Independent Research Notes by: Kaan Alp AÇIK – The Koc School

Presented to: Prof. Dr. Selim YAZICI

Abstract:

Stablecoins (digital cryptocurrencies pegged to an asset for stability) are attracting their due attention from latest financial & economics research to global companies and central banks.  While the investments in stablecoins is increasing significantly, they are still a niche novelty in terms of size, even compared to crypto currencies, let alone traditional corporate finance wealth (Cohan). This niche positioning can change dramatically due to a) the disruptive nature of the exciting innovations i.e. Distributed Ledger Technology (DLT) with open source coding combined with b) the need for higher returns and less regulated medium for wealth accumulation demanded by investors and c) money storage & transfer needs of the unbanked populations. Yet, the major obstacles of transparency, lack of insurance & legal framework in case of disputes and complications, and unclear regulations & central bank(s)’ actions around digital currencies have not allowed stablecoins to be whole heartedly ‘trusted’ by the masses.

  1. Introduction

Money has been present for more than 5000 years now. This has led people to believe that money is a fixed concept, when in fact it has been constantly changing. (Lipton et. al. 2020) Stablecoins and the associated distributed finance apps (dapps) are the latest craze in the financial world which is, not typically known for its innovations such as technology and healthcare industries.  With the advent of blockchain technology, the famous article by Nakamoto (2008) on cryptocurrencies as the best know application of blockchain and DLT, cryptocurrencies (and namely Bitcoin as its star child) is heard and wondered by many but its definition has been blurred. (Lipton et. al. 2020) For most, cryptocurrency investment is akin to a night in Vegas with its win or lose big typical outcome due to its volatility. In fact, in a three-month span from October of 2017 to January of 2018, for instance, the volatility of the price of bitcoin reached to nearly 8%, (Why Bitcoin has a volatile value by Nathan Reiff- Investopedia) meaning one can potentially lose 80 million dollars if he or she converts a billion USD worth assets to cryptocurrencies.

Given the volatility of cryptocurrencies, the generally stated definition of stablecoins – stable cryptocurrencies whose value are pegged to less volatile assets – underscores the inherent motivation, which is all the advantages of the digital currency without the volatility.  As blockchain technology cuts out middlemen by definition, stablecoins relying on DLT blockchain technology can cut out inefficiencies (profits of traditional financial institutions) and substantially lower the cost of transactions.  While this may sound too good to be true, a more comprehensive description which underlines the essential aspects of a stablecoin is proposed in Lipton et. al. 2020. Lipton characterizes the behavior of stablecoins as follows:

  1. A brand-new form of asset storage (not a redefinition of an existing asset)
  2. Can be used without any direct interaction with the issuer
  3. It is tradeable on a secondary market and has low price volatility

In the following paragraphs, the implications of these essential aspects and the pros and cons of the stablecoins will be detailed further based on collective research.

  1. Context

Fintech has resulted in destructive innovation with every technological leap.  Innovations have targeted inefficiencies (I.e. middlemen) and poor user experience via entrepreneurs.   Post 2008, now in Fintech 3.0 era, the common spirit of the emerging innovations can be summarized as democratizing financial services and serving unbanked/underbanked populations. (Reference: Fintech 101 Training by Fintech İstanbul.) The newest product of this novelty wave is stablecoin.

Stablecoins (the rising star of decentralized finance instruments) have a relatively short history, despite the underlying technology of blockchains and distributed ledger technology (DLT) being around for more than a decade. In fact, the concept is so new that the MS Word dictionary does not recognize the word stablecoin, a testament to the innovation’s novelty.

There are namely three types of stablecoins (as covered in Berentsen & Schar 2020 Stablecoins):

  • Algorithmic, where the aggregate supply of stablecoins are controlled by a computer algorithm based on the contemporary demand for stablecoins. However, the absence of a collateral makes this type unreliable for most investors
  • Collateralized On-Chain, where the value of the stablecoins are stored in an Etherium blockchain with its collaterals being minimum 150%. The reason for this is the volatility of such coins.
  • Collateralized Off-Chain, where the values of the stablecoins are not embedded in a blockchain system, rather based on the notion that 1 unit of the stablecoin holds equivalent value to 1 USD.

Tether, an off-chain stablecoin, is the one stablecoin that deserves its own analysis due to its adoption and size. The market cap of Tether is approximately 17 billion dollars as of November 6th, 2020, and the cap has almost tripled in the last 7-8 months as seen from the chart below:

 

………. As of November 7 2020, the value of Tether and its price vis a vis USD is below:

As seen from the graph, Tether has done a remarkable job to peg its value to 1 USD as it had previously promised; therefore, it becomes more attractive for investors over time.

  1. The Premise and Use Cases

What makes any form of money valuable is trust. Trust in a currency builds over time as the use cases of the currency prove to be pragmatic. The same applies for stablecoins. Accordingly, some of the application areas for stablecoins can be:

  • Transfer of Money efficiently and transparently across borders: Stablecoins can revolutionize the method by the help of integrated protocols and financial instruments (Consensys.net/blockchain-use-cases/decentralized finance). Its borderless, scalable, and open infrastructure has the potential to disrupt the inefficient money transfer & payment systems that can currently charge on average 4-5 % (https://www.finder.com/fees-when-sending-money-overseas) at a fraction of the cost.

In its latest report on Oct 2020, IMF stated that digital currencies and related financial reforms have the potential to be transformative by making cross-border payments cheaper, faster, more transparent, and more widely accessible (IMF ‘A leap forward on Cross Border payments).  Giving even more credence to this observation, the G20 countries endorsed a roadmap developed by Financial Stability Board, including IMF, to enhance cross border payments again in October 2020 (available at FSB.org).

  • Settlement of trades: Currently mostly leveraged by cryptocurrency exchanges, stablecoins provide a platform for the trading ecosystem not reliant on banking relationships.
    Stablecoins (as well as Central Bank Digital Coins) have the potential to lower transaction costs by increasing competition by cutting out middlemen, widening access to services, and promoting financial inclusion through mobile devices. They can be used for settlement of trades on e-Commerce platforms globally, even social networking sites, hence one of the main drives of Facebook’s Libra initiative to develop a reliable stablecoin. (https://libra.org/en-US/) While Libra initiative has paused in 2020, Libra is still preparing to launch as early as January 2021, according to people involved in the initiative, but in an even more limited format than its already downgraded vision.  Following concerns from regulators over its initial plan to create one synthetic coin backed by a basket of currencies, the association would initially just launch a single coin backed one-for-one by the dollar. (Financial Times, November 27th, 2020 Article)
  • Decentralized Finance Applications (dapps): Smart blockchain contracts are enabling developers to create applications not just for money transfer & exchange but also any type of financial service such as borrowing, lending, trading, and insurance, among others. The main premise of these applications is to connect multiple parties without a central institution extracting fees.  They are built to run on decentralized setting and hence are referred as ‘dapps’. With no central authority managing and overseeing the transactions, the codes and contracts are open and are stored in all the participants’ computers (DLT), hence not hackable due to sheer size and unfeasibility.  Stablecoins are the common denominator in these apps, allowing them to run and store/exchange value. Maker stablecoin project (DAI), Compound (a blockchain based borrowing/lending app), Uniswap (cryptocurrency exchange) and PoolTogether (common savings platform) are just a few of the dapps that are increasing exponentially. (blog.coinbase.com/Beginners guide to decentralized finance)
  • Bringing Unbanked/Underbanked Populations into formal economy: In his inspiring article Dante (Reference Dante HBR Article Aug 2020 Could Digital Currencies Make Being Poor Less Costly?), points out that more than 1.7 billion people (including 25% of US households) are unbanked or underbanked due to rating systems and expensive usurious fees of financial institutions. Moreover, in his famous stand up, Louis C.K. satirically jokes how it is expensive to be poor (financial institutions charging money for accounts with low balance, a vicious cycle). Digital currencies can turn a mobile phone into a regulated payment endpoint without the middlemen, which can efficiently mitigate the lack of involvement issue that the unbanked/underbanked population faces.
  1. The Obstacles
  • Regulatory Considerations and central banks’ stance for digital money is ‘cautious’ to say the least. While the technology and innovative apps are transforming the financial landscape, the traditional players and regulators are facing many challenges.  Digital currencies have the potential to circumvent individual country’s monetary policies as stablecoins issued in major currencies can induce citizens in highly volatile and high inflation countries to forego their domestic currency, even facilitating bank-runs & allow money transfer abroad at minimal cost.   Capital account restrictions that these countries adopt to traditional currencies would be ineffective with the creative DeFi apps. The level of rigor and spotlight will only increase with the adoption of digital currencies and the competition between issuers of such currencies.
  • Transparency and Low Entry Barrier: The stablecoin with the largest market capitalization is Tether at the time of the paper (December 2020).  It has 40% of the total market share and is rapidly gaining adoption speed as shown previously in the paper. The scenario of whether there will be one or a few stablecoin issuers will eventually come out on top or whether this will be an everchanging landscape is too early to predict. While first movers have the advantage of tipping the market, especially in terms of trust of users, the technological advancement, and the non-complex open-source coding of the underlying blockchain innovation lowers entry barriers.
    Regardless of the end-state scenario, even the largest stablecoin issuer Tether’s transparency is under scrutiny. In May 2019, it was discovered that the stablecoins were only backed partially and in part by a large loan to an affiliate of the technology provider. Even prior to this event, there were legitimate concerns over the absence of public verification by reputable auditors. (Duffie. Digital Currencies and Fast Payment Systems. May 2019)
  • Legal Implications in cases of dispute: The operations are not managed by an institution rather in code, which makes it difficult to adopt a set of concrete rules to regulate the transactions of stablecoins and penalize misconduct. This ambiguity in the legislation of stablecoins is arguably the main reason why it has not been anointed as “preferable” by numerous economists just yet. (A Beginner’s Guide to Decentralized Finance by Sid Coelho Prabhu, Coinbase)
  • Impact on ‘Big Finance’ corporations, banks and their likely competitive response: Digital currencies, especially stablecoins are a disruptive innovation, already changing the nature of financial transactions with the potential to eat into the lucrative margins of large commercial and investment banks and other legacy corporations.
    JP Morgan is choosing to adopt and be a pioneer with its own digital currency known as JPM Coin. The JPM Coin, backed by the issuing JP Morgan investment bank, commits to convert JPM Coin into fiat currency at fixed exchange rate on demand. (Duffie. Digital Currencies and Fast Payment Systems. May 2019)
    Others may choose to retaliate and influence regulators, central banks even governments to implement barriers to digital currency adoption as this innovation will disrupt their margins.  The gap between the average interest rate offered by banks to deposit holders (approx. 0%) and the interest rate on excess reserves they earn, essentially the wholesale overnight market interest rate available to banks, has increased dramatically over years. (Figure 6: Data Source US Federal Reserve & Federal Deposit Insurance Corp.)  Account holders and investors are desperate to find stable options with better returns.

  • Technical limitation possibility: The trade-off theory discussed in Chohan et. al 2019 (The Limits to Blockchain?). The intrinsic tradeoff between scaling to a larger size – which is crucial to handle the volume of transactions for mainstream financial applications – and the essence of blockchain technology, i.e. maintaining decentralized, distributed and transparent ledgers.  The high number of experts involved in developing the DeFi apps providing stricter provision in the transaction process, the rising interest of deep-pocket investors and the sheer continued advancement of network technology may provide a solution to this dilemma, yet the concept is yet to be resolved.
  1. Country Authorities Response

A much-discussed version of stablecoins involve central bank digital currencies (CBDC).  (Duffie. Digital Currencies and Fast Payment Systems: Disruption is Coming).  The subject was under serious consideration from Sweden’s Central Bank, the Riksbank in its 2018 report (Sveriges Riksbank 2018 Reference), with the proposed ‘e-krona’. Sweden’s use of paper-based currency has significantly dropped in 2010s (from ~40% of most recent transaction being in paper currency to less than 15% by 2018 based on Riksbank eKrona report 2018).  Bank of Canada and Monetary Authority of Singapore have also tested prototype token based digital transactions in CBDC. A Survey of 80 central banks conducted in 2018 by Committee on Payments and Market Infrastructures (Reference Speech by Benoit Coeure, Chairman of CPMI Nov 15, 2018); show that 70% of the central banks are working on either wholesale or general use of CBDCs.

The recent announcements by EU central bank (The EU announces its first ever plan to regulate cryptocurrencies- Silvia Amaro, Europe News): European Commission Executive Vice President Valdis Dombrovskis has announced that many digital finances are working for one nation (USA), and the regulations decided by one of the 27 EU countries will provide decentralized finance services to all member countries. This is an important step to promote stablecoins from niche to mainstream.

While the advent of CBDC seems very plausible and even inevitable, many researchers do not classify CBDCs as truly a ‘stablecoin’.  According to the Lipton et. al 2020 paper, the CBDCs do not qualify as novel cryptocurrency or stablecoin, but just a re-definition of an existing currency, as the currency’s value is supported by the presence of a government.

The US Office of the Comptroller of the Currency (OCC) issued a statement in September 2020, stating the national banks can provide services to stablecoin issuers in the US.  The statement gave the first sign of official clarity that stablecoins are legitimate representations of value.  While the statement does not solve many of the challenges, it can be seen as one of the first important official steps of recognition. (Coindesk.com Crypto Long & Short: The OCC’s Stablecoin statement is a seed of financial innovation)

These steps signal the growing regulatory acceptance of stablecoins.  Nevertheless, acceptance is one thing and support is another.  If privately issued stablecoins, such as Tether or Libra, reach significant size, a point where they are a legitimate alternative for fiat currencies, they can significantly reduce the ability of central banks to steer monetary supply. The central banks and the sovereign countries will be less than reluctant to release control of their most potent monetary policy device with a ‘laissez-faire’ (free market economy) attitude. Moreover, governments would oppose such a notion as they cannot claim taxes from exchanges that are completed in a currency untraceable by them. It is reasonable to expect them to defend CBDCs against private market issued stablecoins if the two instruments start getting into each other’s space.  These risks make the regulatory environment even less predictable for stablecoins.

Nonetheless, the need for a basic type of regulation, dictated by authorities or self-governed & self-monitored, is needed. As pointed out by Fatas (INSEAD) in ‘The Economics of Fintech and Digital Currencies’ March 2019; regulating cryptocurrencies could imply giving credibility to these assets, while the alternative of neglecting is also not optimal due to possibility of illegal activities, tax fraud, etc. Ignoring or treating digital assets as any traditional security has not proven successful so far therefore, considering the nature of these assets and the accompanying technology and designing tailored regulations is suggested by Amstad (The Economics of Fintech and Digital Currencies). The specifics will need expert collaboration on worldwide scale.

  1. Private Sector – Risks and Returns

Shifting gears to the private sector, when the true ‘incentives’ of private stablecoin issuers, their possible revenue and cost streams are considered, it is plausible that majority of costs are/will be fixed while revenues will be heavily dependent on scale.  This is mostly true because the revenues will be based on transaction fees, interest earned on collateral deposits, all of which are variable with volume.  While stablecoins will be pushing for volume, a head on competition with CBDCs is not likely in the short term. The private investors want to maximize their income (possibly also democratizing the financial monetary flows for unbanked population) but not changing the monetary policies of governments.

The barriers of entry into stablecoin universe are not very high, with technology (DLT / blockchain) and the operating systems being open source.  The most valuable commodity of the stablecoin issuer is arguably its reputation and early-mover advantage assisting it to build critical mass, like Tether. Tether offers an alternate method to store liquid assets without having a considerable risk of depreciation, which makes the currency attractive for private investors and entrepreneurs.

The fact that central banks cannot gain control of stablecoin is an enticing factor for emerging investors as they find a larger room to grow their businesses in a medium with fewer restrictions. However, the risk of stablecoins not being regulated and backed up by authorities may deter a substantial number of private sector investors and entrepreneurs from committing to the notion of a stablecoin.

  1. Path Forward & Outlook

Demand for stablecoins is strong and expected to remain that way as more and more investors view them as the currency of the future. Currently stablecoins are the major, if not only access point to cryptocurrency exchanges and settlements, hence the natural growth of cryptocurrencies drives the need for stablecoins.  The creation of new DeFi applications can and do increase the demand for stablecoins significantly.

Nevertheless, any major shock to financial markets is bound to have an amplified impact on stablecoins. An unexpected crisis or the revelation of fraud (discovering that the collaterals of the stablecoins are unreliable or non-existent) may lead to the downfall of the niche monetary system. Similarly, news of hacking or insolvency of any of the issuers, no matter how insignificant in size, can have a ‘rush on banks’ for converting stablecoins to their pegged collaterals.

To counter these sources of instability and protect its namesake, stablecoin would benefit from addressing the obstacles of lack of (self) regulation, transparency, and reluctance of central banks to support them. Public-private collaboration and hybrid approaches to money steering may ensure the right balance of regulations/compliance and innovation and decentralized nature of digital currencies. (Disparte, HBR Aug 2020 Article Could Digital currencies…) 

  1. Conclusions

Stablecoins have significant potential.  Quoting Fintech Professor Selim Yazici, “When there is pain there is opportunity.” This statement underlies stablecoins usage areas. While stablecoins originated as a type of cryptocurrency, they have now become an independent concept. (Lipton et. al. 2020) They allow ownership of a virtual (and arguably stable) asset without the need for a central authority, which can change the current financial system from its root. (Berentsen and Schar, 2018).  As DeFi applications get more traction with mainstream investors, stablecoins can evolve from being a niche complementary payment system to a serious alternative to traditional currencies. The attraction and premise of the free nature of decentralized finance in general, i.e. no central authority, can also spell its weakness as it may also be interpreted as ‘no rules, no governance’ besides an offering of absolute economic independence, which is why it has not been favored by numerous investors just yet.

The focus of the stablecoin discussion should not be ‘how to use the blockchain / DLT technology’ with cool apps but ‘how to create value’ while addressing the obstacles of adoption. This disruptive innovation, which does not come too often of this caliber in finance, has the potential to be more than a solution seeking a problem and address the needs of the unbanked population as well as providing a much-needed alternative to traditional ‘safe haven’ assets during times of uncertainty.  Right level of regulations (even self-regulation of issuers and participants) and a cross-border dependable insurance system may provide the push that can propel stablecoins and associated DeFi apps into mainstream use. Provided this shift happens, world banking and currency can completely shift according to development of stablecoins in the foreseeable future, forming a more inclusive and interactive world economy.

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Tahsin Özyer