Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom), author: Qian Bojun, working at HashKey Capital Research, reviewer: Zou Chuanwei, chief economist of Wanxiang Blockchain and PlatON, published with authorization.
Editor's Note: This article comes from
Chain News ChainNews (ID: chainnewscom)
Chain News ChainNews (ID: chainnewscom)
, author: Qian Bojun, working at HashKey Capital Research, reviewer: Zou Chuanwei, chief economist of Wanxiang Blockchain and PlatON, published with authorization.
Despite the ups and downs in the cryptocurrency market this quarter, stablecoins emerged as the biggest winners in the first quarter of 2020. According to statistics from the media The Block, the trading volume of stablecoins in the market soared in the first quarter of this year, an increase of 8% from the fourth quarter of last year, surpassing the $90 billion mark for the first time in history. That compares to $250 billion in total stablecoin trading volume for all of last year.
In addition, data from Coin Metrics also shows that the issuance of various fiat-backed stablecoins on Ethereum has increased by more than 50% in the past 30 days.
What is the current status of the stablecoin market? What challenges do you face? The research team of HashKey Capital, Asia's leading digital asset investment institution, recently completed a report that deeply analyzed the feasibility, stability and potential risks of stablecoins, as well as the scale, trends, usage scenarios and regulatory issues of stablecoins.
After carefully studying the theory and various practices of stablecoins, please allow us to quickly give some overall views on the development of stablecoins:
Risk asset over-collateralized stablecoins have insufficient mechanisms, and algorithmic central bank stablecoins are not feasible.
Stablecoins are still a long way from large-scale commercial applications, and need to overcome issues such as compliance, privacy, and limited application scenarios.
For the specific analysis, we present it in two parts: the first part introduces the main design types of stablecoins and the economic analysis of their feasibility, stability and potential risks; the second part introduces the development of stablecoins and their scale , trends and usage scenarios, and discuss the regulatory issues involved in stablecoins.
first level title
Stablecoins follow the "impossible triangle" (Figure 1): each stablecoin institutional arrangement can only achieve at most two policy goals (that is, the two sides adjacent to the corresponding vertex), and it is basically impossible to achieve three goals at the same time. Tool. If you want both exchange rate stability and free capital flow (corresponding to the free exchange between stable currency and legal currency), then you can only give up the independence of monetary policy (that is, become a "currency union").
image description
Figure 1: The Impossible Triangle of Stablecoins
According to the stabilization mechanism used by stablecoins, we can divide stablecoins into three categories: fiat currency reserve-backed, risky assets over-collateralized, and algorithmic central bank.
secondary title
The value of the fiat currency reserve-backed stable currency comes from the fiat currency reserve. Users exchange stable currency with the stable currency issuer at a ratio of 1:1. The stable currency issuer opens a bank account and relies on a centralized custodian agency to host the user's legal currency pool. The structure can be regarded as a digital bank deposit. The stablecoin exchange object can be the original issuer, or a third party holding stablecoins or fiat currencies. The stablecoin is similar to how the U.S. dollar is pegged to gold in the Bretton Woods system.
The fiat currency reserve stablecoin is currently the largest and most widely used, and it is the type of stablecoin with the highest market share. USDT issued by Tether, TrueUSD issued by TrustToken, USDCoin issued by Circle, etc., and the two stablecoins GUSD and PAX approved by the New York Financial Services Agency are all such stablecoins. The most representative of them is USDT.
distribution mechanism
Fiat reserve stablecoins can be divided into two types according to the issuance mechanism, the Money Service Business model and the Trust Company model.
image description
Figure 2: Fiat Reserve Stablecoin Issuance Mechanism
trust institution model
Stablecoin issuers under the trust agency model need to obtain a trust agency license and have the nature of fund custody. Such stablecoin issuers not only undertake the custody obligation of user funds, but also are stablecoin issuers, subject to strong government supervision. Gemini and Paxos are currently the only stablecoin issuers that have obtained trust agency licenses. In addition to hosting digital assets, it can also host legal currency assets, securities and gold, with a wide range of business.
Compliance is a major advantage of trust institutions, and the trust charter approved by the New York Department of Financial Services (NYDFS) is currently the highest level of supervision. The government has the power to freeze accounts and audit account balances. The trust agency will purchase insurance for the fiat currency reserve and store the funds in a segregated account. The bank account where the fund pool is located is protected by the U.S. federal deposit pass-through insurance with an insurance amount of 250,000 US dollars. Tether, the parent company of USDT, has the problem of opaque funding status, which often raises regulatory doubts, and the openness and transparency of the trust institution model has its market competitiveness.
Fund service provider model
The fund service provider is registered in the United States in the form of MSB, and cooperates with traditional trust institutions to issue stable coins. The specific mechanism is as follows: the user transfers USD to the cooperative trust institution, and the cooperative trust institution sends a message to the stablecoin issuer to confirm the purchase behavior. Afterwards, the stablecoin issuer releases the stablecoin to the user. Under such a mechanism, the fund service provider model only involves the issuance of stable coins, without the nature of fund custody. The fund service provider model is subject to strict audit and legal supervision. Currently TUSD and USDC fall into this category.
There are two main differences between the fund service provider model and the custodian institution:
The former do not assume the obligation to custodial funds, but transfer the risk to more strictly regulated banks. The latter involves the hosting business.
The scope of the former business license is limited to digital assets, but business expansion is more flexible. As long as the business does not involve securities digital assets (Security Token), it does not need to be reported to the regulatory agency.
Stabilization Mechanisms and Economic Models
Fiat reserve stablecoins must follow three rules to maintain stability.
Issuance rules: Centralized trusted institutions issue stable tokens based on a 1:1 relationship with mortgaged legal currency.
Two-way exchange rules: The centralized trusted institution ensures the two-way 1:1 exchange between Token and mortgage legal currency. The user mortgages 1 unit of legal currency to the centralized trusted institution, and the centralized trusted institution issues 1 unit of stable currency to the user. The user returns 1 unit of stable currency to the centralized trusted institution, and the centralized trusted institution returns 1 unit of mortgaged legal currency to the user.
Credible rules: Centralized trusted institutions must regularly accept third-party audits and fully disclose information to ensure the authenticity and adequacy of the mortgaged legal currency used as a Token issuance reserve.
Under the constraints of these three rules, the stability of fiat currency reserve stablecoins is controllable, and the core lies in purchase and redemption arbitrage: as long as there is a high-liquidity purchase and redemption channel, you can find the price difference in the market and carry out arbitrage. This type of stable currency is backed by legal currency of the same value, and users expect the medium and long-term market price to converge to the anchor price. Once the market price deviates from a reasonable range, there will be profit margins, which can attract stablecoin users to participate in market regulation.
In theory, it is not necessary to hold 100% fiat currency reserves to meet most of the stablecoin redemption needs. If the price of stablecoin is allowed to fluctuate slightly and the redemption of stablecoin is controlled in extreme cases, it should be able to reduce the requirement for legal currency reserves and realize stablecoin at a lower cost, but it means greater risk. In this case, in addition to the benefits generated by the actual demand scenario, fiat currency-collateralized stablecoin issuers have two parts of economic benefits: seigniorage and legal currency reserve management benefits.
credit risk
First look at seigniorage. If stablecoins do not have 100% legal currency reserves, the multi-issued stablecoins do not have legal currency reserves as a support, but they also meet the needs of stablecoin holders, which is equivalent to issuing a part of stablecoins "out of thin air". These stablecoins have purchasing power in the real world, corresponding to the concept of seigniorage. This is the case with USDT. Although there are many doubts about USDT in the market, there has been no centralized and large-scale redemption of USDT so far (of course, Tether, the parent company of USDT, has also imposed various restrictions on redemption). Assuming that for a period of time, the supply of stablecoins has increased by ΔM "out of thin air", and the current price level is P. The issuer of stablecoins can purchase goods and services with a quantity of ΔM/P in the market by issuing stablecoins "out of thin air", that is seigniorage. In the USDT scenario, P can be understood as the price of Bitcoin.
Next, look at the benefits of reserve management. Except for a part of the legal currency reserve invested in highly liquid assets that can be realized at any time, the rest can be invested in higher risk investments to obtain higher returns. Because the stablecoin issuer does not pay interest to the holder, the reserve management income is all owned by the stablecoin issuer.
There is a risk
The credit risk of stablecoins comes from two sources. First, the credit risk of the stablecoin issuer, which comes from the uncertainty of the stablecoin issuer's ability to bail out when the currency price is de-anchored. Seigniorage and reserve management benefits may create moral hazard for stablecoin issuers and ultimately manifest as credit risk. If stablecoin issuers pursue seigniorage and reserve management benefits too much, and increase the ratio of stablecoin amount/legal currency reserve indefinitely, or the ratio of legal tender reserve used for high-risk investment, it will hurt the stability of stablecoin. Persistent. When there are centralized, large stablecoin redemptions, issuers may not be able to pay out fiat currency. In addition, opaque asset reserves and poor governance are one of the risk points for stablecoin issuers.
Second, the credit risk of centralized custody institutions. The credit risk of fiat currency custodian institutions is affected by many factors, including the regulatory level of the institution's location and its own risk control capabilities. For example, fiat currency received by stablecoin issuers is deposited with a specific bank located in a country with an inadequate deposit insurance system. If the bank encounters a major business crisis such as bankruptcy, the stablecoin issuer will face the risk of default.
lack of liquidation liquidity
In a payment system with a very large amount of liquidation, if the commercial bank's reserves in the central bank are unable to meet the payment needs, the central bank will meet the demand by overdrafting the commercial bank (called Intraday Credit). However, the issuance of stable coins is limited by the balance sheet and lacks flexibility. It may be difficult to perform the payment and settlement function well when the liquidation volume is large.
secondary title
Over-collateralization of risky assets
Such stablecoins are issued through over-collateralized risk assets, and most of them are anchored to the US dollar 1:1. At present, most of the risk assets used for mortgage are encrypted assets. The price volatility of risk assets is high, and the value of the stable currency cannot be supported when the price drops sharply, so over-collateralization is a must. Most of the over-collateralized stablecoins of risky assets use the adjustment of collateral ratio and liquidation threshold to stabilize the currency price. Dai, Havven, BitUSD all fall into this category.
distribution mechanism
governing body. The governing body decides the liquidation threshold, guarantee ratio and handling fee, and is responsible for adjusting the parameters to maintain the stability of the currency price.
stabilization mechanism
Stabilizer (Keeper). Stabilizers are driven by economic incentives and participate in debt and collateral auctions when liquidating collateral. Another function of the stabilizer is to stabilize the currency price. When the market price and the anchor price are out of anchor, the stabilizer makes the market price converge with the anchor price by buying or selling stable coins.
Oracle. Stablecoin issuers need oracle machines to provide real-time price information of collateral assets to decide when to liquidate. Stablecoin issuers also need real-time stablecoin market prices to determine whether the currency price is unanchored.
Stablecoin users. In the process of exchanging stablecoins, users need to establish a collateral position and transfer the collateral into the position. Then, the user decides the amount of stablecoin he needs to exchange according to the value of the collateral, and the corresponding amount of collateral in the position is frozen. Finally, when the user wants to redeem the mortgage assets, he must repay the debt in the mortgage position and pay the handling fee.
stabilization mechanism
Over-collateralization of risky assets has the characteristics of highly volatile mortgage assets and requires a suitable stabilization mechanism. There are four stabilization mechanisms for risk assets over-collateralized stablecoins:
Arbitrage Mechanism
Theoretically, the anchor price and market price ratio is 1:1. When the market price of stablecoins is lower than the anchor price, users can purchase stablecoins in the secondary market at a lower cost, liquidate mortgage positions in advance, and exchange them for collateral. On the contrary, increase the exchange of stable coins and sell them in the secondary market for arbitrage.
But in fact, the arbitrage mechanism of over-collateralization of risky assets is not as effective as in fiat currency reserve stablecoins. Take Dai as an example. When the market price of Dai rises to $1.01, arbitrageurs will spend $1, buy $1 worth of ETH collateral and generate Dai. Currently, the collateral ratio of Dai is 150%. By mortgaging $1 of ETH, arbitrageurs can obtain 0.67 Dai. Arbitrageurs can sell 0.67 Dai for a 1% profit premium.
However, the ETH mortgaged by arbitrageurs is still locked in the mortgage position and cannot be redeemed. ETH is a highly volatile asset, and it has been locked in the mortgage position for too long, and it needs to bear the risk of ETH falling, which is not conducive to arbitrageurs to control the income. Moreover, arbitrageurs need excessive capital costs (33%) for mortgage arbitrage, which further reduces the efficiency of arbitrage.
Collateral Ratio and Liquidation Threshold
stability fee
The stability fee is the most important way for MakerDAO to stabilize the currency price, expressed in annual percentage income. The mechanism of the stability fee is as follows: when the user redeems the mortgage assets, in addition to repaying the debt in the mortgage position, a stability fee must be paid. Stability fees are paid by collateral position owners in MKR, and the MKR used for payment is burned.
Theoretically, when the stability rate increases, it will cost more to return Dai in exchange for ETH mortgage assets in the future (pay with MKR). Rational investors will choose not to generate Dai, and the supply of Dai will decrease, and the price may rise; otherwise, the supply of Dai will increase, and the price will fall. This is the theoretical basis for MakerDao to maintain the 1:1 anchor between Dai and the US dollar.
According to CoinMarketCap data, the price of Dai has been below $1 since February 2019. The governing body initiated a vote to increase the stability rate, allowing Dai to return to the anchor price. From January 2019 to May 2019, MakerDao raised the stability fee eight times, from 0.5% to 19.5%, an increase of 39 times.
image description
Figure 3: Dai USD Price
As can be seen from the above figure, adjusting the stabilization rate is not an effective price stabilization mechanism. Stabilization rates are no match for central bank policy rates. When the central bank raises interest rates, the demand for people and enterprises to borrow money for consumption and investment will decrease, thereby reducing the money supply; some short-term liquidity funds are converted to longer-term deposits to obtain high interest income, which will also reduce the money supply. It is not direct enough to reduce the supply of Dai by increasing the stable rate, and the effect remains to be seen. And so far, most users hold Dai for leveraged investment. The stable rate adjustment of Dai cannot affect the market supply and demand structure, especially during the rising period of ETH price.
global liquidation
When a black swan event occurs in the market, the collateral depreciates rapidly, and the system will cause the liquidation mechanism to fail because it is too late to liquidate the collateral. Therefore, the risk asset over-collateralized stablecoin system will set up a global liquidation mechanism. The global liquidator is appointed by the governance body and has the power to terminate the entire system in special cases. When the global liquidation starts, the system will be frozen, and all stablecoin mortgage positions will be liquidated by the system at the market price, and the collateral will be returned.
Feasibility and Risk
From the collapse of the encryption market on March 12, 2020, it can be found that leveraged investment within the DeFi ecosystem poses great risks to MakerDAO. Beginning in 2020, investors are expecting Bitcoin to be halved, making the market dominated by long positions, and many investors use leverage. There are two main leverage behaviors in the DeFi ecosystem:
Generate Dai by staking ETH in MakerDAO, and then use Dai to buy coins for investment.
Financing by staking tokens in DeFi decentralized lending. The leverage behavior in the DeFi ecosystem is nested in multiple layers, which is obviously pro-cyclical and unstable, and there are two layers of risks:
On-chain congestion risk
Originally, according to MakerDAO’s system settings, the liquidated collateral has a discount compared to the market price, which can attract stable investors to participate in the auction debt, and the final winning bidder can get at least a 3% discount. However, stable players who should participate in the liquidation process cannot bid because they set a low gas value. In an environment with no other competitors bidding, a stabilizer won all liquidated debts for 0 DAI. MakerDAO suffered $4 million in bad debt losses and needed to repay these debts by auctioning internal MKR.
The first phase of the debt auction was completed on March 19, and the second phase is underway. A total of 17,637 MKRs have been sold at a total price of 4.3 million Dai. The average price of a single MKR is 245.97 Dai, which is slightly lower than the current market price of 259.84. MakerDAO has improved the mechanism of this chain congestion risk and added an auction circuit breaker mechanism: when the market fluctuates violently, MakerDAO can suspend the collateral auction.
Procyclicality brought about by high leverage
The core mechanism of MakerDao is to lend Dai by overcollateralizing ETH, which has the nature of leveraged transactions. When the market sentiment is good, users will repeatedly mortgage ETH and lend Dai for investment, cyclically amplifying leverage. And when the price of ETH drops sharply, the guarantee ratio will drop sharply. Once the guarantee ratio is lower than the liquidation threshold, mortgage debt positions will be liquidated in batches, and the cyclically enlarged leverage will multiply the default positions. The liquidation of collateralized debt positions means that the ETH used as collateral is sold, which will further amplify the decline in ETH prices.
Algorithmic Central Bank Stablecoins
However, although these projects have their own stabilization mechanisms, large-scale currency price decoupling events have occurred and it is difficult to recover. For example, NuBits has experienced two price decouplings. The decline in the price of the currency caused panicked stablecoin holders to dump NuBits in large quantities, causing the price to collapse, and the currency price has since been unable to anchor the currency price to $1. It is now about $0.03 per NuBits with a historical volatility of about 40%.
first level title
market value
secondary title
Stable currency scale and development trend
market value
In 2019, more than $237 billion was transferred on-chain via stablecoins. The total market capitalization of stablecoins also climbed from $2.8 billion to $4.4 billion.
image description
USDT (which is based on Bitcoin’s Omni protocol and Ethereum’s ERC-20 protocol) accounts for 80% of the total stablecoin market cap, more than all other stablecoins combined. USDC and Paxos rank second and third, accounting for 9% and 4% of the total stablecoin market capitalization respectively. From the perspective of time changes, we can find three phenomena:
The introduction of multi-collateral Dai has significantly increased the market value of Dai.
Trading volume
image description
Figure 5: Changes in the market value of stablecoins, except USDT
The average daily trading volume of stablecoins is dominated by USDT, accounting for about 95% of the total. According to CoinMarketCap, the 24-hour trading volume on March 9, 2020 reached $54.7 billion. The figure below is a line chart of the historical transaction volume of the top six stablecoins in the market. The main coordinate is the USDT transaction volume, and the secondary coordinate is the transaction volume of other stablecoins.
volatility
Figure 6: Changes in the daily trading volume of stablecoins
volatility
trend
Currently, the fiat currency reserve-backed stablecoins on the market mainly use the U.S. dollar as the anchor fiat currency, such as USDT, TUSD, GUSD and USDC. The chart below shows the daily volatility of various stablecoins and HKD/USD. The daily volatility of stablecoins is about 5-10 times that of the Hong Kong dollar and the US dollar, and between 5% and 10% of encrypted assets. Although stablecoins can be used as value storage or means of payment in the encrypted asset ecology, there is still a gap in the stability of stablecoins compared with foreign exchange currencies.
image description
Figure 7: Daily volatility (%) of stablecoins, Hong Kong dollars and encrypted assets in USD prices in the past 180 days
trend
Unlike Tether, USDC is issued by a regulated financial institution. Circle, the issuing company behind USDC, has payment licenses in the United States, the United Kingdom, and the European Union. The characteristics of USDC transparency and security, multi-national regulatory credit endorsement and more standardized financial audit mechanism have all become competition highlights. After USDT reported insufficient fiat currency reserves, from October 2019 to February 2020, the average daily transaction volume of USDC increased by more than 500%. Paxos and TUSD also saw a 300% increase in volume.
In the future, we can expect a competitive landscape of "one superpower and many strong" in the stablecoin ecosystem. Despite frequent compliance issues with Tether, USDT has dominated the market. There are two main reasons:
User inertia. Cryptocurrency investors themselves have a high tolerance for risk. Most users pay more attention to the operation experience such as convenience and mobility. At present, USDT is the main fiat currency deposit channel for users, and users have a strong trading inertia.
Ecologically complete. USDT is listed on almost all exchanges, with sufficient liquidity, it is a good trading medium, and exchanges reserve a large amount of USDT. If the USDT market collapses, exchanges will face serious losses.
Stable currency application scenarios
to pay
Crypto Assets TradingCurrently, the largest usage scenario for stablecoins is encrypted asset transactions, which serve as the largest medium for fiat currency deposits. The main place to buy digital currency is the major trading platforms, and many of these trading platforms do not support the direct exchange of legal currency for digital currency. Users need a digital currency with a relatively stable price as an intermediary to exchange. For traders, stablecoins are more cost-effective, with simpler procedures and processes, supported by many exchanges, and do not need to involve banks or other intermediary structures.Crypto-asset traders often convert crypto-assets into stablecoins to temporarily "lock in" profits, thereby shifting exposure to relatively stable assets, especially during times of volatility in the crypto-asset market. Likewise, cryptoasset miners convert their cryptoassets into stablecoins to reduce their directional risk on the cryptoassets they mine.
to pay
Article analysis
. At present, privately issued stablecoins are more used for encrypted asset transactions, but attempts in the field of retail payments are also gradually increasing.
Coinbase Commerce, the payment service of the Coinbase Exchange, added USDC, which was jointly developed by itself, to one of the payment channels in May 2019, and has completed more than $50 million in retail payments. Coinbase aims to drive the retail payment customer base through the USDC encrypted asset trading customer base.
Paxos partners with debit card issuers Spend.com and Crypto.com. Users who hold Paxos stablecoins can directly use them for daily payments. Consumers paying through Paxos enables partner merchants to receive payments immediately, eliminating the settlement risk of merchants using credit card systems.
secondary title
Regulatory Issues Involved in Stablecoins
Stablecoins have many characteristics of encrypted assets, as well as the attributes of traditional finance. The diversified financial attributes of stablecoins increase the complexity of supervision. The regulatory issues involved in stablecoins can be divided into three parts: legal entity establishment, financial anti-money laundering and tax issues.
Establishment of legal entity
At present, the legal entity of the stable currency has not yet been finalized. The legal entity of a stablecoin is established by a clear and well-established contract between the user and the stablecoin issuer. The contract needs to disclose the rights and obligations of both parties, including:
Establish the equity and legal structure of the stablecoin issuer.
tax
Establish the financial attributes of the stable currency and the attribution of the income of the fiat currency pool.
Financial Anti-Money Laundering
Stablecoins pose new risks in terms of money laundering and terrorist financing. Although the decentralized nature of stablecoins is not controlled by individuals or groups, stablecoins have the nature of fund transmission and reception, which meets the definition of money services business (MSB) of the Financial Crimes Enforcement Network (FinCEN) under the U.S. Department of the Treasury. FATF has also established a new regulatory framework for AML/KYC, requiring stablecoin issuers to propose KYC solutions. How to expand business in the compliant field in the future will become a topic for stablecoin issuers.
