After describing what are stablecoins in a previous op-ed, I can now explain stablecoin liquidity. Let’s start with some definitions.
This article is contributed by Carlos Tapang.
Issuer – the stablecoin issuer is the business entity that is the source of the stablecoin. In other words, the issuer is the minter. The issuing price (minting price) is the price of a stablecoin when issued to a user. The issuing price can be different from the market price.
Redemption – a stablecoin is redeemed by the issuer when the issuer takes it back from a user and returns the underlying money to the user. The redemption price can be different from the market price. Normally, the minting price is higher than the redemption price, by a small percentage. The common practice is to burn tokens so redeemed, to simplify the accounting of stablecoins in circulation.
Backing – the simplest type of stablecoin is that which is backed with what people already trust as money, for example, USD. The largest stablecoins are USD-backed stablecoins. USD-backed stablecoin issuers hold on to the USD backing. Banks can lend money deposited with them. Unlike banks, stablecoin issuers cannot lend out the backing as long-term loans. The backing must be as “liquid” as possible, redeemable with a defined delay.
Liquidity – in the context of stablecoins, liquidity refers to how fast one can sell or buy the stablecoin in the market or how fast it can be redeemed by the issuer.
As a user, it won’t matter to you how you convert the stablecoin you own to its backing currency: by engaging with the market or directly redeeming your stablecoin with the issuer. In most cases, arbitrageurs are involved and so you can get a better deal in the market than dealing directly with the issuer. However, liquidity is ultimately determined by the issuer because arbitrageurs deal directly with the issuer.
Here’s the problem any stablecoin issuer must deal with on a second-by-second basis: to fulfill the claim that the stablecoin is a central bank (CB) money equivalent, the issuer has to allow redemption of the underlying central bank money unit for every stablecoin released. For example, for Circle to fulfill the promise that each USDC is indeed equivalent to a US dollar, it allows any USDC to be redeemable for its USD backing anywhere, anytime.
Redemption is simple enough to describe in a single paragraph, but it’s not easy in practice. The issuer may indeed have billions of USD deposited in a bank to back her stablecoin S such that for every S there is a USD in the bank, but this one-to-one backing is not enough to guarantee redemption that matches the speed of a blockchain transaction. Say a user has a million-dollar worth of S stablecoins and she wants to convert that million S units to $1 million in an hour. Not possible, especially if it’s Friday at 5 pm in the location where the redemption must occur.
With blockchain and the internet, it doesn’t matter where one party is in a transaction with respect to the other party. Parties in a blockchain transaction could be thousands of kilometers apart or face-to-face, the blockchain transaction can occur at almost the same speed, anytime, no matter how much the amount. It could even be a billion dollars’ worth of transaction, at midnight on a Saturday, and it won’t matter.
The inconvenience and slowness of central bank money are no match for the 24/7 convenience and speed of a stablecoin. This mismatch is fundamental such that it is impossible to fulfill the promise of instant redemption, unless the stablecoin were backed by a central bank digital currency (CBDC). (CBDC turns out to be the only way that CB money can match stablecoins and I have more to say about this later below).
A Couple of Solutions to the Liquidity Mismatch
A lot of people think that Circle’s USDC is more stable than Tether’s USDT. Both USDC and USDT are now backed mostly by short-term US Treasury bonds, the most stable backing possible for USD-backed stablecoins. However, as with CB money, US Treasury bonds are not as liquid as stablecoins. You can’t redeem your million-dollar worth of USDC or USDT in an hour, 24/7. From this we can see Circle’s fundamental problem: Circle’s promise to redeem instantly 24/7 has less chance of fulfilment than Tether’s commitment of three to four days redemption, with a 100,000 USDT minimum, plus fees.
For us mere mortals, this difference in redemption commitment is not a big deal, but it matters a lot in the open market, where billions of dollars can be exchanged in a single day. Stablecoins are traded with each other, of course, and because this all happens on the blockchain, there is practically no liquidity issue. However, when somebody wants to exchange USDT for USD, there is a problem because of the mismatch, and in large market movements, redemptions are necessary. Tether has had no significant problems meeting the requirements of the market and therefore USDT has mostly been stable. In contrast, there had been a couple of times when USDC lost its peg, precisely because Circle couldn’t meet its redemption commitment.
Tether’s solution to the liquidity mismatch is simple but effective – make your stablecoin redemption speed match CB money speed and establish a minimum amount that can be redeemed at a time, just like any bank would. However, this solution is not competitive against crypto backed stablecoins, which is the second solution to the liquidity mismatch.
Rather than back your stablecoin with CB money, it makes a lot of sense to back it with another blockchain money. This solves the speed of transaction issue, at any amount, anytime. There are stablecoins that are backed by volatile coins like ETH, and there are also stablecoins backed by another stablecoin. The whole point is to match blockchain liquidity.
Comparison of Backing by Another Stablecoin with Backing by Volatile Tokens
The table below compares stablecoins backed by another stablecoin to stablecoins backed by volatile tokens, from the standpoint of both the issuer (and the user).
|What (and Whose Advantage)
|Backed by Another Stablecoin
|Backed by Volatile Crypto (say BTC)
|No over-collateralization necessary
|Must over-collateralize to counteract volatility
|Smart Contracts (issuer)
|Stability can be managed by smart contract
|Stability can be managed by smart contract
|Interest on backing, but may affect liquidity slightly
|Yield is possible from smart contract fees with virtually no effect on liquidity
Liquidity matching when backed by another stablecoin is achieved by basically using the stablecoin backing as a buffer storage. The issuer doesn’t promise instant redemption to the underlying CB money, but rather redemption to the other stablecoin. Of course, the other stablecoin must be established and well-trusted by the market. This type of stablecoin relegates the difficulty of managing the liquidity mismatch to the issuer of the backing stablecoin.
Central Bank Digital Currency (CBDC)
If blockchain technology is so useful, why can’t central banks implement their own blockchains? They can and it’s called a CBDC. A CBDC does not have to be backed by any CB money because it IS CB money. It would be a tokenized version of money as we know it today and no stablecoin can possibly match its liquidity.
Why aren’t central banks rushing to release their own CBDCs then? Some have; in fact, the People’s Bank of China is currently trying out a CBDC. The eYuan is the first CBDC and it is currently being used by a small segment of the population in China.
There are countries dipping their toes into CBDCs, but in general democracies have been slow to get started. Why? Because CBDCs have serious implications for democracy. The eYuan CBDC allows the Chinese Communist Party (CCP) to monitor each citizen’s account; and, because the eYuan CBDC runs on a permissioned system, it is very likely censored, meaning the government can stop transactions at the individual account level.
The main problem with CBDCs is that these are anathema to the whole idea of blockchains: while blockchain money is all about decentralization, CBDCs lead us back into centralization.
However, there’s no question that a CBDC can be very competitive against stablecoins in terms of liquidity.
Examples of Crypto-Backed Stablecoins
Let’s look at examples of crypto backed stablecoins: Liquity’s LUSD and Frax Finance’s FRAX. Both LUSD and FRAX were introduced just last year. While LUSD is purely backed by ETH, FRAX is backed by both USDC and another, free-floating token, FXS. FRAX is ranked sixth largest stablecoin (by market cap in defillama.com, see Stablecoins Circulating – DefiLlama) while LUSD is ranked eleventh.
Like FRAX, Rock Stable’s ROKS stablecoin is backed by Circle’s USDC. ROKS is designed for cross-border money transfers and daily use; and, unlike FRAX, it does not rely on a secondary token. Why not just use USDC or PYUSD? We have designed a Web3 system around ROKS that makes it very easy to convert to PHP and cashout to either GCash and Maya. We built our wallet that allows the remittance recipient to hold ROKS and cash it out anytime. Both minting and redemption can be programmed in a smart contract because ROKS and USDC are both tokens. This liquidity matching means that ROKS does not have to be traded in any centralized exchange (CEX). We are instead building a DEX exclusive to ROKS.
Currently, ROKS is very simple, and it’s focused on cross-border money transfers. It’s not available in the open market and the only way you can buy it is by sending it to the Philippines using our remittance portal https://static.sendroks.com
This article is contributed to Carlos Tapang to BitPinas: Stablecoin Liquidity
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