The family digs deeper today into stablecoins, focusing on reserve and collateral and how some fiat backed stablecoins like Tether is on its way to qualify for being a digital money.
Kimberly: Last time we were talking about depositing $2,000 worth of Ethereum before anyone can claim $1,000 worth of stablecoin. The ETH collateral is twice the value in stablecoin. I wonder if that is true in general.
Greg: Not really. The key question to ask is what are being used for collateral and how stable they are. For stable assets like many fiat currencies are, a stablecoin can get away without over-depositing or over-collateralization like in the ETH case.
Joy: In other words, to claim you have a stablecoin valued at $1 million, you only need to have $1 million in reserve if the asset is stable. That’s 100% backup or 1:1 reserve. But for unstable assets like cryptocurrencies it’s common to see $1.5 million or even $2 million worth of crypto deposited for $1 million worth of stablecoin.
Kimberly: This prepares for the scenario when the unstable asset suddenly decreases value, right?
Joy: Right. It provides an extra layer of protection to investors, just like insurance company will charge you a higher premium if you have a record of drunk driving or other risky behaviors.
Greg: That’s a good analogy. I want to add that even with over-collateralization those stablecoins are not error-proof. In case a cryptocurrency is completely busted, over-collateralization won’t save the stablecoin.
Lily: How about backing up a stablecoin by a basket of cryptocurrencies, would that help?
Greg: Theoretically it would, except the history of crypto has shown a high correlation among the price movements of most if not all cryptocurrencies. This differs from the mature market of stocks and bonds, where diversification helps reduce non-systematic risk in the traditional financial market. Diversified collateralization by a basket of cryptocurrencies may or may not do the trick.
Lily: Why are the prices of cryptocurrencies closely related?
Greg: One reason is that the crypto market is heavily dominated by two big guys Bitcoin and Ethereum, followed by thousands of small guys. If you check out the site https://coinmarketcap.com you will see that except for Bitcoin, which is more than 40% of the market share, and Ethereum, which is around 15%, plus a few stablecoins, the market share for the others quickly drops to 1-2%.
Lily: So the small guys will have a price movement heavily influenced by Bitcoin and Ethereum, right?
Greg: Right. Another reason is that speculators have low royalty to individual crypto. They are constantly searching for the “next big one.” This makes all cryptocurrencies exposed to the same speculative risk.
Joy: I think future cryptocurrencies should specialize in industries or lines of business to reduce the correlation among them and also to grow quickly. Today’s innovations have focused on different features of the same cryptocurrency, but the future lies in “application specific crypto” or ASCs. Even a decentralized financial market has no space for nearly 20,000 cryptocurrencies. Integration will have to happen for the market to settle down, where many small crypto will be bought off by a few big guys.
Greg: I agree. Another thing to bear in mind is that despite its bad reputation of dramatic price shifting, cryptocurrencies may still be better than some fiat. Crypto price can go down but also go up. This is not the case with some fiat. The Argentina money, where the inflation rate hits 58%, is worse because it’s all inflation, unlikely to have deflation. A Bloomberg report says it right that in Argentina, nobody knows the price of anything.
Emily: What’s deflation?
Joy: That’s when prices of many things go down instead of going up. Deflation is good news for consumers as it offers higher purchasing power. Economists used to worry about deflation a lot as a sign for a weaker economy but not as much today, because lower prices can also mean higher productivity or economy of scale.
Lily: Oh yeah. I’ve read an article that lists 10 things that are cheaper now than 10 years ago, like smart phones, calculators, flat screen TVs, domestic flights.
Greg: In addition to what are used as reserves and how stable they are, it also matters a lot how a stablecoin makes its claims. Regulators will always come after you if they believe you’ve made misleading claims. Sometimes firms make their job easier. Tether, the largest fiat-backed stablecoin, used to claim its value has 100% backup “by the dollar.”
Joy: Yeah, they paid a big price for saying that. A Wikipedia page says Tether is to pay $41 million fine to the Commodity Futures Trading Commission, or CFTC. Now Tether only says its token is fully backed by its “reserves,” not dollars.
Greg: That’s true. Looking at Tether’s transparency page, you will see that “All Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s reserves.”
Kimberly: Is the new claim accurate? Does Tether now have sufficient reserves to cover its ground?
Greg: Let’s find out. Jason, please go to this webpage https://tether.to/en/transparency/ and we can check the numbers to see if the total assets and liabilities of Tether on USD match.
Jason: Total assets $72,657,372,695.04 or more than $72.6 billion on June 10, 2022, total liabilities $72,494,981,446.98 or $72.5 billion. Looks like they have more assets than liabilities.
Greg: That’s Tether’s account balance for the dollar. Let’s look at the Euro as well.
Jason: Okay… Oh, same story here, total assets are more than total liabilities.
Greg: They do that to have extra room of cushion, which is called “shareholder capital cushion,” and also to impress investors and regulators.
Joy: There is a report by Quartz that tells us more details. Tether defends itself by saying that the findings were from more than two and a half years ago, that they always had enough money in reserve, that the fine only meant the reserves were not all in cash and all in a bank account titled in Tether’s name, at all times.
Lily: Do you think Tether was wrongly charged? I mean stablecoins have been unregulated and suddenly Tether was thrown a huge fine.
Joy: I’m pretty sure the CFTC has a solid legal ground for imposing the fine. If you read the Wikipedia page on Tether, you’ll see many problems associated with Tether, including the misleading statement of dollar reserves, having $31 million token stolen, and price manipulations and lack of auditing.
Greg: At a deeper level, let’s take one step back and ask ourselves why holding sufficient reserve is so crucial for stablecoins. The answer is in two words: “stability” and “liquidity.”
Kimberly: Could you elaborate?
Greg: “Stability” is easy because that’s what all stablecoins are named after, none of them calls itself “unstablecoin,” right? The whole reason for stablecoin to exist is to provide stability of value, which other cryptocurrencies do not have. Liquidity on the other hand means taking precautions to pass a “stress test” under extreme scenarios.
Kimberly: Can we have an example what an extreme scenario looks like in a stress test?
Greg: Say all owners of Tether tokens were to cash out for dollars, will Tether still have enough cash or cash equivalent to allow investors to get their money out in dollars? Having liquidity means Tether can say “Yes” for sure, otherwise it will fail the test.
Lily: I see it now: When it comes to stablecoins, there is no shortcut and no need for getting creative. You just have to keep enough cash or cash equivalent in reserve. That’s the only way for Tether to possess stability and liquidity.
Greg: That’s right. That’s also why I believe Tether’s self-defense is weak. All reserves must be in cash or cash equivalent, and all must belong to Tether, not shared with anyone else.
Joy: It’s interesting that I’ve read an opinion piece that says the future of payment is not in stablecoins. One of the key arguments is that stablecoins tie up liquidity unnecessarily, making those dollars in reserve unavailable to other uses.
Greg: I see their points but ultimately it all comes down to the issue of trust, which does not fall from the sky — you must earn it over time. For now keeping 100% reserve with stable assets is a price stablecoins must pay, given its currently low public and regulators’ trust. Like Lily says there is no other way around that. I would not however rule out future payment possibility for stablecoins. To say stablecoins are not the future of payment is to deny the possibility for stablecoins to establish trust. That goes too far.
Joy: I agree. Commercial banks are not required to keep 100% reserve for issuing loans. In fact, since March 26, 2020, the Fed reduced the reserve requirement ratio to zero. Of course, that is in the traditional or centralized financial world but who is to say in the decentralized financial world things will never change and stablecoins will always be required to keep 100% reserve?
Emily: What’s the reserve requirement ratio?
Joy: That’s the amount of deposits a bank is asked to hold for customers’ withdraw. Let’s say a bank has $100 million in deposits from its customers. Banks make money by lending the deposited money out to earn a higher interest. But can the bank lend out all $100 million to businesses? Normally not, because the central bank will ask it to keep a part of deposited money, and that part is reserve ratio. Say the ratio is 10%, then the bank must keep $10 million and only lend out $90 million. Sometimes however the central bank may allow banks to lend out all the money to stimulate the economy.
Lily: I think the risk for a stablecoin is higher than for a commercial bank. The latter is a part of centralized system. It has less freedom than a stablecoin but also lower risk because the central bank will come to its rescue in case of a major crisis. A decentralized stablecoin has more freedom but higher risk as the central bank may or may not save it from its own trouble.
Greg: That’s true and we should keep the higher risk of stablecoins in mind. The future relationship between central bank and decentralized financial institutions is a very interesting topic. One possibility is that the Fed will keep its direct reign over all membership banks but will make suggestions or recommendations to decentralized finance entities to implement its monetary policies.
Joy: Maybe the Fed will tell future stablecoins that if you follow or coordinate with our monetary policies we’ll add you to our list of “associated members” to offer partial bailout in case of crisis. It’s unlikely for the Fed to order stablecoins to do anything, though — unless the law says otherwise.
Greg: Meanwhile, without central bank rescue stablecoins will have a higher risk of “bank run” unless they keep 100% reserve all the time. Future regulations may ask them to maintain a higher reserve ratio than that for the centrally controlled banks, other things equal.
Emily: What’s bank run?
Joy: A bank run happens when a large group of bank customers all want to withdraw cash from their bank accounts, either because of the bad news in the market or about the bank. You know banks make money by lending money out and they are only required to keep some cash. When many customers all want to get cash at the same time, banks quickly run out of cash and must close the door.
Lily: Let’s go back to Tether. I think it’s good for Tether now to keep more assets than liabilities.
Greg: If you think of it, having extra assets above and beyond liabilities is for Tether’s own good because it relies heavily on money market instruments, which are either unsecured, like commercial papers, or have penalty for early withdrawal, like certificates of deposit. They are cash equivalent but not exactly cash. Those extra assets help mitigate money market risk.
Emily: I meant to ask it before: What’s cash equivalent?
Joy: Let’s use Tether as a handy example. On Tether’s transparency page there is a reserve breakdown. We can see that more than 55% is US Treasury Bills, about 28% is in corporate commercial papers & Certificate of Deposits or CDs. The rest is money market funds and others. Treasury Bills, commercial papers, CDs are all cash equivalent, meaning they can turn into cash quickly if they must.
Emily: I remember commercial papers are short term debts of companies. What are money market funds?
Joy: Those are mutual funds that invest in cash and securities that are due within one year. These assets can all be converted to cash quickly. Again, they can all be converted to cash quickly.
Lily: Back to your comment, dad, on having extra reserve is good for Tether, did you mean some commercial papers may default, but Tether can use the extra reserve to pay investors? Say Tether has a total of $10 million commercial papers and $1 million defaulted. if Tether only had $10 million assets to meet $10 liabilities, it would be $1 million short after the default. But if Tether has additional $1 million extra reserve, it will cover all payments. Am I right?
Greg: Either that or let’s say they must withdraw CDs before the maturity dates, which will incur early withdraw penalty. Let’s say that’s $1 million. In that case Tether can still use its extra reserve to pay all investors in full.
Lily: That’s pretty impressive for Tether to do what it’s doing now.
Greg: That’s not enough, though. Tether also must constantly add cash or cash equivalent to its pool of reserve whenever it issues more tokens to investors. Let’s say Tether has issued another $500,000 tokens to old or new customers last quarter, Tether must add $500,000 to its pool of reserve to cover the new tokens.
Joy: Let’s not forget the dark side of Tether. If you look at Tether’s fee schedule, you’ll see that Tether requires a minimum of $100,000 per transaction of fiat deposit or fiat withdrawal. In other words, you can’t deposit or withdraw $10, $100, $1,000 or even $10,000. Tether also charges for withdrawing the dollar either $1,000 or 0.1%, whichever is greater. If you withdraw exactly $100,000 from Tether, it will charge $1,000 each time. Besides, it also charges $150 for verification of Tether token.
Greg: Tether also has a central control system, not exactly decentralized. I’m sure critics will say something about that. Finally, it does not serve any US residents, only entities established or organized outside of the United States or its territorial or insular possessions; and those having eligible Contract Participants pursuant to U.S. law.
Lily: That’s strange. Who are “eligible contract participants?”
Greg: Its webpage defines a participant as “a corporation that has total assets exceeding $10,000,000 and is incorporated in a jurisdiction outside of the United States or its territories or insular possessions.” Frankly, many if not most entities with more than $10 million total assets tend to have an overseas base outside the US.
Joy: Now the positive news for stablecoins. In January 2021, the Office of the Comptroller of the Currency, or OCC, has told federally controlled banks to treat stablecoins the same as SWIFT or ACH. Furthermore, these banks can participate in the Independent Node Verification Network or INVN, which is nothing but blockchain.
Lily: If that’s the case, how do we explain the recent crash of Terra/Luna stablecoin?
Joy: The OCC acknowledges the value of blockchain, and the role played by stablecoins. But not all stablecoins were born equal and OCC doesn’t or should not endorse everything about stablecoins. There are always bad apples, and the sad thing is that bad news travels fast.
Greg: All in all, I believe stablecoins — not including crypto backed and algorithmic stablecoins — are designed to be digital money because they meet the three money requirements: Store of value, medium of exchange and unit of account.
Emily: Could you tell us more?
Joy: There is a paper written by Federal Reserve Bank of St. Louis that does a good job explaining what money is. Let’s consider the three requirements one by one. A store of value is all about stability of value, meaning the value of money is stable enough for you to keep it for a reasonable period of time without worrying about losing that value significantly or even completely. Stablecoins meet that requirement because their value is stable, as the name suggests — except for algorithmic stablecoins as we have learned.
Kimberly: How long is that “reasonable period of time?”
Joy: It depends on which currency you are talking about. The key point, as the above Fed paper points out, is that money does not have to be perfect store of value because we do have to watch out for inflation, which lowers the value of money from the value before inflation.
Lily: So the now crashed “stablecoin” Terra Luna can’t pass this test.
Joy: No it can’t. The second requirement of money is a “unit of account,” which basically says money can be used to measure value of different things. Without money we’d have to resort to bartering, meaning we trade one thing for another, like one airplane for one million T-shirts. Fiat backed stablecoin meet that requirement.
Greg: We can break the “unit of account” concept down to three features: divisible, fungible and countable. Divisible means one dollar is always equal to four quarters, 20 nickels, 10 dimes and 100 pennies. Fungible means a dollar is a dollar, whether you get it from the bank or receive from your customer. They are always perfectly exchangeable. Countable means you can add, subtract, multiply and divide money anyway you want and still get the same result. Multiplying $1 10 times gets you $10, dividing $1 million by 4 gives you $250,000, and so on and so forth.
Joy: And that brings us to the last requirement of money as “the medium of exchange.” It essentially says money must be accepted as a way of payment. If you look at a dollar bill you will see a tiny note that reads: “This note is legal tender for all debts, public and private.”
Kimberly: But crypto is not legal tender.
Greg: True, but being a legal tender is not a required criterion of money. In other words, not being a legal tender does not eliminate stablecoins’ function as a medium of exchange for those backed by fiat, which are all legal tenders. The true test is market acceptance. The more a currency is accepted, the higher value it has as a medium of exchange.
Lily: Are you saying not all currencies are equally accepted? I would imagine being a government issued legal tender guarantees its acceptance.
Greg: That’s right. In the near future cryptocurrencies, including stablecoins, are unlikely to compete with fiat in terms of market acceptance but the important thing is to have some and increasingly larger acceptance among some parties in the market. Stablecoins fit that requirement.
Lily: What’s the unique things a stablecoin provides but not by the dollar?
Greg: There is an article in Investopedia that summarizes the advantage of stablecoins well: “Stablecoins promise cryptocurrency adherents the best of both worlds: stable value without the centralized control attributed to fiat.” It also lists a few unique use cases that only stablecoins can do, like “using stablecoins to trade goods and services over blockchain networks, in decentralized insurance solutions, derivatives contracts, financial applications like consumer loans, and prediction markets.”
Lily: I don’t understand why these things cannot be done with dollar.
Joy: All decentralized transactions happen on blockchain, but the dollar is an off-chain asset, not an intrinsic part of blockchain. As far as blockchain is concerned the dollar does not exist. Trading with stablecoins allows investors to stay onchain all the time, not on- and off-chain.
Greg: I won’t say the dollar does not exist on blockchain because the value of all cryptocurrencies is still measured by the dollar. In fact, the link between crypto and fiat is like the “umbilical cord” we all carried on when we came to this world. It explains a great deal why the crypto price movement has so much to do with the fiat, just like decentralized finance or DeFi has so much to do with traditional finance TradFi.
Joy: You are right. I think the notion that Bitcoin is a hedge against inflation also makes little sense, even though its supply is set by algorithm at 21 million. An article by the economist Eswar Prasad said it right, scarcity alone is not enough to create value, there must be demand.
Greg: I won’t use the term “scarcity” for Bitcoin because by the time you call something “scarce” you already implicitly imply a short supply relative to demand. Bitcoin is simply a story of “limited supply,” not scarcity, because Satoshi’s algorithm only governs the supply side. It had no idea how much demand there would be when the algorithm was written. Supply side was all Satoshi could control.
Joy: Okay I’ll buy that. There is a recent report by Bank of America that shows the correlation between Bitcoin and S&P 500 has been very high, while its correlation remain near zero with gold. This defeats another myth that Bitcoin is like digital gold.
Greg: The other “umbilical cord” for Bitcoin, or all cryptocurrencies for that matter, is financial regulations. Satoshi envisioned Bitcoin to be unregulated and disintermediate, meaning banks and existing financial institutions will be cut off from playing any role related to Bitcoin. But that’s utopian as it’s impossible for Bitcoin and all cryptocurrencies to be unregulated completely. If I were Satoshi, I would try my best to gain all the regulatory supports I can get for my innovation.
Joy: I agree. It is also dangerous without regulation. This explains why the price of cryptocurrency is so sensitive to the monetary policy of the Fed. I would change the famous saying: There are three certainties in life: death, regulations and taxes.
