Innovation and Cryptoventures Stablecoins Campbell R Harvey Duke
Innovation and Cryptoventures Stablecoins Campbell R. Harvey Duke University and NBER
Campbell R. Harvey 2019 2
Cryptocurrencies are too volatile • Bitcoin as a transaction method will not be viable until the volatility is decreased. Currently, it fails as a store of value. Campbell R. Harvey 2019 3
Cryptocurrencies are too volatile • Holding for one week: 95% confidence interval is • Bitcoin: +/- 25%[from 2011]; S&P 500 is -4. 3% to +4. 3% • Worst S&P daily return since 1957 is Oct. 19, 1987 at -20. 47% • Over last 6 years, bitcoin has had 8 days with less than -20. 47% return • Second worst daily return since 1957 is Oct 15, 2008 at -9. 03% • In 2018 alone, more than 8 days with <-10% return Campbell R. Harvey 2019 4
Stablecoin basics Four different types 1. 2. 3. 4. Fiat collateralized Real asset collateralized Crypto collateralized Non-collateralized Campbell R. Harvey 2019 5
Stablecoin basics Fiat-collateralized coins • Tether is the largest (USDT) also very controversial • True. USD (TUSD) exchange directly into escrow so TUSD never touches your USD • LBXPeg tied to sterling; • Bit. CNY • Candy backed by Mongolian tugrik • Sometimes called IOU coins – if there was ever a problem with the collateral, the token holders are owed the fiat. Campbell R. Harvey 2019 6
Stablecoin basics Fiat-collateralized coins • USDC (Circle) accepted on many exchanges like Poloniex (which Circle owns) • Paxos Standard (PAX) and Gemini Dollar (GUSD) approved by New York State Department of Financial Services Campbell R. Harvey 2019 7
Stablecoin basics Campbell R. Harvey 2019 8
Stablecoin basics Real asset-collateralized coins • Digix Gold (DGX) ERC-20 and 1 DGX=1 gram of gold. Gold in vault in Singapore and audited every three months. • Can redeem (recast) in physical gold in 100 g or 1000 g lots. Need to be physically present • Proceedures fully compliant with AML/CFT regulations set out by the monetary authority of Singapore. • Transaction fee of 0. 13% • Daily Demurrage Fee covers the cost of vault and audit is 0. 60% (annualized) 9
Stablecoin basics Real asset-collateralized coins • Tiberius Coin (TCX) combo of 7 precious metals used in tech hardware • Technology Metals: Tin (14%) and copper (23%) • Electric Vehicle / EV Metals: Cobalt (10%), nickel (11%), and aluminum (7%). • Stability Metals: Gold (17%), palladium (13%), and platinum (6%). • Fees claimed less than 2% p. a. • Sale delayed due to credit card companies asking for high fees 10
Stablecoin basics Real asset-collateralized coins • Swiss Real Coin (SRC) backed by portfolio of Swiss real estate. Interesting, the holders vote on the investment choices! • This is an Security Token Offering (STO) that will take place in 2019. Reservations live. 11
Stablecoin basics Real asset-collateralized coins • Swiss Real Coin (SRC) backed by portfolio of Swiss real estate. Interesting, the holders vote on the investment choices! • This is an Security Token Offering (STO) that will take place in 2019. Reservations live. 12
Stablecoin basics Real asset-collateralized coins • D 1 Coin. Collateralized with diamonds. Each D 1 coin is pegged to 1/1000 th of the value of D 1 standard grade diamond • Ethereum ERC-20 • 5% fee for receipt of diamonds • 2. 5% for issuance and redemption of D 1 coins • White paper 13
Stablecoin basics Real asset-collateralized coins • D 1 Coin. Collateralized with diamonds. 14
Stablecoin basics Real asset-collateralized coins • D 1 Coin. Collateralized with diamonds. 15
Stablecoin basics Real asset-collateralized coins • D 1 Coin. 16
Stablecoin basics Crypto-collateralized coins: • Suppose you own a house and want a home equity loan. The bank gives the loan but you pledge your house as collateral. The collateral is worth more than the loan (over-collateralized). • If the house drops in value, the loan may be called. If you can’t payback, the house is auctioned off. • This is an example of a Collateralized Debt Position or CDP https: //www. cryptoblockcon. com/stablecoins-are-they-coins-or-security-tokens/ Campbell R. Harvey 2019 17
Stablecoin basics Crypto-collateralized coins: • Augmint (pegged to Euro – called A-Euro), • Uses collateralized debt position • ERC-20 • White paper Campbell R. Harvey 2019 18
Stablecoin basics Crypto-collateralized coins: • Haven • White paper Campbell R. Harvey 2019 19
Stablecoin basics Crypto-collateralized coins: • Havven renamed to Synthetix • White paper Campbell R. Harvey 2019 s. USD 20
Stablecoin basics Crypto-collateralized coins: • Sweetbridge https: //blog. sweetbridge. com/bridging-the-gap-to-a-stable-token-c 4 fdbd 70 e 9 c 3 Campbell R. Harvey 2019 21
Stablecoin basics Crypto-collateralized coins: • Let’s do a deeper dive on Maker. DAO’s DAI • It is an ERC-20 token which means it is native to the Ethereum blockchain. The token represents a small amount of ETH but also represents DAI (which has a much higher value) Campbell R. Harvey 2019 22
Stablecoin basics https: //makerdao. com/whitepaper/Dai-Whitepaper-Dec 17 -en. pdf Campbell R. Harvey 2019 23
Stablecoin basics Crypto-collateralized coins: Maker. DAO • DAI is a cryptocurrency that is has a mechanism that allows it to be pegged to the USD. So $1=1 DAI (approximately). In existence for about one year. Campbell R. Harvey 2019 24
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Suppose 1 ETH= $100. In addition, suppose the initial collateral ratio is 1. 5 (you must post $1. 50 in collateral for every DAI borrowed) • You send 1 ETH to a smart contract which allows you to borrow 66 DAI (some rounding). There is also a “stability fee” which is similar to interest. • As long as ETH>$100, then the system is secure. However, what happens if ETH drops in value? Campbell R. Harvey 2019 25
Stablecoin Campbell R. Harvey 2019 https: //medium. com/cryptolinks/maker-for-dummies-a-plain-english-explanation-of-the-dai-stablecoin-e 4481 d 79 b 90 26
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Suppose ETH drops to $75. In addition, the “maintenance” margin collateralization ratio is 1. 25. The drop in ETH triggers the equivalent of a margin call. • If you are close to the maintenance margin, you need to repay by sending 66 DAI to the contract. After doing that, you would be refunded the ETH (about 1 ETH, there is a stability fee) • If you do not repay and you go below the collateralization ratio, you will be liquidated. Campbell R. Harvey 2019 27
Stablecoin basics Crypto-collateralized coins: Maker. DAO • There is a group called “keepers” that are constantly checking the blockchain for contracts that have fallen below the maintenance margin. They can trigger a liquidation. • Keepers is a general term for those that maintain a blockchain – they are not specific to Maker. DAO Campbell R. Harvey 2019 https: //medium. com/@rzurrer/keepers-workers-that-maintain-blockchain-networks-a 40182615 b 66 28
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Now let’s consider liquidation. In our contract, there is 1 ETH. These ETH are auctioned off for DAI. To be clear, the trade is selling ETH and buying DAI (which should have a positive price impact on DAI) • The auction is looking to sell enough ETH to obtain 66 DAI • Price of ETH is $75. Usually, this would cost 0. 88 ETH (66/75). • However, in the auction you might need to pay more than 0. 88 ETH (which means the price of DAI increases relative to ETH) Campbell R. Harvey 2019 29
Stablecoin basics Crypto-collateralized coins: Maker. DAO • After the 66 DAI are purchased in the open market and returned to the CDP (which is just a smart contract), the residual is paid back to the borrower. Suppose the DAI are bought in auction for 0. 90 ETH. This means that 0. 1 ETH is returned to you. So you have 66 DAI and 0. 1 ETH. You could also sell the 66 DAI for ETH and you would end up with approximately 1 ETH (where you started). • Note, the 66 DAI are destroyed (reducing the supply of DAI) • The stability mechanism works the other way too – if DAI increases above the peg, then the collateralization ratio is changed. Who changes the collateralization ratio? 30
Stablecoin basics Crypto-collateralized coins: Maker. DAO • There is much more to the system than my explanation • The maker token (MKR) holders determine the collateralization rates and they regulate the system (and get paid for it) • However, MKR are the buyers of last resort – if there was ever a situation where there was not enough collateral to cover the DAI, MKR is created and sold to cover the residual • MKR holders are, hence, strongly incented to responsibly regulate. Campbell R. Harvey 2019 32
Stablecoin basics Crypto-collateralized coins: Maker. DAO • There is also a fail safe called Global Settlement • If the system under attack, a Global Settlement is triggered where you can exchange the DAI directly for ETH through a smart contract and collateral will be released to the owners Campbell R. Harvey 2019 33
Stablecoin basics Crypto-collateralized coins: Maker. DAO • DAI also allows for leveraged ETH positions • Suppose you have 1 ETH = $100 and you enter into a CDP and get 66 DAI. • You use DAI to buy more ETH (0. 66 ETH). [Assume do this only once. ] • Now you profit (or lose) with leverage. • Suppose price rises, e. g. , ETH=$200 • You would usually have profited by $100 or 100% return • You have 1. 66 ETH which is worth $332. You buy 66 DAI for $66 and repay the CDP leaving you with $266 (a profit of 166%) Campbell R. Harvey 2019 34
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Note as the collateralization ratio decreases, the amount of leverage increases. • Theoretically, as leverage approaches 1: 1, you can get infinite leverage! • However, importantly, the lower the collateralization ratio, the more DAI are created Campbell R. Harvey 2019 35
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Finally, currently the system allows for only one type of collateral: ETH • In the future, they will generalize this to any ERC-20 or ERC-721 token • This opens a range of interesting ideas. For example, you might have an ERC-20 that represents an investment in a diversified portfolio of stocks and bonds. Essentially, almost any collateral (as long as it is tokenized) can be pledged. Campbell R. Harvey 2019 36
Stablecoin basics Crypto-collateralized coins: Maker. DAO • Other information • Andy Milenius at Devcon 4, December 10, 2018 https: //www. youtube. com/watch? v=2 lxc 7 q. Csv. F 8 • https: //medium. com/@hasufly/maker-dai-stable-but-not-scalable-3107 ba 730484 Campbell R. Harvey 2019 37
Stablecoin basics Non-collateralized coins: Basis, Kowala, Fragment/Ampleforth • Common feature: a dynamic monetary policy to target a particular exchange rate (much like Central Banks attempt) • For example, the Swiss National Bank was worried about CHF appreciating. They tried to peg to Euro. • Wednesday January 14, 1. 2 CHF= 1 Euro • Thursday January 15, 0. 85 CHF = 1 Euro Campbell R. Harvey 2019 38
Stablecoin basics • Basecoin – Basis protocol. Dynamic monetary policy that uses a three token system (coin, bonds and shares). They had to shut down December 18, 2018 because regulatory issues (bond and stocks were securities). Nevertheless, let’s explore their idea. 1. Coin (Basis): • Supply shifts to keep demand at, e. g. , $1 to maintain peg • If price increases, more coin is created; if price decreases, coin is purchased to decrease supply • “A stable cryptocurrency with an algorithmic central bank” Campbell R. Harvey 2019 39
Stablecoin basics Non-collateralized coins 2. Bonds: (Bond token) • Generated whenever supply needs to contract • Bonds are redeemable for 1 coin in future if: • Supply is expanding • Bond hasn’t expired (5 -year window) • Your bond is next in line (oldest redeemed first, FIFO) • Sold for less than $1 to achieve yield (here is where the regulatory issue kicks in because qualifies as a security) Campbell R. Harvey 2019 40
Stablecoin basics Non-collateralized coins 3. Shares: (Share token) • Supply is fixed • Not pegged to anything. Value determined by dividend policy. When demand for basis goes up and blockchain creates new basis, new basis paid to shareholders (after outstanding bonds) • Payments are proportional to ownership (again seems like a security) • Thus bonds incentivize contraction of supply and bond and shareholders are recipients of expanding supply and the peg can be maintained “via game-theory and economics” Campbell R. Harvey 2019 https: //medium. com/coinmonks/a-deep-look-at-the-basis-protocol-1 c 512 f 2356 c 5 41
Stablecoin basics Kowala protocol • Vision is a series of k-coins, k. USD, k. EUR, … (each coin has its own blockchain) • White paper • Three stability mechanisms • 1 second confirmations in Go Ethereum (Using Ethereum code but important change to consensus mechanism for their own blockchain) • There are three popular clients, eth –client written in C++; geth –client written in Go (language designed at Google and similar to C), pyethapp –client written in python. All of these interact with Ethereum (and testnet) blockchain. Think of you being able to send an email using Outlook to someone else who uses Gmail. Campbell R. Harvey 2019 42
Stablecoin basics Kowala protocol • Stability mechanism #1: Minting algorithm • If k. USD rises above $1, then more supply is added (so the block reward is variable) • If k. USD falls below $1, mining reward goes to zero – however, that might not be sufficient to drive the price back Campbell R. Harvey 2019 43
Stablecoin basics Kowala protocol • Stability mechanism #2: Stability fee • Like Ethereum, every transaction sender is charged a fee (in part to compensate miners for maintaining the network). This fee also includes a “stability fee” which is 0 -2% of the transaction amount. The fee serves to reduce coin supply when price is below $1. Note the max is 2% and usually the stability fee would be zero (in normal conditions). Also, no one pockets the fee. The coin is destroyed. Campbell R. Harvey 2019 44
Stablecoin basics Kowala protocol • Stability mechanism #3: Trading activity • First two mechanisms are first order effects and are designed to keep k. USD close to $1. There is a second order effect. Given that market participants understand the peg, there exists a natural Schelling* (focal) point ($1=1 k. USD). That is, arbitrageurs will enter the market if the price falls below $1 and start to buy. *In Game Theory, a solution that people will use in the absence of communication. Named after Thomas Schelling Campbell R. Harvey 2019 45 (Nobel 2005).
Stablecoin basics Kowala protocol • Other • Two token system: k. USD and m. USD, where m. USD is a mining token. There is a fixed number of m. USD for every k. USD. • Consensus mechanism (Konsensus) derived from Tendermint and uses Practical Byzantine Fault Tolerance* (p. BFT). They believe superior to Proof of Work. • There are miners. For every block, a leader (called proposer) is deterministically elected from miners. All other miners are validators. Proposer assembles the next block and the validators decide whether to accept or reject. Proposer gathers pending transactions of offers to the validators formal verification. If two thirds or more vote to accept the block, proposer commits it to the blockchain. If block is rejected, a new proposer is elected. • The likelihood of being elected as a proposer depends on the number of m. USD you have. 46 *https: //blockonomi. com/practical-byzantine-fault-tolerance/
Stablecoin basics Kowala protocol • Other • Dishonest or free-loading miners punished by becoming ineligible to propose blocks (need to be active to participate); Also, in order to be eligible, miner needs to stake m. USD tokens (currently 30, 000); Maximum number of miners; • Based on Ethereum for smart contract purposes • Energy efficient • 7, 000+ tps with processing time of 1 second Campbell R. Harvey 2019 47
Stablecoin basics Nu. Bits • If demand exceeds supply (usually price would go up), Nu. Bits introduces additional circulation into supply. The new supply is authorized by Nu. Shareholders • If supply is greater than demand (usually price falls), excess digital taken out of circulation. Nu. Shareholders buy the excess supply. • Depending on performance of Nu. Bits, Nu. Shareholders are issued dividends by platform. • If demand low for prolonged period of time, Nu. Shareholders can authorize creation of more Nu. Shares. • Example of Seigniorage shares category of stablecoins https: //www. newsbtc. com/2016/01/03/nubits-stable-digital-currency/ https: //medium. com/reserve-currency/the-end-of-a-stablecoin-the-case-of-nubits-dd 1 f 0 fb 427 a 9 Campbell R. Harvey 2019 48
Stablecoin basics Nu. Bits • 2016 saw large deviation from peg • At this time, bitcoin and other cryptos were sharply appreciating • Large selling of Nubits by those wanting to buy non-stable cryptos Campbell R. Harvey 2019 49
Stablecoin basics Nu. Bits • However, notice that it returned to parity. Perhaps arbitrage traders? But oddly, at a number of points it goes to more than $1. 25 at the end of 2017 –around the same time bitcoin is crashing. Uncertainty about bitcoin caused demand for Nu. Bits, driving the price beyond parity. Campbell R. Harvey 2019 50
Stablecoin basics Nu. Bits • Converting bitcoin to USD is slow (and in a crash situation, you need to be fast). Also, there are tax consequences. Converting to Nu. Bits was quick. • Nu. Bits printing money and selling it to bitcoin holders. As cryptomarket crashes, demand for stablecoins increases (less so with collateralized) Tether Campbell R. Harvey 2019 51
Stablecoin basics Nu. Bits • Nu. Bits crashes again March 21, 2018. • Lack of reserves. As price starts to fall there is a “bank run”, and people try to sell the Nu. Bits • One factor was that Nu. Bit reserves were stored in bitcoin! Essentially, the collateral was not diversified. Campbell R. Harvey 2019 52
Stablecoin basics Nu. Bits Campbell R. Harvey 2019 53
Stablecoin basics Nu. Bits • Other Campbell R. Harvey 2019 54
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