A Port in a Storm

One of the most rapid economic collapses of the twenty-first century is currently unfolding in Venezuela. A formerly wealthy and cosmopolitan nation with huge oil reserves, Venezuela has seen its economy shrink a stunning 23% since 2013. Things recently went from very bad to even worse thanks to the government’s desperate turn to printing money: the money supply is expanding as much as 30% in a month, leading to runaway inflation and shortages. Citizens are losing weight for lack of food, basic goods must be smuggled from neighboring countries, and even the armed forces are restive because of cuts to their rations.

But, in contrast to similar disasters in the past, individual Venezuelans have an escape route: many have flocked to Bitcoin as a way to generate income and preserve wealth. That’s a vindication of cryptocurrency’s potential to act as a bulwark against government mismanagement of national currencies, but it’s not a perfect solution – many Venezuelans who bought or mined cryptocurrency in December or January have seen the value of those holdings decline as crypto markets entered a down cycle. Even from one day to the next, it’s not uncommon for Bitcoin to fall or rise more than 20% in a day. While cryptocurrency supporters are used to riding out those short- and mid-term fluctuations, they could be catastrophic for Venezuelans who now earn the equivalent of less than USD$10 a month.

The situation illustrates one of the most obvious and compelling arguments for a so-called “stablecoin” - a cryptocurrency that holds its value over time, usually in U.S. dollar terms, rather than fluctuating with big market swings. The technological advantages of cryptocurrency, the argument goes, have been undermined by its price volatility, which discourage its use for things like daily payments or savings. International remittances are also an important example – currently, an emigrant sending money home using Bitcoin can’t be sure its value will be the same by the time the recipient converts back to a local currency.

Stable Coins: The Backbone of the Internet of Value

All of this is absolutely true, but it’s also limited by an assumption that cryptocurrency is just ‘digital money’ - a faster, more efficient way to transfer value. But cryptocurrency, and the blockchain tech it is built on, is much more than that. Because blockchains are internet-native, open-access, and can execute automated transactions, they have the potential to enmesh the world in an omnipresent network of thinking assets – a new kind of global financial brain, in which a stable coin will be an absolutely vital architectural element.

To understand this, rewind to early 2014, when Vitalik Buterin publicly debuted his plan for Ethereum. While Bitcoin is a fairly simple transaction platform, Ethereum promised both more complex automated transactions – ‘smart contracts’ - and, furthermore, a ‘Turing complete’ blockchain that could host executable code in the same way Bitcoin hosts a transaction ledger. This leads to the most obviously revolutionary part of Buterin’s vision: the distributed autonomous application, or dapp, and its big brother, the distributed autonomous organization, or DAO.

Dapps and DAOs provide services through the blockchain, usually in exchange for their native cryptographic token – for instance, the Storj dapp will let you pay for cloud storage using Storj tokens. A DAO would add broader business logic designed to maintain and profit from those services without day-to-day human involvement, making it, essentially, a self-driving company. A global network of these self-maintaining services and applications, communicating and transacting with each other near-instantaneously, would be a massive efficiency boost for the world economy – the financial corollary to broader trends towards A.I. and automation.

But some form of stable cryptocurrency would also be vital for customers of these distributed services. Let’s imagine a rideshare DAO managing a fleet of self-driving cars on the blockchain. It would take payments in its own cryptocurrency – let’s just call it CarCoin. If you’re a big believer in this DAO, you might have a stash of CarCoin, but an average user might not, especially if they have to interact with a half-dozen other crypto-fueled blockchain services on any given day. The mobile crypto wallets of the near future, then, will almost certainly contain some sort of stable cryptocurrency that can be seamlessly traded for app-specific currency.

The Trader’s Dilemma

The importance of a stablecoin becomes even clearer when you think about all this from the perspective of our ridesharing DAO. Behind the scenes, it will be managing its service, including paying for things like electricity, repairs, and new cars – quite possibly with other DAOs. To do that, they’ll need what’s known in today’s global markets as a vehicle currency – a commonly-agreed-upon way of paying invoices that would both provide a standard for pricing, and reduce the technological load of interoperabililty with thousands of application-specific tokens. That vehicle currency would, of course, have to be a cryptocurrency.

DAOs would also need a fast way to transact with entities outside of the crypto-ecosystem – remember that even now, 60 years after their introduction, there are plenty of businesses that don’t accept credit cards. Their 21st century equivalents will be businesses that don’t have the tech or risk appetite to accept all crypto – but who might be convinced to accept a crypto token that reliably holds its value.

We already have a preview of this future crypto-economy, in the present-day travails of active crypto traders. Buying cryptocurrency for USD through an exchange like Coinbase can take days using bank wire transfers, and often involves fees. That makes it hard to fully capitalize on looming market moves – meaning that the crypto-economy, which thrives on speed, is throttled to a crawl at its contact-points with the old paper-money economy. A blockchain asset that was firmly connected to that paper economy, and didn’t move with the crypto market, would drastically increase the informational efficiency of both.

What We Mean by a “Stable Coin”

So, a cryptocurrency that holds value would be a huge convenience today, and will be a fundamental piece of infrastructure tomorrow. But what exactly do we mean by “holding value”? In the modern global economy, the relative price of everything is nearly constantly moving, including that of essentially every major currency. A dollar will buy you a different amount of yen tomorrow than it did today, and it will also – at least in the abstract – buy you a very slightly different amount of goods and services.

So “stable” doesn’t mean a token that will buy the exact same amount of stuff a decade from now as it does today – even gold bars can’t do that. Rather, the goal is the relative stability which comes from trustworthy convertibility into some specific asset or assets, which themselves enjoy stable market demand.

Venezuela can again provide a useful example, though of course not a positive one. Venezuela ‘pegs’ its currency to the U.S. dollar, maintaining an official exchange rate recently set at 3,345 bolivars to the dollar. Many small or developing nations do this to one degree or another, maintaining dollar parity by buying and selling currency reserves, and in some cases stabilizing a national currency helps encourage international trade – just as a stable cryptocurrency will be important to the development of the networked crypto economy.

But Venezuela also shows the serious limitations of pegging: without enough real reserves to actually maintain the peg, it becomes a dangerous fiction. Most Venezuelans can only buy dollars at a black market price that was recently closer to 250,000 bolivars to the dollar, or about 75 times higher than the official rate. Currency traders, including a thriving trade across the border in Columbia, are arbitraging that gap for their own gain,  and making Venezuela’s economic crisis even worse by essentially pillaging the central bank.

This process is known as ‘attacking’ the peg, but that phrase attributes malice where there is none – these currency traders don’t give a damn if a peg stands or falls, they just see an opportunity for profit, because the government has declared its intention to spend reserves to defy market signals about the value of its currency. Arbitragers have no grudge or vendetta against Venezuela  – a point that also applies to market reactions to certain ‘pegged’ cryptocurrencies.

Venezuelan President Nicolas Maduro is now trying something else – a currency pegged to his nation’s oil reserves. It’s set to be called the ‘Petro,’ and, believe it or not, it’s planned to launch as a cryptocurrency, with each token ‘worth’ a barrel of Venezuelan oil. The problems with the idea are legion, but the key issue is this: there’s little reason to expect that you can convert a crypto-token to a barrel of oil, or that it will maintain an equivalent value in the market, based on nothing more than the word of a regime like Maduro’s. It’s just another fictional crypto “peg” that’s doomed to fail.

How to Build a Stable Cryptocurrency

Amazingly, Venezuela’s bad examples have already been mirrored in several attempts at building a stable cryptocurrency. One of the earliest of these was called BitUSD, which tried to create a dollar-pegged token with tactics vaguely similar to a national central bank peg. The problem is that BitUSD  didn’t have any actual reserves, instead hoping to use assets on its own blockchain as leverage. BitUSD failed within days back in 2014. The broader BitShares platform BitUSD was a part of proposed pegging cryptocurrencies to everything from real estate to oil (sound familiar?), without any actual backing – but its founder has since moved on to other projects, freeing him from the onerous burden of an impossible promise.

Two projects are currently trying to do similar things. Basecoin describes its approach as “an algorithmic central bank,” using multiple versions of its own coins, rapidly bought and sold in response to market moves, to stabilize their peg. Basecoin even refers to these as ‘bonds,’ which makes their approach clear. MakerDAO’s DAI is “price stabilized against the value of the U.S. Dollar” using a basket of crypto-assets as collateral, which at least seems a bit more promising, but is still risky and capital-inefficient. DAI’s dollar peg, while a bit more durable than Venezuela’s, has had some hickups since its December debut.

There is a lot of evidence, then, that self-pegging systems are fundamentally untenable because they’re so vulnerable to arbitrage attacks and other externalities. MakerDAO, because it uses crypto-asset reserves, may have a better chance to invent something new as trust in those assets grows. But that’s a long-term proposition: it’ll be a while before a general public that witnessed the Bitcoin boom of 2017, its accompanying scrum of rampant scamming and vaporware, and then a dizzying year-end crash, will feel confident truly trusting pure crypto-assets (ironic, right?).

And so we move on to the ultimate “good but bad” example in the stable coin space: Tether. In principle, Tether is a stablecoin that does things right – its creators claim to have dollar-denominated bank reserves backing each of its $1 tokens, no algorithmic bonds or blockchain magic required. But ‘claim’ is the key word here – Tether has so far failed to provide transparent auditing to validate its reserves. That, along with some opacity around the coin’s relationship with the Bitfinex exchange, has led to widespread worries that Tether might be revealed as somehow unreliable or fraudulent – with potentially devastating impacts.

One project that wants to do reserve-backed crypto better is TrueUSD, a stablecoin built on the TrustToken platform. TrueUSD proposes to use an existing and reliable legal structure – trusts – to provide transparency and reliability for a dollar-stable cryptocurrency. The trust accounts backing TrueUSD would not be controlled by TrueUSD’s creators, avoiding many of Tether’s problems. Instead, TrueUSD users will be direct beneficiaries of funds in custodianship, and will be able to exchange funds directly with TrueUSD partner banks. It seems like a reasonable compromise between the crypto-ideals of decentralization, and practical and regulatory needs for an interface with the analog economy.

This simple idea of matching stablecoins to dollars one-to-one may seem simply boring, compared to the promises of advanced financial engineering made by projects like MakerDAO. But the reality is that pegging the value of a cryptocurrency – just like stabilizing a smaller national currency – is near-impossible without real-world reserves. That’s because ultimately, currencies are channels for information about entire economies and societies. Many stablecoin projects – not unlike Venezuela -  are essentially promising to defy those signals, using resources that are vanishingly insignificant compared to the forces arrayed against them. At least for the time being, a much more sensible path to building a stable cryptocurrency may be to lean on an asset that most of the world already trusts – the dollar, and the U.S. economy that stands behind it.

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