Are stablecoins stable?



In this two part article we discuss stablecoins and draw our conclusions.
Part I: introduces the topic and moves on to focus on fiat-backed stablecoins, examining in particular Tether's USDT and eventually Gemini's GUSD and Circle's USDC. We conclude that fiat-backed stablecoins are an interesting short to mid term solution, but can't be a long term solution.
Part II: Will focus on Algorithmic Stablecoins as a more decentralised solution, which however faces a higher technological complexity.

Cryptocurrencies emerged at the end of last decade, amidst the 2008 financial market crisis. Satoshi Nakamoto’s Whitepaper presented an alternative currency which tackled several flaws of the current monetary system. Some of the proposed primary advantages were: low transaction costs (although it is debatable for Bitcoin first layer, nonetheless other cryptos maintain low to non-existent fees), international borderless transferability, trustless ownership/exchange, pseudo anonymity, real-time transparency and most importantly decentralisation. The main goal of Satoshi Nakamoto’s solution was to create a system without a single point of failure, by distributing consensus and maintenance. This process also prevented any individual or institution to single handedly control the value of money.
However, even though cryptocurrencies became widely popular among a dedicated crowd of enthusiasts, they have yet to reach mass adoption, and to be treated as money. In fact, a good deal of the audience treats them as a speculation instrument and is hoping for massive appreciation of their cryptocurrency of choice (usually against USD), thus creating phenomena like “HODL”.

What makes money... money?

To understand why cryptocurrencies have not been successfully adopted we must first analyze what makes a currency actual money.
Money, to be considered as such, has to fulfil three functions.

Photo by Sharon McCutcheon on Unsplash

The first function is to be a medium of exchange which facilitates transactions, compared to a barter economy. For a transaction to take place in a barter economy there has to be a "double coincidence of wants", each party desires and values what the other has to offer. Due to the differences in people's desires, the likelihood of this coincidence is rare when bartering. Money solves this problem by serving as medium of exchange that is desired, and thus accepted, by every party in every transaction.

The second function of money is to be a store of value. Money must hold its value over time, otherwise it would become less desirable and wouldn't be able to efficiently create a double coincidence of wants. Of course, money itself is not the best store of value in the long run. It is, however, the most liquid and it can be held (for a reasonable amount time) without experiencing excessive fluctuations in its value.

Finally, the third function of a currency is to be a unit of account. It should provide a commonly accepted measure of the value of a good or service.

Looking at the aforementioned functions we can see how fiat currencies fulfil virtually all of them. In facts while it is true that most currencies experience a certain degree of inflation (with some reaching levels of hyperinflation, e.g. Venezuela and Zimbabwe), in a healthy economy the rate of depreciation of its currency is low enough to allow it to function properly (while at the same time avoiding deflation). For example, it makes sense for both parties to price a multi-year propriety lease with a fixed rate expressed in CHF or USD. Conversely if rent for a flat (equivalent to 4000 USD) was priced in ETH, it would have costed 3 ETH in January this year, but today it would cost more than 17 ETH. Because of their high volatility cryptocurrencies can't fulfil two of three functions, and even their use as a medium of exchange is severely limited by their instability.

In contrast, fiat currencies achieve this stability through monetary and fiscal policies, but lack several of the cryptocurrency advantages mentioned at the beginning of the article. To preserve these advantages while at the same time reaching mass adoption, several projects tried to create stable cryptocurrencies which were grouped under the name stablecoins.

Fiat currencies on a Blockchain

An initial attempt to reach stability was to tokenize fiat currencies, creating the so-called fiat-backed stablecoins.

The most famous (and infamous) fiat-backed stablecoin so far has been Tether with its USDT. The idea behind USDT was to create a token backed 1:1 by USD. It was initially built on the Bitcoin OmniLayer, but Tether later started using ERC20 tokens as well (running on Ethereum). Their key feature was Tether's Proof-of-Reserves process, which is guaranteed that for every USDT issued a US Dollar would be held in several (initially two) bank accounts belonging to Tether. A user automatically generates 1 USDT by sending 1 USD to Tether. Conversely when a USDT is redeemed, the corresponding USD is paid back and the USDT is destroyed.

The amount of existing USDT is easy to find, since they exist on two Blockchains this information is publicly accessible in a transparent way ( OmniLayer , Ethereum ).

The amount of USD in Tether's bank account is trickier to find. According to Tether's Whitepaper, the bank account balance will be published on Tether's transparency page and the company promised it would undergo regular audits. Even though on paper all of this seems bulletproof, Tether has been accused of minting non-backed tokens, which in turn were used to prop the market and create "free money".

While there's no solid proof backing those allegations, there is a series of suspicious circumstances surrounding Tether. For example, the regular audit Tether promised to its users was indeed conducted at least once. The auditor was Friedman LLP. Even though it theoretically confirmed that the amount of held in (unnamed) banks matched the number of Tethers outstanding, it contained many caveats . For example, it was not intended for external use, the legality of Tether's operation wasn't checked, and it's not even confirmed that Tether can access the money held in the bank accounts for the purpose of paying back redeemed USDT. The audit merely stated that a certain amount of money is present in two anonymous bank accounts at two unnamed banks.

Furthermore earlier this year, Tether dissolved its relationship with Friedman LLP due to their "excruciatingly detailed procedures". In June (2018) a new audit performed by Freeh, Sporkin & Sullivan LLP confirmed once again that the amounts of USD held at unnamed banks matched the number of circulating USDT. However FSS LLP is a law firm and not an accounting/auditing firm, furthermore like the preceding audit this one also contains several red flags .

As we mentioned, the names of the banks were never disclosed in the Tether audits, although it recently emerged that Noble Bank of Panama was linked to Tether. Due to an increased pressure in redeeming Tethers, Noble bank is facing severe liquidity shortages and will likely run into insolvency. Tether severed its ties with Noble bank. .

All of these hints support the thesis that Tether has printed a number of non-backed USDT, thus creating free money. However, this raises another question, namely "why?".

There is evidence that Tether was used to manipulate the price of bitcoins . For example in making it reach the price of almost 20'000 USD at the peak of the late-2017 bubble ( statistics ).

Eventually an academic paper researched the issue. By mapping the Blockchains of Tether and Bitcoin, the authors were able to establish that several entities associated with the exchange Bitfinex used Tether to purchase bitcoins when prices are falling, bitcoin prices rise as a result of these intervention. Furthermore, they observed that these effects are only present after negative returns for bitcoin and periods following the printing of Tether. They also demonstrated that these patterns do not occur randomly. The issue is still unresolved but there's a worrisome amount of evidence that Tether might soon become a Black Swan for the cryptocurrencies market, with severe repercussions.

It is clear that while they provide some benefits, stablecoins can also be abused and pose a significant threat both to honest investors and the ecosystem as a whole.

Fortunately, several competitors emerged who appear to be less risky than Tether's USDT. For example, the Winklevoss twins launched Gemini Dollar (GUSD). It follows the same idea of USDT, GUSD are backed 1:1 by USD. However, they seem more transparent. They are issued by Gemini Trust LLC, an entity analysed and approved by NYDFS . The funds are held in State Street Bank & Trust, in the US. The account and the 1:1 peg are regularly audited by BPM LLP , a registered public accounting firm. Finally GUSD the ERC20 Token's smart contract code has been audited by Trail of Bits .

Similarly, another competitor, Paxos, received approval from the NYDFS . They also publish their audit reports , performed by Withum .

Goldman's backed company Circle also launched their USD-pegged stable coin, the USDC. It is based on CENTRE technology. Circle received a BitLicense from the NYDFS , they also promised to release audit reports regularly, however so far they are not to be found.

What's next?

Photo by Gaelle Marcel on Unsplash

The example of Tether has shown how dangerous a manipulated fiat-backed stablecoins can become, however the potential use cases of well managed and transparent stablecoins are plenty. They will play an important role in the quest for mass adoption of cryptocurrencies. However it is also clear that they are only a temporary, band-aid solution.

They retain an important single point of failure, if the banks holding the collateral defaults or freezes the account(s) holding the collateral, the stablecoin becomes worthless. This also means users will have to trust the depository bank. Another intermediary that users will have to trust is the third party auditor guaranteeing the integrity of the 1:1 peg.

Furthermore, if the stability is achieved by following the value of the USD (for example), which retains its stability due to policies of the Federal Reserve, that means that the users will also have to trust yet another third party. All of this is starkly in contrast with the value of decentralization and trustless consensus around which Bitcoin and the following cryptocurrencies were built.

Eventually it appears to be more sensible for Central Banks to issue their own respective fiat-backed stablecoins, rather than having several private companies issuing fiat-backed cryptocurrencies and competing with each other.