# 4 | A Taxonomy of Currency: from Coin to Stablecoin
Pax Multa in Cella, Foris Autem Plurima Bella
This is another issue of Dirt Roads. No financial reports analysis, no marketing material dress downs, no investment advice, just deep reflections on the important stuff happening at the back end of banking. Because banking is nothing but a pragmatic translation of our ability to imagine what hasn’t yet happened, but could. The time you dedicate to read, think, and share, is precious to me, I won’t make abuse of it.
The Chronicles of Money
Scholars tend to fall into the trap of over-glorifying the inevitability of long and successful stories. It happens in history, in football, in business, in biology. We tend to forget Darwin’s lectio magistralis on the role of small advantages, path dependancy, and the implacability of time. I blame it to the fear for our limits (in space and time), to the self-imposed illusion of truly having the ability to influence the reality around us in the span of our short lives. Society-wise, it is a useful illusion.
The same applies to the canonical studies of the history of money. The history of money has been long and messy, almost as long as the history of monetary theory.
What is, in its core principles, money? Simply refined metal and therefore a mere extension of market activity, as stated by Aristotle? Or a mental construct aiming at directing labour towards future value creation, as assessed by Plato and later Schumpeter? The reality is that although it is somehow easy to assess what money was, during a certain period of the past, it is probably impossible to guess what money will be, at some point into the future. Money has worked so well in the last fifty years that we had almost forgotten it hasn’t always been there in the shape we know, and this has inflated the self confidence of monetary theorists.
Recent macroeconomic and political events, however, seem to have ended this monetary pax romana. There has been a lot of attention, recently, in trying to reinvent money, or at least direct its evolution, as I described in last week’s post on CBDCs. Among most activist central bankers Randal Quarles, Supervision Vice Chair at the FED, stands as one of the few to have realised that long periods of peace tend to lie on strong alliances rather than on superior strength (emphasis is mine in the quote below - if you don’t know what a stablecoin is, don’t worry, you are reading the right post).
“In my judgment, we do not need to fear stablecoins. The Federal Reserve has traditionally supported responsible private-sector innovation. Consistent with this tradition, I believe that we must take strong account of the potential benefits of stablecoins, including the possibility that a U.S. dollar stablecoin might support the role of the dollar in the global economy. For example, a global U.S. dollar stablecoin network could encourage use of the dollar by making cross-border payments faster and cheaper, and it potentially could be deployed much faster and with fewer downsides than a CBDC. And the concern that stablecoins represent the unprecedented creation of private money and thus challenge our monetary sovereignty is puzzling, given that our existing system involves-indeed depends on-private firms creating money every day.”
Loyal to Darwin, it is not my intention to try and develop a framework where to encapsulate the role of money in society, or to guess what money will become in the next fifty to hundred years. The sole ambition of this post is to put some order in what’s happening instead at the fringes of money, leaving all qualitative assessment to the only competent judge: time. This entry of Dirt Roads is, therefore, nothing more than a chronicle.
Who Actually Owns GBP Anyway?
I am going to describe the reality of today’s currency in an odd, yet accurate, manner.
The British pound sterling, or GBP, is the official currency of the United Kingdom. Although I live in the United Kingdom I don’t own any GBP. Correct. I don’t because I rarely need them, they are made of paper or metal I can’t be bothered storing and carrying around. Most of my payments happen in digital form and paper and metal is not very useful - I need an electronic alternative.
That’s why I opted for hsbcGBP instead, which is a reasonably good electronic alternative to the GBP and is issued by HSBC UK Bank plc. It is a reasonably good alternative but it’s NOT the GBP. The hsbcGBP has several properties:
It is a private and electronic-only currency issued by HSBC UK Bank plc (or simply HSBC) in exchange of fees
It is hard-pegged to the GBP with a 1:1 ratio
Thanks to a formal agreement with other private issuers, it can be exchanged (with a 1:1 ratio) with all the other private electronic currencies within the system overseen by the Bank of England (examples of those currencies include the barclaysGBP, the lloydsGBP, the rbsGBP) at any time
Thanks to a formal agreement with the Bank of England, it can be exchanged (with a 1:1 ratio) with the GBP in its paper or metal form at any time
In the remote case the hsbcGBP will break its peg with the GBP, the government is committed to swap it for GBP (with a 1:1 ratio) up to an equivalent of GBP 85,000 per person
How does the hsbcGBP maintain its peg? The hsbcGBP is crucial to the HSBC ecosystem and the issuer ensures its peg via an over-collateralisation mechanism. In other words, in order to issue a certain amount of hsbcGBP the issuer demands collateral with a (risk-adjusted) fair value that largely exceeds that same amount. Vastly different types of collateral are accepted, each with a specific issuer appetite and each carrying its own risk-weighting. Clients sign a contract giving certain rights to the issuer over those collaterals, and receive in exchange freshly minted hsbcGBP. Some clients, like states for example, have privileged status: since governments offer a series of perks to issuers for their private money-printing activities, they have explicitly regulated that those issuers can accept an infinite amount of their own debt as collateral without impacting the maximum capacity of private currency they can mint. That’s smart.
What will happen in the case hsbcGBP breaks the peg? The hsbcGBP is hard-pegged to the GBP, meaning that its value doesn’t fluctuate but actually sticks to the GBP all the time. Or at least it does that until it snaps (seeing its value abruptly reduced). Although improbable, it could happen that the fair value of the assets held as collateral by HSBC would fall under the theoretical value of hsbcGBP issued causing the exchange ratio to fall below the 1:1 peg. In order to avoid this, governments have set emergency stop losses and a taxing monitoring framework, as well as the GBP 85,000 backstop we have discussed above. This combination of diversification, over-collateralisation, and back-stopping, has worked very well in ensuring the trust of the system for hsbcGBP and its private peers. It has worked so well that many ignore the existence of the hsbcGBP altogether, confusing it for its most famous sibling, the pound.
All this might seem overly complicated but that’s how it works.
Why Was the GBP Not Enough?
hsbcGBP and its peers were born because the GBP in isolation wasn’t enough to satisfy public needs. The reasons were twofold:
The system needed continuous creation of new money, and central banks and governments weren’t deemed the appropriate institutions to perform a productive allocation of new money to the public - on the other side, private institutions needed some skin in the game while doing so (and couldn’t merely distribute central bank money without recourse - as might be the case with CBDCs)
The public wanted de-materialisation since paper and metal were not a convenient store of value and couldn’t be used across thousands of use-cases
hsbcGBP (let’s call it bankcoin) was, in other words, a functional overlay of GBP (let’s call it coin) building on the existing trust for GBP through a series of preferential agreements with GBP sovereign issuer. The total integration of the ‘HSBC economy’ within the ‘United Kingdom economy’ would ensure that nasty currency defaults common in other currency-pegged sovereign economies across emerging markets wouldn’t materialise.
Why Are Bankcoins Not Enough? A Stablecoin Taxonomy
Most recently, for reasons not pertinent to this issue of Dirt Roads, the public started demanding additional features that weren’t native to bankcoins, namely:
Lower all-in transaction costs to perform certain intermediation activities
Higher yield for their cash savings at (to be proven) comparable risk levels
Higher (perceived) control over currency vs. what happens in a system pivoting around central banks and governments
This while maintaining all the characteristics of bankcoins and coins.
The result was the emergence of a series of blockchain-enabled stablecoins, i.e. digital forms of money with native compatibility with decentralised operating systems (such as Ethereum or Solana) where Decentralised Finance (DeFi) applications proliferate.
Version 1: Full-Reserve Stablecoins
The easiest way to create a stablecoin, i.e. a private blockchain-enabled currency 1:1 pegged to bankcoins such as hsbcGBP (which in turn are 1:1 pegged to coins such as GBP), is by receiving an amount of bankcoins, storing that amount, and issuing the same amount of stablecoins as a token in exchange. Let’s call this type of stablecoins full-reserve/ fiat-backed stablecoins. Examples of this type of stablecoins include USD Tether (USDT - $62.6b in circulation), USD Coin (USDC - $25.4b), Binance USD (BUSD - $10.7b). Given that issuers of those stablecoins do not have (in most cases) a viable internal economy, the utility of those is proportional to the acceptability and exchangeability of those stablecoins in the outer space. Differently from bankcoins, that can be used to repay principal, fees, or other costs within the bank environment, the utility of stablecoins such as the USDT exists only if they are widely accepted (at the desired peg) within the broader DeFi ecosystem.
Assuming they work and they deliver on their promise (this is easier said than done, as the turmoil behind the USDT demonstrates), those stablecoins aim to satisfy the public needs (lower all-in transaction costs, higher yield, higher control) as a pure blockchain overlay without fully substituting bankcoins like hsbcGBP.
Pros: full-backing contributes to stability
Cons: counterparty risk is increased, burden of supervision remains, no advanced features added vs. bankcoins beyond blockchain compatibility
Version 2: Over-Collateralised Crypto Stablecoins
Another, more advanced, version of stablecoins are over-collateralised/ crypto-backed stablecoins. Ignoring the complexity of the name for a second, those stablecoins have a closer resemblance with bankcoins. The most commonly used of those stablecoins is the DAI, that we have discussed extensively (and will continue to discuss) here, and here. The DAI is issued by MakerDAO in the same way HSBC issues hsbcGBP: somebody posts a certain amount of collateral (in the form of crypto tokens), and receives in exchange a certain amount of DAI. The collateral sits protected in a smart contract until the DAI balance is fully repaid (or until the smart contract is liquidated). DAI is soft-pegged to USD, meaning that it is allowed to have some level of volatility around the 1:1 ratio: this is due to the fact that the peg is managed by a system of incentives that leverages arbitrageurs rather than via full reserving.
Differently from bankcoins, DAI doesn’t benefit from diversification (tokens are mostly highly correlated with one another), or regulatory back-stopping. In exchange, it compensates with higher over-collateralisation (currently 150% for ETH-A, its main collateral exposure). At its core, as we have stated several times, Maker is much closer to a commercial bank than to a pure technology overlay.
Pros: architecture allows for expansionary monetary function like for bankcoins, incentives remain aligned in favour of DAI stability and healthy financial returns for MKR token holders, it has worked quite well so far
Cons: lack of diversification across collateral types and high volatility of tokens limits scalability and favours pro-cyclicality
Synthetix provides an alternative to Maker’s approach (the sUSD) with the ambition to solve the supply/ demand disconnect, departing from the more traditional fractional banking model and instead opting for a synthetic, self-collateralising, derivative approach. My gut feeling tells me that synthetic approaches are elegant on paper but offer a set of perverse incentives at a low cost of execution - currently there are c. $200m of sUSD in circulation, we should wait to assess its merits.
Version 3: Algorithmic Stablecoins
There is another, even bolder, version of stablecoins out there: algorithmic stablecoins. Rather than trying to resemble bankcoins, they mimic coins at their root while acting as a central bank via committed open market operations. Algorithmic stablecoins are the smart contract version of small emerging economies’ central banks.
Algorithmic stablecoins come in various fashions (you can read a great summary by Lemniscap and Economic Design on Medium), but ultimately they have a similar approach: a smart contract is initially capitalised with an asset pool and mints in exchange a certain amount of fiat-pegged stablecoin, let’s call it algoUSD, at a certain ratio. With the fluctuation of algoUSD in the open market, the smart contract will purchase (in case algoUSD falls below the peg - using the asset endowment) or mint more algoUSD (in case algoUSD goes above the peg), in the same way a central bank uses hard currency reserves to manage the desired peg of their local currency. The smart contract nature of those algorithms guarantees the trust of the public that protocols will be committed to market-make their native security via using the asset pool without diverting it to other uses - differently from perverse central banks. However, this commitment is as strong as the quality of the algorithm and the balance sheet backing it, and young, under-collateralised, over-levered algorithmic stablecoins won’t necessarily work well. Examples of this type of stablecoins include Terra Money, Frax, Reserve, Ampleforth, Empty Set Dollar, Dynamic Set Dollar, Debasonomics, and Basis Cash. The performance of algorithmic stablecoins has been mixed.
Pros: architecture allows for expansionary monetary function like for coins, solves some of the pro-cyclicality of v2 stablecoins, permissionless nature strengthens the commitment around the peg
Cons: solidity depends on strength of balance sheet, soundness of the algorithm will need to be tested at different size points, past performance has been mixed so far
A Letter to the Future
We have described several different approaches to the creation of stablecoins. Although they all intend to satisfy the need for an ample, stable, usable, enhanced version of money, they employ multiple and radically different methods. It is way too early to tell which one of those will dominate the others, or whether we will live in a reality with a single dominant approach at all. At the bottom of it, it doesn’t really matter.
What is more interesting is to step back for a moment and realise that the utility of the higher levels of the pyramid rests on the stability of the base layer: the coin and the central bank backing it. A perfectly designed USD-pegged stablecoin is quite useless if the USD itself is not working the way it should. My belief is that as long as we will have a government collecting taxes and allocate spending (and a national army), we will have a physical central bank at the centre of the currency construct. We are still far away from crypto-algorithmic taxation! The breadth and power of this central bank will continue to fluctuate with historical events.
The pax romana began with the end of the civil wars and of the Roman Republic. Romans had believed peace was a temporary and unproductive interval that occurred while their enemies, defeated and destroyed, were getting reorganised. Augustus challenged this view, convincing the citizenry that a balanced coexistence of powers would have been more profitable for everybody. And especially for Rome. This period of relative peace lasted for roughly four hundred years, until an inordinate herd of Eastern people, called barbarians, stormed the empire, sacked its cities, and put Western Europe in a thousand years of darkness.
Technical note on pro-cyclicality: Maker’s collateral pool is constituted by crypto-tokens that (currently) have a very high degree of correlation. As a result, users of the protocol are overall incentivised to mint DAI via posting collateral in asset inflationary phases (i.e. when they expect the price of the collateral to go up). On the contrary, during asset deflationary phases those users are incentivised to get back control of the collateral to avoid the risk of punitive liquidation, thus reducing the amount of DAI in the market - with additional impact on the peg. The introduction of full-reserve stablecoins such as USDC in the collateral pool and of a depositary rate mechanism has reduced this effect on the DAI, although still reducing the yield of Maker’s balance sheet during deflationary phases. During bear markets Maker resembles more a cash depositary institution than a lending bank. However, with the DAI acting as a small crypto overlay over bankcoin, the monetary transmission mechanism isn’t affected. However, in a fully blockchain-based economy where the monetary expansion function would be delegated only to banks like Maker, its pro-cyclicality would certainly become an issue.