CBX Research founder
The Libra project raised market’s attention to stablecoin to an unprecedented level. It not only forces global financial regulatory bodies and central banks to take necessary measures, but also stimulates market’s enthusiasm in developing more stablecoins. Since Libra’s project scope is too large, it assumes a lot of risks. There is a big uncertainty in its future. But, Libra’s design and its experience can certainly be learned by other stablecoin projects. Better designed and more feasible stablecoins can be brought to the market.
A couple days after the Libra news was released, I wrote a report analyzing this project (A Business Analysis of the Libra Project) . In the last part of this report, I proposed a new mechanism of developing a stablecoin that can be a competing product to Libra stablecoin. This stablecoin is based on collateralized digital assets and minted by distributed method. In another article later, I wrote in more detail how this mechanism works ( How To Build a Stablecoin to Compete with Libra?). But, since the total amount of digital asset at current is still very small, the actual implementation of this mechanism is still very remote. Besides, whether a stablecoin can be accepted and widely used in the market is determined by many factors other the minting mechanism. Other equally important factors include the positioning of this stablecoin and its initial application scenario. Because of the development of blockchain and cryptocurrency, it is very easy to mint stablecoins technically these days. There are already many stablecoins in the market, and there will be more to come. At present, there is another more feasible mechanism to mint stablecoin. The stablecoin minted this way also has a very appropriate applicable scenario. This mechanism is to use Bitcoin as collateral. It also uses a combined business and technical solution to issue stablecoins.
In most of the time of human history, gold is used as money. Gold’s attributes make it very suitable to be used as money. Its overall supply is limited, can be divided or combined into different amounts, can exist forever, and is easy to carry around. These attributes make it valuable and also a good value carrier. In the recent history of human society, paper money appeared that is pegged to gold. The Bretonwood agreement made dollar the globally accepted currency that is pegged to gold. Because of the development of electronic technology, money can be transmitted via electronic means. This has greatly facilitated the circulation of dollar at the global level.
Because of the US government’s huge expenditure during the Vietnam war years, the US government issued more US dollars that it could not exchange with gold at the pegged price. The Nixon government had to unpeg dollar with gold in 1973. Since then, central banks issue their own respective currencies based their own sovereign credit. Currencies become fiat currencies, not commodity type currencies any more.
Currently, the most representative project of using digital asset as collateral and using distributed way of minting stablecoin is MakerDAO. MakerDAO accepts ether as collateral and uses the market value of ether as the value base, and uses a distributed method to mint stablecoin DAI. The collateralized ether is custodianed on Ethereum. Smart contract is used to control the whole minting process. No central organization is needed in this process. This process is completely different with existing currency issuing mechanism. But, this minting method is limited. It can only accept ether as collateral. Since the total value of collateralized asset is limited, the stablecoins thus produced is also limited. Most importantly, there are some inherent flaws in this minting mechanism (See my article in Chinese, Analyze the Most Hopeful Stablecoin Project MakerDAO), the project therefore cannot support the issuance of large amount of stablecoins.
Stoshi Nakamoto’s original intentional for Bitcoin is to make a digital currency. However, because of its design problem, Bitcoin did not develop into a digital currency. It actually developed into a virtual asset. The asset’s value is determined by 7*24 global trading. This value is therefore the consensus of the whole market. Such a value consensus mechanism is therefore more objective than the way existing real estates or stocks are priced. The only difference is that Bitcoin is a virtual asset while other types of assets are real assets. But, regardless, the value of Bitcoin is completely determined by market. On this value base, stablecoins can be issued.
3.1. The market value of Bitcoin
Since its birth at the beginning of 2009, the total market value of Bitcoin has grown from zero to $200 billion. At its peak, it used to get as high as $400 billion. If some of it are used to as collateral to issue stablecoins, a significant amount of stablecoins can be issued.
3.2. The objectivity of Bitcoin market price
There is no organization to support Bitcoin, its value is completely determined by trading in the market. Even though there are many exchanges providing trading service to Bitcoin, since most of them are not regulated, trading price can be manipulated. There is a study showing Bitcoin trading price was actually manipulated. It was exactly because of this concern, SEC has not approved applications to set up Bitcoin ETFs.
If stablecoins are to be issued based on Bitcoin, the objectivity of Bitcoin trading price has to be guaranteed. One measure for this is to adopt some price index. For example, CME uses a composite price maintained by the Crypto Facility Group. This composite index is based on Bitcoin trading prices among some exchanges in different geographic areas. Bakkt is going bring out one-day Bitcoin future that is settled physically. This can also help to achieve the price objectivity of Bitcoin.
3.3. Enough liquidity support
One fundamental requirement for this minting mechanism is enough liquidity. When the trading price of Bitcoin goes below the threshold, there should be enough liquidity to sell off enough collaterals to prevent losses. This is going to be a big challenge since the quantity that should be sold off would be huge. This should be a big challenge to sell off this big amount of Bitcoin without also affecting the market price.
3.4. The technical framework of minting process
One main reason that there isn’t a stablecoin based on Bitcoin today is that such a stablecoin cannot minted via a distributed method. On Ethereum, smart contract can be used to control ether collateral, the generation of stablecoin DAI and the liquidation of collateral. But since the Bitcoin blockchain does not have this function, this minting process cannot rely completely on technology. A new technical solution is needed for this. One possible solution for this is to have two layers of blockchain. The Bitcoin blockchain is used to custodian Bitcoins. The blockchain layer on top of it should be Turion complete and support smart contracts. The Bitcoins on the Bitcoin blockchain should be mirrored on the top blockchain layer. Smart contracts should be used to control the minting process.
3.5. The custodian of collateralized Bitcoin
There are two ways to custodian collateralized Bitcoins. One is completely centralized custodian method, the other is on-chain custodian using technology.
One advantage of using centralized custodian is to use cold storage. Bitcoins are stored in a physically separated place. This lowers the probability of Bitcoin being stolen by hackers. But this method has its own disadvantages. First of all, it needs a regulated and licensed custodian to do this work. It is not easy for such an organization to provide custodian services to customers around the world. Secondly, since it is a centralized custodian, there exists room for human error and other influences. Bitcoins custodianed this way may not be used freely by customers. Lastly, since it is a centralized custodian, it may not respond to market changes and customer needs in a timely manner.
The advantage of using technical solution for custodian work is that human interference is reduced to minimum level. More customers around the world can be served this way. Users can freely use their Bitcoins in accordance with predefined rules. This method can also respond to market changes in a timely manner.
3.6. Organization to support this minting process
Ever since the birth of Bitcoin, there are three main development themes：digital financial product, the underlying blockchain that supports the circulation of digital financial product, and the application of consensus mechanism in technology and social organization. In terms of the application of consensus in organization, The DAO was the first such attempt. It tried to decide on the development of Ethereum based on the collective vote of the community. The MakerDAO project is also such an attempt. The Libra Association is the most recent such an attempt. Even though Libra Association currently operates using the traditional human governance mechanism, I am sure that it will attempt to formalize governance and business rules into smart contracts and let these rules run automatically. This will definitely help to win the trust of individuals and organizations, so that more individuals and organizations can join the Libra ecosystem. In future stablecoin projects, such alliance type organization that is governed by collective consensus will be the main organization form. In such an alliance type organization, participating members and nodes will provide minimum human participation. “It should be a DAO type organization based on collective voting mechanism by participating nodes. This organization is sort of like a central bank. This DAO should be composed of super nodes that are distributed in main economic areas around the world. Its voting mechanism can be based on the DPOS mechanism adopted some public chains.” ( See my article in Chinese, Bitcoin, a Pioneer in Everybody-Participating Minting Mechanism)
The safety of asset is the top most priority in this business. Regardless which method is used, whether it is a centralized solution or a distributed solution, the safety of customer’s asset should be guaranteed.
The liquidity of digital asset trading is the foundation of this business. Adequate liquidity not only determines the fair market price of Bitcoin, but also guarantees the liquidation of collateralized Bitcoins in case there is a big market volatility.
4.3. The blockchain layer that supports the issuance of stablecoins
The second layer of this framework supports the mirrored Bitcoin asset. This blockchain layer can be a simple one or a function-rich one. If such a blockchain only supports single financial product such as money, it can give up other functions to be more efficient. But if this layer is Turion-complete and supports smart contracts, this layer can support more financial products. But the downside of this choice is to sacrifice some efficiencies. Deciding on which design to use is an important choice the issuing organization has to choose.
4.4. The trustworthiness of the issuing organization
Since this minting process cannot completely done by technology alone, an organization is needed to provide minimum human management. The fairness and trustworthiness of this organization is therefore very important. The organization and governance of the Libra Association can be referenced in this regard. Evidently, the Libra Association’s governance is well accepted by potential organization members. This is why it can attract leaders, and direct competitors in different business areas and industries leaders. In the same vein, this new organization should establish a fair governance mechanism so that other organizations can join to participate in the same minting business.
The application scenarios of future stablecoins will be very diversified. Stablecoin with single function will appear in different application scenarios. Presently, the most robust growth area of digital assets is digital assets trading at the global level. Because of compliance concerns, banking institutions around the world exert limits in providing the fiat and crypto on-ramps and off-ramps on crypto exchanges. This has made it very inconvenient for crypto traders. The first stablecoin Tether was born to solve this problem. Tether was well received in the market. Its circulation quantity kept growing. Stablecoins after Tether are also mainly used in the digital asset trading. If this new stablecoin based on Bitcoin appears, chances are that it will also be mainly used in digital asset trading.
Based on the current $200 billion market value of Bitcoin and the fact that about 2% of Ether is collateralized at MakerDAO, the total value of Bitcoin that is used to mint stablecoin is estimated to be about $4 billion. If we also use MakerDAO’s haircut rate, then about $2.6 billion stablecoin can be minted this way. This quantity is trivial relative to total amount of currencies in the market. Besides, since this stablecoin will be mainly used in digital asset trading, it does not compete with currencies in real financial and economic activities. Therefore, stablecoins minted this way has negligible effect on the existing financial and economic system.
In all, stablecoin is in essence also a product. Its life cycle is also like any other products. Since there is now a healthy demand for this product and this demand is expected to continue to grow, there are opportunities for existing and future stablecoins. Whether one particular stablecoin can survive and grow is not only determined by its minting mechanism, but also determined by its market position and promotion. For most stablecoins, since they do not have the resources of Libra Association, they should have a correct and clear market position. They should establish uniqueness in niche areas. The worst strategy to position itself as an all-purpose currency and compete directly with all stablecoins and fiat currencies in the market. This is doomed to fail.
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