Defining a safe, stablecoin and introducing risk

Today, most transaction cryptos (barring scam cryptos) have emerged from the crypto/blockchain technology side of things with little respect for and understanding of the requirements of the “real world.”

Coming from the non-crypto side of things, a stablecoin representation of central bank issued currency must incorporate risk, for starters.

A dollar bill deposited in a commercial bank and exchanged for an IOU by a commercial bank has less value than a dollar bill. A fact, which most people in the crypto space don’t realize. The IOU is exchangeable upon demand (during bank opening hours) to a dollar bill, but what if the bank can’t pay?

A commercial bank might have closed shop over a weekend, and all money is lost unless of course consumer deposits are government guaranteed, which is the case in many European countries, up to a certain amount. From this also follows (ironically), that the bank deposit is indeed a real and equal representation of government money. In the US FDIC insures deposits of private individuals, which in practice has worked well but it’s not the same as a government guarantee.

This raises the question about why governments should guarantee the bank deposits of individuals, which depending on the maturity of an economy, backs up a significant to very significant part of the commercial interest of banks in search of profit for shareholders.

However, this is a political issue which goes beyond the scope of this article. It is worth noting that commercial deposits are not guaranteed by governments anywhere, and especially worth mentioning that government does not insure stablecoins linked to underlying commercial deposits.

Crypto stablecoins based on other crypto coins are not guaranteed by anything either and could theoretically go to zero.

In short, there is a vast difference between the value of a commercial bank issued IOU if the bank is single C rated and one that is AAA rated — even if the commercial bank is AAA rated, the risk is still higher than a central bank-issued digital coin.

Following simple financial theory, this is compensated for by the commercial banks offering interest on deposits, which exceed the risk available to consumers through, for example, short-term government issued treasury bills. This, however, is rarely provided to retail depositors today.

The consequence of introducing credit into the risk and value equation is that just any issued stablecoin pegged to an underlying currency backed by bank deposits does not have the same value as placing money in central banks (holding physical bills) and therefore introduces an element of credit risk leverage, which in practice might be acceptable but from a theoretical perspective is rather unacceptable.

Credit risk works differently with pure crypto-space stablecoins, where the risk is more related to the market value of the underlying composites based on market prices, which per definition is significantly riskier.

In reference to the idea of backing issued digital stablecoins with government bonds and bills, as in the case of the ARYZE stablecoins, the notion of government-backed stablecoin in this context is only theoretically true if government-issued securities back 100% of the issued digital coins and a more correct notion in part of the liabilities are kept as bank deposits form liquidity management purposes should perhaps be “quasi-stablecoin.”

The only true stablecoins with no credit risk in its currency would be digital cash issued by the central bank itself.

It should be noted that government-issued debt obligations are always AAA rated in its own currency. Central banks issue debt obligations to finance public debt on behalf of the government. If more money is needed, the central bank will just print more money to the point where hyperinflation starts to kick in, but the government debt will remain AAA rated in its own currency because the government can always just issue more money to service old debt. The real value in terms of purchasing power for goods will, of course, be eroded, and the value will diminish relative to other currencies.

A Fintech or Central Bank Role?

I have previously written an article about central banks issuing national stablecoins. Not only do I stand by my views about why fiat backed stablecoins are a role for fintech companies and not a central bank role, but the arguments against a national stablecoin also keeps reoccurring.

One of them is the “Big Brother is watching you” problem.

Assume for a second that there is no cash, only digital cash. In such a situation, it would be very hard for people not to declare income and the black economies would have a hard time because all transactions leave a digital trace and the transactions are stored for a certain time, which is an anti-money laundering (AML) requirement.

In many countries, such a situation could result in unacceptable hard times for people at the edge of society like beggars, homeless people, and people who generally only survive on the goodwill of others with no access to the digital society and banks.

Now, leaving the socio-economic issues aside for a minute, it is quite clear that a private company managing digital cash in the form of a stablecoin would be subject to numerous rules and regulations regarding data security and data sharing (GDPR, for instance).

If digital cash is issued by a central bank as part of a government initiative, there is no telling where data will end up in a public system and how secure the data will be, which could result in significant human rights violations — follow the money and you know everything about a person.

There are already severe problems and concerns of the kind mentioned above in some countries, related to biometric data and public payments.

Article by Morten Nielsen, Co-Founder and CFO of ARYZE

Disclaimer

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of ARYZE.

Morten has many years of experience in finance, fundraising, and the cryptocurrency space. Previously at JP Morgan for five years, where he was mostly working with hedge fund fixed income and derivative marketing. He has also held a position as global head of hedge fund derivative marketing at UBS. He is now CFO and co-founder at ARYZE and is responsible for financial risk assessment and management, as well as management of a range of business and revenue activities.

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