The Kingstons have decided to switch the gear toward what is happening in real life instead of abstract knowledge points.
Lily: I feel we have been out of touch with reality by talking about blockchain, cryptography, hash and hashrate, nonce, and even proof of work and proof of stake. They are foundational of course but we need to look at the “livelier” developments.
Kimberly: I agree. We also have had a very positive tone about cryptocurrency or the blockchain. We rarely talked about whether the whole thing of cryptocurrencies is worth it. After all, if famous investment gurus like Warren Buffett have questions and reservations about investing in cryptocurrency, shouldn’t we think twice about that as well?
Lily: To give a good example, what about the recent crash of stablecoins? I’ve read a report on CNBC the other day, talking about whether this 30-year-old South Korean founder of a stablecoins project will face jail time or just civil penalties.
Emily: What happened to the project? What is a “stablecoin?”
Lily: The idea of stablecoins sounds very attractive. It addresses one of the biggest problems with cryptocurrency. You know, their prices jump up and down dramatically. Stablecoins were born to change that.
Emily: How do stablecoins do that?
Lily: It helps to keep in mind we have two currencies today: dollar and crypto. They are not isolated from each other. The value of all cryptocurrencies is always measured by dollar. Jason, could you find out the dollar prices for Bitcoin and Ethereum today, please?
Jason: Let me Google it: It says $30,041 for Bitcoin and $1,809.64 for Ethereum.
Lily: Thanks. If you think of it, those prices really are the exchange rates between the dollar and crypto. Remember last year we had a trip to France and at the airport we used our dollars to buy Euros?
Emily: Oh yeah. Euro was more expensive than dollars. We gave them $200 but only got about 190 Euros back.
Lily: If you think the Euro is expensive, wait to see the exchange rate of Bitcoin. You heard Jason just said: One Bitcoin is sold for more than $30,000 dollars.
Joy: Just so you know, on May 1st I invested $1,000 on Bitcoin and $500 on Ethereum. Want to guess the prices back then? I have them on my iPhone: Bitcoin (BTC) was $38,890.81 and Ethereum (Ether) was $2,856.45.
Emily: You’ve lost money on cryptocurrencies. No wonder investors all want stabilized crypto prices.
Lily: That’s not true. Many speculative investors actually prefer big movement in price because it’s easier to make money that way. They all try to buy low and sell high.
Greg: Lily said it right earlier: We have two currencies within the country. With two currencies, what’s gonna happen is there will be an exchange rate between currencies.
Kimberly: A quick question: Exchange rate is the rate at which one currency can buy another, right?
Greg: Right. Normally exchange rate keeps changing because things change. However, sometimes a country decides to have a fixed exchange rate with another currency. This is called “currency peg.” The Hong Kong dollar for example has been pegged to the U.S. dollar since 1983.
Kimberly: Why would they want to do that?
Greg: Currency peg is a national policy to promote international trade. Many businesses involved in international trade have a low profit margin. Even a little fluctuation in exchange rate could wipe out their profits. A currency peg means a fixed exchange rate and it’s a godsend because it eliminates foreign exchange risk.
Kimberly: I can see currency peg is useful for international trade but we are talking about stablecoins, why is currency peg relevant?
Greg: Because the same idea of currency peg drives stablecoins. You guys may not have been keeping up with the latest in the payment business. Both crypto platforms like Coinbase and legacy service providers like Visa and Mastercard are pushing for direct deposits or cryptocurrency wallets and accepting both dollars and crypto. In the first half of 2021, Visa reported that it had processed over $1 billion worth of cryptocurrency payments.
Joy: Yeah, for a currency to be useful for payment people all prefer stable value. Price jumping around too much turns people off from using it. This is why so many people are interested in stablecoins, which keep the exchange rate fixed between currencies — or so promised.
Kimberly: I see a big reason for stablecoins. Nobody wants to use a currency that can buy 10 gallons of gas today but only 7 gallons next month.
Greg: Another reason stablecoin is needed is that certain institutional investors like pension plans would desire stablecoins. At retirement ages people just want to preserve their hard earned money, they have little taste for speculation. I read the news that Fidelity Investment now let companies offer their employees Bitcoin in their 401(k) plan for up to 20%.
Emily: What’s 401(k)?
Joy: That’s a retirement savings plan sponsored by employers for employees named after a section in the U.S. Internal Revenue Code. It’s the best deal because if an employee deposits $500 each month to the plan, many employers will match that and add another $500 to your savings account.
Lily: Another reason stablecoins are such a big news is that some platforms offer big incentives to investors. The LUNA project once promised almost 20% annual return on anyone’s deposit on the platform. That’s crazy when others were paying 1% or less.
Greg: If something sounds too good to be true, most likely it’s not true. Unfortunately some always find excuses to believe the unbelievable. This billionaire investor named Mike Novogratz even made a tattoo on his arm to memorialize his membership in this LUNA club. The project quickly gathered almost $60 billion but today is almost worthless. I found this article from Motley Fool published right before Luna’s crash in May very insightful.
Joy: I’ve read from online that stablecoins are valuable to migrant workers who need to sent remittance money home fast and inexpensively compared with other means of sending money internationally. It also preserves value of foreign aids.
Kimberly: Should we get back to Emily’s question of how stablecoin works?
Joy: Of course. From what I understand, there are different models of stablecoins. Some are safer and stabler than others. The key terminology is “algorithms stablecoins.” The LUNA project Lily was talking about is an example of that.
Emily: “Algorithm stablecoins?” It sounds complicated.
Greg: Let’s go back to the “currency peg” and it helps us understand algorithms stablecoins.
Emily: Please give an example of currency peg.
Greg: Let’s say Hong Kong dollar is pegged at 1:8 to US dollar, meaning one US dollar will always buy 8 HK dollars. Normally the exchange rate is not fixed but fluctuates, so bear in mind this is unusual.
Emily: Because a fixed exchange rate helps exporting goods, right?
Greg: Right. Say last year one US dollar could buy 8 Hong Kong dollar, but this year one US dollar can buy 8.5 Hong Kong dollars. We say American dollar is stronger and Hong Kong dollar weaker. A stronger dollar can buy more imported stuff from Hong Kong, or Hong Kong can export more stuff to the US. That’s what Hong Kong wants.
Emily: What if things change and the exchange rate shifts away from 1:8?
Greg: That is called “breaking the peg.” Let’s say for some reason capital starts to flow out of Hong Kong, like businesses are leaving and foreign investments are leaving. What would that mean to Hong Kong dollar?
Lily: I would say Hong Kong dollar will be weaker because Hong Kong economy is weaker.
Greg: Right. A weak currency does not always signal weak businesses, because sometimes a country would intentionally make its currency weak just to increase its trade competitiveness. However, other things equal, a weak economy usually means weak currency.
Emily: But Hong Kong wants to have a fixed exchange rate with US dollar, what can Hong Kong do to keep the peg?
Greg: A country’s central bank keeps watching the exchange rate closely and if there are signs of deviation from the pegged rate the central bank will respond to drive the exchange rate back to the pegged value.
Emily: Details please?
Greg: In order to keep the exchange rate going down from 1:8 to 1:8.5, Hong Kong Monetary Authority will buy Hong Kong dollars from local banks, which will cut down the amount of Hong Kong dollar in circulation. When money supply is reduced, what happens to interest rates?
Lily: We learned from school that the interest rate is the price of borrowing money. So if money is in short supply, just like everything else, its price — the interest rate — goes up.
Greg: Yes, now when Hong Kong interest rate is up, it will attract money back into the city. Say interest rate goes from 1% to 2%, the same $1,000,000 Hong Kong dollars deposited in a Hong Kong bank will get interest payment of $20,000 rather than just $10,000.
Lily: More money flowing back to Hong Kong will make Hong Kong dollar stronger, and that’s how the peg is maintained or restored.
Joy: Hong Kong is a special case because it’s a part of China and does not have central bank. If China wants to maintain a stable exchange rate of Yuan with US dollar, the Chinese central bank will rely on open market operations to keep the pegging.
Emily: So what will Chinese central bank do if the Yuan goes down in value relative to US dollar?
Joy: Ask yourself this question: If the prices for something is down, does it mean the demand for that something is up or down?
Emily: I would say down, otherwise the price would go up for something that’s popular, like housing in California, right?
Joy: You got it. The same idea applies to currency as well. If the value of a country’s currency goes down, it usually means there is insufficient demand for it. Chinese central bank will then sell some of the US Treasuries and use the money to buy its own Yuan. This way it creates artificial demand for Yuan to bring its value up.
Kimberly: If China’s Yuan goes up too much in value relative to US dollar, China’s central bank will buy more US securities to raise the demand — and the value — for US dollar, right?
Joy: Right. Because central bank’s deep pocket, anytime it buys a currency, its value will go up and when it sells a currency, its value will go down. This is called “open market operations.”
Kimberly: I wonder how many countries can afford the pegging. Not all countries have a deep pocket of US currency or treasuries like Hong Kong and China.
Greg: That’s exactly right. It’s never easy nor free to keep the currency peg.
Emily: So for stablecoins to keep a stable value with the dollar, they use the same open market operations to maintain the peg, right?
Greg: Yes and no. There is an article that summarizes four types of stablecoins. I’ll simply break them into two types of collateralized versus non-collateralized stablecoins. The former works just like currency peg and requires collateral asset, such as fiat currency, bonds, commercial paper or crypto tokens, while the latter only depends on algorithm and smart contract.
Emily: I remember Lily told me collaterals are backup asset, but what is a “smart contract?”
Joy: A smart contract is like other contracts with one exception: It does not require an intermediary or a third party because it can execute itself when certain specified conditions are met. Think of them as “If – Then” automatic contracts.
Kimberly: So if a stablecoin’s exchange rate moves away from 1:1, then the contract will automatically trigger open market operations to move it back to the pegged rate.
Joy: That’s the case for collateralized stablecoins. A few things to keep in mind. First of all, keeping a peg requires resources. If you are pegging to Euro, you need to have sufficient amount of Euro in reserve, ready for backing up to keep the peg.
Greg: The same is true for crypto-collateralized stablecoins. Say you want to have $1,000 worth of stablecoins, the smart contract will ask you to deposit $2,000 worth of Ethereum as the collateral. That amount will be locked up before the $1,000 stablecoin is created or “minted.”
Joy: The second condition in a stablecoin smart contract is that you can choose to peg a single currency or a basket of currencies like the Euro, Japanese Yen and the dollar. Pegging to several currencies is generally better than pegging to a single currency because more currencies mean less price movement. The idea is the same as investing in more stocks is safer than pouring all the money into one stock.
Greg: A country can also have a “soft peg,” which allows the exchange rate to stay in a limited range rather than an exact point.
Kimberly: So Hong Kong may choose a pegged rate not exactly one dollar buying 8 Hong Kong dollars, but perhaps one dollar buying between 7:85 and 8:15 Hong Kong dollars.
Joy: That’s right. Finally, pegging can be done not just to currencies but commodities like gold, precious metals, bonds, commercial papers or even real estates.
Emily: Is commercial paper some kind of newspaper?
Joy: No, it is a type of “I Owe You” note issued by a corporation to borrow money from investors and usually will be paid back within 270 days maximum.
Greg: I’ll add one more note regarding collateralized stablecoins: Cointelegraph.com reported last year that the Office of the Comptroller of the Currency, or OCC, allowed national banks to run independent nodes for distributed ledger networks like blockchain.
Joy: Yeah I remember that report as well. The OCC essentially says banks should treat blockchains the same as other legitimate global financial networks like SWIFT and ACH.
Greg: The government formally promised to have collateralized stablecoin backed up with its full faith and credit.
Emily: What about the non-collateralized stablecoins?
Greg: That’s a different story. Let’s talk about it next time.
