Decentralized Bank As A Way To Produce Stable Cryptocurrencies
By Oleg Bakatanov on ALTCOIN MAGAZINE
In this article, I want to describe an idea to create a fully on-chain and decentralized organization (Decentralized Bank), which is designed quite similar to a traditional bank and aims to issue stable cryptocurrencies fully collateralized by third-party debt (tokenized bonds).
Bank model is well developed and tested by ages. A bank transforms risks from interest paying debt into two parts: stability and guarantees for depositors and profits generated by the bank to shareholders. In this system shareholders effectively take risks of debt obligations not been paid and get remuneration for that. Depositors (in our case, stablecoin holders) get stability guaranteed by all bank assets including shareholders capital.
Decentralized Bank aims to replicate this model in a decentralized manner and to avoid using fiat money and traditional banks in its transactions.
Decentralized Bank balance sheet is very similar to a traditional bank — it has assets, consisting of digital bonds, nominated in USD or other stable currencies and liquid cryptocurrencies to provide immediate liquidity (redemption option) to issued stablecoins.
The total amount of stablecoins issued is always equal to USD nominated value of assets. Large part of them (70–80%) are in free circulation (these are accounts of depositors). The rest (20–30% of stablecoins issued) is reserve capital owned by shareholders. Stablecoins in reserve capital can be burned by the smart contract to compensate for any loss in assets.
Tokenized debt (bonds) as collateral of decentralized stablecoins
A bond is a promise of an entity to pay out a certain amount in a certain period of time. A promise to pay out debt in on-chain stablecoins can be perfectly tokenized in a smart-contract and become an on-chain asset itself.
Our Decentralized Bank (stablecoin issuer) can create new stablecoins in exchange of a tokenized bond and use this bond as an on-chain collateral.
Such type of collateral is much better than fiat in a bank because:
- it is fully on-chain but guaranteed by the real business entity;
- can be traded on a decentralized secondary market;
- pays interest (normally much higher than bank deposit);
- credit risk can be easily diversified over many emitents in many jurisdictions;
- doesn’t need a traditional bank to be issued.
Tokenized bond is also better than just a cryptocurrency as a collateral, because:
- it has much more stable value as it is nominated in a stable currency;
- its value is supported by real business (or asset) and is not based on a pure speculation;
- it doesn’t need to have liquid secondary market as margin call mechanism is not used here;
- and, again, it pays a guaranteed interest rate.
Tokenized bond also has its main drawback, it can be defaulted by its emitent. In this case, its value in the stablecoin collateral pool is lost.
To cope with default risk, Decentralized Bank may rely on three levers:
- Diversification of bond emitents in the collateral pool. We may use multiple bonds from multiple emitents as a collateral meaning that any default will erase only a small part of the total collateral value.
- Interest rates paid by bond emitents should be higher than losses from defaults and cover such losses on average.
- Decentralized Bank must create its own reserve capital to cover losses in the case first two levers are not enough to guarantee full collateralization of issued stablecoins.
All these mechanisms are used by traditional banks to ensure their solvency.
Decentralized Bank Shares, Capitalization And Governance Tool
Decentralized Bank financial model assumes that in order to create a truly safe stablecoin solution it needs to form reserve capital. Reserve capital absorbs any loss in collateral and also accumulates all profits generated by interest rates, conversion fees, and other commissions.
To finance creation and capitalization of reserve capital Decentralized Bank can issue share tokens.
Shareholders take system risks and get all profits (current and future) generated by Decentralized Bank.
A share has a nominal value in stablecoins (which represents its part in the capital) and can be redeemed for it. Share also has a market price and can be freely traded on the market.
Decentralized Bank share market price cannot be lower than its nominal value. Furthermore, as long as market expectations on Bank’s earnings are positive, the share token price must be higher than its nominal value.
Decentralized Bank must set and hold a minimal affordable level of the reserve capital to total stablecoins issued, based on expert risk estimates and historical volatility.
If reserve capital level falls below the minimum level, Bank’s smart contract will automatically issue new shares and sell them to the market (most likely via auction) for stablecoins to recapitalize the system.
In which cases, reserve capital may fall below the minimum level?
There are two reasons (or combination of them) which may lead to such a scenario:
- Negative one: Overall collateral fund suffered losses because of defaults or other factors
- Positive one: A lot of new stablecoins has been issued while the reserve capital has been growing at a slower rate
In both cases, recapitalization is needed and will be done by share token sale.
Decentralized Bank should operate as a decentralized autonomous organization (DAO) that means that share token holders will get governance rights similar to shareholders of traditional corporations.
Shareholders should be able to decide on the most important decisions in the ecosystem, elect important actors and grant them permissions.
Multiple Stablecoins And FX Exchange
Bonds (even of the same issuer) can be denominated in multiple currencies. Decentralized Bank can produce stablecoins in multiple currencies using the same technology and approach as for USD, accepting bonds denominated in these currencies as collateral.
Multicurrency stablecoin platform opens new opportunities for its users:
- blockchain accounts and deposits in multiple currencies;
- instant decentralized conversion from one currency to another;
- decentralized FX exchange for speculative margin trading or hedging;
- instant and cheap international cross-currency transfers.
Multicurrency products also create new revenue streams for Decentralized Bank related to FX conversion which will enable to monetize better the same customer base.
Decentralized Bank Tokenomics
Decentralized Bank monetization model is quite similar to a traditional bank. Stablecoins in circulation is a source of capital which then can be effectively invested in interest-paying assets (bonds).
Interest rate margin (the difference between interest received from bonds and interest paid to stablecoin holders) is the main source of revenues which increase reserve capital and, eventually, come to shareholders.
After Decentralized Bank starts issuing stablecoins in multiple currencies, FX conversion fees will create the second substantial source of revenue.
Together with the growth of services provided in Decentralized Bank ecosystem (such as decentralized exchange, payment gateways offering conversion of stablecoins to cryptocurrencies or fiat) new sources of revenue may emerge.
Share token market price comprises two components: nominal value (equal to currently available reserve capital) and anticipated future value of revenues coming to shareholders.
We believe that the described approach to issue stable cryptocurrencies is better than many existing approaches because of the following reasons:
- it is not connected to traditional banks and can operate without any involvement of fiat money. Hence, it has all the benefits of cryptocurrencies such as decentralization, censorship resistance, and transparency;
- it has fully on-chain and valuable collateral managed by smart contract based on transparent rules;
- collateral is diversified, its value guaranteed by real profitable businesses;
- The system is stable not only because of collateral but also because of access to additional capital via share token sales;
- and, finally, this model is scalable.
If you wish to learn more about how a decentralized bank can be built, visit us at depos.io or read our medium publications at https://medium.com/depos
