CBDCs: Crypto killers? Part 2

Research Feb 10, 2022

Part 2 by Ryan Shea, Crypto Economist (10 Feb 2022)

In the last article, we covered fiat backed stablecoins, next up: crypto-backed and algorithmic.

Superficially those two types of stablecoins look very similar to fiat backed stablecoins as they maintain 1:1 parity but they do so in a very different way that will be much more challenging for the authorities to deal with.  

Like Diem, crypto-backed stablecoins also ride roughshod over national borders and conventional geographic boundaries but because of their decentralized design (like Bitcoin).

One of the most popular crypto-backed stablecoins is DAI with a market cap of $9.7bn. It relies on a complex protocol/structure[1] (including keepers, oracles and MKR token holders) to maintain price stability versus the US dollar. Stripped down to its most basic level, DAI uses over-collateralized holdings in other cryptocurrencies (ETH initially but subsequently expanded to other cryptocurrencies) to back it, which in turn are further backstopped by additional decentralized pools of capital (funded by MKR tokens).

Despite aligned incentive structures, in March 2020 cryptocurrency prices tanked amid uncertainty over the impact of Covid-19 – ETH dropped more than 50% in under 36 hours - putting DAI’s infrastructure under severe strain[2]. Evidence of this strain was a surge in forced liquidations (bites in DAI terminology) with collateral being liquidated for pennies and a 13% overshoot in the DAI price relative to its $1 target. In an attempt to mitigate the risk of a repeat (high price correlation of collateral was the problem as it eroded the cushion provided for by overcollateralization) the collateral pool was expanded by a vote of MKR holders to include USDC.

Over subsequent months, additional cryptocurrencies have been added to the DAI collateral list, including other centralized fiat-backed stablecoins[3].In fact, according to the latest statistics more than half of the outstanding supply of DAI is generated from fiat-backed stablecoins as collateral[4]. Forced by market dynamics the leading decentralized crypto-backed cryptocurrency chose to become more centralized[5]. This has proved to be rather contentious with some users given it undermines the ethos of the entire project.

Certainly, increasing their exposure to fiat-backed stablecoins makes them more accessible to governments. This may not be an existential threat because faced pressure from the regulators, holders of the voting MKR token could easily reverse the decision to accept fiat-backed coins in preference to other decentralized cryptocurrencies, albeit at the cost of potentially higher price volatility.

This leads to a rather obvious question: why, if CBDCs offer the same digital functionality but without the risk of price volatility, would one want to hold crypto-backed stablecoins? Two reasons readily present themselves:

it provides unregulated access to leverage to buy non-stable cryptocurrencies, like Bitcoin or Ether, for speculative purposes.
a desire to keep transactions out of sight of the government. The latter does not have to be solely for nefarious reasons, it could simply reflect a desire for privacy. (I am not a fan of the nothing to hide argument[6],  rather I believe privacy is a basic human need and right. In the digital age this is becoming harder to achieve and hence more valued.)

Global policymakers are unlikely to find merit in either of these reasons so, presumably, with the advent of CBDCs a ban of such tokens could be attempted. I say attempted because it is far from obvious a ban could be enforced due to their decentralized nature[7] and likely geographically-wide dispersion. Such legislative action would have to be co-ordinated between governments, almost certainly at the global level, as there is no single point of failure for authorities to exploit. Only those countries prepared to firewall their entire internet, such as China, can hope to succeed[8]. What such efforts would likely do though is reduce their appeal, discouraging uptake with a large number of users.

The final type of stablecoin to consider is algorithmic. As mentioned, software and rules serve as the valuation anchor for this type of stablecoin[9]. They tend to be rather complex in their construction and are very much a work-in-progress. One such example is Terra, which relies upon a second token in its system – the Luna – to ensure its stability versus both individual fiat currencies and the SDR basket – the IMF’s international reserve asset[10]. Like DAI it’s decentralized and relies on oracles to ensure accurate price discovery. Unlike Bitcoin it validates transactions using the more environmentally friendly, and more scalable, proof-of-stake. The way it ensures the price stability of Terra is that Luna supply is adjusted to effectively absorb demand shocks in Terra. When the price of Terra exceeds its pegged value users are incentivized to burn Luna and mint Terra, increasing the latter’s relative supply and vice versa when Terra’s price is below the pegged values. It is a basic price arbitrage mechanism.

Incentives for users to hold the non-stable price token[11] Luna are they are used in governance and are staked in the mining process in return for transaction fee rewards. In addition, seigniorage which is the financial benefit that all issuers of money receive (it is the difference between the value of the token and the cost of production[12]) is burned. This is not unlike corporates using share buy-backs to return earnings to investors and provides a deflationary valuation boost to Luna holders.

It has proved a popular product with users with the Luna token having a fully diluted market cap (i.e. stripping out token supply locked up in smart contracts) totalling USD 54bn. Despite the success, Terra has two drawbacks. First, as their website makes clear, “The more Terra is used, the more Luna is worth[13].” Unfortunately, this relationship is reversible, the less Terra is used, the less Luna is worth and given Luna supply is required to maintain Terra’s peg this is critical. That said, the same applies to all cryptocurrencies and indeed money in general because of network effects.

The bigger drawback, something that is not immediately obvious – it took me some digging and thinking to get it - is its valuation ultimately relies upon the ability to convert Terra tokens back into either fiat currency directly, or into other stablecoins, most of which are backed by holding in fiat assets. (It is a very similar to the way central bank money underpins the value of commercial bank money by being a perfect substitute.) Only when users are indifferent between holding Terra and the fiat-pegged equivalent will this valuation problem be overcome. This may well occur over time if Terra proves its price-stability credentials, but it will also require widespread willingness on the part of users to hold a form of money that may not be readily convertible back into a form that can be used to extinguish tax liabilities. These are not existential problems per se, but they do not appear to be widely recognised or considered in much of the online content I have come across.

Another interesting decentralized algorithmic token is Ampleforth[14]. It is based on a series of Ethereum smart contracts designed to adjust quantities rather than prices in response to demand shocks for its tokens. It is soft-pegged at $1 and 70% of the time its price is within the ($0.95-$1.05) band which triggers supply adjustments. As explicitly stated on the website it is not a stablecoin as it uses price deviations from target to adjust supply, rather it is a “fully algorithmic unit of account”[15].  Although it uses a different mechanism to Terra because it also uses elastic token supply to maintain relative price stability vis-a-vis fiat currency it has the same drawbacks as outlined above.

Such tokens may well succeed. This is potentially bad news for the authorities because even though they are introducing legislation seeking to regulate such tokens, their decentralized cross-border nature makes implementation difficult, a ban may even be impossible. The obvious target, given stablecoins still have a necessary link back to fiat-currency is the off ramp, i.e. the conversion back to fiat. However, unless the world collectively agrees to impose a ban, penalized by a exclusion from the global financial system with potentially serious humanitarian consequences[16], all it would take is a single enterprising government[17] to allow the conversion from private cryptocurrencies into fiat to negate the global effort. Not impossible, but a serious co-operative/co-ordination challenge.

The widespread introduction of CBDCs complemented by regulation of stablecoins – in some cases as stringent as for systemically financial institutions currently – is likely to be a safer and better defensive measure. As mentioned already, money requires a network of participants for it to function. Under fiat money systems governments can enforce the network by the rule of law, private currencies must do so by incentive. CBDCs, to the extent they are viewed by users as a competitor, stand to reduce this incentive damping user uptake that these algorithmic stablecoins require to thrive.

Before finally winding up this article, which has been much longer than originally intended (apologies), I want to offer up a broad thought about stablecoins.

In the article “The Network Theory of Money”[18], I stated that one of the most compelling arguments in favour of owning private-issued cryptocurrencies is the poor global macroeconomic environment, specifically the fiscal backdrop. Meaning that
“The ability to hold one’s wealth in an asset that the government can’t print at zero marginal cost, or easily ban, but without the volatility of individual crypto-currencies is a very attractive proposition.”

The famous author and all-round financial guru, Nassim Taleb[19], in a paper published last year slamming Bitcoin (we disagree on several points[20] but difference of opinion is what drives a market)  acknowledged as much by stating
“… it is indeed desirable to have at least one real currency without a government.”

Obviously I agree, but it was the very next sentence that is most interesting in relation to stablecoins.

“But the new currency just needs to be more appealing as a store of value by tracking a weighted basket of goods and services with minimum error.”

Once again, couldn’t agree more.

An inflation-linked, low volatile form of money should be the holy grail of cryptocurrencies, preferably one that is decentralized and geographically dispersed putting it beyond the reaches of government. Not only would such an asset – assuming it can be designed – be appealing, it could also by the force of competition  provide a highly desirable disciplining force on fiat money, helping to “keep it honest”. This is something governments and central bankers would find hard to object to given that is supposed to be their current stated aim.

Such a currency may not yet exist - a CBDC is certainly not one - but there is plenty of incentive for the crypto-community to keep trying to develop one. (NB: I am happy to provide input/thoughts/feedback on any ideas or projects – just get in touch). Fingers crossed.


Until next time.

Ryan Shea, crypto economist at Trakx


Footnotes

[1]   For a good overview - see: https://makerdao.com/en/whitepaper/#use-of-the-mkr-token-in-maker-governance and https://www.placeholder.vc/blog/2019/3/1/maker-network-report

[2]   The issues were complex reflecting DAI’s complex structure but for a good overview of this episode - see: https://blog.makerdao.com/the-market-collapse-of-march-12-2020-how-it-impacted-makerdao/

[3]   There are 18 tokens that are deemed eligible collateral - see: https://blog.makerdao.com/a-guide-to-dai-stats/

[4]   See: https://daistats.com/#/overview

[5]   A further centralization issue with DAI is that less than 1% of total MKR addresses held over 90% of the supply of MKR tokens. Given these tokens are used to participate in executive votes determining governance, this gives their owners considerable sway on how the token evolves.

[6]    See: https://en.wikipedia.org/wiki/Nothing_to_hide_argument

[7]   For example, no single entity is in control of the blockchain or the governing protocol of Bitcoin and full nodes on the network have complete copies of the blockchain. Bitcore, the Github guardians of Bitcoin, could make unilateral changes to the code if they want to but this does not mean these changes will be implemented. In the event of an unpopular change users/miners only have to ignore the software update and continue running the legacy Bitcoin code. This would result in a hardfork, but Bitcoin in its unrevised form would continue to exist.

[8]   A ban on geographic spoofing VPNs would probably also be required, which is complicated by their widespread use in the business world, particularly given the rise in the work-from-home culture during the Covid pandemic.

[9]   This is not strictly true as we will go on to explain.

[10]   Like Diem the idea being that the basket approach reduces overall volatility. SDR stands for special drawing rights. It is the IMF’s unit of account and comprises of a weighted basket of five major fiat currencies, reviewed every five years. In the last review in November 2015, the CNY was added – see: https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/14/51/Special-Drawing-Right-SDR

[11]    In the face of a demand shock either price is stable or volume is stable over the short-run. You can’t have both.

[12]   It’s a revenue source for central banks in the fiat world, typically remitted back to the government.

[13]    See: https://docs.terra.money/docs/learn/protocol.html#the-market-module-and-arbitrage

[14]   See: https://www.ampleforth.org/

[15]   This is one of the three prerequisite functions of money I discussed in the previous article so it will be interesting to see how this token evolves.

[16]    Think North Korea.

[17]    El Salvador springs to mind for some reason!

[18]    See: https://blog.trakx.io/networktheoryofmoney/

[19]    I had the pleasure of meeting him several years ago. He is definitely interesting to converse with.

[20]    Taleb states that “the fundamental flaw and contradiction at the base of most cryptocurrencies is, as we saw, that the originators, miners, and maintainers of the system currently make their money from the inflation of their currencies rather, than just from the volume of underlying transactions in them.” He obviously hasn’t heard of Terra or Ampleforth – see: https://www.fooledbyrandomness.com/BTC-QF.pdf

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io