Stable coins: the next big thing for the financial industry?
Money has always been at the heart of the economy, with the purpose of facilitating commercial trade. Money has taken physical forms such as coins, notes and gold, but also electronic and more recently digital forms*.
The common denominator of money is its adoption. In Money and the Mechanism of Exchange (1875), William Stanley Jevons analysed money and gave it four functions: a medium of exchange, a unit of account, a standard of value and a store of value. Ten years after the creation of the first digital currency, bitcoin, we have witnessed the launch of more than 2,000 crypto assets and crypto currencies (bitcoin, ethereum, ripple, litecoin, etc...). The marked volatility of crypto currencies since their inception is a hurdle to their development from a consumer perspective but also from a corporate one. The daily valuation that often changes by more than 20% fuels crypto currencies as a speculative asset. Would you use a crypto currency as your official means of payment if you risked paying twice as much for your pizza in a month’s time?
In this context, stable coins are of major interest to all industries. The increasing investment from Venture Capitalists in different projects is a clear sign of this2.
WHAT IS A STABLE COIN?
A stable coin is easily definable as a stable crypto currency. It is primarily a response to the problems of volatility and enables money’s function to be fulfilled. To achieve stability, more than 50 stable coins3 have proliferated using different methodologies:
- Fiat currency-collateralised i.e. a crypto currency pegged to a legal tender currency, also called fiat currency in crypto jargon, or a basket of legal tender currencies. Most of the crypto currencies have a stable value of US$1. The entity that issues the stable coin opens a banking account and mirrors the position. For example, if the entity issues 1 million coins pegged to the USD, they need to credit the banking account with $1M. This could be considered as the simplest stable coin model and is very stable (it also mirrors the model long used by the Bank of England for the issuance of Scottish bank notes, whereby each pound issued must be matched by a pound deposited at the Bank of England). This model requires centralisation and therefore a trusted custodian with a need to audit for transparency. Tether, which is one of the most popular in this category with a market capitalisation of US$2bn, is listed on more than 65 crypto exchanges4.
- Commodity-collateralised i.e. crypto currency guaranteed by a commodity. The operating model is quite similar to the fiat one. Several initiatives have been launched in this space, especially in gold. It is inspired by the Bretton Woods system.
- Cryptocurrency-collateralised i.e. crypto currency guaranteed by another crypto currency. The whole process is done within the blockchain, contrary to fiat currency and commodities, where a custodian is needed to safeguard the collateral off chain. This model has the benefit of decentralisation, as the collateral is held in a smart contract. However, crypto currencies, being unstable, require over-collateralisation to absorb crypto currency fluctuations.
- Non-collateralised. It is supported only by its value thanks to a smart contract that runs automatically. If the total offer or demand of the stable coin is increasing or decreasing, the smart contract will automatically adapt the number of coins in circulation to keep the price unchanged.
The asset-collateralised stable coin is the dominant model, and represents, in value, 83% of initiatives, which mostly run on an Ethereum protocol5.
WHY ARE STABLE COINS SO ATTRACTIVE?
The stability of stable coins reassures the whole industry, retail investors as much as institutional investors.
They are built in such a way that global participation and near real-time transfer are possible, in seconds or minutes instead of days. To secure an exchange, most financial transactions are made delivery versus payment (DVP). For the time being, the absence of fiat currency in the crypto world prevents efficient DVP exchange in the blockchain.
Until a fiat currency is available, a stable coin pegged to a fiat currency is one of the best answers, bringing efficiency to the value chain. Many blockchain initiatives in the post-trade industry would benefit from this introduction. Moreover, it has the potential to be adopted as a real crypto currency from a macro economy perspective.
There is great potential for a number of countries in a situation of hyperinflation or monetary instability (Venezuela, Argentina, etc.) where the stable coin might become an alternative. From a trading perspective, the stable coin will be a good alternative, allowing them to add a new pair. A number of crypto exchanges do not accept fiat currency yet, and stable coins can help better manage the risks. During her speech6, Christine Lagarde, the outgoing Managing Director of the IMF (International Monetary Fund) even mentioned the possibility of the IMF taking greater control in this domain, including issuing its own crypto currencies whose exchange rate would be governed by macroeconomic mechanisms. Governments around the world are prototyping and testing their own digital currencies. They have definitely acknowledged the potential of DLT technology with the trust of their national bank currency. This is what we call the Central Bank Digital Currency (CDBC). Different projects are already public, in the UK, Sweden, Singapore and Switzerland.
WHAT ARE THE KEY CHALLENGES FOR STABLE COINS? AND LASTLY WHAT ARE THEIR FUTURES?
KYC (know your client) is still the cornerstone of all stable coin projects, especially due to their volume to capitalisation ratio that is substantially higher than traditional crypto assets. Tether’s 30-day volume is similar to that of bitcoin whereas its market capitalisation is on average 30 times less valued. A good management of all aspects of KYC elements is crucial to its efficiency. JP Morgan, through JPM Coin, and Facebook,7 have also launched initiatives in this context. That demonstrates the appeal and potential of stable coins. Despite substantial interest from the regulators and the industry as a whole, we are still at the beginning of the journey. There are still clear structural and regulatory concerns to be addressed.
We need to keep in mind the role of money; TRUST will be the answer.
(*) Using digital for cryptocurrencies.
(2) www.bloomberg.com/news/ articles/2018-10-29/stable-coin-backed-by-circle-coinbase-draws-most-earlydemand
(7) coin24.fr/actualites/ facebook-va-t-il-revolutionner-le-monde-des-crypto-monnaies/