I recently read a post by Seshree Govender on stablecoins. In case you’re new to crypto, stablecoins are crypto assets which are backed by the value of a ‘stable’ asset. For example, the cryptocurrency Tether (USDT) is linked to the US dollar and Facebook’s Libra will be backed by a basket of real-world assets including bank deposits and short-term government securities.

The classic approach to evaluating a cryptocurrency is to measure it against the three primary attributes of money: a medium of exchange, a unit of account and a store of value. Some cryptocurrencies have attracted significant attention and investment and have a market cap that indicates that they are perceived to have some permanent ‘store of value’ benefit. However, there has been significant volatility in their prices, relative to a range of fiat currencies.

Stablecoins are designed to minimize volatility. Although they do reduce the volatility experienced by many cryptocurrencies, this solution has some fatal flaws. I anticipate that these flaws will cause the stablecoin bubble to burst and that these projects will be abandoned. Although volatility in the price of cryptocurrencies will persist, I expect that this will moderate over time as regulation of cryptocurrency exchanges cools down speculative trading. Even extreme volatility is not problematic for properly-structured BitcoinSV merchant payment processing. A much more serious problem is high mining fees (such as those with BTC), which act as ‘friction’ for payments.

In my opinion, the fundamental reason that stablecoins exist is flawed. The argument is that without price stability, cryptocurrencies cannot be used as a medium of exchange or a unit of account. This argument may be based on old-school bank thinking, where the time difference between when a transaction is initiated and when the underlying funds flow could be hours or even days. A BitcoinSV transaction is ‘cleared’ and ‘settled’ (using banking terminology) simultaneously, so there is no volatility in price through the duration of the transaction.

Furthermore, simple mechanisms exist for merchants to price their goods and receive their payments in fiat currency, without having any exposure to cryptocurrency volatility. These mechanisms are inherent in the BitcoinSV ecosystem, without the need to build a complex and unnecessary stablecoin infrastructure on top of the cryptocurrency itself. The mechanism is simply that the merchant (or their processer) sells any BitcoinSV received as soon as they receive it. This function is provided by service providers (called Bitcoin Payment Processors) to merchants, analogous to the role bank card acquiring companies play in processing international transactions for bank customers.

Stablecoins also require merchants to create new tender-acceptance mechanisms for each stablecoin. As it is, merchants are very reluctant to introduce new tender mechanisms into their till-points, have barely started accepting Bitcoin, and will simply not be interested in accepting a host of new stablecoins. Without an ability to spend the stablecoin, it loses the ability to be used as a medium of exchange.

By definition, a stablecoin is not its own unit of account as it is tied to the price of another asset. It is merely a store of value. But if its value is tied to the value of another asset why not simply purchase that asset instead, without all the hassle of using a stablecoin cryptocurrency?

If owning a stablecoin is essentially the same as owning the underlying asset, then the regulations of that underlying asset will naturally accrue to that stablecoin. This means that a stablecoin will very likely be seen as deposit-taking by financial regulators, and the stablecoin issuers will quickly face the same regulatory and compliance burdens as a bank. Regulators will also require that moving that stablecoin across national borders will require ‘processors’ to validate that both the sender and receiver of those stablecoins have proven their sources of funds, have been checked against global anti-money-laundering and terrorist financing watchlists, and have their tax affairs in order.

People often see cryptocurrency as a measure to mitigate the systemic risks associated with fiat currency. Primary amongst these is inflation, as all fiat currencies lack tangible backing and are debt-based. Stablecoins are exposed to the exact same systemic and idiosyncratic risks as the underlying fiat currency, so can they really work as a store of value when compared to non-debt-based cryptocurrencies? I don’t think so.

In cryptocurrency, there is no counterparty against whom you can exercise your rights of ownership. This is an important concept. When fiat currency is created, a simultaneous sovereign debt obligation is created, exposing holders to risks such as political risk and the inadequacy of monetary policy. Under the theory of Relative Purchasing Power Parity, the difference between countries’ rates of inflation and the cost of commodities drive changes in the exchange rate between them. Why would you choose to own an inherently depreciating stablecoin when you could own negative-inflation cryptocurrency as a real store of value instead?

In my opinion, all the infrastructure required to operate a stablecoin is unnecessary and wasteful. Validation of the fiat currency resources backing the stablecoin must be transparent, be done diligently by independent auditors and be an on-going process. Currently, there are absolutely no regulations or compliance in effect and no consequences if the company behind the stablecoin isn’t actually doing that. The recent accounting concerns around the stablecoin Tether should be noted. The opportunity for fraud and scams in stablecoins is very lucrative. It doesn’t take much to manipulate the fiat treasury – an easy thing for insiders to do and hard for outsiders to detect.

This leads me to the fatal flaw of stablecoins: they are massively centralized. It is intrinsic in their design that a single organization issues the stablecoin, acquires and manages the fiat-currency reserves, and releases that back to the sellers. This also raises governance concerns, such as where the issuing company is domiciled, the strength of local regulation, who the appointed auditors are and the standards to which they adhere. Again, no-one has oversight of this and it is completely unregulated. Due to the financial risk, this function is centralized to the original management team. This requires all users of the stablecoin (holders and merchants) to place full faith in a single central point. Why even adopt a blockchain mechanism when the most efficient technical solution would be a simple database operated by the founders?

An argument is often made that stablecoins are better for cross-border remittance than ordinary cryptocurrency, as the backing asset is well-known on both sides of the remittance corridor. Although that may be true, remittance end-users (typically a poor person in an emerging economy) still convert that stablecoin to local fiat currency, as that stablecoin is not legal tender in the receiving jurisdiction. As a stablecoin is typically less liquid than the major cryptocurrencies, this increases the total cost to the receiver. It has been noted that the primary use case for stablecoins is to act as a ‘cash account’ for cryptocurrency traders closing out positions – thereby fueling speculative trading and price volatility!

Facebook’s proposed Libra is actually a pseudo-stablecoin, in that it is not stable against any single fiat currency but pegged to a basket of major currencies. That is probably a natural response to the fact that Facebook has a global customer base but this ‘efficient’ solution will actually disappoint every customer. Ordinary people do not measure their wealth against a basket of currencies, but against a single fiat currency – that of the country where they live. The problem is that Facebook is so big (2 billion users) that they have the financial muscle and captive customer base to keep investing in and promoting this completely flawed idea. The only upside to the Facebook Libra idea is that regulators will be forced to take a more proactive stance towards regulating cryptocurrency, something that I support.

There has been some speculation about a Rand-based stablecoin. The South African Reserve Bank successfully demonstrated through Project Khokha that they are interested in innovative technology to improve payment system operations. In principle, this sounds like a good idea, but in practice a Rand-based stablecoin suffers from all the flaws I’ve pointed out in this post. In addition, a Rand-backed stablecoin would be limited to a single country. This offers no benefits to the many millions of people in South Africa who remit billions of rands annually to recipients across our borders while paying some of the highest fees in the world.

The classic characteristics of money are durability, portability, divisibility, uniformity, limited supply and acceptability. All of these characteristics are embodied in the original vision for Bitcoin as described by Satoshi Nakamoto’s whitepaper. Currently, the only cryptocurrency that is built according to the original whitepaper for Bitcoin is BitcoinSV (BSV). The multitude of variations on the original bitcoin idea, including BTC, ETH, XRP and stablecoins are an illusionary diversion. Cryptocurrencies still have a long way to go, but the focus should be about building useful services on top of the existing stable protocol.

Angus Brown

Monday 22nd July 2019

References:

@SeshreeGovender https://www.webberwentzel.com/Specialists/Pages/Seshree-Govender.aspx

Tether Accidentally Minted $5 Billion of Its Stablecoins, Then Deleted Them

Facebook Libra Risks to Financial Stability Demand ‘Highest’ Regulatory Standards, Says G7

https://www.reuters.com/article/us-crypto-currencies-explainer/explainer-stablecoins-in-the-spotlight-as-facebook-unveils-libra-cryptocurrency-idUSKCN1TJ1T6

https://en.wikipedia.org/wiki/Tether_(cryptocurrency)

https://cointelegraph.com/news/changes-to-tethers-terms-of-reserves-raises-fresh-concerns