Blockchain innovation has already delivered major disruptive “use-cases” to the world. This has primarily been in the finance sector, although we can already see future “use-cases” in other sectors beginning to emerge. The major disruptive use cases in finance thus far include Bitcoin, as a store of value and medium of exchange, and ERC20 Tokens, which has brought innovators a new form of finance. For example, Block.one has raised approximately US$4 billion in funding through this new form of finance, which rivals in size major institutionally underwritten public offerings, such as by Meituan in September 2018.
LEX anticipates the next wave of disruptive innovation in two areas: Stablecoinsand Security Tokens. This LEX will discuss Stablecoins, and in a future report, we will discuss the development of Security Tokens.
A Stablecoin is a digital currency that is pegged to another stable asset such as gold, or to a major fiat currency, such as the US dollar, Euros or Pounds. The leading Stablecoin, Tether (USDT) is 1:1 US dollar backed, and is by far the most widely used Stablecoin in the market today. The mostly widely adopted use-case has been as a store of value and a medium of exchange. Many businesses that take Bitcoin for payment are now also taking USDT, and this has become a growing medium for Blockchain companies to compensate advisors and employees. Hence, Stablecoins are emerging as a measure of performance, unit of account, remittance, and eventually, we see emergence in the United States, Europe and other jurisdictions for pegged lending based on Stablecoins.
New trends we see over the past several months in Stablecoins include the emergence of Cryptocurrency-backed Stablecoins and Algorithmic Stablecoins (non-asset backed), as well as Hybrid Stablecoins, which are discussed further below. Meanwhile, in September 2018, we also saw the launch of regulatory approved Stablecoins in New York State, Gemini Dollar (GUSD) and Paxos Standard (PAX), which are both 1:1 US dollar backed. We should all hail this major milestone in Blockchain because hurdles have been cleared for three areas that have in the past stumbled Blockchain cryptocurrency projects: Regulatory Approval, Custody and Insurance.
As of today, LEX counts almost 60 major Stablecoin projects globally. 22 of these projects have already been launched, the rest are in various stages of development and financing. We anticipate more major Stablecoins launches over the next 12 to 18 months, as we see innovation in terms of algorithmic approaches, a broader range of fiat currency collateralization, and regulatory approvals in various jurisdictions. Of these 60 Stablecoins that have launched or are being developed, 77% are asset backed. Meanwhile, 23% are algorithmic based, bringing stability by using algorithmic software to match demand and supply instead of through collateralization of an asset. This method is similar to how monetary authorities in some countries also stabilize their currencies. An example of an Algorithmic Stablecoin is the one being developed by Basis, a company funded by LEX’s Investment Partner, ZhenFund, amongst other global investors. Basis is a USD-pegged Stablecoin that operates by expanding and contracting the supply of Basis Stablecoins to maintain its peg to USD, as well as other methods that are software based.
Amongst the asset-backed Stablecoins, USD dominates as collateral in 2/3rds of the projects we have seen thus far in the market. Meanwhile, other currency anchors are also in the works, such as one based on Japanese Yen, another based on Swiss Franc (called project Alprockz), and another based on CNH (overseas RMB) announced this week by CITIC International in Hong Kong. As an alternative to fiat currency collateralization, LEX anticipates the emergence of a number of Crypto-currency backed Stablecoins over the next 12 months, including “Hybrid Stablecoins” which combine asset collateralization and also algorithmic support. This is because both methods can be effective for generating stability, while the algorithmic-only approach may not scale in terms of wide spread confidence – and thus, algorithmic approaches may have to also utilize collateral, even though their whitepapers’ initially claim to be only algorithmic.
One interesting development is a Crypto-currency backed Stablecoin project, MakerDao (MKR), which is behind Dai (DAI), an Ethereum (ETH)-based Stablecoin. On September 24, 2018, MakerDao was invested by Andreesen Horowitz. LEX observes that Andreesen Horowitz and other venture capital funds have invested in a number of Stablecoin projects that use different methods, indicating that they believe the market will be large, yet they also have decided to back multiple horses in the race for Stablecoin supremacy. Who will win? We foresee that there will be room for eight to twelve major Stablecoins that are widely used by 2021, representing large scale transactional volume in global instant trading. The key to winning will be Transparency, Automation and Scalability. Today, we find that Centralization is a key component of confidence in the stability of a Stablecoin; the top Stablecoins are centralized. Yet in the future, as Decentralized automated platforms prove their stability, adopters will seek more Decentralized platforms in the general spirit of Blockchain. We also found that about 50% of the Stablecoins are building on ERC20 protocol, and most of are legally domiciled in the United States or Switzerland, as well as a handful of other European jurisdictions.
US DOLLAR STABLECOINS: USDT, TUSD, GUSD, PAX
Tether (USDT) is the horse that is by far in the lead in the Stablecoin race. It is a pillar of most of the major cryptoexchanges and has the highest transactional volume. The current second place Stablecoin is TrueUSD (TUSD) developed by TrustToken, a company financed in June 2018 by LEX’s Investment Partner, ZhenFund, amongst other global early stage investors. TrueUSD has the second highest adoption by major exchanges, yet still lags far behind USDT in terms of trading volume.
One of the main issues with USD-backed Stablecoins has been transparency. Primarily related to whether collateralization is at 1:1 ratio with the Stablecoins in circulation. LEX’s Partner, DFund is an early investor in Bitfinex, which created Tether (USDT). The founder of DFund, Zhao Dong, along with Lao Mao of Big.one went to Europe to meet with Bitfinex’s CEO Giancarlo Devasini in January 2018 to examine the bank accounts which holds the USD cash reserves backing USDT. Upon their review, they confirmed that the accounts had a total of $3 Billion in cash holdings, which was greater than the circulation at that time of USDT. A Stablecoin that is asset backed, like USDT, in order to be stable, needs to have at least as much of the value of the asset (in this case, USD) to back the circulation of the Stablecoin itself. Yet this issue of transparency has dogged almost all asset-backed Stablecoins, and related to that, so has the issues of custody and the safe storage of the assets. Just how much USD can one group safely hold in cash to collateralize a scaling Stablecoin that becomes geometrically adopted around the globe? And how can institutional investors trust the collateralization?
One key milestone for Blockchain occurred this month when the New York Department of Financial Services (NYDFS) approved GUSD and PAX. This not only helped improve the transparency issue related to USD-backed Stablecoins, but also cleared three major hurdles confronting the Blockchain cryptocurrency industry in general: Regulatory Approval, Custody and Insurance. To understand the significance of this development, we have to understand the history of Blockchain regulation in New York State.
As one of the leading financial markets in the world, New York State was one of the first jurisdictions in the world to regulate cryptocurrencies with the announcement of the NYDFS BitLicense in November 2013. With the launch of the licenses in 2015, the BitLicense framework was widely regarded as overly strict, and unfortunately, the NYDFS only issued three Bitlicences in its initial years up to late 2017. And they were to firms that were backed by major institutional investors, such as Circle, which is funded by Goldman Sachs, instead of other companies that are not backed by large institutional money. This caused not only a major backlash from the Blockchain industry, but an exodus of some of the top companies and top talented individuals from New York to other states in the US and even to overseas countries, resulting in what we call in the West, “Brain Drain”. The New York Business Journal called this the “Great Bitcoin Exodus” from New York.
One of the panels at the Consensus 2018 event in New York was to bring attention to this issue. It was led by some of the major companies such as ShapeShift and Kraken, which left New York because of the BitLicense matter. This exodus hurt New York’s competitiveness in the development of Blockchain innovation and commerce. However, the NYDFS seems to have taken some important steps over the past 12 months to rectify this problem. It accelerated the issuance of BitLicenses, as well as approval of other cryptocurrency business activities. Since late 2017, NYDFS has issued 6 more BitLicenses, including to Asian companies such as Tokyo based bitFlyer and Hong Kong based Xapo. The NYDFS has also allowed certain groups to operate under ‘provisional licenses’ or engage in cryptocurrency business, so long as they ‘comply with the BitLicence framework’. Both Paxos and Gemini are two such groups.
Gemini and Paxos were granted charters by the NYDFS to operate as a Trust under New York Banking Law. As of yet, they do not have BitLicenses, but both companies licensed as Trusts by the NYDFS are required to ‘comply with the NYDFS BitLicense framework’. Over the past year, both groups were granted various approvals to allow for trading of certain cryptocurrencies, and also offer custody services. In May 2018, Paxos was even authorized by the NYDFS to operate a blockchain platform for the settlement of gold bullion. Then, this month, both were granted approvals to issue cryptocurrencies pegged to USD. This clears the Regulatory Approval hurdle faced by many cryptocurrency companies. In the case of Gemini, the US dollars will be kept in the accounts of State Street bank, and so customers will have the benefit of pass-through FDIC-Insurance of their deposits. This solves the Custody and Insurance hurdles faced generally by cryptocurrency companies. Also, there is a requirement for regular audits by a CPA to ensure 1:1 collateralization and audits of their computer systems by third party computer security firms. These transparency and security measures give users more assurances than other USD backed Stablecoins in circulation. And these are the types of measures many institutional investors from the traditional global financial world are seeking to enter the cryptocurrency market.
Stablecoins present the financial industry with a multi trillion dollar use-case opportunity. The annual trading volume of USDT alone is already in the 1 trillion dollar range, with daily volume in the US$3 Billion range. In the future, Stablecoins may be backed by hundreds of billions of dollars in assets, and develop into a highly adopted medium of exchange and store of value. Many institutional investors in all of the world’s major financial centers are waiting on the sidelines, seeking ways to invest into the cryptocurrency market. Yet stability is one of the major gating factors. Stablecoins help bring stability to a highly volatile market. Increased regulatory approvals in various key jurisdictions will also help Stablecoins bring more institutional investors into the market from the traditional global finance world. This month’s approvals by New York State may just be the beginning, as other major financial regulators around the globe examine Stablecoins along with other forms of cryptocurrencies. The U.S. Securities & Exchange Commission (SEC) has taken a strict view that tokens are ‘securities’, with the exception of Bitcoin, and perhaps the exception of Ethereum (the SEC has yet to officially say ETH is not a security, even if reported in the media otherwise). Even with the SEC’s wide interpretation of cryptocurrencies as securities, LEX anticipates that Stablecoins may be excluded from being classified as ‘securities’ because there is not an ‘expectation of profit’ from buying Stablecoins, as per the SEC’s Howey Test analysis. However, certain activities under some Stablecoin models, such as the usage of basis bonds, may trap them in the U.S. securities framework.
We also see increased adoption in the various use-cases outlined above, most notably Stablecoin for store of value, medium of exchange and for pegged lending. One of the main outcomes of the rise of Stablecoins, LEX believes, is the integration of the traditional global finance world with the crypto finance world – as Stablecoins represent another layer of the building of the global digital asset infrastructure we all strive to develop together. It is another innovation in Blockchain – this time utilizing innovations in computer code, finance and law. In 20 years from now, when we look back at the early development days of our global Blockchain and cryptocurrency industry, Stablecoins may be one of the major disruptive developments we acknowledge as a significant contributor to the growth and success of our ecosystem.
A. Why do we need Stablecoins?
1.Stability. To steer cryptocurrencies towards a wider adoption, wide-spread circulation and daily use, the volatility of many cryptocurrencies is a big hurdle. Stability is fundamental for cryptocurrencies to be used for payment and to participate in traditional finance. In addition, a Stablecoin backed by a fiat currency that has lower inflation rate gives the Stablecoin more purchasing power.
2.Faster and cheaper trading. Compared to fiat currency, adopting Stablecoins in our current financial system creates the ability to cut out the middleman and third-party institutions. Also, just like all cryptocurrencies, Stablecoins can be traded 24/7 365 days on a global basis worldwide with instant settlement. These aspects of cryptocurrencies, including the future development of Security Tokens, are a game changer.
B. What are the different types of Stablecoins in the Market?
There are many ways to categorize the Stablecoins in the market, by the asset they are pegged to, or by the collateral they use to ensure the maintenance of its market peg. To better understand the issues Stablecoins try to solve, it’s better to fit them into these three broad categories:
1.Fiat collateralized (e.g. Tether, TrueUSD, GUSD and PAX). A certain amount of fiat currency is deposited as a collateral and Stablecoins are issued 1:1 against this fiat money. To guarantee the issuance and redeemability of the Stablecoin exchanging with fiat currency, a central party (custodian) is required. Regular audits are needed to ensure that the Stablecoin is indeed fully collateralized.
2.Crypto collateralized (e.g. BitShare, MakerDao and Havven). It is similar to fiat collateralized stablecoins, but it’s normally over-collateralized with crypto assets to cover the volatility. Crypto collateralized Stablecoins are more decentralized and more liquid than their fiat collateralized counterparts but also more unstable.
3.Non-collateralized (e.g. Basis and Saga). Non-collateralized Stablecoins are not actually backed by by anything other than the expectation that they will retain a certain value. Non-collateralized Stablecoins are more decentralized and independent, but it is difficult to ensure their stability. Many of the non-collateralized Stablecoin projects are Algorithmic Stablecoins, which create stability through software based algorithmic formula. LEX anticipates that as the market sees the advantages of Algorithmic Stablecoins, yet scalable adoption is limited because of confidence in non-collateralized Stablecoins, we will see the emergence of Hybrid Stablecoins, which will combine the advantages of algorithmic price support with full or partial asset collateralization.