Stablecoins - The T0000000.1 Problem

It is easier to understand why something acts as a solution, than understand why it acts as a problem.

Rightly embedded within the Blockchain and DeFi space, is Stablecoins.

Stablecoins (SC’s) are a viable alternative to cryptocurrencies, as they are pegged to a fiat currency and supposedly give digital coins a stable price (1:1), something that has been an issue for un-pegged crypto coins and tokens.

SC’s could effectively provide the best of both worlds of traditional finance and DeFi by utilizing the full scale of DeFi and blockchain, whilst eliminating coin price volatility. This latter point is something that we have come to expect from digital assets, as explosive price swings have hampered the trust-of-use system.  

The Crypto market is robust. It includes thousands of different digital assets, crypto companies, and decentralized financial products. Yet, there is still so much potential that is not being fulfilled by Blockchain tech and DeFi, as it still does not make sense in the mostly centralized system we have today. Stablecoins have the potential to close this gap, as they connect to centralized systems, rather than compete with them. This makes much more sense when looking at the future of Blockchain, Oracle Protocols and DeFi.

SC’s also make the public’s interaction with DeFi more practical and more realistic.

For instance, If someone places ETH into the Compound protocol to earn interest, for example, there is the possibility that an ETH price drop offsets any yield earned, leaving that person with a loss. However, if the same person uses a SC, such as USDC, the value of the underlying asset would remain stable so the yield would remain unaffected by crypto market price volatility.

When looking for above-average yield than traditional fixed-interest investments — such as savings accounts, money market funds, or bonds —digitized funds in the DeFi market seem to be the answer, yet the tender that invests in these, needs protection. Arguably, the easiest and safest way to do that is to tokenize US dollars into a SC, which can then be used to deposit into DeFi protocols.

Stablecoins are therefore a solution to a host of bridge problems being raised in DeFi and centralized systems. Yet, the DNA of SC’s does not intertwine very well into our current system, if that at all. They bring native problems that are hard to fix overnight.

One of the problems revolves around the core of the solution - t00000000.1

95% Of all Stablecoins are asset backed (other 5% are algorithmic supply based) — whether that’s by the corresponding fiat currency, digital assets, or by other financial instruments such as money markets, gold, stocks or bonds.

Let’s look at SC:Tether and their breakdown of asset-backed collateral. As you can see most of Tether’s reserves are in ‘off-chain’ market instruments, such as Cash & Cash equivalents, making up 85.64% of reserves with Treasury Bills making up over half of that figure. Treasury Bills are t(1) instruments, meaning they take a day to settle. If Tether wanted to sell it’s position at 9:00am Monday morning, they would receive the funds AM Tuesday. Yet if Tether sell’s it’s position at 9:00am on Friday, it would receive the funds AM Monday.

This is an extremely big flaw in off-chain collateralized SC’s.

If SC’s had settlement terms t(n) it would probably be t000000000.1, which is lightspeeds faster than t(3) (Saturday (t1), Sunday (t2), Monday (t3)). This is because SC's settle near instantly and trade 24/7.

For instance, If the blockchain economy fails and the market rejects the fiat-backed SC and hypothetically every holder demands redemption at t0000000.1, then there is a timing mismatch of available redemption funds and a huge liquidity risk, as off-chain collateral is held at a minimum of t1 and possibly t3 at the weekend. SC’s do have designated redemption days, yet a run on the SC makes these days worthless.

One way to get round this, is to hold reserves on-chain, thus matching t0000000.1.

Yet you would need to hold a huge reserve premium to account for the price swings of being on-chain. This is why SC’s such as Tether don’t like to do this, as it’s in their interest to tie up as little capital as possible, whilst on-chain is also considerably more risky.  

There are other options such as using Chainlinks Proof-of-reserve protocol that provides smart contracts with the data needed to calculate the true collateralization of any on-chain asset backed by off-chain or cross-chain reserves. This does not solve the timing issue directly, but makes the reserve process incredibly more transparent. Yet, as the PoR protocol is an autonomous auditing of collateral in real-time, it does allow the protocol to make decisions about how best to protect user funds.

For instance, the PoR can protect funds in a undercollateralized event (less than the amount of reserve backing the coin) by using autonomous circuit breakers, similarly to traditional financial markets.

A good example is how PoR’S work to power (SC) TUSD (TrustUSD). Chainlinks Oracles collect Trusttoken’s reserve data from it’s accounting firm – Aemanino, which audits the data off-chain. If the reserves were to deviate from the coins supply threshold, a trigger would be released and the PoR protocol (however it was set up) would decide what action to take instantly, whether that be reducing the buyer ability or selling ability.  

Although Oracles can bridge the gap between on and off-chain, this does not solve the timing mismatch issue per-say, all it does is make the market more realistic at scale. Circuit breakers should be seen as an action of last-resort, not a pillar of process that could happen on a bi-weekly circle. Although Chainlink has the right idea, they are considering protocols for the current environment of SC’s, when they should be considering them in a sandbox scenario where SC’s are at the heart of digital transactions.   

This is where regulators could help.

The European Central Bank (“ECB”), The Financial Stability Board (“FSB”), the Bank for International Settlements (“BIS”) and the Commodity Futures Trading Commission (“CFTC”) have all issued guidance on SC activity to bring them under regulatory oversight yet have not issued any requirements around reserves, specifically related to SC’s.

There has been no rulings on SC reserve make-up, on-chain and off-chain minimums, settlement issues, mandatory maximum risk weightings, reserve auditing or any mention of any type of Oracle protocols being used to audit collateral. Regulators are acknowledging SC’s existent but refusing to put a hand in the game. They are instead trying to fuse SC’s into categories already regulated such as digital payment assets and securities, which complicates things further as SC’s have native features. We have already seen how this plays out with Neufund.

A further worrying sign is the use of ‘Return-in-Kind’ arrangements. These effectively allows SC’s to return an asset of the their choice (In-Kind) to the coin owner, at redemption. Therefore, you could end up buying a Stablecoin with Euros, but end up redeeming your Stablecoin to a bond, stock or even an asset on-chain. These arrangements are also vague when it comes to the value of the Asset-In-Kind you receive, compared to your SC holding value. There is no universal method of correlating the two, something that is sure to prop up as a problem sooner or later. Regulators could easily ban this approach as it dents the trust in digital payments and benefits the SC community in few ways.

Regulating Stablecoins is effectively regulating part of the bridge between on-chain and off-chain funds. Stablecoins offer a host of benefits to financial markets and consumers, yet regulation needs to account for how DeFi will evolve overtime so that it does not limit any protocols and innovation in this bridge. Getting SC Reserve requirements right is extremely challenging, yet there needs to be universal guidelines that clearly define that the SC transactions are legitimate and that the worth of the transaction is backed and readily available at redemption. Solving the t0000000.1 problem, mandating reserve risk breakdown, banning Return-In Kind and introducing credible universal proof of reserves either by Oracles or off-chain should be the regulators first priorities.