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\begin{document}
\title{The State Of Stablecoins- Why They Matter \& Five Use Cases}
\author[1]{Sheikh Mohammed Irfan}%
\author[2]{Robert Lin}%
\author[3]{Mark Conrad}%
\affil[1]{MIT}%
\affil[2]{University of Washington}%
\affil[3]{Affiliation not available}%
\vspace{-1em}
\date{\today}
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\begin{abstract}
Price-stable cryptocurrencies, commonly referred to as stablecoins, have
received a significant amount of attention recently. Much of this has
been in hopes that they can fix some of the issues with
cryptocurrency---most notably price instability. However, little
analysis has been done with respect to the drivers and investment
potential of stablecoins. Stablecoins fulfill different functions of
money based on their implementation. As a result, they have unique
trade-offs from one another and from physical currency (fiat) itself.
Stablecoins offer a similar value proposition to fiat, but the two
should not be compared on a one-to-one basis as stablecoins contain
unique trade-offs and benefits. These differences will drive the demand
for these tokens while enabling specific use cases. The purpose of this
paper is to shed light on the adoption and the potential of market share
growth for stablecoins given five selected use cases: dollarization,
smart contracts, peer to peer (P2P) and peer to business (P2B payments),
safe haven for exchanges, and as a reserve currency. We will discuss the
opportunities within each of these use cases and assess the factors
which will determine the success of stablecoins. Using insights
contained in this paper, technologists can think about how best to
position themselves in the short, medium, and long term.~%
\end{abstract}%
\sloppy
\section*{Introduction}
{\label{874460}}\par\null
A stable digital currency has the largest total address market (TAM) of
any cryptocurrency---\$90 trillion---according to Myles Snider, an
advisor to the cryptocurrency venture capital firm Multicoin Capital.
This estimate assumes global adoption of stablecoins as an alternative
currency replacing fiat altogether. This is certainly a far-fetched
possibility. However, it does convey the opportunity for stablecoins to
impact billions of people in the way they transact.
Potential opportunities to leverage this technology include the use of
stablecoins as safe-haven assets on cryptocurrency exchanges, the
expansion of dollarization in emerging economies, P2P and P2B payments,
integration with smart contracts, and the use of stablecoins as a
central bank reserve currency. These opportunities vary in the time
frame of addressability and factors leading to success.
This paper is divided into two sections. The first section consists of
an overview of key concepts about the roles of money, the different
types of stablecoins, and the historical circumstances surrounding
stablecoins. The second section of the paper consists of use cases of
each opportunity.
\par\null
\section*{TABLE OF CONTENTS}
{\label{367199}}
\textbf{Abstract\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}..2}
\textbf{Introduction\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}.3}
\textbf{Section I:History and Context for Stablecoins}
\textbf{1.1 History of
Currencies\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}3-4}
\textbf{1.2 What is the key opportunity for
stablecoins?\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}.4-5}
\textbf{1.3 The Meaning of
Money\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}5-7}
\textbf{Section II: State of Stable Coins}
\textbf{~~~~~~~~~ 2.1 The Tether
Project\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}7-10}
\textbf{~~~~~~~~~ 2.2 Three types of
Stablecoins\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}10-14}
\textbf{2.2.1 Fiat-Collateralized
Stablecoins\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}.10-12}
\textbf{2.2.2 Crypto-Collateralized
Stablecoins\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}..12-13}
\textbf{2.2.3 Uncollateralized
Stablecoins\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}.13-14}
\textbf{Section III: Five Use Cases of Stablecoins}
\textbf{3.1 Safe Haven for
Traders\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}15-18}
\textbf{3.2 Dollarization
2.0\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}18-21}
\textbf{3.3 Peer to Peer (P2P) and Peer to Business
(P2B)\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}21-23}
\textbf{3.4 Smart Contract
Integration\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}23-25}
\textbf{3.5 Reserve
Currency\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}.25-29}
\textbf{Conclusion\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}\ldots{}29-30}
\section*{1. History and Context for
Stablecoins}
{\label{915161}}
\subsection*{1.1 History of Currencies}
{\label{577698}}
\textbf{Long ago, trade was done by barter and, as a result, exchange
rates were uncertain and dependent on the goods being traded. Over time,
people found it easier to use specific forms of value to simplify trade
(i.e. currencies). Goods were denominated in shells, stones, and
eventually metal coins. Banks came into existence out of the need for a
secure housing of currencies. Eventually, in order to make transactions
easier and after significant trust (a recurring topic of importance in
this paper) had been developed in banks, people began trading orders to
transfer currency between accounts
(}\href{https://www.telegraph.co.uk/finance/businessclub/money/11174013/The-history-of-money-from-barter-to-bitcoin.html}{\textbf{banknotes}}\textbf{).
These banknotes established evidence for the negotiable settlement of
debt---meaning verifiable documents which told the banks to transfer
currency from one person to another. This is how much of the developed
world operated until the}
\href{https://www.telegraph.co.uk/finance/businessclub/money/11174013/The-history-of-money-from-barter-to-bitcoin.html}{\textbf{Bretton
Woods system}} \textbf{---the beginning of global dominance for the US
dollar (USD).}
\textbf{Under the Bretton Woods system established in 1944, all
currencies were indirectly backed by gold because they were convertible
to USD (likewise,}
\href{https://www.federalreservehistory.org/essays/bretton_woods_created}{\textbf{banknotes
were convertible to gold}}\textbf{). In 1971, however, US President
Richard Nixon suspended the ability to convert USD to
gold,}\href{https://www.federalreservehistory.org/essays/gold_convertibility_ends}{\textbf{thus
decoupling much of the global system from gold}} \textbf{and making the
US dollar an unbacked, free floating, fiat currency. Relative stability
remained despite no concrete peg or exchange rate for USD. After the end
of the Bretton Woods system, global currencies have been mostly fiat
(unbacked by anything other than a government's agreement to recognize
the value of a specific currency).}
\subsection*{1.2. What is the Key Opportunity for
Stablecoins?}
{\label{135082}}
\textbf{Although not broken, the global currency market has room for
improvement. Many regions in the world are experiencing hyperinflation,
often resulting in the disappearance of wealth virtually overnight.
Monetary policy tools are mostly indirect and their effects on the
future are often debated. Cash transactions often come at a}
\href{https://www.cnbc.com/2013/10/10/cash-costs-americans-20-billion-a-year.html}{\textbf{high
cost}}\textbf{.}
\textbf{In short, technologists have created stable, digitally-native
currencies which are built on top of the underpinnings of existing
blockchain technology. Stablecoins help avoid the volatility associated
with cryptocurrencies while retaining the benefits of full provenance
(auditability) of transactions, programmability, and the capability to
efficiently transact across borders. Hundreds of bright minds and vast
amounts of capital are pushing for stablecoin adoption---both as a fiat
currency alternative and as a new payment system. For example, top
financial institutions and investors such as Goldman Sachs, Peter Thiel,
Andreessen Horowitz, Bain Capital Ventures, Y Combinator, Facebook
(specifically developing
a}\href{https://www.bloomberg.com/news/articles/2018-12-21/facebook-is-said-to-develop-stablecoin-for-whatsapp-transfers}{\textbf{stablecoin
for remittances in India}}\textbf{), and countless others have invested
millions into projects in this space. For the first time in history, we
could see the adoption of disintermediated value transfer systems; these
systems are uncensorable, not dependent on any sovereign system, and act
as a non-volatile store of value.}
\textbf{Even governments are looking into ways they can improve their
currencies. For example, the Russian Association of Cryptocurrency and
Blockchain plans to release a}
\href{https://hi-tech.mail.ru/news/ehksklyuziv-kriptorubl-budet-vypushchen-v-seredine-2019-goda/}{\textbf{``crypto-ruble''}}
\textbf{in 2019, and a fund backed by the government of the Chinese city
Hangzhou is working with a Japanese bank to create a}
\href{https://www.scmp.com/business/companies/article/2164575/hong-kong-listed-grandshores-raising-hk100m-digital-token-fund}{\textbf{Yen-pegged
stablecoin}}\textbf{. The use cases for a government stablecoin include
seeking means to}
\href{https://mashable.com/2018/01/08/cryptocurrency-bitcoin-governments/\#uRvc4CV8zaqO}{\textbf{track
transactions}}\textbf{,}
\href{https://www.macrovoices.com/107-publications/480-beyond-blockchain}{\textbf{maintaining
capital controls, implementing effective monetary policy}}\textbf{, and}
\href{https://www.ft.com/content/54d026d8-e4cc-11e7-97e2-916d4fbac0da}{\textbf{avoiding
sanctions}}\textbf{. Many governments are also wary of the risks that
decentralized stablecoins pose. These risks include undermining the
effectiveness of monetary policy (depending on implementation), loss of
seigniorage profits, money laundering, loss of government autonomy, and
other threats.}
\subsection*{1.3. The Meaning of Money}
{\label{655607}}
\textbf{The qualities that make money usable are often taken for
granted. According to the International Monetary Fund (IMF), in order
for money to be successful, it must have
these}\href{https://www.imf.org/external/pubs/ft/fandd/2012/09/basics.htm}{\textbf{three
functions}}\textbf{:}
\begin{itemize}
\tightlist
\item
\textbf{Store of value: Its value does not depreciate (quickly). For
example, vegetables are a poor store of value in that they rot and
become worthless within only a few weeks. As a result, they are not a
good asset for storing wealth. Compare this to USD, which hovers at
\textasciitilde{}1.5\% depreciation per year.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Medium of exchange: People must ~use it in transactions. For
example, real estate stores value very well, but no one buys goods or
services using their home as means of exchange due to the high costs
associated with transferring ownership. Thus, these assets are not
well-suited as a medium of exchange. Similarly, payment platforms,
such as Stripe, have stopped accepting Bitcoin due to its transaction
costs and high volatility, resulting in reduced value as a medium of
exchange.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Unit of account: The currency should exhibit the ability to be
denominated in a useful manner. For example, gold may hold its value
well and could be carried in a transportable manner (e.g. gold coins),
but it would still be difficult to pay for goods and services using
gold because most products and services are not denominated in it.}
\end{itemize}
\textbf{(Economists differentiate between currency and money---for the
purposes of this paper, we will use the two terms interchangeably.)}
\textbf{All of the functions above are necessary for a currency to reach
widespread adoption over time. So the question remains:}
\textbf{Why should anyone use stablecoins instead of fiat, such as USD?
The answer is not so simple.}
\textbf{As a medium of exchange, fiat has the clear advantage of
mainstream adoption. Cryptocurrencies, on the other hand, are generally
not used in transactions, thus limiting their use as a medium of
exchange. However, fiat can be slow and relies on antiquated technology
and regulatory restrictions. On the other hand, cryptocurrencies offer
instant settlement (barring current network limitations) and the
potential for anonymity/pseudo-anonymity. Therefore, stablecoins hope to
benefit from the foundations of cryptocurrency and act as a medium of
exchange similar to traditional fiat.}
\textbf{As a store of value, fiat is at risk of centralized default.
This means that one's money is only as safe as the}
\href{https://www.thebalance.com/understanding-bank-runs-315793}{\textbf{depositors'
confidence}} \textbf{in the centralized system and only up to the}
\href{https://www.thebalance.com/what-is-the-fdic-315786}{\textbf{government's
insured amount}}\textbf{. Most stablecoins in the market today, on the
other hand, are built on a publicly distributed ledger that ensures
trustless immutability and removes the need for a central party to
``police'' the ledger. In more complicated purchases (prone to error or
arbitration), the immutability ~of cryptosystem logs actually becomes a
shortcoming. Moreover, traditional cryptocurrencies suffer from extreme
volatility, making them an unreliable store of value. Stablecoins carry
the benefit of cryptosystems and solve the problem of volatility.}
\textbf{As a unit of account, fiat has the advantage of being the
default unit of account for purchasing goods and services. In the
majority of stores, goods are priced in government fiat currencies. This
is why the vast majority of current stablecoins are pegged to the value
of a fiat currency. Some stablecoin projects, such as}
\href{https://reserve.org/protocol}{\textbf{Reserve}}\textbf{, seek to
someday move away from this peg and become an independent unit of
account.}
\textbf{}
\textbf{In becoming a useful medium of exchange, store of value, and
unit of account, currencies have changed much throughout history. One of
the most critical factors developed over time is trust. ~}
\textbf{Before societies could make use of currencies like metal coins,
people needed to trust that other people would find value in these
coins. Before societies transitioned from precious metals to banknotes
as currencies, people needed to trust that banks would be faithful in
their promise to redeem the notes for precious metals. Otherwise,
banknotes and metal coins would be a poor store of value.}
\textbf{Similar to how trust in the value of a coin or in the
faithfulness of a bank was built up over many years, we can expect that
trust in stablecoins as a unit of account, medium of exchange, and store
of value will take time to develop. These qualities, however, will
develop as iterations upon existing projects take stablecoins further in
terms of technical functionality and public trust.}
\textbf{Currently, the combined}
\href{https://stablecoinindex.com/marketcap}{\textbf{market cap of the
top stablecoins}} \textbf{is almost \$2.5 billion USD (about 2\% of the
market cap of all crypto projects combined). The majority of the
stablecoin market cap is held by one project---Tether. Although Tether
currently enjoys market dominance, there is an opportunity for
second-movers to excel in specific use cases by employing new technology
and business models. In Section 2 we will explore the history of Tether
and outline the three main types of stablecoins.}
\textbf{}
\textbf{2. The State of Stablecoins}
\textbf{2.1. The Tether Project}
\textbf{The current stablecoin ecosystem is mostly dominated by one
player---Tether. Tether is a crypto asset built on top of both the
Omnichain and Ethereum networks. At the time of writing, the project
enjoys a \$1.877 billion market capitalization which represents 75\% of
the whole stablecoin market. Tether claims to be collateralized by USD
at a}\href{https://tether.to/faqs/}{\textbf{1:1 ratio}}\textbf{. In
theory, this means each token is a promise to redeem one USD from a
reserve, although in practice this has been difficult due
to}\href{https://www.bloomberg.com/news/articles/2017-11-21/tether-theft-isn-t-the-first-controversy-for-cryptocurrency-firm}{\textbf{opaque
agreements}}\textbf{.}
\textbf{Starting in August, Tether has fallen under scrutiny because of
its relationship with the Hong Kong-based exchange, BitFinex.
Journalists and researchers have alleged Bitcoin price-fixing schemes
enacted on the Bitfinex exchange (the entry point for most Tether coins)
by publishing critical articles such
as}\href{https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3195066}{\textbf{``Is
BitCoin Really Un-Tethered?''}}\textbf{. Furthermore, both BitFinex and
Tether share the same management team
(CEO,}\href{https://www.bloomberg.com/news/articles/2018-11-20/bitcoin-rigging-criminal-probe-is-said-to-focus-on-tie-to-tether}{\textbf{Jan
van der Velde}}\textbf{, and Director/Chief Strategy Officer, Phil
Potter), adding additional weight to the research-based indictments.}
\textbf{These allegations have significantly undermined the public's
trust in Tether. As a result, the allegations of Tether fixing Bitcoin's
price has prompted
the}\href{https://www.bloomberg.com/news/articles/2018-11-20/bitcoin-rigging-criminal-probe-is-said-to-focus-on-tie-to-tether}{\textbf{US
Justice Department to open a probe}}\textbf{. This has caused Tether's
price volatility (see chart below).}
\href{https://coinmarketcap.com/currencies/tether/\#charts}{\textbf{Figure}}
\textbf{1: Tether Price Instability from September 2018 to January 1st
2019 (data from Coinmarketcap.com)}
\textbf{In spite of this recent negative publicity, as a
proof-of-concept (POC), Tether has demonstrated an immense upside for a
stable digital currency. Tether's market cap increased almost 90\%
(Figure 2) while the top 15 cryptocurrencies (excluding stablecoins)
decreased by almost the same amount. With the project's regulatory
issues and public distrust, there is an opportunity for second-movers in
the stablecoin space to leverage new business models, technologies, and
practices in order to leapfrog Tether and take away its market share.}
\href{https://coinmarketcap.com/currencies/tether/\#charts}{\textbf{Figure}}
\textbf{2: Tether Market Cap increase from January 2018 to October 2018
(data from Coinmarketcap.com)}
\textbf{To demonstrate the investability of these new asset classes we
need to classify stablecoin projects by common traits. Then we will
describe the upside and downside of each of these variations}
\href{https://trends.google.com/trends/explore?q=tether\&geo=US}{\textbf{Figure}}
\textbf{3: Google Trends analyzing the increasing interest in
stablecoins relative to Tether (not to scale).}
\textbf{2.2. Three Types of Stablecoins}
\textbf{2.2.1. Type 1: Fiat-Collateralized Stablecoins}
\textbf{The first classification of stablecoins is fiat-collateralized
stablecoins. Collateralization refers to a pledge to a specific asset by
a lender. By this, a collateralized stablecoin is sold to an individual
for one USD with the promise of a reserve backing of each token. ~This
category includes Tether as well as second-movers, such as}
\href{https://www.trusttoken.com/trueusd/}{\textbf{TrueUSD}}\textbf{,}
\href{https://www.paxos.com/standard/?gclid=CjwKCAiAkrTjBRAoEiwAXpf9CT4eOK6LD0Cx1bR4mIV0loIyOGF8mOta7K2zy1op4Dtf6ggsPUFMqhoCQokQAvD_BwE}{\textbf{Paxos}}\textbf{,}
\href{https://www.stably.io/}{\textbf{Stably}}\textbf{, and}
\href{https://www.circle.com/en/usdc}{\textbf{Circle}}\textbf{. These
projects derive their stability from the promise that each token is
issued on a 1:1 basis with a corresponding fiat currency held in
reserve.}
\textbf{The second-movers differentiate themselves from Tether with a
more thorough regulatory compliance (including}
\href{https://en.wikipedia.org/wiki/Know_your_customer}{\textbf{Know
Your Customer}}\textbf{and}
\href{https://en.wikipedia.org/wiki/Money_laundering\#United_States}{\textbf{Anti
Money Laundering}} \textbf{compliance) and increased transparency for
consumers at the onset. However, this requires these currencies to have
100\% reserve of fiat (as a reference, banks exceeding \$122.3 million
in net transaction accounts are required to have a reserve ratio of
10\%). Furthermore, despite the fact that this model is simple and
proven, there are risks associated with its}
\href{https://www.youtube.com/watch?v=E35poTWzWZA\&t=2357s}{\textbf{centralized}}
\textbf{nature. ~This can include default risk (also known as
counterparty risk), which means a stablecoin company can make claims of
redemption that it does not have the reserves to satisfy the
requirements. This is a trust-reliant model; if consumers don't trust
the integrity of the bonds, their value will not hold. For example, many
countries trust the value of U.S. bonds because they believe that the
U.S. government is unlikely to default on its loans.}
\textbf{These stablecoin companies issue tokens on a 1 to 1 basis with
fiat reserves that they hold. For example, if we were to purchase \$5
worth of Tether, the company will issue 5 USDT tokens.
Fiat-collateralized stablecoin companies earn interest on the reserves
that they hold. Therefore, a larger market cap means more revenue. As a
result, the fiat backed stablecoin companies that are valued higher are
those which have the potential for more adoption. For example, let's
assume company A's projected market cap is \$275M. At the current
risk-free rate (1-yr = 2.7\%), the stablecoin entity would be earning
\$7,425,000 per year from the incurred interest. Because many valuation
methods use earnings or cash flow, the value directly relates to the
interest earned. It}
\textbf{should be noted that companies with other forms of revenue may
have earnings in addition to interest.}
\textbf{Fiat-Collateralized Token Benefits:}
\begin{itemize}
\tightlist
\item
\textbf{Simplicity: Users easily grasp that their tokens can be
redeemed for fiat currency at any time. Because of the 1:1 reserve,
price stability is naturally maintained in the market.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Centralization: Many supporters believe that it is easier for
most to trust a service provider over a smart contract. In this model,
accountability is held by a single entity. Furthermore, changes can be
implemented easily and quickly.}
\end{itemize}
\textbf{Fiat-Collateralized Token Drawbacks:}
\begin{itemize}
\tightlist
\item
\textbf{Centralization: A single point of failure makes the system
risky. Centralization encourages corruption within the system. For
example, the trustworthiness of Tether, a centralized system, has been
called into question.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Slow Processing Time: These services require anti-money
laundering and know your customer compliance in countries such as the
US. These services take time.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Risk of a Bank Run: In a centralized reserve system, when
individuals lose trust in the centralized entity, they will likely
liquidate their asset. For example, negative publicity associated with
Tether led to a mass sell off---resulting in heightened price
volatility.}
\end{itemize}
\textbf{2.2.2. Type 2: Crypto-Collateralized Stablecoins}
\textbf{The second class of stablecoins are those collateralized with
cryptocurrency. Unlike the first category, the collateralized asset for
this category of stablecoins is highly volatile. Because of this, the
value of the collateralized cryptocurrency has the potential to fall
below the value of the stablecoin---at which point the stablecoin would
also drop in value. For example, if a stablecoin is collateralized with
Ethereum, it would need to have a collateralization ratio which accounts
for this volatility---meaning the stablecoin must be overcollateralized.
In other coins, it is not in fact a 1:1 to ratio for redemption, ~but
one that is \textgreater{}1:1.}
\textbf{The most popular project using this framework is}
\href{https://makerdao.com/}{\textbf{MakerDAO}}\textbf{. To put it
simply, the MakerDAO platform is a decentralized, autonomous
organization where investors can generate Dai (a stablecoin) by locking
up ETH in instruments called Collateralized Debt Positions (CDPs).
MakerDAO uses a 150\% reserve ratio (1.5 USDs of ETH to 1 USDs worth of
Dai). If the total volume of collateral falls below this ratio, the
system automatically starts selling MKR (which bear interest and grant
voting rights) for Dai. This removes Dai from the}
\href{https://medium.com/cryptolinks/maker-for-dummies-a-plain-english-explanation-of-the-dai-stablecoin-e4481d79b90\&sa=D\&ust=1544131168499000\&usg=AFQjCNHdawiyeyfQ3_0MWur7QB3LAgY6oQ}{\textbf{system}}\textbf{---pushing
the ratio back up to a}
\href{https://medium.com/stabletrade/the-risk-of-cryptocurrency-collateralized-stablecoins-cccd3577b6be\&sa=D\&ust=1544131168499000\&usg=AFQjCNFlx7HPSIyiRrTw0nc_XQU0k_zyHQ}{\textbf{safe
level.}} \textbf{}
\textbf{While this suggestion does not bear the responsibility of
investment advice, hypothetical projected returns for investors in this
project could be calculated as follows:}
\textbf{(Interest on MKR tokens via closing of CDPs) * (percentage of
yearly revenue) * (market cap of tokens) -
(}\href{https://www.reddit.com/r/MakerDAO/comments/80d0jn/how_do_you_make_money_with_mkr/}{\textbf{\%
dilution of MKR from undercollateralized CDPs}}\textbf{).}
\textbf{Crypto-Collateralized Token Benefits:}
\begin{itemize}
\tightlist
\item
\textbf{Working PoC for Cryptocurrency Collateralization: This
maintains price stability in spite of a bearish market (further market
instability will test this).}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Built on Top of a More Mature Technology (Ethereum): This
allows for more mature developer tools and latitude for technological
advancements in the future.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Market Validation: A16z crypto fund (Andreessen Horowitz)
purchased 15 million USD worth of MKR tokens
(}\href{https://medium.com/makerdao/a16z-crypto-purchases-6-of-mkr-backing-stablecoin-vanguard-makerdao-ff410a692393}{\textbf{6\%
of total supply}}\textbf{) demonstrating strong stewardship.}
\end{itemize}
\textbf{Crypto-Collateralized Token Drawbacks:}
\begin{itemize}
\tightlist
\item
\textbf{Lack of Accessible Collateral:}
\href{https://medium.com/reserve-currency/our-analysis-of-the-makerdao-protocol-4a9872c1a824}{\textbf{To
create Dai, a CDP is needed to be created}}\textbf{. This process
requires locking up capital that is unaccessible ( 1/3 of capital
required is taken out of circulation) to create a CDP.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Black Swan Events: This describes a vulnerability to
unpredictable market downturns that can be difficult to model.
Examples of these black swan events include the the}
\href{http://clsbluesky.law.columbia.edu/2018/09/10/a-retrospective-on-the-demise-of-long-term-capital-management/}{\textbf{LTCM}}\textbf{hedge
fund crash and the software vulnerability that allowed a cybercriminal
to steal \$67 million in Ethereum from the}
\href{https://www.wired.com/2016/06/50-million-hack-just-showed-dao-human/}{\textbf{DAO
hack}}\textbf{. ~}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Technology Limitations: Difficulty of scaling (limitations in
throughput via core consensus protocol and nascence of layer 2
solutions, such as} \href{https://raiden.network/}{\textbf{Raiden
Network}}\textbf{, as well as business integration).}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Vulnerability to Oracle Manipulation: Oracles must be heavily
relied upon and trusted to feed the network accurate exchange rate
information. ~}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Downside Risks. MKR holders also get stuck with the}
\href{https://medium.com/reserve-currency/our-analysis-of-the-makerdao-protocol-4a9872c1a824}{\textbf{downside
risks}}\textbf{; if the system is not able to raise enough DAI to
cover CDP's debt, then the MKR shares get diluted, and newly created
tokens are needed to recover DAI to pay off the CDP debt.}
\end{itemize}
\textbf{2.2.3. Type 3: Uncollateralized Stablecoins ~~}
\textbf{The third classification addresses fully algorithmic systems---a
notable project is}
\href{https://www.kowala.tech/}{\textbf{Kowala}}\textbf{. These systems
are not collateralized. Instead, they rely on a strong monetary policy
to act as a fully algorithmic central bank. The algorithm maintains the
stability of the coin by issuing new tokens when the supply is too low
and by burning tokens when the demand is too low.}
\textbf{Investors purchase the promise of future tokens at a discount
via bond tokens. Bonds are typically paid for using the platform's
stablecoin---this is the mechanism by which the algorithmic central bank
reduces the supply. When the algorithm must expand the supply, it issues
tokens to bondholders. Bonds have a set expiration date at which point
they no longer represent a future payment of stablecoins. Therefore,
investors who purchase bonds are essentially betting that the demand for
these stablecoins will outstrip supply before the expiration date.
~However, bonds and shares are fundamentally designed to make investors
money. But with the obvious costs of selling securities, the popular}
\href{https://www.basis.io/}{\textbf{Basis}} \textbf{project disbanded.
They have since promised to return the \$133 million raised in its
initial investment round with big backers, such as a16z crypto fund
(Andreessen Horowitz), GV (formerly Google Ventures), Bain Capital
Ventures, and Polychain Capital.}
\textbf{Uncollateralized Token Benefits:}
\begin{itemize}
\tightlist
\item
\textbf{Autonomous: In the long run, uncollateralized stablecoins
incur less centralization risk and greater revenue upside with a fully
automated clearing house system}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Scalability: With the right conditions, a fully algorithmic
system can scale to global demands of a currency more easily than
other stablecoin models.}
\end{itemize}
\textbf{}
\textbf{Uncollateralized Token Drawbacks:}
\begin{itemize}
\tightlist
\item
\textbf{Regulations: A designation for shares and bond tokens as
securities carries heavy associated costs and regulations.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{The Risk of}
\href{http://lexicon.ft.com/Term?term=black-swan}{\textbf{Black Swan
Events}}\textbf{: Detrimental events that are hard to predict and
describe effectively via algorithms or modeling techniques pose a
~threat to these forms of stablecoins. For example, the exploit in the
Solidity scripting language that culminated in the DAO Hack of
Ethereum where a thief stole}
\href{https://www.bloomberg.com/features/2017-the-ether-thief/}{\textbf{\$67.4
million}} \textbf{in Ether, and the reliance on flawed financial
modelling that led to Long Term Capital
Management}\href{https://www.economist.com/books-and-arts/2007/05/31/the-perils-of-prediction}{\textbf{hedge
fund implosion}}\textbf{.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Excessive Complexity of System
(}\href{https://en.wikipedia.org/wiki/Rube_Goldberg_machine}{\textbf{Rube
Goldberg Machine}}\textbf{): This makes it difficult to understand and
may undermine the effectiveness of the stability mechanism,
compounding the risk of a black swan event.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Oracle Manipulation Concern: Similar to the issue associated
with crypto-collateralized stablecoins, Oracles that feed exchange
rate information may not be fully trustworthy.}
\end{itemize}
\textbf{3. Five Use Cases of Stablecoins}
\textbf{}
\textbf{The demand for stablecoins arises from the core advantages of
stablecoins over their fiat alternatives. As discussed previously, some
of these advantages include programmability, independence from
traditional centralized systems, and non-physicality. Stablecoins offer
the ability to capitalize on use cases where fiat currencies fall short.
However, it is unlikely that one stablecoin will be dominant over all
use cases. This is a result of the differences between various
stablecoins themselves. As a result, there are many investment
opportunities within the realm of stablecoins which flow from various
use cases.}
\textbf{This section seeks to shed light on these investment
opportunities by looking at five key use cases: safe haven assets on
cryptocurrency exchanges, dollarization in emerging regions, peer to
peer (P2P) and peer to business (P2B) payments, value transfer over
smart contracts, and reserve currencies in an international context. As
will be shown, these use cases vary in time frame, upside potential, and
requirements from the individual stablecoins.}
\textbf{}
\textbf{3.1. Use Case 1: Safe Haven for Traders}
\textbf{Solving the problem of crypto volatility.}
\textbf{In order to avoid downside volatility, traders use ``safe
haven'' assets. These assets are relatively stable, even when broader
market prices fluctuate. In U.S. equity markets, when traders sell, they
sell into USD. This point is often taken for granted. In crypto markets,
when traders want to sell out of an asset which has appreciated, they
have many options to sell into. In order to protect the gains made on a
trade, traders often choose to sell into stablecoins.}
\textbf{As we can see from figures \#3 and \#4 below, during periods of
high downside volatility, the trading volume of stablecoins
significantly increases until stability returns. Further evidence of
this finding is that six out of the top ten pairs (by 24-hour volume)
contain a stablecoin (figure 5)---meaning that when people buy or sell,
they do so with a stablecoin.}
\textbf{Figure 3: Top 10 Crypto Market Cap (Data from coincodex.com)}
\textbf{Figure 4: Stablecoin Trading Volume (Data from coincodex.com)}
\textbf{Figure 5: Top exchange pairs on Binance by 24h volume}
\textbf{Opportunity for crypto traders with stablecoins as safe havens.}
\textbf{Using a conservative estimate, exchanges around the world
process \textasciitilde{}\$5.4 billion daily. Further, according to the
Satis Group, crypto trading volume is expected to grow by}
\href{https://research.bloomberg.com/pub/res/d3h2iTlKWIa4FTLKGJsUn3mis5g}{\textbf{over
50\% through 2019}}\textbf{. This projects the global crypto trading
volume to be over \$8 billion through 2019. ~This growth in trading will
fuel the demand for stablecoins. Stablecoin companies have the
opportunity to capitalize on this growth and improve where existing safe
haven assets fail.}
\textbf{Traders who employ this strategy are looking for stability in
their safe haven assets. We can understand why stability is important by
looking at the example of Tether. If a trader used Tether during a
period of downside volatility while it was priced at one of its highs
(\$1.08), the trader would be buying each unit of Tether at an 8\%
premium (Tethers real value is 1\$). This would translate into a 7.4\%
overall loss of wealth once Tether's price stabilized (\$1 is 7.4\% less
than \$1.08). In this scenario, a \$10,000 trade out of bitcoin would
ultimately be worth only \$9,260. Because perfect stability has not yet
been reached, there is still a need in the market for better
stablecoins. For example, Binance recently announced their plan to
include trading pairs denominated in a}
\href{https://cryptovest.com/news/binance-unifies-stablecoins-in-single-market/}{\textbf{basket
of stablecoins}}\textbf{. By spreading trading volume across multiple
stablecoins, there is less pressure on any one asset---ultimately
reducing volatility. Consequently, this further reduces the volatility
of the safe haven asset as well.}
\textbf{Factors leading to success with stablecoins and exchanges.}
\textbf{Stablecoin companies listed on many exchanges (especially large
ones) have a higher likelihood of success. This is because by being
listed on many exchanges, they gain exposure to more traders, thereby
capturing a larger market share and establishing a better network effect
than stablecoin companies who are listed on a few small exchanges.
Furthermore, being listed on many exchanges increases the likelihood of
being included in a bundle of stablecoins (such as the Binance bundle).
By being included in a bundle, the token is guaranteed higher volume
(the number of trades that occur over a set period of time) which
supports the liquidity of the token. Increased liquidity in an asset
increases its price stability because when buy and sell orders at a
given price are being settled quickly, the trader does not need to
change their bid or ask price.}
\textbf{The use of a basket of stablecoins in a trading pair is meant to
create an asset with more liquidity by spreading trading pressure across
multiple tokens. By spreading pressure across multiple assets, exchanges
reduce the risk of price volatility of the assets in the basket, thereby
increasing the stability of the basket itself. That being said, if a
stablecoin is even more stable than a basket of similar assets, that
stablecoin would immediately become the preferred safe haven asset.
Therefore, stability is an important factor with respect to being
included in a stable basket and with respect to being a stand-alone safe
haven asset.}
\textbf{3.2. Dollarization 2.0}
\textbf{Solving the problem of hyperinflation in developing countries.}
\textbf{In the year 2000, when the Ecuadorian Sucre had 96.1\%
inflation, the citizens of Ecuador turned to the USD to hedge against
the inflation. The country began to unofficially accept the US dollar
until the government decided to make a formal switch in the same year.
With the adoption of the USD as the national currency, the financial
markets stabilized. Citizens in countries whose currency has high
inflation often turn towards more stable assets to protect their wealth
and allow them to participate in commerce.}
\textbf{The process of a country using USD as a means to offset high
inflation and local currency instability is known as}
\href{https://www.basis.io/basis_whitepaper_en.pdf}{\textbf{dollarization}}\textbf{.
During dollarization, the population may or may not coordinate the
adoption of a foreign currency with their local government. Despite
governmental currency controls, populations may create black markets for
physical USD. One such market can be found in Argentina, a country that
had an inflation rate of greater than}
\href{https://tradingeconomics.com/argentina/inflation-cpi}{\textbf{45\%
in October 2018}}\textbf{. Citizens of Argentina use USD in black
markets as a currency hedge against the naira, their inflationary
national currency. What if these assets were instead digitally native?}
\textbf{Opportunities with stablecoins and Dollarization 2.0.}
\textbf{Dollarization gives countries suffering from hyperinflation a
means to protect themselves against the rapid depreciation of their
buying power. Cryptocurrencies extend this hedge and give citizens of
these countries access to a safe haven asset. Furthermore, stablecoins
can be introduced digitally, whereas USD must be imported by tourists.
Developing nations are primed for stablecoin dollarization for multiple
reasons.}
\begin{itemize}
\tightlist
\item
\textbf{Onboarding Infrastructure: Whereas traditional financial
inclusion requires banking infrastructure, stablecoin systems only
require digital wallets (which can be housed on mobile phones). In
Africa, for example, the number of unique mobile phone subscribers is
projected to be}
\href{https://www.gsma.com/newsroom/press-release/more-than-half-of-sub-saharan-africa-to-be-connected-to-mobile-by-2025-finds-new-gsma-study/}{\textbf{634
million by 2025}} \textbf{(52\% penetration rate). These mobile phones
can host digital wallets and give access to exchanges which list
stablecoins. This, in turn, will infuse stable capital in their local
markets. (The global penetration for mobile users is approximately}
\href{https://venturebeat.com/2017/06/13/5-billion-people-now-have-a-mobile-phone-connection-according-to-gsma-data/}{\textbf{64.5\%}}\textbf{).}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Hedge against inflation: According to our analysis, 47.33\% of
Africa's population is experiencing}
\href{https://tradingeconomics.com/country-list/inflation-rate?continent=africa}{\textbf{inflation
of over 10\%}}\textbf{(inflation data from 2018, population data from
2017). If stablecoins are able to maintain price stability and
appropriate ease of access, they could be attractive means to hedge
against the volatility of local currencies. According to Kate
Mitselmakher, CEO of Bloccelerate:}
\end{itemize}
\textbf{"}\href{https://medium.com/the-future-of-blockchain-technology-top-five/the-future-of-blockchain-technology-top-five-predictions-for-2030-67df1d7c2391}{\textbf{Consider}}
\textbf{the Zimbabwe dollar, for instance, which has suffered a
staggering inflation of 500,000,000,000\%. Many Zimbabweans have already
turned to Bitcoin as a hedge against their national currency, thereby
driving the Bitcoin price up on the local crypto-market. Creating a new
cryptocurrency presents a viable solution for the Zimbabwean government
to alleviate the bleak perception of its country's monetary challenges.
"}
\begin{itemize}
\tightlist
\item
\textbf{Ecosystem Support: An ecosystem which develops around
stablecoins---such as entrepreneurs leveraging it as a their primary
form of value exchange---is essential to stablecoin adoption. Emerging
countries have an increasing opportunity to take advantage of this
trend. For example, there are 6,000 startups in Africa, with over 150
having secured funding in 2017 (data from Crunchbase, Angel List, and
Disrupt Africa). Therefore, this emerging market has incredible
opportunity to adopt stablecoins for ease of doing business, low
transaction fees, ease of access, and other reasons discussed above.}
\end{itemize}
\textbf{Factors leading to successful dollarization 2.0.}
\textbf{}
\textbf{Some important factors which will drive success of dollarization
in emerging regions are interface integration, appeal to businesses,
user base trust, and compliance.}
\begin{itemize}
\tightlist
\item
\textbf{Interface Integration: Integration with existing
infrastructure is critical for mainstream adoption of stablecoins.
Successful stablecoin companies must be able to develop relationships
with existing digital wallet providers or develop their native digital
wallet applications in their respective geographies.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Enterprise Adoption: Enterprise adoption of stablecoins
reduces the need for financial intermediation and improves the
`stickiness' of the stablecoin currency. The more heterogeneous the
market of safe haven assets is, the harder it is for one particular
stablecoin to gain traction. However, enterprise adoption of a
particular stablecoin(e.g. as a payment mechanism), would greatly
increase the adoption of such an asset.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Gaining User Trust: Gaining user trust is the key prerequisite
of broader market adoption. ~Therefore, stablecoin companies must find
ways to communicate the value of their token. The more users buy into
the underlying value of the asset, the higher adoption this particular
asset will likely incur. ~For example, before 1971 when the USD was
backed by gold, people could exchange convertibility notes (dollars)
into gold. This practice was fairly common while people were still new
to transacting with notes (as opposed to precious metal coins).
Eventually, however, note-to-gold conversion waned as citizens began
trusting the notes could be converted anytime.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Overcoming Regulatory Uncertainties: Unfavorable regulation is
likely the largest limiting factor for adoption. This is because an
outlawed currency is unlikely to be accepted by enterprises and is
unlikely to be listed on existing digital wallets. Many governments
are opposed to dollarization for three reasons: Loss of seigniorage
profits, reduced effectiveness in monetary policy, and ~loss of a
sense of autonomy. By choosing regions with a favorable regulatory
environment, stablecoin companies can mitigate the risks associated
with negative regulation. Also, by working directly with governments
to repay seigniorage losses or to rebrand as a government token would
be effective ways to encourage positive regulation.}
\end{itemize}
\textbf{3.3. Use Case 3: P2P and P2B Payments.}
\textbf{Opportunities for stablecoin adoption in the P2P and P2B use
case.}
\textbf{According to eMarketer, only 1\% of millennials use mobile
payment (digital wallet) services as their primary source of payments
(see figure 6). Furthermore, mobile payments are projected to have a}
\href{https://www.alliedmarketresearch.com/mobile-payments-market}{\textbf{CAGR
of 33.8\% through 2023}}\textbf{. Stablecoin solutions have the
potential to capture some of this growth.}
\textbf{}
\textbf{}
\textbf{Figure 6: Payment Methods Chart (data from eMarketer.com)}
\textbf{Conventional digital payment companies make money by charging a
fee to merchants (see figure 7). For example, Square Cash charges a
2.75\% per transaction fee to merchants. Venmo charges a similar 2.9\%
of the transaction plus \$0.3. A stablecoin company could potentially
undercut this fee by leveraging blockchain to lower their own costs per
transaction. Businesses could be incentivized to use a stablecoin
solution in order to drive the profit margins.}
\textbf{Figure 7: Comparison of Existing Digital Wallet Services}
\textbf{Incremental improvements could be leveraged when targeting user
groups who have specific preferences. For example, improved anonymity
could be marketed to those demanding privacy in purchases. Loyalty
points or rewards could be easily implemented when a P2B payment is
made. In Europe, there is a significant need for borderless transaction
solutions given the variety of currencies in close proximity. Frequent
travelers may find the borderless qualities of stablecoins attractive.}
\textbf{Factors leading to success of adoption.}
\textbf{For mainstream adoption to occur, a stablecoin firm must either
develop its native wallet or develop strong partnerships with existing
wallets. The market for digital wallets is highly competitive. In the
US, Venmo, Cash App, and Zelle dominate. In China, AliPay
(}\href{https://intl.alipay.com/}{\textbf{520 million users}}\textbf{)
and WeChat Pay
(}\href{https://www.cnbc.com/2018/07/19/tencent-to-push-wechat-pay-in-us-despite-trade-war-with-china.html}{\textbf{800
million users}}\textbf{) have reached mass adoption. In Europe, currency
borders have hindered development. However, blockchain startup Circle
(backed by Goldman Sachs) is gaining attention. Also, large companies
like Apple, Google, and Facebook are now offering digital wallet
solutions (Apple Pay, Google Pay, Facebook Messenger Payments).}
\textbf{Given the intense competition and demand for value-added digital
wallets, introducing a new currency is not enough to drive adoption. In
order to drive adoption, important factors are network effects and the
leveraging of competitive advantages.}
\begin{itemize}
\tightlist
\item
\textbf{Network Effects: Network effects are important for stablecoin
companies because the number of users impacts how useful the currency
is as a medium of exchange (see section 1.3). In the context of P2P
payments, the utility of the stablecoin is a function of the number of
people who use it to exchange value. As a result, stablecoin companies
must find ways to incentivize participation. One way to help a network
grow is to offer perks for joining (such as cash). Peter Thiel, the
founder of PayPal, mentions in his book ``Zero to One'' a very similar
logic about network effects which led him to}
\href{https://www.businessinsider.com/peter-thiel-paypal-paid-customers-2014-9}{\textbf{pay
customers}} \textbf{to join the network.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Leveraging of Competitive Advantage: Existing payment
solutions in developed nations are not broken. As shown, the space is
highly competitive and, as a result, stablecoin companies are unlikely
to immediately gain significant market share in the broad payments
domain. However, by targeting niche markets in which stablecoins and
blockchain technology solve problems, stablecoin companies can acquire
users who view the existing system as broken. For example, privacy
concerned individuals who are hesitant to services, such as Venmo or
PayPal, may be very attractive to pseudo-anonymous wallets or
obfuscated public ledgers (like}
\href{https://www.getmonero.org/}{\textbf{Monero}}\textbf{). In these
markets, stablecoin companies can leverage their competitive advantage
to quickly gain users and build their network.}
\end{itemize}
\textbf{3.4. Use Case 4: Stablecoin Smart Contract Integration: Solving
lockup volatility and widening the user base.}
\textbf{Smart contracts are an innovative way to decentralize and create
efficiency gains for common everyday transactions. The benefits of using
smart contracts are wide-ranging (for more in-depth information on the
use cases of smart contracts,
see}\href{https://www2.deloitte.com/insights/us/en/focus/signals-for-strategists/using-blockchain-for-smart-contracts.html}{\textbf{here}}\textbf{).
Smart contract adoption is still in its early stages because smart
contracts are mostly only compatible with highly volatile
cryptocurrencies. This creates two limitations: smart contract users are
mostly people who are risk-tolerant and comfortable with
cryptocurrencies and smart contracts require capital lock up, which
creates risk when capital is highly volatile and subject to wild
fluctuations. ~}
\textbf{Stablecoins can expand smart contract use beyond that of the
early adopter audience and into that of a mainstream audience. This is
because a crypto asset pegged to a familiar unit of account (e.g. USD)
is more palatable to users who may be wary of cryptocurrencies. Because
stablecoins are both price stable and have the ability to interact with
smart contracts, they overcome the significant challenge of volatility
risk associated with using smart contracts. To better illustrate how
stablecoins enable the smart contract space, imagine the dynamic of a
tenant and landlord.}
\textbf{Imagine Jill is leasing a house to Jack. Traditionally, Jill
would bill Jack on a monthly basis for the right to live in the house.
In this example, a smart contract could be used to replace the lease by
maintaining the legal documents allowing Jack to live in the house
if---and only if---he pays. Furthermore, the smart contract could
execute agreements in the lease, such as utility bills and maintenance.
While smart contracts could greatly improve the current process, the
problem is that they are only compatible with cryptocurrencies. Since
proprietary tokens and major cryptocurrencies are very volatile in
price,it's unlikely that Jill would agree to a lease denominated in
these assets given her potential losses associated with the volatility.}
\textbf{On the flip side, stablecoins offer a way to avoid this
volatility while also being smart contract compatible. If the leasing
smart contract was programmed to accept a stablecoin, Jill could be
certain that the value of the payment would not depreciate before
exchanging the token for fiat. The applications go way beyond leasing
services--- banks can use smart contracts for mortgage payments,
companies can use smart contracts to pay employees, prediction markets
can be created, and much more.}
\textbf{Factors driving growth and success for stablecoins in smart
contracts. ~}
\textbf{The following factors are driving the growth of stablecoin
adoption within the context of a smart contracts use case.}
\begin{itemize}
\tightlist
\item
\textbf{Cross-platform Compatibility: Currently, the smart contract
space is nascent and few useable products have been created. In the
future, however, successful smart contracts will be developed on
multiple blockchain platforms. This is because different platforms
have different characteristics. A smart contract developer will take
this into account when determining which platform is best suited for
their application. Stablecoin companies that deploy their token on
multiple platforms will maximize their market penetration by
increasing their exposure to many smart contracts.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Building Trust: A trustable token is one in which users have
confidence that they can redeem it for fiat. Fiat-backed stablecoins
with a strong brand, a good track record, and transparent audits
already possess this value proposition. Crypto-collateralized
stablecoins, such as DAI, however, face some criticism regarding the
instability of the ~underlying cryptocurrency peg---such as
Ethereum,which has lost 90\% of its value in 2018. As skepticism for
cryptocurrencies and smart contracts decreases, the opportunity for
non-fiat-backed models to take dominance will emerge.}
\end{itemize}
\textbf{}
\textbf{3.5. Use Case 5: Stablecoins as Reserve Currency}
\textbf{}
\textbf{The current status of central bank reserves.}
\textbf{Governments and banks around the world hold reserve currencies
which are low in volatility and highly liquid in order to reduce risk in
their wealth. This is very similar to the hedge against volatility known
as safe havens. In 1971, much of the world held USD as their reserve
currency, since it was pegged directly to gold until Richard Nixon}
\href{https://www.federalreservehistory.org/essays/gold_convertibility_ends}{\textbf{ended
this system}}\textbf{. Today, the USD is still the de facto reserve
currency for most of the world, which currently stands at}
\href{http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4}{\textbf{57\%
of the world's reserve composition}}\textbf{, according to the IMF
(figure 8).}
\textbf{This fact causes many benefits to accrue to the US. As a result,
other nations may seek to reduce dependence on USD and increase the
international use of their own currency. For example, China recently
released}\href{https://www.reuters.com/article/us-china-oil-futures-dollar/china-oil-futures-launch-may-threaten-primacy-of-u-s-dollar-ubs-idUSKBN1H227E}{\textbf{oil
futures which are denominated in RMB}}\textbf{. Furthermore,
China's}\href{https://www.gfmag.com/magazine/june-2018/one-belt-one-road-one-currency}{\textbf{Belt
and Road Initiative}}\textbf{, a one to eight trillion dollar
infrastructure plan, is meant to facilitate international trade
denominated in RMB.}
\textbf{This system also grants the U.S. the ability to exercise control
over the global trade system. For example, the US recently made a
unilateral decision to impose sanctions on Iran by coercing the dominant
international settlement system (SWIFT) to exclude Iran. This has caused
many American allies to realize the need for a change in the status quo.
The German Foreign Minister, Heiko Maas, proposed a}
\href{https://www.handelsblatt.com/meinung/gastbeitraege/gastkommentar-wir-lassen-nicht-zu-dass-die-usa-ueber-unsere-koepfe-hinweg-handeln/22933006.html?ticket=ST-3668928-sQyoQFSETkXMgdVQxlzt-ap4}{\textbf{payment
channel independent of the U.S}}\textbf{. in order to protect European
companies from legal sanctions.}
\textbf{Furthermore, the International Monetary Fund (IMF) has clearly
stated their goal of reducing sovereign currencies as reserves (figure
9). In 2010, the Strategy, Policy, and Review Department of the IMF
published a document entitled}
\href{https://www.imf.org/external/np/pp/eng/2010/041310.pdf}{\textbf{``Reserve
Accumulation and International Monetary Stability''}}\textbf{, which
outlines the risks associated with one nation having outsized control
over reserves, saying that members of the fund should have the objective
of ``\ldots{}making the Special Drawing Right (SDR) the principal
reserve asset in the IMS {[}International Monetary System{]}.''}
\textbf{}
\textbf{Figure 8: Currency Composition of Official Foreign Exchange
Reserve (Data from data.imf.org)}
\textbf{Figure 9: Ideas to Mitigate Demand and Diversify Supply of
Reserves for IMS Stability}
\textbf{Opportunity for Stablecoins to be Reserve Currencies}
\textbf{Based on the IMF's goals, China's efforts to usurp the reserve
throne, and the E.U.'s efforts to establish an alternative to the US
dominated SWIFT system, there are many reasons to believe that USD
dominance may fade in the long term. There is little predictability in
regard to how fast this will happen, or which nation's currency (if any)
will gain dominance. As a result, investors may seek to hedge against
this shifting power dynamic by placing funds in an asset outside of the
system altogether. This creates an opportunity for stablecoin companies
who are developing assets that exist outside of these systems. There are
a few types of stablecoin projects that can offer reduced exposure to
these systems:}
\begin{itemize}
\tightlist
\item
\textbf{Diversification of Collateral: By being pegged to a basket of
currencies, a stablecoin project could spread the risk of correlation
to any one single currency. For example, because Tether is backed
fully by USD, if the US suddenly experiences hyperinflation, the value
of USDT would fall in tandem with USD. Compare this to Globcoin (GLX),
which is backed by a basket of 15 currencies and gold. When USD
experiences hyperinflation, the value of GLX only falls by a fraction
because it is diversified.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Algorithmic Central Bank: A stablecoin whose stability is
maintained through an algorithmic central bank is not reliant on
existing monetary systems for its value. As a result, its purchasing
power would not decrease---even in the case of an international
government meltdown. Currently, however, projects in this category,
such as MakerDAO, are pegging the value of their token to a fiat
currency. This is being done in order to kick-start the token's use as
a unit of account (see section 1.3). ~}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Non-traditional Collateralization: Stablecoin projects which
are backed by assets with inherent value are somewhat protected from
the above systems. For example, intellectual property (IP) is valuable
in itself;as the value of a fiat currency fluctuates, the price of IP
would rise and fall to reflect a constant underlying value.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Crypto-Collateralization: Stablecoin projects collateralized
by other crypto-assets may exist outside of the current monetary
system in that their underlying token exists outside of the current
monetary system. For example, Maker DAO issues DAI stablecoins when
users deposit Ethereum. Currently, DAI are pegged to USD, but
eventually, voters on the system may choose to peg DAI to a basket of
goods, or to drop the peg entirely.}
\end{itemize}
\textbf{Factors driving growth and success for stablecoins.}
\textbf{It is important to note that the opportunity to use stablecoins
as a hedge against global reserve currencies is primarily targeted for
the long term. It is unlikely that the dynamics of international trade
will shift a great deal in the near term. Nor is it likely that
governments and banks will feel comfortable holding crypto assets in
their reserves to manage risk until private and institutional investors
begin to do so. That said, we can estimate the factors which will be
influential in a stablecoin's success given a changing central bank
reserve environment.}
\begin{itemize}
\tightlist
\item
\textbf{Non-correlation: Some ways to ensure non-correlation to
existing monetary systems are diversification, use of an algorithmic
central bank, use of non-traditional collateralization, and use of
crypto-asset collateralization. Currently, stablecoins are pegged to
established units of account. If this does not change, any investor
who holds these tokens is still exposed to the risks associated with
the currency it is pegged to. Therefore, the stablecoin companies
which are best positioned to take advantage of this opportunity are
companies that have viable plans to become their own unit of account.}
\end{itemize}
\begin{itemize}
\tightlist
\item
\textbf{Black Swan Resistant: Stablecoins which do not utilize at
least a 1:1 reserve mechanisms are at risk of black swan events (see
Models of Stablecoins section above). Algorithmic central bank and
decentralized models must be proven over long periods of time before
people will believe they are secure from hacking, algorithm errors, or
underlying asset volatility.}
\end{itemize}
\textbf{Projects such as MakerDAO anticipate that they will be able to
drop their peg to USD. For this to happen, they must be trusted as a
meaningful unit of account by their user base. In the medium term, it is
likely that projects will emerge that are well-positioned to be their
own unit of account---making it fully uncorrelated. This asset would
have huge market potential given investors' need to diversify.}
\textbf{Conclusion}
\textbf{}
\textbf{The current state of stablecoins is one of opportunity for
founders and investors alike. However, a great deal of thought must be
put into the driving factors of adoption for a given stablecoin.
Stablecoin companies cannot simply expect that their token will receive
mass adoption without careful targeting of specific user bases. By
looking at various use cases of stablecoins, we can identify multiple
opportunities that companies can capitalize on. These opportunities vary
in time frame as wells as factors that drive success.}\selectlanguage{english}
\begin{longtable}[]{@{}lll@{}}
\toprule
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Use Case}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Factors}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Adoption Timeframe}\strut
\end{minipage}\tabularnewline
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Dollarization}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Number of useful businesses accepting currency, consumer trust,
government regulation}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Medium-Long term (5-10 years)}\strut
\end{minipage}\tabularnewline
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Smart Contracts}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Compatibility with Smart Contracts, consumer Trust}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Short-Medium (1-5 years)}\strut
\end{minipage}\tabularnewline
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Exchange Safe Haven}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Liquidity, number of exchanges listed on}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Short term (\textless{}1 year)}\strut
\end{minipage}\tabularnewline
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{P2P/P2B payments}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Number of users, number of digital wallets, number of useful
businesses accepting currency}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{(Medium term 1-5 years)}\strut
\end{minipage}\tabularnewline
\begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Reserve Currency}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Uncorrelated with Fiat, black swan resistance}\strut
\end{minipage} & \begin{minipage}[t]{0.32\columnwidth}\raggedright\strut
\textbf{Long term (10+ years)}\strut
\end{minipage}\tabularnewline
\bottomrule
\end{longtable}
\textbf{Stablecoin companies that understand their target audience will
be able to create and enable new services. As Andy Milenius, CTO of
MakerDAO, postulates,}
\href{https://a16z.com/2018/12/20/stablecoins-why-matter-what-how-daos-maker/}{\textbf{these
services will act in the same magnitude as mp3 encoding}}\textbf{. By
integrating with many blockchains, stablecoin startups will gain
exposure to the value creation on multiple smart contract platforms.
Moreover, by being listed on well-designed digital wallets, stablecoin
companies will position themselves as an on-ramping service to the world
of cryptocurrency, and more and more people will turn to digitized value
exchange. By maximizing the number of exchanges they are listed on and
by ensuring price stability, stablecoin companies can increase use as a
safe haven for crypto traders and general consumers. By maximizing the
number of businesses that accept the token and by pursuing user trust,
companies can increase their chances of adoption in developing
countries. By maximizing liquidity and by minimizing correlation to
sovereign currencies, stablecoin companies can also offer value as a
fiat hedge.}
\textbf{Given the momentum and added benefits of digital money on the
blockchain, stablecoin adoption is almost inevitable. With successful
stablecoin projects, we will see a more secure and borderless world. In
the future, the infrastructure for instantaneous settlement similar in
function to FedWire,}
\href{https://youtu.be/Bv33vah7-wY?t=1814}{\textbf{a service that banks
use to interact with the Federal Reserve}}\textbf{, will be distributed
to all businesses across the world. We will inhabit a future where
mainframe-based Automated Clearing House (ACH) settlement systems are
retired, and, because of this, transaction costs will be lowered for
small businesses and dollarization will be expanded. Central banks will
wire funds directly to individual wallets and thereby cutting out
expensive intermediaries.}
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{\label{144518}}
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\textbf{{}}
\section*{Acknowledgements}
{\label{687807}}
Written By:
Robert Lin, Investment Associate - Bloccelerate VC
Mark Conrad,~ Investment Associate - Bloccelerate VC~
Edited By:
Sheikh Mohammed Irfan, Managing Partner - Bloccelerate VC
Special Thanks To:
Kate Mitselmakher, Managing Director- Bloccelerate VC
Sam Yilmaz, Managing Partner - Bloccelerate VC
Eyal Granit, Technology Lead - Bloccelerate VC
Joe Giordano, Venture Partner - Bloccelerate VC
Anthony Waddell, Research Associate -Bloccelerate~VC~
David Segura - Chief Operations Officer of Carbon-12 Labs
James Gan - Global Innovation Exchange University of Washington Masters
Student
Deryck Gebe - Business Analyst at Stably and studying Business
Administrations at
~~~~ University of Washington
Kory Hoang - Founder and CEO of Stably
Katey Harrison - Director of Program Management at Bittrex
Eric Moos - Editor at CryptoSlate
Brian Freyburger - Former CTO of Basis
\selectlanguage{english}
\FloatBarrier
\end{document}