Stablecoins as settlement instruments for global financial transactions
This is the first of a series of articles outlining the potential for the use of Distributed Ledger Technology in financial infrastructure.
In recent developments and Distributed Ledger Technology projects, Stablecoins and Security Tokens have caught the attention of the financial industry. The use of blockchain technology for the representation and exchange of financial assets worldwide is an obvious route. As an example, major companies such as Facebook or JP Morgan entered this market by announcing the creation of Stablecoins (Whatsapp Stable Coin and JPM Stable Coin).
Is the combination of Stablecoins and Digital Securities a game-changer for financial market transactions? Are Stablecoins and Digital Securities inseparable? Is this the starting point for a massive shift in financial infrastructure?
What is a Stablecoin?
The main reason for the existence of cryptocurrencies such as Bitcoin is the storage of value and a means of exchange without the need of intermediaries. The idea of a peer-to-peer electronic cash system is not something new. In 1999, Milton Friedman said: “I think that the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the internet you can transfer funds from A to B without A knowing B or B knowing A”. However, the actual implementation of this concept took place, for the first time, in late 2008 with the publication of the white paper of an anonymous person called Satoshi Nakamoto. At that time, the financial world was facing the worst financial crisis since the 1929 financial market crash that led to the Great Depression. Without the introduction of Quantitative Easing strategies from Central Banks and the US Federal Reserve especially, the banking system would have collapsed. Therefore, the idea of a peer-to-peer electronic cash system based on computer power instantly appeared as a great one and soon came into force through the Bitcoin network. Over the last ten years, Bitcoin has become more and more popular. Nevertheless, this new technology has led the way to major capital inflows in a relatively small market while incurring the risk of limited volumes causing big price swings. Speculation and unpredictable price fluctuations are among the main criticisms of cryptocurrencies as their price instability makes them ill-suited for daily transactions. For this reason alone, more and more people have been looking at less volatile solutions and it is hardly surprising to see ever increasing interest in Stablecoins. In our humble opinion, Stablecoins are a logical step towards the adoption of the Distributed Ledger Technology in financial infrastructure.
Stablecoins have the advantages of the Bitcoin, for the instant settlement of cost-efficient transactions, without incurring the risk of price volatility. In other words, it is money that is programmatically issued and tracked through the use of blockchain technology.
How do Stablecoins work?
There are several kinds of Stablecoins depending on their price stability mechanism.
- Fiat collateralized Stablecoins
They are either a substitute or a mirror for traditional bank deposit accounts. As a bank deposit, each token is backed 1:1 by a fiat currency omnibus account. Therefore, users can own their Stablecoins within their cryptographic wallet without the need for an external custodian. Because the blockchain is used as a record of ownership, the bank does not need to adjust the customer’s account balance on their own books. All transaction processes and record-keeping are automated and give customers instant access to money transfers 24/7. On the other hand, this process is still exposed to a bank’s default risk. In order to mitigate this risk, issuers can create several omnibus accounts with different financial counterparties.
- Asset collateralized Stablecoins
These Stablecoins are backed by assets such as commodities. So far, the most common asset that has been used for value-backing is gold. In this specific case, the price of the Stablecoin follows the price of gold. With this approach, issuers are required to store physical gold in a trusted third party’s vault.
- Digital Securities — debt tokens
As Digital Securities evolve we will see more and more tokenization of debt instruments that can be categorized as Stablecoins due to the low volatility of the underlying asset. However, the owner of such Digital Securities is subject to the credit default risk of the issuer.
- Crypto collateralized Stablecoins
This type of Stablecoin requires a given amount of cryptocurrencies to be included into a smart contract from which Stablecoins are then issued. To mitigate cryptocurrency excessive price volatility, each Stablecoin is over-collateralized. The main difference with the previous methods, is that this approach is decentralized and transparent because all the transactions are trackable on a public blockchain.
- Algorithmic Stablecoins
It is the most complex model. This approach seeks to recreate a central bank mechanism that is able to act on the fluctuation of monetary supply. There is no collateral at all. Instead, an algorithmic mechanism is used to expand or contract the availability of Stablecoins in order to stabilise coin value. It is not yet known whether such as decentralized system is scalable.
Even with the improvements brought on by technology, the adoption of Stablecoins has been limited to date. One of the reasons for this is its regulatory framework as a set of rules used by the banking system has to be adopted in order to abide by regulatory compliance legislation. To date, Stablecoins have mainly been used to lock-in profits made by cryptocurrency traders. Regulatory mechanisms are a must to make blockchain technology a trusted settlement mechanism. The first rule known as KYC/AML is key. It means that each user of Stablecoins needs to register and get verified before being allowed to hold Stablecoins. One solution could be to introduce an obligation to pass KYC processes and AML verifications only when one wishes to convert stablecoins in fiat and transfer them to a traditional bank account. Thus the concept of Stablecoins would maintain the original philosophy of Bitcoin whilst avoiding massive price fluctuations. A viable solution could be a wallet that has passed KYC/AML on-boarding checks, playing a substitute to a bank account role with an anonymous wallet used as a current cash wallet.
The limit for Stablecoin use is the sky:
- Stablecoins can be used as a means of payment of clearing and settling securities’ transactions. Because Stablecoins offer the same technological benefits as cryptocurrencies, we can also imagine a better, cheaper and faster mechanism for cash transactions across the globe. There has been a substantial amount of research on various use cases such as mobile app payment and alternative currency in emerging markets as well as global payment systems leading large financial institutions to acknowledge their potential. As an example, a consortium, lead by UBS, invested more than $60M in Fnality International who developed a Stablecoin allowing banks to improve cross-border payment systems as well as clearing and settling securities transactions. Another example is JPM Coin that intends to facilitate instantaneous transfer of payments between institutional and private accounts. Last but not least, Facebook Coin will be used through whatsapp in order to address a monetary solution to the unbanked population.
- Stablecoins can be used as coupon and dividend distribution mechanisms. This way a large amount of redundant operations between intermediaries are foregone.
- KYC/AML can be embedded into Stablecoins in order to automate compliance procedures and verifications.
To conclude, Stablecoins are catching the attention of financial institutions including central banks. Central banks introduced the term of Central Bank Digital Currency (CBDS). CBDS could have an important role regarding monetary policy tools. Imagine a quantitative easing that reaches the population directly through an airdrop and is controlled by the Central Bank ensuring that this money supply is used only for consumption. In other words, launching “helicopter money” where the money supply will be injected directly into the consumption chain and will be “burned” after a certain period of time (monthly) if the money is not used. Wouldn’t this be more effective than the current quantitative easing used to purchase assets like governmental bonds serving only the banking system to make more profit? Stablecoins are at the forefront of a new and modern financial application.
Pierre-Yves Dittlot
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