Stable coins: Backed enough for the future?

Until now, stable coins have been used almost exclusively by traders which has driven the volume and market cap of USD Tether (USDT) soaring. In the short-term it is fair to say that, for traders, it doesn’t appear to matter how the stable coin is pegged, backed or governed, so long as it reflects $1 because, despite its lack of transparency, its centralization and business relationships, USDT dominates the stable coin market with a market capitalization over 30-times that of its nearest competitor, TrueUSD (TUSD).

What purposes a stable coin should serve

With so many different asset iterations and methods being used to peg stable coins to real world prices we should evaluate each coin on how well they function in the following roles:

• A stable currency for large hedgers
• Safe haven for traders
• Doesn’t fluctuate in volatile times
• Easy to transact with for businesses/consumers
• Protects against inflation

The idealized “perfect stable coin” would serve all the purposes above and combine the benefits of a decentralized crypto with the universality and fungibility of a fiat that can’t be debased and holds its value during volatility.

Quest for the ‘Holy Grail’ stable coin

In economics, there is a term known as the ‘impossible trinity‘ which states that central banks cannot fulfill all three of the following functions at once:

1. set a fixed exchange rate between its currency and another while allowing capital to flow freely across its borders,
2. allow capital to flow freely and set its own monetary policy, or
3. set its own monetary policy and maintain a fixed exchange rate.

There are projects, such as Basis, striving for a decentralized central bank that could possibly fulfill all the functions in this trilemma model when traditional central banks are failing. Achieving such a DAO with its own currency would be something of a holy grail not just in crypto, but economics in general.

Evolution: From stable coin to multi-coin economies

While there are literally dozens of stable coin projects underway and under construction, for the purpose of this discussion we’ve only included the most salient in terms of debate/media coverage.

In 2014, the first stablecoin, BitUSD, was launched on the decentralized exchange BitShares purely as a trading instrument priced 1:1 with the USD but only backed by the platform’s native token. Tether was created shortly after as a digital representation of USD with “100% reserves” of USD backing the supply.

Tether has been criticized for being – among many other things – too centralized and in the new “third generation” stable coins there has been a trend towards creating multi-coin economies that operate autonomously in the vein of a DAO. MakerDAO with its MKR and DAI coin is one prominent example of a functioning stable, multi-coin project and Havven recently launched its stable coin Nomin, nUSD, backed by its HAV token.

Big money is getting behind the stable coin movement. Crypto unicorn Circle is also about to launch its own Tether rival, called USDcoin. The distribution of USDcoin will be governed by a central company set up by Circle – aptly named Centre – that will be a membership-based body of corporations that want to issue stable coins versions of various fiat currencies. IBM, which is betting on all things blockchain, is also getting behind Stellar network’s Stronghold stable coin.

The quest for this “Holy Grail” of currencies is also being taken seriously in academic circles, as evident from the by high profile advisors behind upcoming projects. Saga, the fractional reserve stablecoin, is being advised by the chairman of JP Morgan Chase Jacob Frenkel; the co-creator of CME financial futures Leo Melamed; and Dan Galai, the developer of the CBOE volatility index (VIX) and Nobel Laureate Myron Scholes. Stanford economist John Taylor is an adviser for the  algorithmic central bank stable coin Basis, formerly Basecoin.

Despite the proliferation of new breeds of stablecoins and all the criticism it has received, USD Tether dominates around 90% of the USD stablecoin market. That may infer traders and exchanges have been happy to forfeit the decentralization of a cryptocurrency for the sake of expediency and cheaper transaction fees.

Different tokes for different folks

With the year-to-date volatility of bitcoin (perhaps the least volatile crypto of non-stablecoins) around 5-times that of Apple based on an average true range, many believe the lack of stable currency is the main thing hindering the mainstream adoption of crypto.

A well-functioning stablecoin would bring in institutional and industrial players and incentivise individuals to spend the assets instead of holding them.

Below are some of the players that could benefit from a stablecoin and how it could benefit them:

• Employers paying salaries
• Employees paying rent/retail spending
• Traders as a safe haven asset, fungibility, global access and for arbitrage
• Hedgers as a store of value eg. mining company protecting against fluctuations in oil price

Where is demand for USD Tether coming from?

Outside of traders and boutique Hedge Funds specializing in crypto there is no evidence of any other industry or institutions making use of stable coins. Over the past year Tether saw 10x growth in market cap and 36x increase in traded volume.

The charts above and below show a comparison of the trading volume for bitcoin and ether in USD vs. USDT. The combined market capitalization of both crypto assets represents over three quarters of the total crypto market. These charts demonstrate a complete flip away from USD trading of bitcoin and ether accounting for 90% of all volume last year, to USDT trading now dominating the market by as much as 90% and USD as little as 10%.

 Demand for USD Tether not coming from US

Tether is by far the most traded stablecoin and has maintained a remarkable stability against the USD since its inception in 2015 despite surges in volume. Despite this it isn’t traded on many of the most “official” (and popular) US exchanges – Coinbase, Gemini, and Kraken. And its centralization (one company handles all the USD reserves backing the currency) and lack of banking transparency undermine it as a viable safe haven fiat alternative for real businesses/enterprise.

Although Tether is not legally obliged to disclose the location where it holds billions of dollars on deposit, evidence points to the funds being kept with a Puerto Rican bank, Noble.

Chinese demand driving USDT volume

The surge in volume and market cap in USDT against BTC and ETH in particular can be largely attributed to the proliferation of crypto-to-crypto (C2C) exchanges which are now some of the world’s biggest exchanges by volume.

Five of the top 10 global exchanges by reported volume are Chinese – OKEx, Huobi, ZB, LBank and BiBox – and do the majority of their volume in USDT pairs. However, many of these exchanges are known for fabricating their volumes.

Crypto-to-crypto exchanges have proven wildly popular among retail traders as they offer a wider selection of assets, cheaper fees (some even offering zero fees) and others offer rebates for trading in USDT pairs. On their part, trading C2C relieves exchanges of the burden of banking millions/billions of real USD and the custodial hassles involved.

From 2013 to 2017 fiat-to-crypto exchanges flourished in China and at one point the Chinese Yuan (CNY) accounted for over 90% global bitcoin trading volume until the government outlawed all crypto exchanges in September 2017, forcing many to close shop and others to move jurisdiction. Despite the ban, there are still dozens of Chinese exchanges operating outside the mainland (primarily in Hong Kong) and others that have set up in Hong Kong since the ban.

Trading in BTC/CNY fell off a cliff in December/Jan 2016, possibly on the back of a government warning to exchanges around security and the exchanges’ subsequent ban on all BTC and LTC withdrawal from February to July 2017 while they upgraded their systems.

Chinese ban causes flood into USDT

In late September 2017, the Chinese government ordered all fiat-crypto exchanges to cease operations and outlawed all ICO activities. This effectively killed off what was left in CNY/BTC trading volume as exchanges closed shop and others relocated to continue their operations, followed by many traders. This last drop in CNY/USDT also coincided with the ramp up in BTC/USDT.

Shortly after leaving from China, in late October 2017, two of its biggest exchanges OKEx and Huobi added USDT to their pairs, followed by many other smaller exchanges LBak, ZB.com etc. Around this time, trading volume in USDT started an exponential climb from November 2017 onwards.

It’s important to remember with the surge in USDT volume and market cap that it is mainly traded on Asian, and particularly Chinese exchanges, which have become synonymous with volume manipulation, washtrading and, more recently, trade mining. What is clear is that there is very little US demand for USDT as none of the top US exchanges offer it (Bitfinex, Gemini, Coinbase Pro, Kraken, BitStamp). Only Bittrex offers USDT trading.

Huobi and OKeX have been among the top 5 biggest global exchanges but both have also come in for a lot of scrutiny of their reported volumes and accused of faking up to 93% of their daily volumes. Trading in USDT pairs account for the majority of volume on both exchanges and if they are fabricating their volumes the “fully backed” USDT isn’t providing the 1:1 digital representation of USD it’s meant to but is a conduit for fraud.

Wash trading isn’t limited purely to crypto-to-crypto (C2C) exchanges and fiat-to-crypto (F2C) exchanges like Bithumb and Bitfinex have also been accused of falsifying volumes. When we compare the average volumes of BTC/USDT trading on the top five C2C exchanges with the top five fiat-to-crypto (F2C) we could assume that C2C have recently overtaken in them in terms of bitcoin trading.

C2C: Binance, OkEx, Huobi, ZB.com, HitBTC     F2C: Bitfinex, Kraken, Bithumb, Coinbase, Bitstamp

Trade mining also inflates Tether volume

“Trade mining” is a more explicit strategy to manipulate exchange volumes and has recently become a trend among Asian exchanges, again many of which are Chinese (Coinegg, FCoin, BitForex). Boldly advertised on their websites, traders can “earn free tokens” (created by the platform with no other utility than speculation) with every trade they place on major USDT pairs (BTC, ETH, EOS etc). This “rebate” has had a similar effect to wash trading and exchanges active in the practice have been dropped from Brave New Coin’s asset pricing.

Much demand for USDT is being driven by fabricated Asian demand.

The chart above shows the ramping of BTC/USDT trading volume during the "trade mining" offer on Chinese exchange BigOne. As we can see volumes were turned on and off like a switch with the suspension and resumption of the offer, taking BigOne from obscurity to briefly doing more BTC volume than Binance.

Backed for the future?

As we have seen throughout, any successive stablecoin will have a long way to go to dethrone Tether as the de facto digital USD. From the uptake in volume and its undeniable success at pegging within a very narrow volatility band over the years, a superior stablecoin will have to offer more than just more transparent banking to take a significant share from Tether.

It’s unlikely crypto-liberals or those people it was created for (victims of hyperinflation and constantly debased currencies) would be enthused about complex projects like Saga or Basis although they might serve the needs of finance and wealth management industries.

The MakerDAO (Dai) sticks to the libertarian crypto ethos of being a decentralized asset and its own autonomous entity. If an official digital dollar was issued, however, would it render USD-pegged stable coins obsolete? It could come down to philosophical semantics: would you rather put your faith in a centralized entity (US Federal Reserve) or a decentralized body?

Going by real world precedents, currency pegs in the real world have been notoriously prone to attack by speculators and exogenous shocks – the Mexican Peso Crisis in 94; George Soros’ run on the British Pound in 1992 and more recently the Swiss Franc unpegging from the Euro in 2015.

Will stable coins may just be another flash in a crash.

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Since stable coins were first proposed as a less volatile arm of cryptocurrency their intended role has expanded far beyond an instrument for pure arbitrage to the lofty realm of a global currency ‘Holy Grail’. The race is truly now on to build the first institutionally adopted, universally accepted stable coin, with Tether rivals TrueUSD, Havven, USDCoin and Stronghold all joining the fray. But are stable coins being used in enterprise for any practical purposes or are they just a conduit for trading on the crypto markets?