Stablecoins in Cryptoeconomics: From Initial Coin Offerings to Central Bank Digital Currencies

In a recent article, I highlight the links among initial coin offerings (ICOs), cryptocurrencies, stablecoins, and central bank digital currencies (CBDCs).  Although these entities exist in different contexts (securities law and capital formation, payment systems, monetary policy), they are intertwined and share an evolutionary process.

ICOs raise issues related to securities law because digital tokens are tokenized equities and, therefore, securities. At the same time, they have increased the amount of outstanding cryptocurrencies and, as a result, highlighted the problems generally associated with money, in the context of cryptocurrencies.

Cryptocurrencies, including Bitcoin, have suffered tremendous volatility, impairing their role as a currency: a store of value, a medium of exchange, and a unit of account. As a result, developers and entrepreneurs have explored “stablecoins,” stable cryptocurrencies pegged to fiat currencies such as the U.S. dollar and the Euro.[1] Stablecoins generally combine liquid collateral (such as gold or the U.S. dollar)[2] or algorithmic mechanisms of stabilization with the management of supply “to incentivize the market to trade the coin for no more or less than $1.”[3] A new breed of stablecoins implements models that use other digital assets as collateral or not collateral at all, opting for riskier algorithmic mechanisms of price stabilization.[4]

Three main categories of stablecoins have emerged, each using a different method to stabilize their value. First, fiat-currency asset-backed stablecoins (so-called off-chain collateralized stablecoins) rely on fiat currencies as collateral and so cannot be fully decentralized. The most famous off-chain collateralized stablecoin is Tether, with a theoretical ratio of 1:1 between USDT (Tether’s stablecoin) and the U.S. dollar. A second category of stablecoins, so-called on-chain collateralized stablecoins, is collateralized with digital assets, generally one cryptocurrency or a basket of cryptocurrencies. This category of stablecoins is fully decentralized, making them in principle more transparent. Non-collateralized stablecoins are a third category, implementing algorithmic tools to maintain stability. This alternative method of stabilization is based on an elastic supply rule capable of adjusting the quantity of coin supply as a reaction to changes in coin market value. Non-collateralized stablecoins are not backed by any form of collateral and instead are based on “self-sustaining models that incorporate additional layers of game-theoretic incentives to encourage self-interested user behavior that would be instrumental in sustaining the peg.”[5] In this context, the role of a central bank managing the supply of fiat currencies is overtaken by smart contracts in charge of algorithmically expanding or contracting the supply of the stablecoin.[6] The majority of non-collateralized coins are based on a “seigniorage system” where two types of coin co-exist, one acting like money and one acting like shares: While the two coins share the same features, the two processes regulating their supply differ.[7]

From a theoretical perspective, stablecoins should help cryptocurrencies serve the fundamental purposes of currencies. Furthermore, stablecoins may help solve the practical difficulties of circulating dollars in the cryptocurrency world in different ways. While Bitcoin was considered useful both for storing value and serving as a medium of exchange, the expectation of continuous growth in the value of Bitcoin and the spectacular growth (and fall) of other alt-coins encouraged speculation.[8] Their ability to function as a money was compromised.

All three categories of stablecoins do, however, present problems. Off-chain collateralized stablecoins require a centralized structure and a level of auditing adequate to ensure transparency. On-chain collateralized stablecoins still depend heavily on traditional cryptocurrencies, whose volatility makes them a questionable way to ensure stability. Finally, algorithmic stablecoins implement a seigniorage mechanism, which  would require a continuous growth of the network to be sustainable. Causing further uncertainty are the relationships among stablecoins, other cryptocurrencies, and potential regulatory frameworks. With regard to the first problem, evidence of the role of Tether in the Bitcoin bubble is a major concern. The unclear relationship between the exchange ownership and Tether ownership raises unresolved conflicts of interest. With regard to the second problem, the regulatory uncertainties characterizing the wave of cryptocurrencies and ICOs between 2017 and 2018 have not been fully solved. Although stablecoins might qualify as payment tokens rather than securities, they might also be subject to securities and commodities laws in Europe and the United States.

These private initiatives (in particular JPMorgan’s JPMCoin and the Libra Association’s Libra Coin) prompted governments and central bankers to design and issue official CBDCs, whose utility and function are fungible with stablecoins. The term CBDC refers to “a new form of central bank money” that combines “new and already existing forms of central bank money.”[9] A CBDC is “a central bank liability, denominated in an existing unit of account, which serves both as a medium of exchange and a store of value,”[10] that could be account-based (implementing payments through the transfer of claims recorded on an account) or token-based (with payments involving the transfer of a digital token).[11] Notwithstanding their being a central bank liability, CBDCs differ from other forms of money issued by central banks,[12] such as balances in traditional reserve or settlement accounts.[13] At the same time, CBDCs would be, in principle, stable and would grant many of the advantages generally associated with cryptocurrencies.

CBDCs can potentially serve as alternatives to cryptocurrencies, in particular to stablecoins. Not surprisingly, a long list of governments and central bankers have considered or started new projects in the field, including India, Japan, Russia, Ukraine, Switzerland, the Republic of the Marshall Islands, China, Estonia, Iran, and Sweden. At the international level, the Bank of International Settlement[14] and the International Monetary Fund published important contributions to the discussion,[15] and the Monetary Authority of Singapore (MAS), the Bank of England, and the Bank of Canada have considered cross-border interbank payments and settlements, in part based on CBDCs.[16] The timing of all these initiatives is not accidental; a major crisis affected the capitalization of cryptocurrencies, favoring the growth, both in terms of popularity and value capitalization, of stablecoins.

With the increasing tokenization of real assets, it will be crucial to bridge the gap between the real and digitized worlds, as well as between cryptocurrencies and fiat currency. To do this, a stable cryptocurrency may be important, as stability is necessary for blockchain to function and grow. However, past stablecoins have failed or were traded for less than $1, and there is no empirical evidence that they may be sustainable in the long term or that they do not increase volatility by increasing opportunities for speculation. A public alternative may be more reliable and stable. This option leads to uncertain scenarios. In particular official CBDCs may disrupt the disruptors (both traditional cryptocurrencies and stablecoins), as well as today’s banking sector. An alternative scenario would be a hybrid solution based on the complementarity of private anonymous cryptocurrencies and public digital currencies, as advocated by some academics and IMF former managing director, Christine Lagarde.[17]

ENDNOTES

[1] Nathan Sexer, State of Stablecoins, 2018, Medium (July 24, 2018), https://media.consensys.net/the-state-of-stablecoins-2018-79ccb9988e63.

[2] Sherman Lee, Explaining Stable Coins, the Holy Grail of Cryptocurrency, Forbes (Mar. 12, 2018, 12:15 AM), https://www.forbes.com/sites/shermanlee/2018/03/12/explaining-stable-coins-the-holy-grail-of-crytpocurrency/#4db76f8f4fc6 [https://perma.cc/L9AR-VNTS].

[3] What is a Stable Coin?, Cryptocurrency Facts, https://cryptocurrencyfacts.com/what-is-a-stable-coin/ (last visited July 21, 2019) [https://perma.cc/N5BU-HXL6].

[4] Kirill Bryanov, Breaking the Peg: Every Stablecoin Has Its Points of Failure, Cointelegraph (Nov. 19, 2018), https://cointelegraph.com/news/breaking-the-peg-every-stablecoin-has-its-points-of-failure [https://perma.cc/3KFD-3VPB].

[5] Id.

[6] Id.

[7] See Sams, supra note , at 3.

[8] Patrick Tan, Security Tokens Versus Stablecoins, Medium (Sept. 27, 2018), https://medium.com/predict/security-tokens-versus-stablecoins-2d33b91e2fd [https://perma.cc/GPP8-X6R8].

[9] See Bank for International Settlements [BIS], Central Bank Digital Currencies, at iii (2018), https://www.bis.org/cpmi/publ/d174.pdf.

[10] Id.

[11] See Tommaso Mancini-Griffoli et al., IMF Staff Discussion Note, Casting Light on Central Bank Digital Currency 13 (Nov. 2018), https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2018/11/13/Casting-Light-on-Central-Bank-Digital-Currencies-46233.

[12] BIS, supra note 9, at 3.

[13] Mancini-Griffoli et al., supra note 11, at 7.

[14] BIS, supra note 12, at 5-6.

[15] Mancini-Griffoli et al., supra note 11, at 7.

[16] Bank of Canada, Bank of England, & Monetary Authority of Singapore, Cross-Border Interbank Payments and Settlements: Emerging Opportunities for Digital Transformation (2018).

[17] Id.

This post comes to us from Marco Dell’Erba, an assistant professor of law at the University of Zurich and a fellow at NYU School of Law’s Institute for Corporate Governance and Finance. It is based on his recent paper, “Stablecoins in Cryptoeconomics. From Initial Coin Offerings (ICOs) to Central Bank Digital Currencies (CBDCs),” forthcoming in the NYU Journal of Legislation & Public Policy and available here.

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