transparent Reserves + Expected Reserves + Market Liquidity Available to Support the Peg) * ‘Credibility of the Promise’
Transparent Reserves, Expected Reserves, & Market Liquidity Available to Support the Peg are integers.
(And ‘Market Liquidity Available to Support the Peg’ can be described as 24h Volume on CMC)
‘Credibility of the Promise’ is a percentage between 0% and 100%.
USDT would look like this:
Transparent Reserves = 0
Expected Reserves = 50%*$2.7B = $1.35B (we believe there is a 50% chance that they have the reserves in a bank account somewhere to back the peg)
Market Liquidity Available to Support the Peg = $1.8B
‘Credibility of the Promise’ = 80% (The peg has held thus far, and as long as Bitfinex is a cash machine, the peg should continue to hold in the future).
So we get:
(0 + $1.35B + $1.8B)*80% = 2.52B
2.52B, or 2.52, is USDT’s Stablecoin Score
Reserve Protocol would have the highest ‘Credibility of the Promise’ to use those reserves to support the Peg at 100%.
The Stablecoin Score Equation means for 3P Stablecoins with the same ‘Market Liquidity Available to Support the Peg’ , the one with a Transparent Reserve > Expected Reserves will have a higher Stablecoin Score.
I’ve talked shit before about how 3P Stablecoins with Transparent Reserves tell an adversary exactly how big of a short is needed to destroy the peg, but with this equation I think that is wrong because the higher your Transparent Reserve integer and the higher your ‘Credibility of the Promise’ integer, the easier it is to gather a large integer value of ‘Market Liquidity Available to Support the Peg’.
So I’ve changed my mind.
Re: ‘Market Liquidity Available to Support the Peg’
This came from thinking about our ‘New Scenario’ up above, where Hong Kong is the King of the World. In that scenario, we said a short seller would have to first cut through the market liquidity supporting that peg in order to start depleting the reserves of the Hong Kong Monetary Authority.
This trait is present in 3P Stablecoins as well. For people to start depleting Tether’s reserves of dollars that Tether has to support the USDT peg, they first have to deplete all of the Liquidity that speculators are willing to put up to ‘profit from other speculators also putting up dollars to support the peg’/’Tether eventually jumping into the markets to support the peg’.
This ‘Market Liquidity Available to Support the Peg’ is a very important property for a 3P Stablecoin to have. They can increase it by having a fully Transparent Reserve with Audits, by having a strong Community, and by just having your 3P Stablecoin survive for a longer period of time (as people will join the ‘Market’s Liquidity Pool’ with more confidence in fulfillment of the Lindy Effect)
[7/25/18 Edit]
This is actually how I view 3P Stablecoin teams trying to defend their peg (aka financing their difference in opinion with the market).
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