After the TerraUSD debacle, we need to rethink the design of stablecoins

Bitcoin and other cryptocurrencies are considered by many to be a new form of money. Others wonder if these alternative assets actually meet the definition of money from a practical perspective.

“Money” is defined by three pillars: as a store of value; a medium of exchange; and as a unit of account.

This last pillar is the point of contention given the volatility associated with cryptocurrencies such as Bitcoin. The volatility of cryptocurrencies made it difficult for users to transact in these cryptocurrencies as the price fluctuated wildly from second to second. This has exposed cryptocurrency holders to unacceptable levels of market risk. This concern has been answered by an innovation called the stablecoin.

Stablecoins solved this volatility problem by being pegged 1:1 to fiat currencies such as the US dollar, which consequently gave it a stable value that allowed it to be considered a unit of account. Essentially what was created was a cryptocurrency capable of moving across the internet through the use of blockchain technology similar to its peers but without the volatility.

Two similar but quite different types of stablecoins were then released. The first was a stablecoin backed by fiat currencies held in the issuer’s bank account. The second was an algorithmic stablecoin that holds, buys and sells various underlying cryptocurrencies and in doing so it mimics the price of the US dollar through this balancing act. However, we recently saw the catastrophic flaw posed by this model, when TerraLuna’s algorithmic stablecoin, known as UST, broke away from the US dollar and ultimately led to the erasure of billions of dollars from the market. crypto in days.

Read: Terra didn’t kill crypto, but it was a narrow breakout

This raised the question of whether the simpler method of holding fiat as collateral and issuing stablecoins might not be the better option as opposed to these algorithmic stablecoins. Today’s largest US dollar stablecoin, known as USDT and created by Tether, is currently the most traded stablecoin in the world. Tether’s business model is quite simple in that a KYC (Know Your Customer) verified Tether user – be it an exchange, individual trader, trader or trading company – deposits fiat (US dollars) into Tether’s bank account. Tether delivers USDT tokens issued on existing blockchains such as Ethereum to the client.

Tether then holds these fiat currencies as collateral, giving primary and secondary holders of the USDT token reassurance that their token is actually worth $1. However, this business model was not without flaws either, as Tether was fined $41 million in 2021 to settle allegations that they falsely claimed that their digital tokens were fully backed by real-world fiat currencies. So many people might well ask – what then is the solution based on what we have learned from these historical events?

My point of view favors a triple solution that combines independence, transparency and clear segregation. This solution addresses another potential weakness that has yet to materialize: what if a company issuing these stablecoins is sued, which gives the plaintiff equal rights to the collateral alongside the holders tokens? If the company were to declare bankruptcy or go into liquidation following a claim, this would lead to a discounted and de-indexed token, as the company’s assets would not exceed the liabilities that should have been secured. It is for this reason that fiat currency reserves should be segregated from the entire business to mitigate the risk posed by the day-to-day operations of the token issuer.

Ideally, the issuer of the stablecoin would create a separate legal entity such as a trust in which the beneficiaries of the trust would be the token holders. There would be a mandate that the trust is required to maintain a diversified interest-bearing portfolio of trust-backed funds from various commercial banks in order to diversify company-specific risk. Interest earned should then be used to pay the token issuer a management fee, maintain a pre-determined reserve of fiat to cover expected credit losses of these commercial banks as well as for an independent auditor to issue audited financial statements annual and/or intermediate. monthly or quarterly proof of reserve statements and/or reports that are publicly available.

Such a separate and transparent structure with independent confirmation will provide holders of these stablecoins with the security and transparency necessary to trust the issuer and be assured that their stablecoin will not be detached from the underlying fiat currency. .

Wiehann Olivier, Head of Digital Assets and Partner at Mazars in South Africa.

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