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What is a stablecoin, and why do central bankers care? 

Nobody in 2009 could have imagined central banks around the world chasing innovation in 2020 to maintain and manage their mandate. After all, they were busy trying to deliver on their mandate of price stability, low but predictable inflation and, in some cases, full employment in a crumbling financial system.

Still, in the shadow of the Great Financial Crisis, Central Banks could not have envisioned the crypto reality show they would be thrust into ten years later.

Imagine being challenged by ideas presented in a simple white paper, brought to life by a mysterious unknown entity, and transformed into an asset through…pizza.

Then imagine your all-powerful monetary organization being challenged by…Facebook.

They would have stared blankly as you told tales of the virtuous evolution of Bitcoin and its suite of technologies. They might have asked you politely, what the hell you were talking about, if you described Bitcoin’s spawn, Ethereum, with its smart contracts that would evolve into a variety of digital financial instruments called stablecoins.

Image of skyscrapers shrouded in cloud cover with stacks of golden coins superimposed in the lower part of the image from left to just past center.

Stablecoins are a bridge

Stablecoins are a product with a somewhat ironic name. Ironic in the sense that their very presence is somewhat destabilizing. They are not one thing, but rather, an evolving technology product that is programmable and flexible. They can be a payment network, a financial asset and a derivative all wrapped into one.

They are almost a programmable central bank…er.

Now the reason for the creation of stablecoins is to address the issues of working between two parallel financial architectures. One is the newer crypto-based architecture, and the other is the existing financial system. Stablecoins act as a bridge.

As a result, stablecoins provide an antidote to some important crypto-related problems.

They solve some crypto problems

One problem is the inherent volatility, lack of regulation, and no central authority of almost all crypto products in secondary markets. These characteristics create some consternation for businesses, consumers and monetary authorities.

For the consumer, the crypto asset volatility creates friction and uncertainty, which reduces participation. In a dollar-denominated world, this volatility is difficult to ignore.

For businesses, it adds a level of risk and uncertainty while potentially increasing costs to manage unpredictable crypto remittances.

Crypto creates an impossible situation for monetary authorities because crypto alleviates them of the control they require. Then there is the lack of regulation. Crypto projects proliferate like a barn full of rabbits, and they are distributed across the world in numerous different jurisdictions with different laws and rules.

With stablecoins, crypto technology is applied to stable assets providing the consumer and businesses with low volatility, speed, ease of use and access.

And by having these resources regulated and easily trackable means that central banks and regulators have more visibility of money movement.

A next-gen payment system 

On the Unqualified Opinions podcast by Ryan Selkis, he discussed the concept of using stablecoins as a payment rail with Jeremy Allaire, founder of Circle.

Allaire talked about stablecoins not as a currency per se, but as a vision of a payment system that increased efficiency and unlocked opportunity. The idea of the stablecoin consortium is a similar process used to develop existing payment systems in traditional finance.

One of the big advantages of stablecoins for payments and trading is a reduction of friction. This product helps consumers and businesses move seamlessly in and out of the crypto market. By having a native crypto asset that represents underlying fiat, transaction speed is increased.

Rather than transfer funds to an exchange, buy crypto with various potential delays, resources can be held in a requisite stablecoin. Stablecoins can be allocated quickly inside the system. And or held there until required for other activities, redemption or cashout.

An ETF, derivative or pure play? 

Like many aspects of crypto, stablecoins borrow heavily from the traditional financial system.

Stablecoins, as their name implies, are focused on providing a consistent value relative to an underlying benchmark or asset. This can be achieved by using different financial mechanisms.

One way is to operate the coin like an exchange-traded fund (ETF) with either a monetary or physical underlying asset. This is common with dollar or currency backed stablecoins like Tether, USDC or the recently announced QCAD. Some stablecoins use metals like gold or a basket of various metals as the underlying.

In another approach, stablecoins can be backed by another crypto asset where it looks more like a traditional derivative product.

Or they can be a standalone crypto stablecoin product where the value of the asset is adjusted exclusively through smart contracts.

All of these approaches are based on applying crypto technologies to existing financial product and infrastructure ideas.

Let’s take a closer look at the mechanisms of each.

The ETF approach

Stablecoins using an ETF approach base the value of the digital asset on the underlying value of a single fiat currency.

It is the issuer or consortium of issuers that manages the float or outstanding units of this stablecoin. While a unit is in circulation, it can be traded or exchanged in a variety of ways.

If a unit or coin is redeemed, it is exchanged for cash held in trust and the stablecoin unit is burned and taken out of circulation.

So let’s take the Canadian stablecoin, QCAD, for example. An authorized member of the consortium would exchange dollars for QCAD on a one for one basis from the vendor, Stablecorp. QCAD could then be sold to buyers on an exchange, like Canadian crypto exchange Bitvo, while the dollars backing them are held in trust at an authorized financial institution.

QCAD units or stablecoins are created as dollar deposits are collected, and units are subsequently burned as units are redeemed. All units are backed one for one, regardless of the number of units in circulation. This is how the value is maintained for an individual unit.

Stablecoins can also use a basket approach like the one proposed by Libra.

Borrowing from the GLD

Now, some stablecoins are also backed by assets like gold or other metals. These act in a very similar way to an ETF structure. If you look at the mechanism for the SPDR GLD ETF (The S&P gold ETF), you will see that buyers can buy and sell units on an exchange freely while market makers (the equivalent of a consortium or authorized dealer) will create and retire units as demand ebbs and flows.

They do this by depositing gold to create units or returning gold as units are redeemed. Gold is held at a registered depository and registered as a trust structure for legal purposes.

In this stablecoin model, you own a small portion of a gold bar, either a gram or an ounce. The coin is usually redeemable for cash and can be exchangeable for gold once you meet a threshold holding.

Now, like currency backed stablecoins, you can also use a basket approach for metals. The downside here is the management of the value of the coin could become very challenging during surprise supply events for one metal or another.

The derivative stablecoin approach

Another kind of stablecoin is backed by a crypto asset or currency. The most common example here is Maker’s DAI, which acts more like a traditional derivative. Maker has both a single and a multi collateral option. Collateral is typically Ether, and both units are equal to 1 USD.

To offset the inherent volatility of the underlying crypto asset, depositors supply a multiple of the collateral required. The deposit is held as a collateralized debt product (CDP), a type of derivative. CDP has been renamed to Vault.

In this stablecoin model, the deposit is like initial margin on a futures contract, and DAI is like a borrow associated with a short sale. As long as your deposit exceeds the collateral requirement, your position remains open.

To cash in DAI, you return it to Maker and pay the Maker Stability fee or rate used to manage the supply and demand of DAI relative to the Ether deposit.

Now, there’s also a stablecoin approach that uses smart contracts exclusively and has no underlying asset to track. The value is maintained by minting and burning coins based on a pure supply and demand model.

Of these three models, the ETF based fiat-backed stablecoin is the most dominant and readily available.

Central banks are awake

There are numerous stablecoin projects taking place around the world. The stablecoin index  shows more than 30 projects, the biggest of which is Tether. However, the ECB has indicated that there are about 50 projects underway in Europe, and there are numerous others taking place around the globe.

And it is through this lens that Central Banks are racing to create Central Bank Digital Currencies.

It is also interesting to note that there are a variety of national payment network projects under development in conjunction with central banks at the same time. These are in part to compete with the Visa and Mastercard system. In Europe, they are working on the Pan European Payment System Initiative (PEPSI). In Canada, a consortium created by an act of parliament manages a payment system through Payments Canada. And they are exploring DLT payments through Jasper.

Now all of these initiatives will be competing with stablecoins that already act as a fast, efficient and inexpensive way to move resources using modern technology.

For participants and users of cryptocurrencies, stablecoins provide a level of convenience and efficiency. Stablecoins will also act as the easy gateway for broader participation of the general public into crypto.

But they also could represent unexpected existential disruption to the core of many nation’s financial infrastructures, which has some Central Bankers raising eyebrows.

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