Rationale for Including Multiple Fiat Currencies in Terra’s Peg
The purpose of this analysis is to share Terra’s approach to creating a price-stable cryptocurrency (stablecoin) for global adoption. Specifically, we solve for an optimal composition of currencies that will comprise Terra’s currency peg. Since Terra is a new stablecoin, it makes sense to first begin by drawing understanding from the practices of fiat monetary regimes and then applying this knowledge to cryptocurrencies. We then solve for an optimal currency basket to comprise the peg, resulting in Terra’s decision to peg its stablecoin to the International Monetary Fund’s Special Drawing Rights.
Most official sector foreign exchange reserve portfolios are diversified amongst a small set of currencies, though there are some central banks or governments whose reserves are entirely denominated in a single currency such as the U.S. dollar. In addition, there is significant dispersion in the size of official reserves held among countries, across any metric of adequacy or comparison. There is no straightforward answer to the problem of optimal reserves composition and size, though the most fundamental question regarding adequacy is: does a country have sufficient reserves to meet its foreign exchange obligations, mitigate disruptive currency volatility, and ward off speculative attacks. Fiat monetary regimes which peg the value of their domestic currency relative to a foreign currency generally provision a foreign currency reserve equal or greater in size than the domestic money supply, in order to thwart volatility and attacks, with the reserve composition mirroring or resembling the peg itself.
Terra’s Mission and Approach to Establishing a Currency Peg
Terra’s mission is to power the innovation of money by building a price-stable cryptocurrency that will be used as a means of payment and store of value at a global scale. Being a stablecoin means that Terra’s value is programmatically pegged relative to another real-world asset. The Terra protocol is the algorithmic entity (the decentral bank) that is responsible for maintaining this peg. In order to perform this function, the Terra protocol must operate under a monetary framework similar to other pegged currency regimes. This is because Terra’s peg is subject to exogenous shocks greater than its fiscal reserves can absorb. Therefore Terra the currency must be fully collateralized by a monetary reserve such that all ecosystem participants are assured that the protocol can fully contract the money supply at the pegged price if necessary. Full or over-collateralization is required for Terra to be considered a credible medium of exchange and store of value.
Terra will peg its stablecoin to fiat currency at genesis because fiat currencies have earned a reputation for safety, liquidity, credibility, and stability relative to other global assets, over many decades (and in some cases centuries) of use. Fiat currencies represent the primary global reference point for determining and exchanging value.
Most Stablecoins are Inherently Centralized
Most of the largest stablecoin projects solve the stability (store of value) problem by pegging their cryptocurrency to a single currency such as the U.S. dollar, and hold their reserves in a single bank. While there’s nothing critically flawed with this simplified method for bootstrapping a stablecoin, it is inherently centralized and the barrier to entry is rather low as already numerous projects have copied this idea.
Pegging a cryptocurrency to the U.S. dollar alone solves the store of value problem, but it is an inherently centralized approach for any number of reasons: i) no alternative currencies are offered, ii) all reserves are held in a single bank account, iii) the protocol mechanism ensures unilateral decisions regarding the reserves. Most of the largest stablecoin projects are placing their full faith in the U.S. government and linking their monetary policies to that of the U.S. Federal Reserve, whose own policy is not necessarily correlated with other global central banks’ policies. This allegiance to a single sovereign is a brazen move for a stablecoin, as it is not at all obvious that U.S. fiscal, monetary, and regulatory policy trumps that of every other nation, either now or in future states of the world.
Since stablecoins have a fixed exchange rate and free capital flow, they cannot achieve fully sovereign monetary policy according to the ‘impossible trinity’ theory. Thus, centralized single-currency pegged stablecoins are exposed to potentially imprudent unilateral policy actions by the single sovereign upon which they are reliant. Creating a price stable cryptocurrency that is explicitly tied to a single central authority is by its very nature a centralized approach, and not a robust method for creating a new global decentralized currency that can be widely adopted. A centralized approach can also inhibit adoption among people and institutions not directly affiliated with the United States (which is most of the world). And as described in the next section, stablecoins that are pegged to the U.S. dollar alone actually subject their global users to greater volatility and potential losses compared to stablecoins that have a properly diversified multi-currency peg.
The Rationale for a Multi-Currency Peg
The U.S. dollar is the predominant global reserve currency, but it is not the only game in town. In fact, the majority of foreign exchange transactions and local currency transactions around the world are not denominated in U.S. dollars. From this simple standpoint alone, it is worth exploring the option of pegging a global stablecoin to a basket of real world currencies. Widely traded currencies issued by other large, diversified economies make great candidates for a multi-currency basket. The U.S. dollar, euro, Japanese yen, and British pound, which each represent more than 5% of global effective FX trading turnover, are strong contenders for consideration.
Diversifying the basket of underlying fiat currencies that comprise the peg also helps reduce the peg’s daily volatility, accounting for correlations. Applying a little portfolio theory goes a long way to ensuring that global stablecoin adopters can transfer their financial dealings to the blockchain and then back to their home fiat currency with less concern about price volatility and financial loss along the way. Pegging a stablecoin to the U.S. dollar alone actually exposes global users (outside the U.S.) to greater daily currency volatility relative to their home currency. This could be considered a cost or tradeoff for providing access to stability, but it is also a competitive disadvantage and an unnecessary burden imposed on the stablecoin ecosystem.
Terra’s Currency Peg Explained
The following section will elaborate more on the process to solve for an optimal composition of currencies that will comprise the Terra peg. As mentioned in the previous section, pegging a stablecoin to the U.S. dollar alone exposes global users to greater daily currency volatility relative to their home currency, which makes it more costly for users and businesses to transfer their financial dealings to the blockchain and back to their home fiat currency on a regular basis. Since cryptocurrency volatility is one of most significant barriers to real-world adoption, this limitation must be designed around.
It is Terra’s view that a new global price-stable cryptocurrency which aims to be used by the greatest number of people should be pegged to a basket of multiple fiat currencies in order to minimize volatility, similar to how the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) are comprised of five currencies. The SDR currency basket includes the four most liquid and widely traded currencies — U.S. dollar, euro, Japanese yen, and British pound — and also includes an allocation to the Chinese yuan. Though the yuan is the 8th highest currency in terms of turnover, China is the world’s second largest economy, and the yuan’s turnover ranking has increased rapidly in recent years as the economy expanded and financial account opened. Since the yuan is a managed floating currency, its daily volatility is relatively low.
The IMF SDR Is Less Volatile Than the U.S. Dollar
To analyze the impact of different currency pegs, first we demonstrate the risks associated with holding a U.S. dollar pegged stablecoin from three different perspectives, that of i) a eurozone business, ii) a Japanese business, and iii) a Korean business. Then we analyze two other currency pegs to see if they offer a lower risk solution for these stablecoin users. The first peg is a sample 70% USD, 10% EUR, 10% GBP, 10% JPY currency basket, the second peg is the IMF SDR basket.
The results conclude that the more the currency basket comprising the peg is properly diversified, the lower the daily currency risk for participants in the stablecoin economy, with the exception of users in the U.S. who would be exposed to higher currency risk by adopting a more diversified currency basket rather than using the U.S. dollar alone. The analysis shows that the IMF SDR peg is a superior basket for reducing global risk, reinforcing Terra’s decision to peg to the IMF SDR. This analysis holds true across various time horizons and domestic perspectives.
Daily volatility, value at risk (VaR), and conditional value at risk (cVaR) are all greatest for global businesses and investors with exposure to only the U.S. dollar, and lowest for users with exposure to the SDR basket of currencies. Using a simplified example applied to a eurozone business, the business is expected to lose 1.74% of their stablecoin value on any given day 1% of the time, if the business uses a stablecoin pegged to the U.S. dollar, while there is a much lower risk of loss when the stablecoin is pegged to the SDR. This protection gives businesses, investors, and other users more freedom on deciding when they want to convert their stablecoin back to their home country currency, and with less risk of financial loss.
Other Reasons, Beyond Diversification and Stability, which Make the SDR Peg an Optimal Choice
Not only has the IMF assembled a strong set of currencies to comprise its SDR peg, but the SDR also has a lengthy history of existence and prominence in the international financial system as a reserve asset. It was created by the IMF in 1969 and so far about SDR 204 billion (equivalent to about US$291 billion) have been allocated globally. According to the IMF, the SDR plays a “role in providing liquidity and supplementing member countries’ official reserves, as was the case with the 2009 allocations totaling SDR 182.6 billion to IMF members amid the global financial crisis.”
The IMF publishes the official SDR rate on a daily basis. This ensures a high degree of transparency and credibility with the marketplace, allowing arbitragers, market makers, and Terra to closely align the exchange rate to the peg. The peg is continuously maintained throughout the day because the currency weights and values are known. The SDR is also future-proof in a way the U.S. dollar is not, as the IMF assesses the SDR currency composition and weights every five years so that the SDR “reflects the relative importance of currencies in the world’s trading and financial systems.”
Terra is excited to be the first entity to bring the stability and credibility of the IMF SDR exchange rate basket to the entire world, finally unlocking its potential as a currency for use in everyday transactions and commerce. This significant feat is enabled through blockchain technology and Terra’s unique approach to maintaining liquidity and stability to the SDR peg. In addition, Terra is taking another tremendous leap forward by joining forces with a formidable alliance of global e-Commerce partners to drive adoption. You can read more about the Terra stablecoin and e-commerce alliance on our website (https://terra.money/) and by following us on social media (Medium, Telegram, Twitter, YouTube, Discord). Stay tuned for Terra coming to a store near you.