Cryptocurrencies came into being with an anti-bank fervor that still runs hot in the technology community. Libertarians see Bitcoin and the rest as an alternative to fiat money controlled by financial institutions and the government. But the quest to create a cryptocurrency with a stable $1 value—a so-called “stable coin”—has startups acting like banks.
For cryptocurrencies, extreme price volatility remains a huge problem and has already caused some big players to back off. For example, volatility was cited by mobile payment company Stripe in its decision to drop support for Bitcoin in January, and by Steam (the largest online retailer for video games) when it did the same in December.
It’s easy to understand why. The dollar value of one bitcoin today can’t be counted upon for tomorrow, either because the price skyrockets unpredictably, or it suddenly tanks. The first scenario isn’t a problem for most people, but the second is dangerous for any business holding cryptocurrency, which may suddenly find that it traded real goods for worthless digital tokens. All of the other problems with Bitcoin and cryptocurrencies writ large—that they’re inefficient, expensive, and so on—pale in comparison to the simple fact that nobody wants to use money they can’t depend on.
“I don’t think [a stable coin] is possible, but I may be wrong”
The creation of a “stable coin,” a cryptocurrency that can hold its value and be used as a digital stand-in for the US dollar, has long been seen as an innovation as fantastical and mythic as the holy grail of Arthurian legend. Now, several startups are pursuing this goal with varying levels of success and big names in tech are paying attention. Last week, New York City-based startup Intangible Labs announced that it received a $133 million round of funding from big-name investors like Bain Capital and GV, Google’s venture capital arm, to create a stable coin called Basis.
Stable coins claim to solve some of the biggest issues with cryptocurrencies today, so it’s no surprise they’re attracting interest and investment—even if the startups behind them are acting a bit like banks did in the literal Wild West by issuing currencies backed by their own assets, or like central banks today by managing money supply. According to experts I spoke with, it all seems too good to be true.
Why is anybody excited about a stable coin?
The price of any cryptocurrency traded on a market is the result of a confidence game played between speculators each deciding how much their tokens are worth, which is the same as saying how much they think someone else might buy them for. The incentives for speculators and other players in the ecosystem—like the miners that validate transaction data and generate new coins as a reward—can change at any time, meaning that the value of tokens is up to the whims of gamblers. Nobody wants this, except for said gamblers.
“If you get paid in dollars, that’s great—everything around you is priced in dollars, and you can predict what the purchasing power of that salary is going to be,” Preston Byrne, an independent consultant and former COO of Monax, an early blockchain tech startup, said over the phone. “If someone pays you in Bitcoin, however, your salary is subject to the vagaries of price movements in that market.”
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According to Byrne, a coin that can hold a $1 USD value would eliminate the risk inherent in cryptocurrencies and accelerate their adoption. Then, nobody has to worry about their money suddenly becoming worthless, or negotiating new payments to clients if its value unexpectedly goes up.
According to Bitcoin developer Jimmy Song, a digital stand-in for the US dollar would make it easier to do coin-for-coin trades (called an “atomic swaps”) say, one bitcoin for one stable coin, without the need for an exchange to mediate the transaction because the stable coin’s value will always be the same.
“You could utilize Slack or Telegram to do trades, which people already kind of do but it’s fraught with fraud,” Song said over the phone. “If you have something like that, where you can convert easily back and forth with the dollar or some digital equivalent, then you can have atomic swaps,” he explained, adding that you’d still need an exchange for “price discovery.”
Considering these factors, it’s not surprising that a stable coin is a popular idea—after all, it purports to solve one of cryptocurrency’s biggest problems: price volatility. Despite several startups working on a stable coin, though, neither Song nor Byrne were convinced that a truly stable coin is on the way.
“I don’t think [a stable coin] is possible, but I may be wrong,” Song said over the phone.
“Holy grail is a pretty good description, because what they’re trying to build doesn’t exist,” said Byrne.
How is a stable coin supposed to work?
Stabilizing a coin means finding creative ways to tame the market dynamics that make Bitcoin and other cryptocurrencies so volatile. So far, that’s made the startups attempting to do so look a lot like banks—because they’re either issuing a digital notes backed by their own assets, or manipulating supply like a central bank does.
The first approach to stabilizing a cryptocurrency is what Song described in our phone call as the “we have the money” method.
Imagine that Scrooge McDuck wanted to stick it to the US government and issued his own banknotes like it was the 1800s. One DuckBuck is equal to one gold coin stored in Scrooge’s personal vault, and can be redeemed at any time. Everyone in Duckburg has seen Scrooge diving into his mountain of gold in his skivvies, and so everyone knows that Scrooge is good for it. Thus, everyone trades DuckBucks safe in the knowledge that one DuckBuck will equal one gold coin for as long as Scrooge has a pile of gold.
One startup taking this approach is Tether, which is attempting to “peg” its token to the US dollar by claiming that every token is backed 1:1 with real cash in Tether’s own bank account. No full, public audit has been done on Tether’s cash reserves and the company was recently subpoenaed by the US Commodity Futures Trading Commission, sparking fears of an old-style bank run if the startup is not solvent. Tether didn’t respond to Motherboard’s request for comment.
“It doesn’t make a lot of business sense. It’s a very expensive way to create a stable coin,” Byrne told me over the phone. “You could just go out and buy dollars and that would be more efficient. But it is something people in [cryptocurrency] are doing because they have enough money to do it.”
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One startup melding the “we have the money” approach with complex incentives is MakerDAO, a blockchain startup with a stable coin called Dai. In MakerDAO’s current scheme, some of Dai’s users put up the collateral for the tokens. These users “lock up” $3 USD worth of ether, Ethereum’s in-house cryptocurrency, and in turn receive one Dai token pegged to $1. In effect, these users are receiving a loan in Dai tokens from MakerDAO in exchange for their collateral, which they can use to buy more ether or anything else. “Locking up” ether accrues a bit of debt that must be paid down to release the funds. The 3:1 backing of Dai tokens means that people can trade Dai for $1, knowing it’s backed by more.
“It’s a bet on the future price of ether,” Rune Christensen, founder of MakerDAO, said over the phone, adding that the startup will diversify the collateral it accepts. Due to Dai’s total dependence on ether for collateral right now, though, a severe market crash in the price of ether could cause the $1 peg to fail, although Christensen contended the crash would have to be extreme and near-instant in order to have this effect. The next version of Dai, coming this summer, will use different assets like gold or stocks to collateralize Dai, reducing the risks posed by price swings in cryptocurrency, Christensen said.
Other approaches to creating a stable coin, Song said over the phone, are “even more similar to central banking except they’re using market forces to [stabilize the coin] and they have all sorts of incentives.”
“It’s just not how the world works. It’s not how risk works, and it’s not how financial assets work”
The best example of this so far is Basis, the project by Intangible Labs that received $133 million in investment funding from established sources including Google’s venture capital wing. Indeed, the white paper for Basis proclaims that the startup will keep the price stable with an “algorithmic central bank” and openly invites comparisons to the US Fed.
The company’s FAQ argues that a currency can be stable without the backing of a tangible asset. Instead of backing a token with its own cash reserves like Tether, or collateral from a portion of users like MakerDAO, Basis will constantly manipulate the market dynamics of its token with a complex system of incentives involving the basis token itself, but also “shares” and “bonds.”
“This stable coin is based on the idea that you can have an asset that’s totally free-floating, which isn’t backed 1:1 by its mirror image, and that you can create a bunch of arrangements around it that ensure you can always convert it,” Byrne said over the phone. “It’s just not how the world works. It’s not how risk works, and it’s not how financial assets work,” he said, adding that Basis’ bonds are not really bonds.
Here’s how Basis is supposed to work, and fair warning—it is extremely complicated. The token at the centre of the system is called basis and it’s pegged to $1 USD, but it’s not backed by real money. Instead, the price of basis tokens is managed via the incentives of users who hold two other tokens: “bond” tokens and “share” tokens. It’s a “three-token system,” according to the white paper.
If basis prices go below $1 and need to be pushed up, the system automatically auctions “bonds” to users. Bond tokens are sold for under the $1 peg and simply guarantee a payout in basis at a later date when the price is $1. Buying bonds destroys basis, contracting token supply and pushing up the price. Basically, bond token holders get a deal on future basis and the long-term nature of their bet guarantees the peg; it’s like spending 80 cents today to get $1 in a year. If basis goes above $1 and supply needs to be diluted, the system automatically releases new basis tokens to share token holders.
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Bond token holders are paid on a first-in-first-out basis, which “incentivizes people to buy bonds sooner than later,” according to the Basis white paper. But there’s a problem: If the bond queue gets too long, people near the end of the line could lose faith that their investment will be repaid at the promised rates, triggering a crisis of confidence. So, there’s a five-year maximum expiration date for bonds, designed to keep the queue from getting too long and the bonds from becoming worthless.
“It doesn’t have to take five years for those bonds to more or less be worthless,” Song said over the phone. “If it looks like the bonds are not going to get fulfilled after three, then those are going to trade at a discount, and future bonds are going to be in line and they’re going to trade for less and less. As far as I can tell, there’s a possible death spiral there.”
This scenario, although different from Tether or MakerDAO’s collateralized models, also raises the specter of a bank run-like catastrophe.
On this point, Basis’ FAQ states that the bonds’ timed incentive would allow Basis to “‘default’ transparently” and temporarily lose its peg. The company also says it has conducted a “stability analysis” that will be released later.
“It’s a system which depends entirely on new investors buying into this game, at prices that make sense for existing investors,” Byrne said over the phone. “There are a lot of names for that—I’m not going to use any of them.”
Spokespeople for Intangible Labs didn’t respond to Motherboard’s requests for comment.
So what’s the takeaway?
After a brief survey of some of the most popular stable coin projects out there, it’s clear that for some people, making cryptocurrency usable means implementing a system of control that looks a lot like what banks do, or did in the past.
If the point of cryptocurrencies is to resist any sort of central financial administration, then stable coins miss it entirely.
This article was originally written for Motherboard.com by Jordan Pearson.