March 30, 2021
Can the strict regulatory requirements for traditional investors lead to a stablecoin that better serve crypto users, bridging both markets?
TLDR; – The global securities market provides a mature regulatory framework for traditional funds to invest and earn returns on the hundreds of trillions in fiat investments they manage (when valued in USD), with clear classifications and risk grading mechanisms to establish whether an instrument is investment grade, or not. More than any other potential participant in decentralised finance (DeFi), these funds must account for the investment risks they take when crossing from the real world to the blockchain in a regulatory compliant manner, and demonstrate that stakeholders’ funds and rights are properly protected - which to date has not been easily achieved. Stablecoins are the primary mechanism used to make the crossing between these worlds, and so the EURxb’s founding team set out to design a stablecoin that would meet the strict requirements of traditional investors and provide these same benefits to existing cryptocurrency users - and hopefully lay the foundation for future securities tokenisation in the process.
One of the recurring themes in thinking about blockchains is the interface between the “off-chain” world and the blockchain. It’s no secret that blockchain currencies are mostly traded and valued in the context of what they would fetch in off-chain real world currencies, and this presents one of many economic and even legal challenges to this growing industry.
How can a blockchain system truly trust an input that does not originate on the blockchain itself? We see this in the problem of Oracles, used to provide a source of truth to a blockchain application; and we see it in the question of who you will trust, for example your bank or the code.
At the same time, many blockchain based applications are replicating and improving products and services that we are familiar with in their off-chain versions, particularly in DeFi, where a community of innovators are recreating loans, deposits, investments and other financial tools in an open source, collaborative and composable environment.
Stablecoins are one of the fundamental building blocks for financial applications in DeFi and crypto more generally, providing a digitisation of real world money in the blockchain that allows participants to bridge easily between the two worlds, and so are a hot topic for those working and investing in this space.
Traditional funds that want to engage in the cryptocurrency space face several practical challenges, because the interesting decentralised finance products and services that they could participate in require them at the very least to hold stablecoins on their books instead of the normal money they are used to report on - and unfortunately the far greater majority of traditional financial institutions can’t effectively account for the perceived difference between most of today’s stablecoins and a price volatile cryptocurrency.
This is especially true when they need to see proof that a stablecoin is actually stable in price and value, will afford them the same legal protections as a fiat deposit or financial security, and is fundamentally a different type of instrument when compared to Ethereum or Bitcoin. Failing to prove this just means that they are not able to treat a stablecoin as anything other than a risky cryptocurrency - and they are stuck back at square one, unable to participate in this exciting new DeFi world, no matter how much they would like to.
We will not go into the many exciting and beneficial uses of stablecoins here; we are working on the assumption that you are familiar with that already. What we will talk about is the process of creating stablecoins that can answer this tougher level of scrutiny - and more importantly, examine what goes into making a stablecoin, stable. What are the options available to stablecoin providers, what are the pros and cons of the various types, and is there a better way? (Spoiler alert: we think there is.)
When you enter into any financial arrangement, whether it’s giving out a loan or investing your money, the wise thing to do is ask yourself “what happens if the person, company or system on the other side of this transaction does not do what they promised?”. It is exactly because things sometimes go wrong that financial institutions have to be regulated in the real world - ensuring they follow best practices, undergo audits, and comply with policies set out by their respective regulators. We don’t appreciate lawyers and rules until we need them, and in the stablecoin world the core question we need to answer is “what is behind your stablecoin?”, and therefore what would happen if someone does not do what they promised.
This question obviously applies only to stablecoins backed by conventional assets; algorithmic stablecoins are a different beast with different benefits and challenges which we will leave for another day. To help unpack the questions we are taking on now, we will look at three types of conventional asset backed stablecoin, before introducing a fourth.
- Licensed fiat deposits. This requires the stablecoin issuer to have a deposit taking or e-money licence in some form, and means that they are a regulated financial institution.
- Unlicensed fiat deposits. Here the issuer is normally some private company that does not have a financial license, and provides their assurances, possibly with transparent proof or audit, that the money you pay for your stablecoin is kept in one or more bank accounts. It is generally not possible for unlicensed entities to hold money on a customer’s behalf for the purpose of withdrawing it later, so normally the legal argument would be that you bought the stablecoin from them so that the funds paid belong to them as their profits, but that they are keeping those profits in reserve to be able to buy the stablecoin back from you at some later date.
- Commodity or asset custody. An asset (like gold bullion or other precious metals) that you own is legally encumbered and custodied, and stablecoins are issued to you against that collateral. This is similar to a Lombard loan, where your liquid assets can be used as security for a loan to provide you with temporary liquidity, usually at a fairly high collateral ratio.
If and when something goes wrong, there are several areas that you will need to consider, probably in a specific order of importance. Firstly, what is the legal framework that applies to this situation; second, what reserves are backing the stablecoin; thirdly, what form do those reserves take; and fourth, what level of claim seniority do you have on the reserves.
We should also consider the wider concerns involved with stablecoins such as (question five) secondary market liquidity - can you sell them quickly and with confidence?, and the implications of how your funds are being put to work: (question six) does it slowly devalue or generate a return for you?, and (question seven) is it contributing to making the planet a better or worse place?
Let’s look at each of these seven questions from the perspective of those three types of stablecoin described above - and remember that we are playing a hypothetical game where we imagine what we would have to do if we did not get what we were promised…
We cannot stress enough that the reason why the blockchain industry has been able to grow so successfully is that there has been a surprising level of integrity in the sector of stablecoins (especially when the larger cryptocurrency space is riddled with opportunists trying to make a quick return at your expense). This speaks to the tremendous spirit of pioneering and innovation that is embodied by many stablecoin teams as they help bridge the off-chain and blockchain worlds to make it more accessible to all, which deserves special recognition - and has served as exceptional inspiration to us on this journey.
If you want to recover the money that you paid for the stablecoin, who decides whether you are legally allowed to even ask for it, and could you use the legal system to enforce payment by the issuer?
In the case of a stablecoin backed by licensed fiat deposits, regulations vary around the world, but usually include some kind of deposit insurance backed by a central bank. You will also want to think about the jurisdiction you are trusting in this process. The cost and complexity of pursuing a claim will vary enormously depending on the respective legislative environments of you and the issuer, but generally this is a relatively strong legal framework for you to work from - as there is little dispute that the deposited funds rightfully belong to you.
For unlicensed fiat deposits, you are relying on the issuer to honour their promise, as enshrined in the stablecoin’s user agreement. If that doesn’t work, then you rely on the legal process in their jurisdiction, and your ability and appetite to enforce your claim. If they say you bought the tokens from them, and they don’t HAVE to buy it back from you - you are going to have a harder time convincing the legal system to help you get a refund on your purchase unless there are some crystal clear contracts in place.
In the case of your own assets being used as collateral, there should be no issue. The contract between you and the custodian of your assets will need to be carefully scrutinised, but in time this approach may become more common. In Liechtenstein’s proposed blockchain laws, for example, the role of a “Physical Validator” is envisaged: someone who will custody an asset and issue a token denominating ownership of that asset. The holder of the token owns the asset.
How can you verify the reserves of the stablecoin issuer, and thus the issuer’s ability to cover all creditors if they were to claim all at once?
With licensed fiat deposits, fractional reserve banking rules require that generally between 25% and 65% of deposits are held in liquid assets to ensure on-demand customer withdrawals. At the scale of a large bank, it is unlikely that they would fail to honour such claims, and even though the 24/7 and instant nature of the online world makes a “bank run” potentially faster and more likely than it is offline, the backing should still be sure.
For unlicensed fiat deposits, your assurance comes from the issuer, along with any entity or method they have used to provide that assurance. You will rely either on the details of a purchase agreement that you probably didn’t read, or the report of an auditor at a point in time.If, for whatever reason, the issuer is reluctant or unable to pay you, then your recourse options may be very limited.
For your collateralised assets, the issuer of the stablecoin will value them using conventional principles, and will collateralise them at a rate that reflects their liquidity and volatility. This process is clear and transparent.
What is the probability that the entity’s reserves will be worth as much as the entity claims, if they need to be withdrawn or sold to pay creditors?
In the case of fiat deposits, whether licensed or unlicensed, the same issues apply. The reserves backing a stablecoin are subject to the normal features of fiat currency and the banking system, so withdrawal charges and fees are commonplace. The currency in question may also have devalued against your preferred currency since your deposit, or literally reduced while being held due to negative interest rates becoming more commonplace, or in a less obvious case - had its value eroded by inflation.
For asset custody, the main potential issue here is with the volatility of the asset’s value. In extremes, the need to cover the value of stablecoins issued may trigger a sale by the holder or a request for further assets to be provided so that adequate collateral is available.
If the issuing entity somehow ends up with insufficient funds to pay its creditors, where do you stand, and how much will you get back, if any?
For licensed depository institutions, the situation here is usually clear. Up to the amount that is centrally insured, you will get 100%… eventually. Beyond that, you will usually be paid pro rata with other creditors of the same standing. You may rank behind creditors who have secured seniority at the time of their initial transaction.
For unlicensed deposit takers, keeping reserves in segregated customer accounts would give you a reasonable expectation of claim seniority, but no guarantee. Your claim would depend on legal action in the issuer’s jurisdiction.
With your own assets as collateral, there is no question - they are your assets, so this problem does not apply.
Now that we’ve studied the “what happens when it goes wrong” scenarios, let’s take a look at the more general impact questions around stable-coins.
How can you be sure that you get paid out on demand for your stablecoins? Or, will there be enough reliable buyers in the market for my stablecoin to sell to so you don’t have to withdraw?
For both licensed and unlicensed fiat deposits, there is a potential range of liquidation times depending on the type of deposit account in use, however the delay in withdrawal generally does not diminish the market’s confidence in the certainty that withdrawal will in fact occur at the specified time. For most large stablecoins this gives confidence to other buyers who then provide sufficient liquidity in the market for you to your sell your stablecoin to at a small loss, and who will wait out the time delay to convert the stablecoin themselves to the pegged fiat in turn for a small profit, usually via an exchange off ramp.
This assumes that an unlicensed issuer did not pledge their fiat reserves as part of a surety or collateral guarantee to finance an undeclared loan, or some other contractual lock-up of the funds, and that the funds are legally unencumbered and can be withdrawn.
For assets used as collateral, these will simply be returned, with the same liquidity characteristics as when you deposited them in the first place.
Are your funds being put to work; what are the returns on it and the risks involved for you; and who is getting those returns - or at least a share of it?
With licensed deposit takers, you can be certain that your funds are being put to work generating returns for the institution - but you will likely not get any share of it. Most licensed deposit takers apply Fractional Reserve Banking principals - which allow them to invest a share of your funds (sometimes the majority depending on the local regulations) for their profits. These institutions are normally insured by their central bank, so your funds are not materially at risk, but you most likely won’t be rewarded for providing the funds to work with.
The unlicensed deposit takers normally would need to leave funds in their deposit account to prove the reserves - which at low to negative interest rates could actually slowly erode the value of your funds instead of growing it, while the bank they in turn are depositing it with are the ones to benefit from the time-value of your money… Depending on the terms of service agreement and level of audit and public scrutiny they submit to, unlicensed depositors could make “side-contracts’’ to raise investment capital by offering the stablecoin reserve money in their depositing account as surety / security. This capital can then be invested into riskier but higher yield instruments, however this not only places your funds at risk, but you certainly won’t see any upside for providing the original liquidity to the stablecoin entity.
Assets or commodities as collateral would not easily be put to work, unless they were somehow pledged as surety on aside-contract as per unlicensed deposits - however that would only be possible if the stablecoin provider could prove to a lender that they were the owner of the assets, which would be quite unlikely as these kind of stablecoin providers are normally quite clear that the assets held in custody belong to the depositors - not the provider.
How does the stablecoin provider manage their reserves - are your funds making the planet a better or worse place for us all while it is in the entity’s care?
Licensed depository institutions generally have a diverse range of shareholders who care about the initiatives that it is involved with, however few institutions have been able to shift a meaningful share of their investments to green, sustainable and socially responsible programs. It is likely that your money is working for whomever is willing to pay the highest interest rate - and not necessarily who is most committed to improving our world for the future.
Unlicensed deposit takers vary greatly in this regard, as they would likely have green, charitable, and sustainable programs as part of their core promise to holders - but in reality they would not be able to decide how the funds kept in the depositary account is applied, as that would still be the domain of the bank the account is held with as it is the bank who will actually put those deposits to work under the Fractional ReserveBanking principals we previously discussed.
Asset or commodity custodians would likely have some great support programs, but again your assets / commodities cannot really be put to work, so unless the asset is something that is innately contributing to a better planet (such as carbon credits for example!) not much is being done to improve the world with your deposit.
At the start of this article we promised to share with you our vision of a modern stablecoin, and how it addresses the 7 aspects we highlighted above… So without further delay, let’s finally look at how the EURxb measures up in these areas!
Backed by Senior Secured Green Bond Securities
We set out to build a better public stablecoin with real world reserves, able to satisfy institutional investors that they were not holding a price volatile cryptocurrency on their books but rather a new digital instrument equivalent (in all practically measurable ways) to traditional finance instruments. This is why the EURxb is backed by investment grade, senior secured corporate green bonds, and audited and certified by recognised entities, following a well established process with a robust legal framework. The bond tokens exactly mirrors the terms attached to the conventional bond that they represent, and are locked up to issue a stablecoin: the EURxb, which we believe is the world’s largest Euro denominated stablecoin, with currently 100 million Euros in issue.
In respect of the worst case scenarios outlined above, the EURxb performs well. There is a very clearly defined and regulated process for issuing the bonds that back the stablecoin, with full legal recourse if necessary via the bond tokens.
The proof of reserves is fully transparent, with all contractual documentation online, and the bond’s ISIN number verifiable through an international system. The value of the bonds is potentially subject to the currency fluctuation of the Euro, and to the effects of inflation, as with other fiat linked coins, however they are not subject to negative interest rates like many larger Euro fiat deposits today.
The underlying bonds are senior secured bonds, and so not only have assets valued at 133% of the bond held in collateral against it as security, but also provide a priority claim to the debt holder in any liquidation event; the likelihood of such an event can be judged from the published documentation of the issuer and the report of the trustee who has reviewed and approved the bond process.
Additionally, the bonds can be fully liquidated (including interest) at maturity, with a healthy secondary market demand driven by bond investors and the issuer - at little or no fees, supported by market makers who see the profit opportunity to bridge liquidity supply peaks and troughs.
What differentiates the functionality of the EURxb from other stablecoins is when we consider the time value of money. This stablecoin attracts interest at 7% per annum, in line with the underlying bond returns - of which the entire yield is allotted to the stablecoin holder, and so will appreciate while simply being held in a wallet. In addition, the launch issuer and its assets that are bound by the regulated securities market to the bond are certified as a key green and sustainable contributor by a well recognised agency, and as a specialist property developer with almost 2 decades experience produces buildings that generate more energy than they use.
We began by referring to the link between blockchain and the off-chain world - and why this bridge seems harder to cross for institutional players. We believe that with the EURxb, we have bridged this gap more effectively, building a stablecoin with robust and transparent backing, making use of conventional finance mechanisms without hindering utility in DeFi.
We also hope that the additional features of being environmentally responsible, and providing fair returns to users will soon become commonplace in the category, even if - for now - they are simply the “cherry on top”. The future however holds great potential for institutional investors as the obstacles to their participation in DeFi are reduced and eventually removed altogether.
The ultimate integration between these markets remains largely dependent on clear regulatory guidance around the legal protections traders have for on-chain transactions, as well as whether a security must reside within the CSD; can co-exist with a blockchain; or could exist entirely as a stand-alone instrument on a permissioned or public blockchain.
Our implementation of the EURxb protocol serves to demonstrate that there are certainly steps that can be taken to introduce these worlds to each other right now, and as the adoption of these type of conservative compliance-first implementations become more mainstream they may even help inform regulatory policy. It is also our clear ambition to evolve our approach as the regulatory landscape develops, and more of the providers within the existing securities markets embark on serious forays into blockchain based offerings - most likely with regulatory tech that enable these players to migrate their services for investors and traders onto permissioned national networks, and from there into the decentralised finance market. Such national networks would provide cost effective and tokenised securities transactions within a permissioned market and extend or replace the role of the traditional CSD, while offering a regulated gateway to decentralised markets, similar to how a layer 2 solution integrates with the Ethereum mainnet.
But what would the next spontaneous evolutionary leap forward look like from the traditional finance world? It is not unimaginable that literally overnight a few forward thinking Central Securities Depositaries (CSDs) - who currently serve as the primary record keeper of financial securities by law in their regions, and together with their partners (CSDPs) perform the functions of creating, trading, collateralisation, custody, and all the associated clearing and settlement actions for securities right now - establishes oracle services to a public blockchain for the transparent verification of any of the securities and respective subscriptions held within their records… Then they would just need to deem a specific stablecoin acceptable to facilitate settlement, and could start offering a tokenisation service to their customers for any existing security - minted as an NFT on the public network and ready for inter-CSD trading in a dedicated decentralised marketplace. They could even allow some very specific tokenised securities to interact with current NFT marketplaces, and other DeFi services…
Whether through a leap forward or a cautious sandbox, we stand ready to welcome and support all who share the vision of bridging these markets, irrespective of whether they hail from the traditional or the decentralised finance space. The benefits of an integrated traditional and decentralised finance market could usher in an entirely new era of economic growth for all, especially during a time where so many economies are looking for new ways to provide financial inclusion.
Either way, while the financial service provider community waits for regulators and CSDs to take the next step, institutional investors are finding clever ways to participate in the innovation and excitement of decentralised finance markets that continue to accelerate every day.
If you would like to know more, please visit eurxb.finance, or read our position paper at Dematerialisation to Tokenisation - Position Paper
Special thanks to Paul Mitchell for his help translating my thoughts on this article.