This week started on a fun tone as I dug up news about a USD-backed cryptocurrency whose creators were caught lying about the amount of cash they had in reserves, but by Friday I found myself ranting about currency stabilizing tactics with limited to no collateral over an Aperol spritz at some friends on vacation who were just trying to have a good time. I’m ashamed, but I stand by my actions- I can’t think of anything else that is so widely used and yet so poorly understood like our day to day currency.
This piece began as a simple exercise in describing how people are plotting to use the blockchain to build a successor world reserve currency to USD proliferated into something too unwieldy for just one post, so I’m making a two-part post about creating stable currencies and crypto “central banks” called Stablemania. “Stability”, in my view, is the last characteristic cryptocurrencies haven’t achieved which prevents them from being widely adopted in everyday use. I describe some key innovations, theories, and efforts to create a viable cryptocurrency to power everything from your future mundane grocery runs to global economic productivity.
In Stablemania Part 1, I will describe why we needed to build a stable-value cryptocurrency and some of the early efforts, which paved the way to creating a decentralized “central bank” to manage monetary policy for a currency. Please share your feedback about how I covered this topic, and enjoy.
The Genesis of the Stablecoin
When the Ethereum foundation was trying to get their new blockchain off the ground, they raised money from people in the form of Bitcoin. It seemed like a no-brainer to demonstrate they had full faith in the technology they were building alongside right up until the price of Bitcoin crashed because a bunch of speculators got scared. The Ethereum team barely made it out alive when their money evaporated overnight, and this even served as a clear illustration of why even crypto believers don’t use Bitcoin as currency everyday. An important role of currency is valuing your labour against other people’s labour, and having that value remain constant for the foreseeable future.
A year later, Ethereum would scrape its way out of being on the brink of death to launch a platform that others could build apps on, like exchanges, games, and payments apps. The catch to make payments and token exchanges on any of these blockchain-based apps was that you could only use cryptocurrency on them. This presented a problem for a user who wanted to use, say, a decentralized payment app to send money to friends, but didn’t want to keep or be paid in volatile Ether coins in case the price of it tanked. There was simply no way to send regular USD (or other fiat currencies) on these decentralized apps.
In 2014, three dudes by the names of Brock Pierce (a former actor), Craig Sellars (some guy with a CS degree), and Reeve Collins (some guy with a business degree) dreamt up a solution for those who wanted a USD cryptocurrency: They made a USD cryptocurrency.
Let me unpack the rocket science: These folks launched a token called RealCoin (first launched on the Bitcoin blockchain) that you could buy for $1USD. They would [theoretically] take your money and put it in a bank account. Now you could take your RealCoin and use it on the blockchain for payments, and they would do the work of ensuring that your RealCoin was always worth $1USD if you wanted to convert it back to fiat. Think of what they built as a Visa payments network on the blockchain.
When you keep assets in the bank equal in value to every unit of currency you lend to people to use, you create a fully collateralized currency. Fully collateralized currencies are the ultimate symbol of trust among currency because if everybody went to the bank tomorrow to withdraw their deposited assets, everyone would get their money back and the system wouldn’t collapse. RealCoin promised they would always be fully collateralized with USD, and in theory if you redeemed your RealCoin for USD, they would destroy your token to maintain this stability.
Here are 2 numbers about RealCoin (now Tether, ticker USDT) today:
It is the highest traded cryptocurrency by volume, surpassing Bitcoin in 2019
There are 69.3 billion USDT coins as of August 2021
USDT’s astronomical trading volume validates that there is a need for a cryptocurrency that is stable, which probably surpassed anyone’s wildest dreams in 2014. USDT has now built protocols on other huge blockchain protocols such as Ethereum and Algorand, with their stablecoins serving as the “link” you can use on the decentralized exchanges on their supported blockchain networks. The utility of these tethered currency coins is palpable when you interact with decentralized finance (DeFi) applications. It all seems really awesome, great, fine and dandy until you ask the Tether folks a simple question:
“Do you really have $69.3 billion sitting in a bank somewhere?”
“That’s absurd, obviously not,” They say, after being having the whistle blown on them and getting fined $41 million dollars for “not having sufficient monetary reserves”. “We’re providing unparalleled transparency instead, dummies. Look at these pie charts we made for you.”
Let’s be optimistic and decide that Tether thought it would be a more productive use of its capital to loan and invest it on behalf of their users. If that’s the case, it kinda seems they thought they could be a central bank, all while insisting to authorities they were just a lowly fintech company.
Back up. What does a central bank do?
Determine and maintain the value of currency by minting or limiting money supply and setting the interest rate
Manage reserves by maintaining collateral according to policy; includes bonds and stocks
Provide/manage payment system by enabling currency to be used as a payment
Maintain stability of government which in the crypto world is TBD
By this definition, it’s clear to see that Tether acted like a central bank of their own currency in almost every regard as an independent company. As the usage of USDT grew, the more risk everybody invested in crypto was exposed to. It’s an understatement to say they weren’t the decentralized kings the world yearned for. Since currency is a public service that is supposed to work selflessly for the people, shouldn’t it be democratically governed, which the blockchain was supposed to make possible?
Stable AND Distributed
In Vitalik’s original Ethereum whitepaper where he proposed the types of programs that could be built on his new smart contract blockchain platform, he argues that fully decentralized governance can be written in code to create what is called a decentralized, autonomous organization (DAO).
What are DAOs?
People working in an organization are [ideally] working toward the same clear and defined goals. What if the functions, rules, checks, and balances were simply written into code? It would certainly be more efficient than having people achieve and enforce those goals. Above, I listed the goals and functions of a central bank- With the Bitcoin protocol already controlling money supply with code, it’s arguably not that far of a stretch to write code to ensure that the price of a coin stays fixed at a certain value.
But doesn’t that mean the one person who writes the code is the one who runs this central bank?
Recall the fundamental breakthrough of blockchain technology, which distributes computing power across many “nodes” (theoretically, 1 node = 1 user’s computer) in order for the software built on top to run at all. The one person writing all the code needs other people to validate and accept all the code they’re writing before they agree to run it on their computer as well. Anyone can make changes to the underlying code; and if a large enough group agrees on one version of the code and software, that’s how rules are adopted by a network. This fundamentally prevents one group implementing rules and policies without publicly announcing what they are doing, and anyone can propose a change to the code at a later date. If Tether was run by a DAO, everyone would have to agree with how they were composing their collateral base and Tether would be forced to be fully transparent.
On that note, allow me to introduce another dollar-pegged stablecoin that is run instead by a decentralized organization: DAI currency, run by MakerDAO. The DAI currency itself is another fully collateralized stablecoin that is pegged to $1USD; The difference is that instead of keeping USD in reserve, they are backed by cryptocurrency assets. Like Tether, MakerDAO needs to make decisions around when to mint and limit supply, how much collateralization is needed to back their currency, and how to allocate their collateral with the right balance of risk against productivity so their currency can function. Apparently, all those decisions can be boiled down to setting a few parameters (see MakerDAO’s whitepaper):
Collateral asset types: The assets, such as Ether, that underpin the value of a DAI and are deposited to create more DAI
Target rate and target rate sensitivity parameter: In the event of extreme volatility in underlying assets, they need to determine the rate of change for target price (again, $1USD) and how quickly the target price should change (sensitivity parameter). In normal conditions, both the target rate and sensitivity parameter are set to 0 so that DAI maintains its target value of $1USD.
Appointing global settlers: In the event that DAI is going under and all assets need to be liquidated to be returned to DAI holders, there are certain computers responsible for settling everyone’s sum. They need to determine how many settlers are needed and who those trusted settlers are.
Appointing oracles and feed sensitivity: The DAI system needs several decentralized computers/nodes to report the worth of its underlying assets as they are valued on other exchanges into the system so that the value of DAI can be maintained. If an attacker manages to trick everyone into thinking that the price of Ether is worth nothing, they could cause DAI to collapse, so it’s very important that these sources are trusted. These sources are called “oracles” and they need to be appointed.
With all the parameters to govern this currency outlined, all that’s left is to determine who gets to make these decisions. To enable anyone to participate in this governance, MakerDAO minted another separate token (called Maker token, ticker MKR) that you can buy from an exchange just like Bitcoin. Any MKR holder can propose a change to these parameters, which are then voted upon by every MKR holder with impact proportional to how much of the governance token they hold. It should go without saying that MKR holders are incentivized to vote in favour of policies that benefit the growth, stability, and usability of DAI because they paid for these tokens and don’t want them to be worthless. Here’s an example of a vote:
Does it work?
MakerDAO successfully maintains its soft peg to this day and as perhaps the ultimate flex symbol of its success in decentralizing, Rune Christensen was able to dissolve the founding organization of MakerDAO because it could be completely governed through its democratic voting protocol. MakerDAO is a huge cryptocurrency, but some have argued that it will never achieve the scale necessary to be the global currency for the same reason that the USDollar was taken off the gold standard in 1933: Using fully collateralized currencies will limit financial productivity and economic growth (especially in a recession when everyone wants their assets back).
In part 2, I’ll discuss theoretical proposals for stablecoins that are not fully collateralized, which are known as Algorithmic Stablecoins because, well, they’re nothing but a set of code rules for a central bank. After everything I’ve learned about stablecoins, I will share what I believe to be the most likely path for stablecoins to gain public trust and mass adoption.
To end off this essay, I hope you found the concept of DAOs to be as exciting as I did when I started to grasp how they worked. To me, blockchain technology is most exciting for its governance potential for “public good” organizations such as charities to combat world hunger, human rights violations, and climate change, not as a currency. I plan to cover these applications of the blockchain in upcoming essays.
Thanks as always for reading.
Works Referenced
How stablecoins follow federal reserve format: https://medium.com/dragonfly-research/a-visual-explanation-of-algorithmic-stablecoins-9a0c1f0f51a0
Rune Christensen proposes MakerDAO on Reddit 6 years ago: https://www.reddit.com/r/ethereum/comments/30f98i/introducing_edollar_the_ultimate_stablecoin_built/
What are MakerDAO Oracles: https://makerdao.world/en/learn/Oracles/how-it-works/
All the ways to participate in MakerDAO (not limited to voting participating): https://makerdao.world/en/learn/governance/participate/
About the MKR token: https://makerdao.world/en/learn/governance/mkr-token
MakerDAO code documentation, as code is the new policy documentation in the decentralized world: https://docs.makerdao.com/
MakerDAO whitepaper, my primary source: https://makerdao.com/en/whitepaper/#abstract
A few MakerDAO explainers: https://decrypt.co/resources/makerdao-guide-learn-explained-decrypt-3-minutes, https://www.gemini.com/cryptopedia/makerdao-dai-decentralized-autonomous-organization#section-dai-not-the-only-stablecoin-but-the-most-ubiquitous, https://thedefiant.io/what-is-makerdao-and-how-does-dai-work/
Whistleblowing on Tether: https://bitfinexed.medium.com/
This is not investment advice. I do not hold positions in MKR, DAI, or USDT.