The Little Black Dress Of Crypto: Stablecoins (Part 1)
Recent months of turbulence and instability on the cryptocurrency market has inspired authors of cryptocurrencies to design and deploy a number of instruments that are supposed to tame the volatility of the cryptomarket and maintain a stable price. There is creativity in the design of these stable assets — in ways how assets are issued and the mechanism that is supposed to keep their price stable. This series aims to identify and describe some of the concepts, with a particular interest in “the spirit of crypto” — decentralization and expense of the stability. With roughly 60 either pre-launch or live projects (and the number is growing day-to-day) seems that the stablecoin is becoming to the cryptocurrency market what a little black dress is to a woman.
A somewhat in-depth study of stablecoin projects, both live and those on various stages of pre-launch, show several approaches to the design in terms of achieving price stability of the stablecoin. Each of the distinct approaches comes at a certain price — which is reflected in the method of governance of the new coin and the actual financial cost of issuing and maintaining it.
In terms of the method of achieving the price stability, the following types of stablecoins can be identified:
- Cryptocurrencies backed by fiat currencies
- Cryptocurrencies backed by exchange-traded commodities
- Cryptocurrencies backed by cryptocurrencies
- Algorithmic/seigniorage stablecoins, and
- Tethered cryptocurrency assets
Given that fiat backed cryptocurrencies are by far the most popular group of stablecoins, the first part of this series is dedicated to them.
Fiat backed stablecoins
Fiat backed cryptocurrencies are the oldest and the most common type of stablecoins. Their most important feature is that they are backed by a fiat currency (most often the USD, EUR and the Swiss franc) in a fixed ratio. The peg is realized off-chain, by keeping the amount of the fiat currency required to maintain the peg (i.e. the stable price) deposited in banks or other types of regulated financial institutions. The main risk of this type of stablecoins is the loss of value of the backing fiat currency. Since the governance is highly centralized, the trust in the issuer and the custodian is also a significant factor in maintaining a stable price.
By definition, stablecoins are not investment vehicles, and as such have a limited use — most issuers target institutional investors, who are not bothered by meeting compliance requirements and wish the use the crypto space as means to bypass the traditional banking system to execute fiat transactions with lower latency and fees.
Fiat backed stablecoins are issued based on the amount of the backing currency deposited to the issuer, and their circulating supply should always reflect the amount of fiat deposits held by the nominated custodian(s). Most issuers guarantee the redemption of the stablecoin by paying its’ value in the backing fiat amount to holders who require it, and who are willing to submit themselves to KYC/AML procedures required by the regulator.
These stablecoins are traded on a number of crypto exchanges, and are also issued by business entities that operate them (e.g. Coinbase/Poloniex — USDC, issued by Coinbase and Circle or Bitfinex — USDT, issued by Tether).
The Tether controversy
It is impossible to consider fiat backed cryptos without referring to the proto-stablecoin — the USD Tether (USDT). It has been in existence since 2014 and in trading since 2015. In spite the issuer’s obligation to provide regular audits of the amount of deposited backing fiat it has, the business governing the Tether has failed to do so. The closest it ever got to being “audited” was the publishing of a statement of Freeh, Sporkin & Sullivan LLP,a legal firm, that on June 1st 2018, Thether indeed had enough US dollars deposited on two accounts at undisclosed banks to back the circulating supply of the USDT token. The reason why this is at best an “audit” is also given in that report — in the “Further details as to engagement scope” section — FSS LLP is not an accounting firm, and has not used Generally Accepted Accounting Principles to produce the report, and as such, the report cannot be compliant to Generally Accepted Auditing Standards. With all this known, and the intense crypto-media coverage of all things happening to and surrounding the Tether, it is quite strange that the USDT had little problems maintaining its’ peg to the US dollar. Except for several stronger pushes below the peg value, the USDT hasn’t suffered considerable sanctions by the crypto-market for the lack of transparency of the valuation of the stablecoin or its’ governing entity (which in itself is an anomaly of the cryptocurrency market in general, and is out of scope of this article).
During October (1–31) the market capitalization of the USDT has been reduced by 31.42%, while the issuer has “burnt” around 500 million USDT tokens, thus reducing the circulating supply. This move might indicate that the competition represented by new stablecoins of the same class are taking their share of the market or that Tether is preparing for an actual audit.
Governance and regulation
Due to the design of fiat backed stablecoins, their governance is highly centralized and dependent on trust. Paxos Standard has gone a step further, by introducing the possibility of third-party law enforcement intervention over the circulating supply of the PAX coin, which can freeze or even seize PAX tokens from accounts. This is, per statement from the issuer of PAX, done to “keep the token KYC friendly”.
The regulation of this class of cryprocurrencies in the general case doesn’t extend to usage of stablecoins on exchanges. The KYC/AML procedures are required only when holders of tokens either buy them using fiat (from the issuer) or redeem them.
In this setting, the cost of maintaining price stability of fiat backed stablecoins, on top of the cost of fiat deposits, includes also the cost of running a legally compliant business.
The Huobi stablecoin solution
Mid-October, Huobi, the third biggest cryptocurrency exchange announced the introduction of their own “stablecoin solution” — the HUSD. The HUSD can be obtained by depositing any of the four supported stablecoins to Huobi: PAX, USDC, TUSD or GUSD, which are automatically converted into HUSD. The HUSD can be used on its’ native exchange for trading BTC, ETH and other cryptos available on Huobi Global. When a customer wishes to withdraw HUSD, they can select one of the four stablecoins which will be deposited on their account: PAX, USDC, TUSD or GUSD. The parity of HUSD towards these four stablecoins is 1:1 (for 1 deposited PAX, the customer gets 1 HUSD, which they can later withdraw as 1 GUSD — Houbi Global fees apply to all transactions). An another curiosity of this solution is that the USDT (Tether) will be traded against the HUSD.
The question regarding the HUSD, in terms of the classification of stablecoins introduced in this article is if the HUSD is a fiat backed cryptocurrency or a cryptocurrency backed by cryptocurrency. The best answer is probably — it is both. It is de jure backed by the four stablecoins used to obtain the HUSD, while it is de facto backed by USD deposits held by issuers of said four stablecoins.
This solution might introduce the situation when the value of the deposited stablecoin and the stablecoin the user wishes to withdraw aren’t an exact match, and the handling of such situations will be an interesting topic to follow.
Fiat backed cryptocurrencies are a step away from the values of the blockchain-cryptocurrency paradigm proclaimed in the iconic Satoshi paper: they are neither decentralized nor trustless. In exchange for centralization and expectation of trust, historically they haven’t given transparency and full compliance and disclosure, yet.
Now that the USDT has gotten some competition in GUSD, TUSD, CUSD, and the PAX — all of which operate in the same way (with CUSD planning to switch to algorithmic price targeting in the future), the cryptocurrency market should be able to obtain some new values in timely, diligent and transparent disclosure of relevant information by issuers of this class of stablecoins, and then we can call it a somewhat fair trade.
The views expressed in this article are not investment advice nor recommendations. The facts contained herein are not necessarily complete and readers of this article should do their own due diligence, including seeking independent financial advice, before investing. This article is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.