Stablecoin Market Trends & Societal Obstacles They Present
Note: This several part series is the result of a paper I wrote in January 2019. Rather than publish it, I thought it’d be most helpful to break things down and share it with the broader crypto-community. You can find the long form PDF version of the paper here and each part here:
- The Problem of Social Sector Transparency and an Introduction to Stablecoins (Pt. 1)
- Stablecoin Market Trends & Societal Obstacles the Present (Pt. 2)
- Stablecoins & Central Banks (Pt. 3)
- Stablecoins & Fiat-Crypto Payment Ramos (Pt. 4)
- Stablecoins & Improving Donation Transparency (Pt. 5)
- This is a much longer post….my bad..
- There are over 200 stablecoins in the market, with varying stages of progress (live vs. pre-launch phase).
- The total market value of all stablecoins is $3 billion, or 1.5% of the total market value of all crypto-assets.
- There are three main types of stablecoins, Fiat-collateralized, Crypto-collateralized, and Non-collateralized
- There are certainly more than three types of attacks that can be conducted if stablecoins were to hit the mainstream — and many of them are pretty messed up
- Download the full paper here
Stablecoin Market Prevalence
“The ‘winner’ of the stablecoin race will have to make a product easy enough to be used by mainstream consumers, safe and secure enough to be trusted by regulators, and flexible enough to entice the involvement of multinational banks — All while hopefully not sacrificing the decentralized, immutability, and transparency pillars of the underlying blockchain technology that made stablecoins possible.” — Yours truly 👌🏾
There is a growing interest, need and demand in stablecoins from businesses, decentralized applications and individuals. Typically used for trading today, stablecoins will soon be used for a wide variety of use cases and applications (eg. donation for nonprofits?). The asset type is an essential brick of the blockchain ecosystem to enable cryptocurrencies to live up to their full potential. People start to understand it — calling it the “holy grail” of cryptocurrencies. Indeed, Reaching stability is key; achieving it is the new crypto gold rush and dozens of projects (+50) are working on it. It is still a good timing to enter the race as there is no best-practice and current market leaders (e.g. Tether, NuBits) are being challenged (eg. by TrueUSD). However, with the amount of projects and money in the ecosystem, the market will soon consolidate and strong market leaders are likely to emerge.
As of 2018, the stablecoin market could be summarized by the following overarching analyses (The State of Stablecoins, Blockchain):
- Over 200 stablecoins in the market, with varying stages of progress (live vs. pre-launch phase). The total market value of all stablecoins is $3 billion, or 1.5% of the total market value of all crypto-assets
- Stablecoins can be broadly divided into two main stability mechanism categories: algorithmic and asset-backed
- Stablecoins are listed on over 50 different exchanges at present, with Tether featuring the greatest number of total individual exchange listings (at least 46)
- Tether continues to dominate with approximately 98% of total stablecoin daily trading volume. Tether comprises 93% of the all stablecoin market value
- Key near-term regulatory issues for the stablecoin market include whether stablecoins (or aspects of stablecoin systems) are in compliance with securities and money service laws in some jurisdictions.
Overall, the stablecoin market is developing quickly and are changing the landscape of consumers interact with digital assets. As they become increasingly prevalent and integrated into beta software products, we are beginning to witness how the digital asset markets are gradually connecting with mainstream markets. Despite progress, stablecoin technology is still nascent and it is highly unlikely that the perfect stablecoin design exists at present. Further experimentation (and innovation) is expected and, due to the aforementioned design uncertainty, as well as regional factors (e.g., local regulations), there may be space may exist for approximately 5–8 significant stablecoins in the short to medium-term (The State of Stablecoins, Blockchain). In the longer-term, some stablecoins may be deemed to pose greater direct competition to fiat currencies than bitcoin and may spark a competitive response or regulatory backlash from central banks, which in many jurisdictions have largely remained on the sidelines of cryptocurrency regulation to date. The latter brings us to a deeper dive on the obstacles associated with stablecoins.
Obstacles Presented by Stablecoins
“Mo money, mo problems” — The Notorious BIG
There are of course, mo’ problems when there’s mo’ money involved. Outside of the great security token debate striking fear in many a crypto-spectator and “bitcoin bro,” stablecoins have to achieve a high level of security, trust, and adoption to even be remotely considered feasible in contrast to cash. Here we breakdown the obstacles that each type of collateralized stablecoin might run into.
1.0 Obstacles Presented by Fiat-Collateralized Stablecoins
While developing a tokenized fiat solution to help minimize the operational inefficiencies of money transfer services between municipalities and rural areas, there does exist potential attack vectors that a more mature solution will need to defend against. By identifying these structural weaknesses that may manifest themselves within earlier iterations of a proof-of-concept and minimal viable product, a team can better prepare an adaptive development strategy to sustainably and reliably deploy a later stage product. Potential attack vectors to a tokenized fiat system include the following:
- Double Spending Attack: Issue of double spending attacks
- Unbacked Currency Attack: Issue of unbacked cryptocurrency attacks (ex: how does destroying legal tender, which back the cryptocurrency, affect the system)
- Unrecognized Currency Economic Sanction: Future policy concerns (governance, transparency — what happens when the crypto-cash crosses the border and another country will not recognize it?)
- Rural Bank Economic Arbitrage: how central banks can control liquidity constraints of rural banks if they are not adequately included in the governance consortium
- Central Bank Ledger Collusion: Central bank collusion due to the lack of systematic transparency
We will dive into each concern in more detail to determine how the attack could be carried out and the level of difficulty a malicious actor would need to overcome to effectively utilize such methods. The proposal includes a following section “Attack Vector Recommendations” that outlines suggested actions that can take place (within policy or within the development of the solution) to help defend (or minimize the probability of) these attacks.
1.1 Double Spending Attack
A ‘double spend’ is an attack where the given set of coins is spent in more than one transaction 1. There are a couple main ways to perform a double spend within a (currently) Proof-of-Work (PoW) blockchain network like Ethereum or Bitcoin:
- Send two conflicting transactions in rapid succession into the network
- Pre-mine one transaction into a block and spend the same coins before releasing the block to invalidate that transaction. This is called a Finney attack
- Own 51+% of the total computing power/stake of the network to reverse any transaction you feel like, as well as have total control of which transactions appear in blocks. This is called a 51% attack
To prevent damages from the first attack — wait for one confirmation to appear on a given transaction. To prevent damage from the second attack — wait for 6 confirmations to appear on a transaction, or less if the transaction is small (but still require at least 1). Damage from the third attack can cripple the entire network, so don’t worry about it — your business most likely won’t be the main target (it’s unlikely to happen without a huge financial expenditure).
How do these attacks, and their proposed solutions, map to a tokenized fiat system? In fact, such a system lends itself to two types of double spending attacks.
- Unbacked Currency: The first category concerns itself with how the overlying digital currency is backed and where that supporting fiat amount is located
- Transactional: The second more closely relates to the aforementioned example, where the network is relying upon a Proof-of-Stake and or Proof-of-Work system
Double spending attacks within systems like Ethereum and Bitcoin or extremely expensive and highly improbable. The first category, comparatively, has a much higher probability of occurring, so let’s discuss the details of this type of attack in more depth.
1.2 Unbacked Currency Attacks
The following delves into unbacked currency attacks via the destruction of legal tender and system of fractional reserve banking (loans).
Destruction of Legal Tender
Transacting an asset backed token assumes that the underlying asset exists somewhere in the real world. If the underlying asset were to be comprised by being damaged or destroyed, the overlying token should accurately reflect a depreciation in value. If such a depreciatory event does not take place, and the overlying token continues to be transacted with the assumption that the underlying asset hasn’t been compromised, the system begins to spend capital that no longer exists (because it is not backed). For example, the latter would be akin to consumers transacting gold backed IOUs in the late 1800s. If the banks did not accurately maintain their gold reserves, or 80% of the gold was stolen, the IOUs would immediately become worthless. The concerns of double spending arise when the underlying asset is being spent in a different transaction as the overlying token. One transaction is cash-based, meaning that there will be no record of the exchange on-chain, while the other transaction is on-chain and misrepresenting an exchange of value as ‘backed.’
Loans, by nature, embody the double spending attack because they artificially create capital that can be spent in different transactions simultaneously. When leveraging the mechanism of a deposit receipt to back crypto-cash, the natural accountability framework put in place is that every digital representation expressed as a ‘token’ has a unique backing by the underlying asset of fiat currency. Once the token has no backing, it becomes useless. We come to see that tokenizing fiat, although it has operational benefits to the traditional function of banking (i.e to process payments and secure funds, and to to act as a clearing system). In the crypto-economy, loans currently require the amount of capital being lent to be completely sent (albeit with smart contractual conditions) to the lendee until the full amount is repaid (plus interest). If loaned capital is tokenized in a crypto-cash system, unpaid obligations would equivocate to the ‘minting’ of capital, which, en masse, could cause hyperinflation over time.
The ‘double minting via loan’ attack uncovers the systematic and dynamic opposition to the operational gains of tokenized fiat on-chain and the economic benefits of the traditional monetary system. The latter makes the following abundantly clear:
- The power of the banking system to create money is an extension of its role in taking and creating deposits
- The reason for the taking of deposits has functions and incentives beyond just the purely operational benefits
A potential solution to this attack is to ensure that all future loans within a crypto-cash system are represented via a different token, rather than the same token that represents fiat currency. This ‘loan token’ would be minted by a protocol of smart contracts that can dynamically set the conditions of the loan, and, most likely, will need to leverage some form of collateral to mitigate risk.
1.3 Unrecognized Currency (Economic Sanction)
The ‘unrecognized currency’ attack posits the following question: What happens when the crypto-cash of one nation crosses the border and the receiving nation will not/does not recognize the tokenized fiat as legal tender?
Indeed, it seems quite possible for neighboring countries to ignore the validity of the use of crypto-cash in one nation as a form of economic sanction, particularly if the use of tokenized fiat gains mass adoption. Banking networks are often international in scale, and it is highly probable that there will be multiple crypto-cash denominations across borders. Neighboring nations, or interdependent nations could stop accepting transactions in a certain denomination of crypto-cash in an effort to withhold fiat liquidity from that country, leaving loan engagements unsettled and potentially draining a nation’s reserves (which is supposed to back the overlying token). The same could be said about intra-national disputes between banks leveraging different crypto-cashes. What if competitors are looking to settle against different tokenized denominations backed by the same fiat currency with different fee structures?
A potential solution for this attack is to mandate that all banks within a single country adopt the same tokenized-fiat standard, and, in the future, also ensure that external parties (banks of other nations) have reconciled the use of crypto-cash within their own borders as well.
1.4 Rural Bank Economic Arbitrage
If rural banks engaging within the crypto-cash system do not have equal governing rights as the rights of central banks, then how will central bank incentives to monopolize transactional leverage be curved? The ‘rural bank economic arbitrage’ attack comments on how central banks could control the liquidity constraints of rural banks if they (rural banks) are not adequately included in the governing consortium. An early manifestation of this type of attack would be the gradual increase of transactional fees that rural banks incur when receiving crypto-cash (i.e. a remittance transaction or intra-bank transaction). A more exaggerated example of the attack could be dictatorial control over when money can be transferred to rural areas at all, particularly during times of national economic crisis where liquidity becomes more scarce.
The only solution to curve perverse incentives is governmental, economic policy that mandates that any consortium of banks leveraging the advent of crypto-cash must be equally represented by central and rural banks alike. Each governing entity should have the same voting rights and privileges within the consortium.
1.5 Central Bank Ledger Collusion
If the bank serves as the intermediary settlement entity and nodes are confined to few organizational agents, corrupting the ledger becomes much, much easier. In fact, if there is an economic incentive to fraud the ledger, and transactions are not being committed to the Ethereum public chain, banks will most likely participate in this behavior. The latter could be complete erasure of transactions, changes in terms, etc. The only solution to curve perverse incentives, in this case scenario, is to ensure that transactions are settled on a public ledger (albeit maybe in a confidential manner).
2.0 Recommendations for Responsible Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins have a major, trust-oriented surface of attack. Fiat-collateralized stablecoin projects hoping to avoid the aforementioned attacks could take the following measures to combat potential downfalls:
- Development of crypto-cash policy that sets legal mandates in place to disincentivize perverse collusion amongst banks and ensures that any ledger used is completely immutable and accessible/audit-able to regulatory authority)
- Development of crypto-economic considerations around the usage of loans to prevent ‘double minting’
- Development of crypto-cash policy that sets legal mandates of how crypto-cash consortiums are governed and who can/should be represented in such consortiums
3.0 Obstacles Presented by Crypto-Collateralized Stablecoins
Crypto-collateralized assets, much like their fiat-collateralized counterparts, suffer drawbacks of their own. The following consist of some of the more serious drawbacks associated with stablecoins that are collateralized with other crypto-assets:
- Regulatory Uncertainty — The vast majority of cryptocurrencies are quickly being considered unregistered securities by regulatory bodies (e.g. the SEC), meaning that assets collateralized by zed cryptocurrencies that have been identified as unlawful digital assets could diminish the integrity of the overlying asset
- Extreme Volatility — The vast majority of cryptocurrencies are extremely volatile, and thus, any asset that is collateralized with these cryptocurrencies must hedge against wide price spreads of their underlying asset via over-collateralization
- Liquidity Risk — The vast majority of cryptocurrencies have small market capitalizations in contrast to traditional asset markets. Many crypto markets suffer from liquidity costs (i.e. liquidity risk) because of this, which making them a reliable form of collateral even more difficult. Note that ‘liquidity risk’ is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Given these concerns, developing crypto-collateralized stablecoins requires a complex financial system to support the asset, particularly when secondary market effects like pump and dump schemes can trigger liquidation events within your system.
4.0 Recommendations for Responsible Crypto-Collateralized Stablecoins
The only tried and tested crypto-collateralized stablecoin has been the DAI stablecoin (up until the time of this writing). DAI’s collateralized debt position framework, collateral ratio, and automated liquidation functionality has allowed it’s cryptocurrency to have less than a 1% variance rate since its release in December 2017.
In addition, MakerDao is forming payment ramps and financial service partnerships to spur global adoption. It is recommended that, before attempting to develop a crypto-collateralized stablecoin based off an underlying asset that is not commodity backed (i.e. using a form of crypto collateral that is not also backed by something much more stable), organizations analyze the model developed by MakerDao and simulate various scenarios that could undermine the stability of the asset.
5.0 Obstacles Presented by Non-Collateralized Stablecoins
Lastly, the limitations of non-collateralized stablecoins include the following:
- Decentralized (price) oracles have to be trustless, like with any other dApp. (Except price is here absolutely central — bad pun intended).
- Monetary policies remain complex, unclear and unproven. Incentives described may not be enough.
- Stabilization is often partially maintained via centralized mechanisms (e.g. Basis’ centralized reserve)
Only a few non-collateralized stablecoin projects are live and most suffered from high volatility and drops in value — hard to tell from white papers if others will work (applicable to other categories).
Next: Stablecoins and Central Banks
Next, we dive into the considerations that need to be made concerning stablecoins and the oligopoly of the financial services industry (i.e. banks).
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I commonly write about crypto-economics and blockchain technology with a social impact focus, though I often times stray into lower-level, more technical analyses as well!