The Danger In the Stable Coins (Thought Experiments and the Real Price of Bitcoin

Introduction

Albert Einstein when creating first the special and then general theory of relativity did use lots of though experiments. A though experiments is a metaphor, an explanation to reach understanding by analogy — like for example what happens if we sit and ride on a light beam.

This article uses also thought experiments designed to provide analogy and bring clarity in time of euphoria of a bull crypto-market.

It may have been almost 2 years ago when I did answer a question on Quora — ‘What is the most dangerous crypto-currency’. At that time as well as now my answer is the same — it is the group of so called ‘stable’ coins.

The Two Types of Stable Coins

While there are a wide variety of ‘stable’ coins, I can divide them in 2 groups:

• derived from fiat currency: like for ex. USDT / Tether and USDC / Circle — receiving fiat USD and giving a crypto-coin which promises its worth is 1 USD
  
• derived from a major crypto coin: like DAI — receiving Ethereum and giving a crypto-coin which promises its worth is 1 USD, based on the ETH-USD exchange rate at the time of purchase.

Please note that I use the verb ‘promise’. The majority of crypto-traders and crypto-investors are certain that the peg (the 1:1 exchange rate) is guaranteed.

But, is it?!

The Decent and the Not So Decent ‘Stable Coins’ Issuers

After receiving of the fiat currency and giving the crypto trader/investor (fiat based) stable coins the crypto-exchange or the ‘stable’ coin issuer can consider the fiat that was received to be earnings — to be spent and consumed.

A decent exchange/issuer on the other hand treats the fiat received not as an earning but as a savings — to be returned back when demanded.

The first example is of a fraudulent exchange or coin issuer. But let’s consider the stable coins obtained form an issuer that I consider to be decent — the USDC of Circle.

Looking at the documents provided by Circle here reveals a warning that what is considered a guarantee is just a promise:

• https://support.usdc.circle.com/hc/en-us/articles/360001233386
  No guarantee of price stability

• Subject to the limitations set forth in this User Agreement, (i) when Circle tokenizes U.S. Dollars for USDC it will always do so at a rate of one U.S. Dollar ($1) per one (1) USDC and (ii) when Circle redeems USDC for U.S. Dollars, it will always redeem such USDC at a rate of one U.S. Dollar ($1) per one (1) USDC, less fees where applicable.

• For each USDC that is issued by Circle and remains in circulation, Circle will maintain the equivalent of one U.S. Dollar ($1) with its banking partners in Segregated Accounts, on behalf of, and for the benefit of, Users. Circle believes these actions will promote the price stability of USDC with an intended goal of one (1) USDC being worth one U.S .Dollar ($1). However, this does not guarantee that the value of one (1) USDC will always equal one U.S. Dollar ($1). Due to a variety of factors outside of Circle’s control, the value of USDC, particularly on third-party platforms such as cryptocurrency exchange platforms, can fluctuate above or below one U.S. Dollar ($1). Circle cannot control how third parties value USDC, and Circle is not responsible for any losses or other issues that may result from fluctuations in the value of USDC.

Alice and Bob — Using Fiat Based Stable Coins

It is time for our first thought experiment.

Let say Alice and Bob are crypto traders and new customers of a crypto exchange which has its own ‘stable’ coin — USDST. They deposit $1000 fiat each, and get 1000 USDST from the crypto exchange. Then they both purchase 1 Bithot coin which at the moment is 1000 USDST (BTH-USDST = 1000). At that moment Alice and Bob both have 1 BTH each and the exchange has $2000 fiat.

In real life, when trading, there is a spread — the difference buy-sell price, and there is a trading commission. For the sake of the though experiment we consider that the spread is zero, the commission is zero and the crypto exchange has only Alice and Bob as customers. In addition let’s assume the crypto-exchange is holding the fiat deposits in its bank account.

One month later the BTH-USDST becomes 1200 and Alice decides to sell her 1 BTH and as a result she gets 1200 USDST. Then she withdraws the USDST and converts 1:1 to fiat — getting $1200 in her bank account.

A week later after Alice sells the BTH-USDST becomes 1300. Glad about it and thinking that he did outsmart Alice he sells his 1 BTH and gets 1300 USDST and then requests a withdraw to get the fiat.

However at the time of the withdrawal of Alice the exchange is left with $1000-$12000 = $800 in fiat currency. How is the crypto-exchange going to deal with Bob’s request?

Unfortunately the crypto-exchange can not issue fiat currency. It is only a central bank which can issue (print) fiat currency and it jealously guards this privilege.

So the crypto exchange is left with 2 choices — either declare bankruptcy and repay Bob $1300 through the bankruptcy process or change the 1:1 peg to 1:0.61 so that 1300 USDT exchanges to the amount of $800 which it has on hand and can give it back to Bob.

Alice and Bob — Using Major Crypto Based Stable Coins

The above case deals with the first type of the 2 types of stable coins. It also describes a case of the purchased crypto-asset going up in value.

The case here is dealing with the second type of stable coins and describes a case of the purchased crypto-asset going down in value.

Alice and Bob have Ethereum / ETH and the current exchange ratio of ETH-USD is $500. They both go to a decentralized exchange and change 1 ETH and get 500 DUI — a stable coin ‘soft’ pegged 1:1 to USD. The meaning of ‘soft’ is that the peg is at best 1:1 and will change to any rate needed to keep the decentralized exchange still operating.

In addition they both have to put some collateral required for owning of DUI , in the amount for ex. of 110% / 1.1 ETH. At this point locked into the decentralized exchange are -> (1 + 1.1)*2 = 4.2 ETH of Alice and Bob.

A month later after their purchase ETH is not doing well having current exchange rate of ETH-USD going down and becoming $450. Alice wants to get out — she initiates a swap back to ETH but gets back less than the 1+1.1 ETH amount that she put initially.

Hoping for some improvement in the market Bob does not follow the action of Alice. A week later he gets bad news — the price of ETH-USD drops down further to $400 . Wanting to get out he initiates a swap back to ETH but gets back even less than what Alice got.

The Real Price of Bitcoin

Our third thought experiment involves Alice and Bob deciding to invest in Bitcoin. They do a deposit of $5000 in fiat currency to a crypto-exchange which was replaced with 5000 USDx, which is the stable coin of the exchange.
 
Then they both buy 1 BTC and at this time the exchange rate BTC-USDx is 5,000 . The crypto exchange has $10,000 in deposited fiat. Several months later Alice and Bob deposit and then buy 1 BTC each again — at the time the exchange rate BTC-USDx is 15,000. The crypto exchange collects $30,000 and now it holds $40,000 in fiat deposits. Alice and Bob hold now 4 BTC together.

The market levels off and holds the same — BTC-USDx pricing of around 15,000.
If Alice and Bob both consider this the top of the market and decide to sell their 4 Bitcoins the crypto exchange can not satisfy the sell request at the current BTC-USDx = 15,000 price quote.

The exchange holds only $40,000 in fiat deposits it can give back to Alice and Bob only $10,000 for each of their Bitcoins ($40,000USD / 4 BTC).

Lambo - Moon scenario

The end of year 2020 lets us witness a bull market in Bitcoins. Prices go up and up leading to levels close to the highest price on record from the end of 2017 — BTC-USDx = 20,000.

Old and newly minted ‘gurus’ of the crypto-market keep making bold prediction of Bitcoin going to $100,000 , or $500,000 or more — to the Moon, allowing the Bitcoin holders to get and drive Lamborghinis.

Why is the BTC price going up and up?

The global pandemic makes the our future uncertain and lets us look for some safe heaven which can preserve the value of what we have.

Bitcoin and some other crypto currencies are viewed as safe-heaven by many people in the world. Currently there is a steady inflow of fiat currency going into crypto-exchanges and buy orders for Bitcoin and some other major crypto-coins. As there are much more buy than sell orders, the crypto-coin prices keeps going up.

However even if a fraction of the inflows of fiat reverses direction — when selling Bitcoin and withdrawing to cash, the 1:1 peg of the stable coin is going to break, as demonstrated in the above examples.

Connect with me on Linked in -

https://www.linkedin.com/in/paul-arssov-arstech-com-biz-org/