By Francesco Roda, Chief Risk Officer at Koine
Digitalisation of value is beginning to permeate markets, following the launch of several initiatives in 2019[1]; in June of the same year, Facebook catapulted digital assets to notoriety with Libra[2].
Markets are attracted by the benefits of the new digital world: broader liquidity, efficient distribution, lower costs and more efficient use of capital.
At the intersection of the digital world and financial markets lies the handling of rights over assets and the transmission of value, firmly anchored to the concept of a currency.
Currencies are well defined and understood in financial markets but have fuzzy contours in the digital world. Uncertainty renders the translation of cash from financial to digital problematic. Banks invariably point the finger to risk; money laundering is deemed to be higher in the digital world. This is, in my view, unsubstantiated – so long as intermediaries follow the rules.
Stable coins appear to address this issue elegantly: a token linked to fiat but that does not require intermediaries[3] – neither new nor established ones.
Yet, stable coins and large-scale electronic money initiatives[4] may soon see a third contender in the race for innovation.
The current generation of mainstream crypto assets possess very few traits of real-world currencies; the absence of yield and material costs of carry, coupled with high volatility, render crypto assets unsuitable for payments. Similar considerations apply to gold; indeed, early initiatives of gold backed coins failed to attract interest or failed to launch at all.
Proof of stake is a new consensus algorithm that could reshape crypto assets; this is an alternative to proof of work, the consensus mechanism that underpins all major coins like Bitcoin and the current implementation of Ethereum[5].
Staking refers to the coins that miners[6] are required to deposit to guarantee their work. The network rewards authentic verification with a fee and penalise bad miners by taking away their deposit if it determines that they violated the blockchain rules.
Miners can continue to earn a fee, which is proportionate to the amount of coin deposited, for the duration of the deposit held by the network. This makes the return on deposits risk free.
In other words, proof of stake blockchains offers the opportunity to earn a risk-free interest on the deposits; this makes them akin to central banks which provide money supply management and risk-free deposits[7] to the economy[8]. The risk-free return paid on the coins deposited anchors their value, albeit endogenously, to a known reference point, potentially rendering valuations relative to exogenous prices, more stable.
New coins may render stable coins redundant and, if successful, compete with central bank issued currencies. Their classification from a regulatory point of view may prove challenging: the decentralised nature may prevent them from being treated as currencies or financial assets. Their ability to transmit and store value would point to the opposite conclusion, with intermediaries would face regulatory uncertainty. The pooling of coins from different parties, for example, to meet the minimum amount required to participate in the staking process, could be viewed as a collective investment scheme, albeit no cash nor financial instruments are involved.
[1] For example, SocGen issued a covered bond (EUR 100m) in April 2019 on Ethereum and the German regulator authorised a USD 250m real estate-backed token on Ethereum.
[2] Lybra is issued by a consortium on a permissioned blockchain and is backed by a basket of currencies. If it is successful in satisfying regulation which is ill prepared and not coordinated globally to deal with large scale electronic money services initiatives, Libra will be a major innovation in cross border and domestic payments.
[3] With the exception, of course, of its initial issuance against, and redemption for, cash.
[4] Mobile payment volumes in China reached 277.4 trillion yuan ($41.51 trillion) in 2018, up more than 28 times from five years ago, according to the People’s Bank of China (PBOC). Alipay alone has over 600m active users.
[5] Ethereum has a plan to migrate to a proof of stake algorithm.
[6] Miners are the agents on a blockchain that verify the authenticity and validity of transactions, prior to adding them to the blockchain.
[7] As opposed to a central bank, proof of stake blockchains pay interest on deposits on an almost continuous basis, with the interval given by the time difference between blocks; given the short time interval between blocks, compounding can be approximated with a continuous function.
[8] This is valid only if the blockchain is truly decentralised, i.e. no parties can exercise control on it.
