How Stablecoins may facilitate everyday transactions

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Token or Coin?

Most people tend to use the terms coin and token interchangeably. However they are distinctly different. A coin (or currency) is a virtual asset which is an integral part of a distributed ledger technology. You may view a coin as a blockchain-based electronic money. A coin has its own blockchain, i.e. transaction logs and register, for example, Bitcoin. A token, however, is a crypto-asset that is an inherent and integral part of a smart contract executed on top of a distributed ledger. This was made possible by Ethereum protocol, its smart contract allow anyone to issue their own tokens, as we witnessed in initial coin offerings (“ICOs”). So tokens do not have their own ledger.

Types of tokens

i) Security token — a tokenized security that represents either an equity or debt-like instrument and provides certain economic rights to its holder (such as dividend income, interest income or even voting rights).

ii) Asset backed token — a cryptographic representation of an underlying asset that provides the values and rights of that asset to the holder of the token.

iii) Utility token — is a form of pre-paid instrument that allows the holder of the token to access the services or products or the functional usability of the issuer’s platform. Examples are gaming tokens.

Stablecoin

Let’s get the definition of stablecoin out of the way first. A stable coin is a tokenized currency that is backed by assets with stable prices such as gold, or fiat currencies (USD, EUR, Pounds etc). A tokenized currency means to make storage and management of an asset digitally represented by such token. Actually by strict definition, we should call them stable tokens instead of stablecoins because they are unlike Bitcoins and do not have their own ledger. But since the latter is more well known, I will just stick to this reference.

There are generally 2 types of stablecoins:

i) Stablecoins backed by assets and the price is pegged 1-to-1 to the price of such asset. This also means a holder of such stable coins can go to the issuer to exchange for an equivalent value of the actual asset.

ii) Stablecoins that are kept stable by using certain mechanisms to prevent extreme divergence from the price of the asset. It does not represent actual ownership of such underlying asset. Example: Basis tokens

For the purpose of this paper, we will limit the reference to stablecoin as a coin that is pegged 1-to-1 to the price of an underlying currency or asset.

Why bother with Stablecoin?

Why is stablecoin important? Well, imagine you go to a bank and buy a bearer bond. A bearer bond is a bond or debt security issued by a business entity such as a corporation, bank or a government. You exchange $100 for the bearer bond. The bond represents the total value of the $100 fiat money you just surrender at the bank counter. Bearer bonds are also called coupon bonds because the physical bond certificates have coupons attached to them, redeemable at an authorized agent for biannual interest payments. Even though bearer bonds have been phased out due to the potential money laundering risks associated with its use, essentially that is the idea of an instrument that has a stable value, i.e. the value stated on the bond represent the underlying the value of the tokenized currency.

A stablecoin, as the name suggests, has low volatility in prices as it is pegged to a major fiat currency and the issuer should theoretically hold the same value of assets that represent the total value of stablecoins in circulation. Thus, stablecoins can be used as a store of value or medium of transaction on the blockchain network. It is more useful for digital payments because neither merchants or customers would want the value of the tokens fluctuate too much.

Currently, cryptocurrencies are being used at selected merchants with digital point of sales. However, 10 years after the first cryptocurrency (Bitcoin) was launched, there are only around 35 million blockchain wallet users worldwide[1]. This indicates a relatively slow rate of adoption of such a transformative technology. The blockchain technology offers better security, privacy and anonymity for online transactions. But at the same time, cryptocurrencies also suffer a number of disadvantages such as lack of liquidity, exchange rate volatility, slow transaction speed, unregulated leading to potential money laundering risks and lack of scalability of the network[2]. But I believe one of the main reasons of the slow rate of adoption by businesses is the price volatility of cryptocurrencies.

Increasingly there have been many stablecoins issued by various stakeholders, from cryptocurrency exchanges, blockchain projects to even financial institutions. JP Morgan announced earlier this year that it would issue its own version of stablecoins pegged to the USD. IBM has been experimenting with a stable coin called Stronghold USD that is backed by US dollar deposits. This stable coin operates on the Stellar network and enables almost real time settlement, thereby eliminating post transaction processes.

Increasingly, startups that are raising funds via Initial Exchange Offerings are accepting stable coins as a funding currency instead of the traditional cryptocurrencies such as Ethereum or Bitcoin. Of course, most exchanges that facilitate IEOs such as Binance would require you to fund the IEO using its own token, BNB but I believe this is changing. Eventually when more exchanges start to offer IEOs, I expect more will accept the major stable coins such as Tether (USDT), TrueUSD, USDC, GUSD, PAX and DAI. Even in Singapore, so far there are two Singapore dollar stablecoins that have been launched, namely the SGDR and 1SG. According to the 1SG website, it states “users can complete various cryptocurrency exchange, fund hedging, asset storage, cross-border transactions, payment settlement through [its] exclusive wallets.” This is a good start for Singapore.

Benefits of Stablecoins

According to Forbes[3], an optimal cryptocurrency should possess the following characteristics: price stability, scalability, privacy and decentralization.

Stablecoins essentially leverage all the characteristics of cryptocurrencies (in fact most of them are based on the Ethereum protocol) that come with cryptographic security, easily transferable between parties (peer to peer) at a fraction of the cost of traditional telegraphic transfers. Anyone can now easily create a wallet online to purchase and store such stablecoins. Users can also spend these stablecoins at merchant outlets that accept cryptocurrencies. The main advantage of stablecoins is that it does not have high volatility common to most cryptocurrencies out there. This is because most cryptocurrencies have a fixed supply and any surge or drop in demand would affect their prices. Stablecoins on the other hand are pegged to the value of an underlying asset or currency. The prices of such assets do fluctuate, albeit not as volatile as cryptocurrencies. Thus, a stablecoin may be used as a safe haven instrument within the crypto economy during market turmoil.

First obvious use case for stablecoins would be cross border remittances. A migrant worker overseas could potentially send funds home in the form of stablecoins, via the blockchain without the need to pay exorbitant fees currently charged by banks or remittance companies.

Secondly, retailers that are accepting cryptocurrencies can also accept stablecoins of their national currencies. For example, a retailer in Singapore that is already accepting Bitcoin can add a SGD stablecoin to its digital point of sale. This would remove the common risk of volatile price fluctuations of cryptocurrencies.

Thirdly, traders and investors can also store their cryptocurrency holdings in the form of stablecoins while waiting for the right opportunity to make a trade or investment without having to worry that the value of their holdings would deteriorate in value at extreme market conditions. Currently, most investors or traders would convert their cryptocurrency holdings to fiat currencies during volatile market conditions, causing them to incur losses on spreads.

Fourthly, it is very hard (near impossible) to create counterfeit stablecoins because stablecoins are created on a distributed ledger with every transaction history recorded on the immutable blockchain. No one can change the transactions on that history on other people’s computers. One can change his own copy but as the overall network consensus will not agree with the amended copy, the change (counterfeit) will be refused.

Fifthly, bank issued stablecoins may allow real-time peer to peer transactions between the issuing bank’s own customer network. Silvergate was the first bank to issue stablecoins to be used within its own network. Another example is the planned JPM Coin, which is an initiative intended to target payments between businesses that have an account at JP Morgan, i.e. internal bank transfers, that a user with an account can make transfers to any other user of that bank in real time. Using stablecoins within the bank network enable banks to consolidate many transactions before a settlement with external parties.

Finally, stablecoins may encourage more people to move into the crypto economy. The most common objections cited by people who have yet to adopt cryptocurrencies are the price volatility and cryptocurrencies do not have intrinsic values. Stablecoins that are backed by real assets would solve these two problems.

Flaws of Stable Coins

Stablecoins are not a cure all solution to the problems faced by cryptocurrencies. In order for stablecoin to earn the trust from the community, it must demonstrate transparency in the way its asset reserves are accounted for. One way is to allow the fiat currency reserves to be audited by reputable audit firms.

Let’s look at the most commonly used stablecoin, the Tether (USDT) which was subject to much controversy. On 2 Feb 2018, over $100 billion was wiped out of the cryptocurrency market due to concerns over Bitcoin price was manipulated by Bitfinex using USDT. Tether was invented in 2015 and issued by a company called Tether Limited. In theory, every USDT is backed by real a USD$1. USDT’s market capitalization is $2.777[4] billion at the time of writing. That means the entire circulation of USDT should be backed by the same amount of USD. Whether that is true or not is subject to much speculation due to the lack of transparency behind the actual amount of USD held by the issuer. Many have also raised concerns that USDT is issued by the same people who own Bitfinex. The U.S. Commodity Futures Trading Commission sent subpoenas[5] on 6 December 2017 to Bitfinex and Tether.

An alternative stablecoin, Gemini Dollar (GUSD) claims to be pegged 1-to-1 with the US dollar and differentiates itself from Tether and other stable coins citing transparency and regulatory compliance as its main advantages. The US regulators, New York Department of Financial Services superintendent, Maria Vullo approved the coin’s launch with the following comment: “These approvals demonstrate that companies can create change and strong standards of compliance within a strong state regulatory framework that safeguards regulated entities and protects consumers”. Although GUSD provides the needed transparency to its actual USD reserve, it comes with certain downsides. GUSD is a regulated stablecoin and it will abide by what the government instructs it to do. Gemini can freeze the GUSD token if it desires to do so. The smart contract codes uploaded by Gemini indicated that Gemini can make GUSD non-transferrable at any moment[6]. More importantly, the centralized nature of GUSD also mean it is subject to single point of failure.

Finally there are other types of stablecoins that are partly collateralized by an underlying asset. This can mean the value of the coins may be backed by less than 100% real fiat currency. The uncollateralized portion may be backed by another cryptocurrency or crypto bond which are subject to price volatility. In extreme situation such as a major sell off or speculative attacks, the issuer of the stablecoin may need to buy back its own coin in order to defend the price. Once the company has exhausted its reserves and give up defending the peg, the stablecoin would quickly collapse. This situation is not so different from how George Soros broke the Bank of England[7] in 1992, just that it is much easier to break a stablecoin ‘bank’.

In Singapore, The Payment Services Bill (the “Bill”) was introduced and passed in Parliament on 19 November 2018 and 14 January 2019 respectively. Stablecoins in this paper would fall under the broad definition of e-money in the Bill. One of the requirements stated in the Bill regarding e-money concerns consumer protection. Major payment institutions are required to safeguard relevant customer monies and therefore requiring those that issue e-money to safeguard the e-money float they hold. One key risk is that customer monies entrusted to payment service providers may be lost, such as when the service provider becomes insolvent. The Bill requires major payment institutions to safeguard customer monies from loss through the institutions’ insolvency using the following means:

i) An undertaking or guarantee by any bank in Singapore or prescribed financial institution to be fully liable to the customer for such monies;

ii) A deposit in a trust account; or

iii) Safeguarding in such other manner as may be prescribed by Monetary Authority of Singapore.

These measures will largely address the major flaw of stablecoins that are not 100% backed or collateralized by fiat currencies.

Conclusion

Stablecoins provide the stability for merchants, retailers, traders, investors and end customers to transact and make payments safely and securely on the blockchain network. They can also be used by cryptocurrency exchanges to facilitate token generation events and IEOs as well as allowing users to fund their accounts and keep their funds with the exchange over a longer period. This would promote ‘stickiness’ of funds placed with the exchanges as users do not need to worry about the price volatility of their funds.

For merchants, stablecoins allow them to accept payments without having to worry about potential losses due to volatile exchange rates. Likewise, stablecoins held in a customer’s wallet will maintain the same value regardless of the fluctuations in the cryptocurrency market.

Once the early adopters (you and I) find it easy, safe and hassle-free to transact and make payments using stablecoins, the rest of the general population will follow suit. The only way that the crypto economy will see mass adoption is when the users do not even realize that they are making a transaction over the blockchain network, just as today, web browsers use TCP/IP to communicate with web servers. The transfer of information work so seamlessly that millions of people use TCP/IP every day to send email, chat online, and play online games without ever being aware of it.

And the day will come when everyone will be using the blockchain technology without even realizing it. And stablecoins may just be that catalyst we need.

References

1. https://hackernoon.com/tokenized-assets-security-tokens-and-stos-ae72dc0e275e

2. https://www.ibm.com/blogs/blockchain/2018/07/stable-coins-enabling-payments-on-blockchain-through-alternative-digital-currencies/

3. https://www.investinblockchain.com/how-long-does-it-take-to-mine-bitcoin/

4. https://www.forbes.com/sites/shermanlee/2018/03/12/explaining-stable-coins-the-holy-grail-of-crytpocurrency/#3f2f47504fc6

[1] Source: https://www.statista.com/statistics/647374/worldwide-blockchain-wallet-users/

[2] Current BTC block reward is 12.5 BTC, which works out to be around 10 minutes to mine a single block

[3] https://www.forbes.com/sites/shermanlee/2018/03/12/explaining-stable-coins-the-holy-grail-of-crytpocurrency/#3f2f47504fc6

[4] https://coinmarketcap.com/currencies/tether/

[5] https://www.bloomberg.com/news/articles/2018-01-30/crypto-exchange-bitfinex-tether-said-to-get-subpoenaed-by-cftc

[6] https://blog.goodaudience.com/gemini-can-make-gusd-non-transferrable-at-any-moment-code-review-a28d58ef6a61

[7] https://moneymorning.com/2015/06/10/how-did-george-soros-break-the-bank-of-england/

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CEO, WB Fleming

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