A three-pronged solution to poor confidence in stablecoins

Bitcoin and other cryptocurrencies are seen by many as a new form of money. Others query whether these alternative assets truly meet the definition of money from a practical point of view.

‘Money’ is defined by three pillars: as a store of value; a medium of exchange; and as a unit of account.

This latter pillar is the point of contention given the volatility associated with cryptocurrencies such as bitcoin. The volatility of cryptocurrencies made it difficult for users to transact in these cryptocurrencies as the price would fluctuate strongly on a second-to-second basis. 

This exposed holders of cryptocurrency to unacceptable levels of market risk. This concern was responded to with an innovation called a stablecoin.

Stablecoins solved this issue of volatility by being pegged 1:1 to fiat currencies such as the US dollar which consequently gave it a stable value that allowed it to be seen as a unit of account In essence what was created was a cryptocurrency able to move over the internet through the use of blockchain technology similar to its peers but without the volatility.

Two similar yet quite different types of stablecoin were then brought to market. The first was a stablecoin collateralised by fiat currencies held in the bank account of the issuer. The second was an algorithmic stablecoin which holds, buys and sells various other underlying cryptocurrencies and which effectively mimics the US dollar price. However, recently we saw the catastrophic flaw posed by this model, when TerraLuna’s algorithmic stablecoin known as the UST became de-pegged from the US dollar and ultimately led to billions of dollars being wiped off the crypto market in a few days. 

This raised the question of whether the simpler method of holding fiat as collateral and issuing stablecoins might not be the better option as opposed to such algorithmic stablecoins. Today’s most prominent US dollar stablecoin known as USDT and created by Tether, is currently the most transacted stablecoin in the world. The business model of Tether is fairly straightforward in that a KYC (Know Your Customer)-verified Tether user - be it an exchange, an individual trader, a business merchant or a trading firm - deposits fiat (US dollar) into Tether’s bank account whereafter Tether issues the customer with USDT tokens issued on existing blockchains such as Ethereum. 

Tether then holds these fiat currencies as collateral which provides the holder of the USDT token with the reassurance that their token is actually worth US$1. However, this business model too was not without flaws as Tether was fined US$41 million to settle allegations where they falsely claimed their digital tokens were fully backed by real world fiat currencies. So many may well ask - what then is the solution based on what we have learned from these historical events?

My view favours a threefold solution: one that has a combination of independence, transparency and clear segregation. This solution addresses another potential weakness that has yet to materialise: what if a company issuing these stablecoins is sued resulting in the claimant having equal rights alongside the token holders? Effectively if the company would have to declare bankruptcy as a result of a claim it would lead to a discounted and de-pegged token as the company’s assets would not exceed the liability that should have been collateralised. It is for this reason that reserves of the fiat currency need to be segregated from the business in its entirety to alleviate the risk posed by the day-to-day operations of the token issuer.

Ideally, the issuer of the stablecoin would create a separate legal entity such as a trust whereby the beneficiaries of the trust are the token holders. There would be a mandate that the trust is required to keep a diversified interest-bearing portfolio of fiat-backed funds with various commercial banks to diversify the firm specific risk. The interest earned should then be used to pay the issuer of the tokens a management fee, keep a predetermined reserve of fiat to cover the expected credit losses of these commercial banks as well as to have an independent auditor issue annual and/or interim audited financial statements and/or monthly or quarterly proof of reserve reports that are available to the public.

Such a segregated and transparent structure with independent confirmation will provide the holders of these stablecoin with security, and the transparency required to trust the issuer and have confidence that their stablecoin will not be de-pegged from the underlying fiat currency.