Let’s face it, cryptocurrency is a mess. I’m sure nobody who reads my blog has any doubt that I’ve never been a fan of the concept. “Currency” that has nothing behind it is just a bubble-in-waiting. But what about the stablecoin concept? Suppose you pegged crypto to an asset? Could that solve the problem? That’s a big “Maybe”.
The framework for stablecoin, as Wikipedia describes, involves backing it with a reserve of a specific asset or asset class. That asset can be money (US dollar, for example), a commodity, stock or fund, etc. The theory is that as long as the stablecoin represents a real asset, its value is tied to that asset. The holders of a stablecoin could demand redemption in the underlying asset if they thought the coin was in a bubble state, and the asset’s value would set a floor price. It’s a great idea but there are some major caveats.
The first caveat is the reserve requirement. Suppose I mine a trillion dollars worth of my stablecoin and back it with ten bucks. Obviously, if holders lose faith (which they should), there isn’t nearly enough reserve to actually allow them to convert their stablecoin holding to the underlying assets that “back” it. How much reserve do you need, and do you need to adjust reserve levels as the quantity of stablecoin holdings that those reserves back increase due to mining?
Then there’s the question of how the reserves are held and accounted for. Suppose I back my stablecoin with what I purport to be US dollar holdings in the Last Bank of Under Foramia. Can we trust that custodian to certify reserve levels? Can we trust a promise to redeem even if they make one? Some proposed regulations would require a major-bank reserve system, but many in the crypto world object.
Suppose, though, that we have credible reserve levels and credible custodial facilities. We back our stablecoin with US dollars. The problem is that people buy crypto because they think it’s going to explode in value. Does the stablecoin appreciate faster than what backs it? If it does, then the reserve assertions become useless. If it doesn’t, why not stuff dollars in your mattress?
What if the stablecoin claims to have fixed backing but also invests the money in something that can actually appreciate? Let’s suppose that we have dollar reserves and we promise to invest stablecoin funds in the S&P 500 index. OK, that might address some of these issues, but it raises the question of why you couldn’t just buy an S&P 500 index fund. Could a stablecoin reserve of dollars have met the demand for redemption we might have seen in 2022? If it could, then a major chunk of fixed assets lie behind the coin, and that can’t be invested or it’s not in reserve, so the upside of this model isn’t as large as the upside of the S&P.
But we’re not done yet. Consider the question of the honesty of the stablecoin issuers and the exchanges that handle them. Every intermediary player in a model like this expects to make a profit, will have to make enforceable financial and legal commitments, and could be subject to hacking and other forms of fraud. If I hand you what I purport to be a dollar, you have only me to hold accountable if it isn’t true. If I hand that same dollar to a chain of a hundred people who must cooperate to pass it to me, anyone along the way can defraud you and there’s a good chance you’ll spend more than a buck figuring out who to sue or charge.
Blockchain security and distributed validation aren’t the answer either. A stablecoin blockchain could be totally valid, but the underlying reserve might be worthless, which means that as soon as people start to doubt the value proposition the whole thing falls apart like the Dutch Tulip Bubble. Validation by acclimation isn’t helpful here because the “value” is what needs validated, and even if a million crypto enthusiasts said they backed a given stablecoin, could you sue them all to recover your losses?
The issues with FTX have certainly impacted crypto’s credibility, but there are two basic truths to contend with at this point. First, crypto has always been a major risk proposition because it’s a natural bubble; value is set by buyer sentiment alone. Second, regulators should have taken action on this from the first, because it would be a major financial problem for many if they tried to do the right thing now. These points should be considered now with stablecoin.
I don’t think stablecoins are really stable at all; they hide risk in a different and likely more effective way, but that only makes the risk worse. So, while it may be too late to get control of crypto overall, it’s perhaps not too late to get control of stablecoin, and to establish it as a kind of halfway point between the wild west of crypto and the at-least-familiar risks of Wall Street. How?
The regulatory measures that are being discussed are a part of the answer. We need to have stability in stablecoin, not just to preserve the meaning of the term but to prevent them from being a problem even greater than that of cryptocurrencies in general. The foundation of all currency, crypto or otherwise, is the full faith and credit of something whose faith and credit are credible to all.
The second thing we need to do is ensure that the blockchain process doesn’t either enshrine or at least tolerate practices that could render all that credibility worthless. We have to protect currency from counterfeiting, and we need to do that with stablecoins. That doesn’t just mean ensuring that a given token is valid, but also that tokens aren’t created outside the framework of the backing that roots them. Reserves have to be maintained as needed, which means that we have to limit mining to the amount that the reserves cover.
All that’s fine, but it isn’t the big issue. That big issue is the why. Why are we creating a stablecoin? Just to demonstrate cryptocurrency and blockchain, or promote Web3 concepts? To be really stable it has to be a financial instrument that’s as trustworthy as a dollar or a stock certificate. So why not have physical currency or stock certificates? I know that “money” and “stocks” really exist more as an electronic record than as something real, but that only makes the “why” question more important.
Stablecoin can be a real value if it can present something old—trusted records of financial assets—in a more useful form. What utility are we seeing? A good answer to that will justify the other steps that need to be taken. If we can’t offer one, then we have to assume that the goal here is the same as it is for many new “investment vehicles”, and that’s to fulfill the financial markets’ ever-growing desire to create bubbles. We don’t need more of those.