Campbell R. Harvey Duke University and NBER Innovation and Cryptoventures Stablecoins Campbell R. Harvey Duke University and NBER

Campbell R. Harvey 2019

Cryptocurrencies are too volatile Bitcoin as a transaction method will not be viable until the volatility is decreased. Currently, it fails as a store of value. Campbell R. Harvey 2019

Cryptocurrencies are too volatile Holding for one week: 95% confidence interval is Bitcoin: +/- 25%[from 2011]; S&P500 is -4.3% to +4.3% Worst S&P daily return since 1957 is Oct. 19, 1987 at -20.47% Over last 6 years, bitcoin has had 8 days with less than -20.47% return Second worst daily return since 1957 is Oct 15, 2008 at -9.03% In 2018 alone, more than 8 days with <-10% return Campbell R. Harvey 2019

Stablecoin basics Four different types Fiat collateralized Real asset collateralized Crypto collateralized Non-collateralized Campbell R. Harvey 2019

Stablecoin basics Fiat-collateralized coins Tether is the largest (USDT) also very controversial TrueUSD (TUSD) exchange directly into escrow so TUSD never touches your USD LBXPeg tied to sterling; BitCNY Candy backed by Mongolian tugrik Sometimes called IOU coins – if there was ever a problem with the collateral, the token holders are owed the fiat. Campbell R. Harvey 2019

Stablecoin basics Fiat-collateralized coins USDC (Circle) accepted on many exchanges like Poloniex (which Circle owns) Paxos Standard (PAX) and Gemini Dollar (GUSD) approved by New York State Department of Financial Services Campbell R. Harvey 2019

Stablecoin basics Campbell R. Harvey 2019

Stablecoin basics Real asset-collateralized coins Digix Gold (DGX) ERC-20 and 1 DGX=1 gram of gold. Gold in vault in Singapore and audited every three months. Can redeem in physical gold. Tiberius Coin (TCX) combo of 7 precious metals used in tech hardware Swiss Real Coin (SRC) backed by portfolio of Swiss real estate. Interesting, the holders vote on the investment choices! D1 Coin. Collateralized with diamonds.

Stablecoin basics Crypto-collateralized coins: Suppose you own a house and want a home equity loan. The bank gives the loan but you pledge your house as collateral. The collateral is worth more than the loan (over-collateralized). If the house drops in value, the loan may be called. If you can’t payback, the house is auctioned off. This is an example of a Collateralized Debt Position or CDP New space: Augmint (pegged to Euro – called A-Euro), Haaven (Haaven is the collateral and nUSD is the stablecoin), Sweetbridge Let’s explore MakerDAO’s DAI https://www.cryptoblockcon.com/stablecoins-are-they-coins-or-security-tokens/ Campbell R. Harvey 2019

Stablecoin basics Campbell R. Harvey 2019 https://makerdao.com/whitepaper/Dai-Whitepaper-Dec17-en.pdf

Stablecoin basics Crypto-collateralized coins: MakerDAO DAI is a cryptocurrency that is has a mechanism that allows it to be pegged to the USD. So $1=1 DAI (approximately). In existence for about one year. Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO Suppose 1 ETH= $100. In addition, suppose the initial collateral ratio is 1.5 (you must post $1.50 in collateral for every DAI borrowed) You send 1 ETH to a smart contract which allows you to borrow 66 DAI (some rounding). There is also a “stability fee” which is similar to interest. As long as ETH>$100, then the system is secure. However, what happens if ETH drops in value? Campbell R. Harvey 2019

Stablecoin Campbell R. Harvey 2019 https://medium.com/cryptolinks/maker-for-dummies-a-plain-english-explanation-of-the-dai-stablecoin-e4481d79b90

Stablecoin basics Crypto-collateralized coins: MakerDAO Suppose ETH drops to $75. In addition, the “maintenance” margin collateralization ratio is 1.25. The drop in ETH triggers the equivalent of a margin call. You need to repay by sending 66 DAI to the contract. After doing that, you would be refunded the residual (about 0.25 ETH) If you do not repay, you will be liquidated. Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO There is a group called “keepers” that are constantly checking the blockchain for contracts that have fallen below the maintenance margin. They can trigger a liquidation. Keepers is a general term for those that maintain a blockchain – they are not specific to MakerDAO Campbell R. Harvey 2019 https://medium.com/@rzurrer/keepers-workers-that-maintain-blockchain-networks-a40182615b66

Stablecoin basics Crypto-collateralized coins: MakerDAO In our contract, there is 1 ETH. These ETH are auctioned off for DAI. To be clear, the trade is selling ETH and buying DAI (which should have a positive price impact on DAI) The auction is looking to sell enough ETH to obtain 66 DAI Price of ETH is $75. Usually, this would cost 0.88 ETH (66/75). However, in the auction you might need to pay more than 0.88 ETH (which means the price of DAI increases relative to ETH) Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO After the 66 DAI are paid off, the residual is paid back to the borrower. Suppose the DAI are bought in auction for 0.90 ETH. This means that 0.1 ETH is returned to you The 66 DAI are destroyed (reducing the supply of DAI) The stability mechanism works the other way too – if DAI increases above the peg, then the collateralization ratio is changed. Who changes the collateralization ratio? Campbell R. Harvey 2019

Stablecoin basics Campbell R. Harvey 2019 https://medium.com/cryptolinks/maker-for-dummies-a-plain-english-explanation-of-the-dai-stablecoin-e4481d79b90

Stablecoin basics Crypto-collateralized coins: MakerDAO There is much more to the system than my explanation The maker token MKR holders determine the collateralization rates and they regulate the system (and get paid for it) However, MKR are the buyers of last resort – if there was ever a situation where there was not enough collateral to cover the DAI, MKR is created and sold to cover the residual MKR holders are, hence, strongly incented to responsibly regulate. Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO There is also a fail safe called Global Settlement If the system under attack, a Global Settlement is triggered where you can exchange the DAI directly for ETH through a smart contract and collateral will be released to the owners Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO DAI also allows for leveraged ETH positions Suppose you have 1 ETH = $100 and you enter into a CDP and get 66 DAI. You use DAI to buy more ETH (0.66 ETH). [Assume do this only once.] Now you profit (or lose) with leverage. Suppose price rises, e.g., ETH=$200 You would usually have profited by $100 or 100% return You have 1.66 ETH which is worth $332. You buy 66 DAI for $66 and repay the CDP leaving you with $266 (a profit of 166%) Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO DAI also allows for leveraged ETH positions Note as the collateralization ratio decreases, the amount of leverage increases. Theoretically, as leverage approaches 1:1, you can get infinite leverage! However, importantly, the lower the collateralization ratio, the more DAI are created Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO Finally, currently the system allows for only one type of collateral: ETH In the future, they will generalize this to any ERC-20 or ERC-721 token This opens a range of interesting ideas. For example, you might have an ERC-20 that represents an investment in a diversified portfolio of stocks and bonds. Essentially, almost any collateral (as long as it is tokenized) can be pledged. Campbell R. Harvey 2019

Stablecoin basics Crypto-collateralized coins: MakerDAO Other information Andy Milenius at Devcon4, December 10, 2018 https://www.youtube.com/watch?v=2lxc7qCsvF8 Campbell R. Harvey 2019

Stablecoin basics Non-collateralized coins: Basis, Carbon, Kowala (mUSD, kUSD), Fragment/Ampleforth Basecoin – dynamic monetary policy that uses a three token system (coin, bonds and shares). They had to shut down December 18, 2018 because regulatory issues (bond and stocks were securities). Nevertheless, let’s explore their idea. 1. Coin: Supply shifts to keep demand at, e.g., $1 to maintain peg If price increases, more coin is created; if price decreases, coin is purchased to decrease supply “A stable cryptocurrency with an algorithmic central bank” Campbell R. Harvey 2019

Stablecoin basics Non-collateralized coins 2. Bonds: Generated whenever supply needs to contract Bonds are redeemable for 1 coin in future if: Supply is expanding Bond hasn’t expired (5-year window) Your bond is next in line Sold for less than $1 to achieve yield (here is where the regulatory issue kicks in because qualifies as a security) Campbell R. Harvey 2019

Stablecoin basics Non-collateralized coins 3. Shares: Supply is fixed Excess basecoin supply paid to shareholders (after outstanding bonds) Proportional to ownership (again seems like a security) Thus bonds incentivize contraction of supply and bond and shareholders are recipients of expanding supply and the peg can be maintained “via game-theory and economics” Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Vision is a series of k-coins, kUSD, kEUR, … White paper 1 second confirmations in Go Ethereum Three stability mechanisms Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Stability mechanism #1: Minting algorithm If kUSD rises above $1, then more supply is added (so the block reward is variable) If kUSD falls below $1, mining reward goes to zero – however, that might not be sufficient to drive the price back Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Stability mechanism #2: Stability fee Like Ethereum, every transaction sender is charged a fee (in part to compensate miners for maintaining the network). This fee also includes a “stability fee” which is 0-2% of the transaction amount. The fee serves to reduce coin supply when price is below $1. Note the max is 2% and usually the stability fee would be zero (in normal conditions) Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Stability mechanism #3: Trading activity First two mechanisms are first order effects and are designed to keep kUSD close to $1. There is a second order effect. Given that market participants understand the peg, there exists a natural Schelling (focal) point (parity). That is, arbitrageurs will enter the market if the price falls below $1 and start to buy. Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Other Two token system: kUSD and mUSD, where mUSD is a mining token. There is a fixed number of mUSD for every kUSD. Consensus mechanism (Konsensus) derived from Tendermint and uses Practical Byzantine Fault Tolerance (PMFT). They believe superior to Proof of Work. There are miners. For every block, a leader (called proposer) is deterministically elected from miners. All other miners are validators. Proposer assembles the next block and the validators decide whether to accept or reject. Proposer gathers pending transactions of offers to the validators for formal verification. If two thirds or more vote to accept the block, proposer commits it to the blockchain. If block is rejected, a new proposer is elected. The likelihood of being elected as a proposer depends on the number of mUSD you have. Campbell R. Harvey 2019

Stablecoin basics Kowala protocol Other Dishonest or free-loading miners punished by becoming ineligible to propose blocks (need to be active to participate); Also, in order to be eligible, miner needs to stake mUSD tokens (currently 30,000); Maximum number of miners; Energy efficient 7,000+ tps with processing time of 1 second Campbell R. Harvey 2019