Commodity coins could prove a better long-term hedge than fiat stablecoins

Bitcoin has legally been defined as a commodity by the CFTC since 2015, referred to as a "virtual commodity" in the category of "exempt commodities" alongside gold, oil and other metal and energy commodities. The commodity-like traits of crypto is one of its greatest value propositions over fiat currencies or even fiat-backed stablecoins and the future will likely see many more cryptocurrencies backed by real commodities like coffee, food, water and common resources like clean air, minerals and energy.

Like their real world counterparts, commodity pegged or backed cryptocurrencies have had lacklustre demand so far but this could soon change as commodity prices and demand come off decade long lows and may provide a hedge against USD devaluation and market volatility.

The Virtual Commodity Association

The Winklevoss twins of the Gemini exchange have been leading the effort to create the Virtual Commodity Association (VCA) which is an industry-sponsored, self-regulatory organization for virtual commodity exchanges and custodians.

The buying and selling of virtual and real commodities has been exempt from CFTC jurisdiction because it assumes its spot/cash markets, unlike derivative markets, are used for operational purposes (eg a farmer buying grain) and not for speculation.

The stated mission of the VCA is to be (i) a non-profit, independent regulatory organization that does not operate any markets, (ii) will not be a trade association, (iii) will not provide regulatory programs for security tokens or security token platforms, and (iv) will be in compliance with global standards and best practices for SROs.

Commodity prices bouncing off decades’ low

There is concern about the growing ratios of physical precious metals to their paper derivatives and how short interest in the paper market has kept a lid on the spot prices of gold and silver. Commodity prices have been in the doldrums for over a decade since the global financial crisis depressed demand, suppressed inflation and strengthened the USD.

The spread between the S&P 500 (red line) and the PowerShares DB Commodity Index Tracking Fund (DBC) – the largest commodity ETF by assets under management – is at an all time divergence.

As we exit a time of record low volatility (the short vol trade on VIX etc was the most crowded trade for years) the future is likely to proceed quite differently. Geopolitical tensions are rising, interest rates are rising, stock markets are teetering and there’s a global debt mountain of $260 trillion.

Real assets are currently at their cheapest relative valuation to financial assets in decades if not all century and the traditional hedges against inflation – gold and silver – are hovering around decades lows. This is in part due to the low inflation environment we have been in (which buoys stocks and suppresses real assets etc) but with interest rates creeping back up it looks like commodity demand could be bottoming out.

Commodities are also negatively correlated with the US dollar (and positively correlated with emerging market currencies and equities) as a lower USD encourages more buying of commodities that are priced in USD.

DBC, a commodity ETF that tracks an index of 14 commodities moves inversely to the dollar and provides a hedge to USD Index DXY.

Tiberius Coin: ‘Democratizing’ commodity metals

The Swiss-based Tiberius is a global commodities asset manager and metal merchant trader operating since 2005 based in Zug, now known as the "Crypto Valley". Its digital asset venture Tiberius Coin (TCX) is a proof-of-concept crypto representing a basket of seven industrial metals most integral to the production of future technologies, from robotics to space exploration.

The focus of Tiberius is on issuing and selling physical metals and not selling the Tiberius Coin, which will be purely a digital delivery receipt to redeem the underlying metal. According to its whitepaper it will conduct "an Initial Metals Sale ("IMS"), and not an Initial Coin Offering ("ICO")" – unlike an ICO it will already have a product, metals.

‘T-Coins’ will be issued as ERC20, eventually migrating from Ethereum to the Zilliqa blockchain, to be created when a customer buys the physical metals. According to the white paper: “The old-world parallel would be the purchase of metal from a smelter, and then asking a warehouse company to issue an identification paper upon the underlying product – something like a warehouse receipt”.

Each T-coin will have a claim upon the underlying industrial metals:

Technology metals: 25g copper, 5g tin

Electric Vehicle metals: 25g aluminium, 6g nickel, 1g cobalt

Stability metals: 3mg gold, 1.5mg platinum

Using commodities to hedge against crypto and fiat

Tiberius’ value proposition is that it is uncorrelated with crypto and its value can’t go to zero, which is due to the arbitrage incentives to buy TCX when the coin is below the cost of the underlying, redeem it for the physcial metals and resell them. This sounds like a cumbersome assumptive stability mechanism but Tiberius foresees this being practiced by wholesale investors and not individuals.

Because metals are highly liquid and tradeable across all fiat currencies (though benchmarked in USD) and, like most commodities appreciate during a time of inflation, Tiberius propose that TCX could be a useful hedge for individuals in emerging markets whose national currency is losing value due to inflation, such as the Turkish Lira, Argentinian Peso or Venezuelan Bolivar.

The performance of DBC, a commodity ETF that tracks an index of 14 commodities since 2017 compared to the Turkish Lira (TRY/USD), in orange, and Argentina’s Peso (ARS/USD) in red.

What makes a commodity coin stand out as a long-term hedge is the intrinsic utility value of the metals the natural demand for which will foreseeably only increase. This is an improvement even over USD stablecoins as the USD no longer has an intrinsic value, only nominal value as a global price benchmark for trade that can changed or phased out by competitors.

Being a Swiss company, Tiberius also keeps cash reserves in Swiss Francs, which in itself is a hedge against the USD as it is negatively correlated to the dollar index DXY and is a flight to safety currency in times of turmoil.

The dangers of a gold ETF

All ETFs have to rebalance the net asset value (NAV) of their outstanding units on a daily basis which means they must buy or sell the underlying asset to realign it with the price of each of its units. This is easier to do with stock ETFs that can acquire the shares much more readily than the physical metal, locked in vaults.

With any ETF, including precious metals, you never really own the underlying asset even if it is a physically (as opposed to futures) backed ETF. For physically backed gold ETFs such as SPDR’s GLD, which is the biggest of its kind with $30b in assets under management (AUM), if demand surges for real gold, thus demand for gold ETFs, there is the possibility that the fund provider may struggle to buy enough gold quickly enough to cope with demand and lose its peg.

The spot price of gold (XAUUSD) in red, the GLD ETF in green, and the very first gold ETF, GOLD, in blue shows GOLD started at a pegged price to XAU and GLD at the start but underperformed from 2007 onwards – illustrating not all ETFs are equal.

The strategy of passive investing spurred by the proliferation of ETFs in recent years has yet to be truly tested in a volatile market environment. There is now over $5 trillion invested in ETFs globally and this also poses a threat to stability.

When there is a broad sell-off in stock markets initially equities and precious metals correlate and fall together in the panic: this sell-off will be compounded by ETFs as there is a double up in investors (and fund managers) exposure by owning stocks outright and indirectly through investment in passive market-weighted index funds (such as the S&P 500 SPY ETF). When heavy selling begins by real shareholders in a stock this triggers fund managers/providers to compound that selling to rebalance their ETF weightings which could spiral in a panic and would affect gold and stock ETFs.

In the event of a black swan – what gold traditionally hedges against – having a paper derivative gold ETF isn’t anything near as valuable or safe as owning the physical gold – akin to subordinate shareholders in a company that is being liquidated – they will only be paid out after the bondholders and senior shareholders.

At the moment gold-backed coins, including stablecoins are in the nascent stages but offer an interesting alternative to gold ETFs.

Gold-backed cryptocurrencies

Digix Gold is the first of many proposed gold-backed cryptos to start trading, currently on Bitfinex and the Singapore-based exchange Kryptono. 1 toke of DGX represents 1 gram of Gold on Ethereum which is backed by gold from the London Bullion Market Association (LBMA) certified refiners. Similar to how USD-backed stablecoins function, DGX coins are only created when someone wants to buy gold on their marketplace by sending the required amount to the smart contract address eg. buy 100g gold = 100DGX @$39 = $3,900

Physical redemption, however, maybe more awkward as gold can only be redeemed from its vaults in Singapore.

After a volatile start in October, DGX volatility has dropped since September, with the daily 12-day average true range (ATR) under $1.

The Digix whitepaper is light on technical detail but assuming the token derives its price purely from the price of gold per gram (which spot price is valued per ounce) then the DGX token’s current price of about $39 per gram is "undervalued" compared to the spot price of gold of about $1,224 per ounce (about $43 per gram). There are currently around 83,000 DGX in circulation with a diminutive market cap $3.3m.

Digix also has a DAO governance token (DGD) which allows access to the platform to tokenize any real asset. DigixDAO is a self-organizing Ethereum entity (essentially just a smart contract) that DGX holders can participate in by voting on the governance and direction of the platform or through the advertising and promotion of it.

Digix isn’t fully a decentralized organization – it still requires trusted third party bullion custodials – and like fiat-backed stablecoins, publishes its audited holdings reports to ensure trust.

Alternatives to hedge against USD

While short-term the USD’s strength is likely to continue as there are few safer alternatives, it could be wise to hedge against the USD in the long-term. This can be done through commodities which are correlated with emerging market currencies or even through IMF Special Drawing Rights (SDR).

The SDR is an IMF-issued convertible token tied to an underlying basket of currencies including the USD, EUR, RMB, JPY and GBP. Its price is adjusted daily and can be converted into any one of the basket’s currencies. Although USD has the heaviest weighting in the basket SDR has a negative correlation with it and instead moves more in correlation with safe haven currency the Swiss Franc in times of market uncertainty. Saga is one such crypto project that pegs its value to the SDR, however, it hasn’t yet launched.

The IMF’s Special Drawing Rights (XDR), in red, is negatively correlated with the US Dollar Index (DXY), in blue.

Conclusion

The revelation of blockchain was to create a store of value and data autonomous of governments and third parties so to reintroduce it in the form of virtual fiat seems an oxymoron. Despite this, a "holy grail of crypto" narrative is pushed by the venture capitalist backers and exchanges issuing fiat stablecoins as "the low volatility crypto we’ve all been waiting for".

A degree of decentralization is also lost in commodity-backed coins as they unavoidably rely on third parties for physical storage. But holding a commodity-backed crypto could be a better long-term inflation hedge than fiat stablecoins as they stand to benefit from the premium in the underlying asset when commodity prices rebound.

Most importantly, commodity coins entitle an investor to redeem the physical good unlike an ETF which in times of turmoil will correlate with other ETF products and could potentially end up worth less than face value if it cannot rebalance with the underlying commodities during a black swan event.

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