Dollar-Denominated Cryptocurrencies: Flops and Tethered Success

Bitcoin, Blockchain, cryptocurrencies, currency board, Tether
Modified ThinkStock image: http://www.thinkstockphotos.com/image/stock-illustration-dollar-and-surfing/494783029

A well-known obstacle to the greater popularity of Bitcoin as a medium of payment is the high volatility of its exchange value. This volatility results from its built-in quantity commitment: because the number of Bitcoins in existence stays on a programmed path, variations in the real demand to hold Bitcoin must be accommodated entirely by variations in its unit value. When demand goes up, there is no quantity increase to dampen the rise in price; and vice-versa for a fall in demand.

Not surprisingly, several cryptocurrency developers have thought of creating a cryptocurrency with a price commitment — namely a pegged exchange rate with the US dollar — rather than a quantity commitment, in hopes of greater popularity. The aim is to create a system in which dollar-denominated payments can be made with the ease, security, and low cost of Bitcoin payments, but without the exchange-rate risk.

The development of “Blockchain 2.0” platforms has enabled the launching of a variety of new digital assets, including such dollar-pegged (and euro-pegged and gold-pegged) currencies. As we will see, the histories of early (2014-2016) dollar-pegged cryptocurrencies show a series of flops. But one project, Tether, has become a late-blooming success. Tether had $55 million in circulation as of March 29, 2017, making it the #13 largest cryptocurrency. To keep this size in perspective, a brick-and-mortar US institution with $55 million in deposits is a tiny bank or a mid-size credit union, and Tether is currently only 1/300th the size of Bitcoin.

The Tether white paper explains in more detail the motivation for developing a dollar-pegged cryptocurrency by listing advantages to individuals using it for dollar-denominated transactions rather than using dollars held in “legacy bank” accounts:

  • Transact in USD/fiat value, pseudonymously, without any middlemen/intermediaries
  •  Cold store USD/fiat value by securing one’s own private keys
  • Avoid the risk of storing fiat on [cryptocurrency] exchanges ­– move crypto­fiat in and out of exchanges easily
  • Avoid having to open a fiat bank account to store fiat value

In sum, “Anything one can do with Bitcoin as an individual one can also do with” a dollar-pegged cryptocurrency, namely, “avoid credit card [or debit card] fees,” maintain greater privacy, “remit payments globally” more cheaply, and access blockchain financial services.

But what is the claimed advantage over using Bitcoin? It is the expectation of wider acceptance in payments, because of the advantages to merchants of accepting a dollar-pegged cryptocurrency over accepting Bitcoin in a US-dollar-dominated economy:

  • Price goods in USD/fiat value rather than Bitcoin (no moving conversion rates/purchase windows)
  • Avoid conversion from Bitcoin to USD/fiat and associated fees and processes

The Flops

First we consider the projects that have flopped. Three projects were launched in September 2014: CoinoUSD, NuBits, and BitUSD. Their pegging mechanisms were different, and are difficult to describe briefly (partly because they were not all entirely transparent), but two common features are important to note.

  1. The rate-pegging mechanisms were not programmed into a source code, like Bitcoin’s quantity commitment, but relied on non-programmed policy actions by a trusted central authority.
  2. None used the traditional currency pegging method of having the issuer hold reserves in physical dollars or dollar-denominated debt securities. (On the NuBits mechanism see this critique by a BitUSD promoter. On the BitUSD mechanism see this critique by the CoinoUSD developer.)

We can examine the fortunes of each project by looking at its price and “market capitalization” (value-in-circulation) history on the cryptocurrency tracking site CoinMarketCap.com.

CoinoUSD

CoinoUSD, which began trading in December 2014, was developed by a for-profit payments firm called Coinomat and built on the blockchain of the NXT cryptocurrency. (In November 2014 NXT was the #6 cryptocurrency with a market cap of $19 million; currently it ranks #38 with a market cap around $13 million.) CoinoUSD reached a market cap plateau of $2.7 million in early 2016, but shut down in early 2016, due to a “payout glitch” that flooded customers with free CoinoUSD units, making it impossible to maintain the exchange value at $1. Coinomat announced a reboot in which the erroneous payout would be reversed and said, “NXTUSD will replace CoinoUSD completely, and enhance it,” but this appears not to have happened. Since then it has had a market cap of zero, and its webpage at the Coinomat site declares it “disabled until further notice.”

NuBits

The history of NuBits, also a for-profit enterprise, shows that it gained only a similarly small market foothold. Its market cap plateaued early on below $2.5 million, and since April 2015 has remained below $1 million. In June 2016 NuBits had a devaluation crisis, with the price falling to 20 cents. Its rate-pegging intervention mechanism, despite claiming many layers of reinforcement, was not robust and failed. Although the price later returned to par, today NuBits shows very little market activity. Since January 2017 the market cap has hovered around only $135,000, with daily trading volume in the neighborhood of $2000.

BitUSD

BitUSD is built on the blockchain platform of the cryptocurrency BitSharesX. Its highest market cap plateau was around $1 million soon after introduction, but it fell to below $200,000 in April 2015 and is currently less than $110,000.

BitUSD uses a novel pegging system that so far has proven robust. A piece promoting BitUSD emphasizes that “the bitUSD is an asset that is not backed by real dollar in someone's bank account.” (It claims this a virtue: “We cannot trust anyone to hold and secure a physical asset so that people can redeem it eventually. History has repeatedly shown: It doesn't work!” In fact, history shows the major banks in unhampered banking systems routinely justifying the public’s trust by redeeming their liabilities on demand for decades. Paypal works on the same supposedly non-working model, backed by Paypal’s dollar deposits at Wells Fargo Bank.) By contrast, BitUSD are created through collateralized forward currency contracts. The network provides an escrow service that credibly ensures repurchase (or “redemption”) of the BitUSD at or near par. Someone who wants to acquire BitUSD, say in order to buy from a seller who prefers a dollar-denominated medium of exchange, offers a contract: so many BitShares (hereafter BTS) for a certain amount of new BitUSD. Under the BitShare network rules, the acquirer must not only pay at the outset in BTS but also agree to post collateral in BTS equal to the value of the bid. If the bid is accepted by another network participant, explains the BitUSD white paper, “the collateral and purchase price are held by the network until the BitUSD is redeemed” by some third party repurchasing it. The acquirer of BitUSD thus puts 200% collateral into a contract “that only allows access to these BTS when the BitUSD are paid back.” In effect the acquirer is shorting the dollar price of BTS.

Note that the new BitUSD units are initially 200% collateralized not in dollar-denominated assets, but in BTS. If BTS fall 25% or more against the dollar, such that the value of the BTS collateral declines to 150% or less of the value to be repaid, under the network rules redemption can be compelled by any BitShares miner who “enforces a margin call.” (It should be noted that to enforce the collateral rules, the BitShares network relies on trusted human agents to inform it about the current $ price of BTS.) The system then “uses the backing BitShares to repurchase the BitUSD…thereby redeeming it.” Conversion back into dollars is thus not always at the initiative of the holder, as it is for a holder of ordinary demandable bank liabilities. Instead a BitUSD holder faces a risk of “forced settlement.” If the value of BTS falls so quickly “that the margin is insufficient, then the market price of the BitUSD may fall slightly below parity for a short time if there is insufficient demand for BitUSD relative to the supply of sellers.”

The white paper concludes: “The critical thing to understand is that BitUSD is an asset used to hedge a position in BitShares against changes in the price of USD and is not supposed to have an exact 1:1 exchange rate with USD.” A close look at the chart indeed shows that the price of 1BitUSD has not been exactly $1. It has vibrated around $1 but has not experienced any lasting devaluation. Nonetheless its clientele has declined and is currently small. No doubt this reflects in part the declining popularity of BTS, its market cap having fallen from more than $60 million in September 2014 to around $15 million today.

The Success: Tether

Now to the success story. Tether was launched in February 2015. In contrast to the previous contenders, as the chart shows, it started slowly and has grown in market cap. The series of discrete steps in its market cap path indicates that there have been a series of large purchases. The most recent step, on Wednesday, March 29, 2017, raised the value in circulation to $55 million from $45 million. Logically these are not speculative position-takings, because there are no capital gains to be had so long as the price per tether remains solidly pegged (or “tethered”) to $1. And Tether has in fact successfully maintained a steady peg throughout its history with only one small and brief blip. The steps are presumably big acquisitions for transaction use. Transactions volume in recent weeks has been running mostly in the neighborhood of at $20-40 million per day.

Tether transfers are executed using the Bitcoin blockchain. Tether’s pegging mechanism is also not programmed into a source code, but it is the traditional one: the issuer holds dollar-denominated reserve assets and pledges to redeem Tethers on demand. (Euro-Tethers have recently been introduced, but I focus here on dollar-Tethers.) According to the official FAQ, “Tether Platform currencies are 100% backed by actual fiat currency assets in our reserve account. Tethers are redeemable and exchangeable pursuant to Tether Limited’s terms of service. The conversion rate is 1 tether USD₮ equals 1 USD.”

The parent Tether firm, in other words, operates like a currency board: It holds 100%+ dollar-asset backing, and passively swaps Tethers for dollars and back again. Like a currency board, it can earn interest income by holding some of its dollar-denominated assets in interest-bearing form. The Tether white paper reveals that Tether’s dollar reserves are currently held in accounts at two major Taiwanese commercial banks: Cathay United Bank and Hwatai Bank. (Why these particular banks? “They also provide banking services to some of the largest Bitcoin exchanges globally,” they are okay with Tether’s business model, and they are experienced at compliance with Know-Your-Customer and Anti-Money-Laundering regulations.)  It adds that “additional banking partners are being established in other jurisdictions” to reduce political risk of the accounts being frozen. Tether is thus not a “100% reserve” institution in the sense of a money warehouse holding 100% literal cash reserves (which would mean Federal Reserve notes in a vault).

How does a potential purchaser of Tether verify the 100% backing claim? The website declares: “Our reserve holdings are published daily and subject to frequent professional audits. All tethers in circulation always match our reserves.” A webpage does give dollar values for assets and liabilities, but does not identify the auditors or provide copies of the audit reports, so the claim of being “fully transparent” is somewhat exaggerated. The transparency is as great as that of historical note-issuing banks, however. And perhaps the important test of trustworthiness is that Tethers have in practice been redeemed every day at par for about two years.

Dollar-pegged cryptocurrencies, by contrast to Bitcoin, separate blockchain-secured payments from the speculative holding of an irredeemable private currency. Thus they provide a potential window for learning how much of the demand for cryptocurrencies is transactional, and how much is speculative. The competition among dollar-pegged cryptocurrencies provides something of a market referendum on the relative credibility of alternative pegging arrangements. The much larger size achieved by Tether suggests (though not definitively, because other factors are also in play) a popular verdict that its pegging mechanism is more credible than those of CoinoUSD, Nubits, or BitUSD. It will be interesting to watch Tether’s progress from this point on, and to observe whether its model is copied by other entrants.

  • Ray Lopez

    Sorry but Dr. White's examples of failed cryptocurrencies don't cut it. All they show is a 'bust', not failure. But Bitcoin itself has gone through "boom" and "bust" cycles. The popularity of Bitcoin might be not due to any merits it has (I was a brief investor for a while, until I realized how much of a hassle, technically, it was to keep, even with an online deterministic wallet), but because of its supposed popularity, not unlike Keynes beauty contest if you know the analogy. First to market = success.

  • Correct me if I am wrong somebody, but US law prohibits the development, marketing, entry and competition of/from any non US FR dollar currency system. I do not agree or condone these restrictions, but how are these "competing" currencies able to function inside this law? It would seem to me that they exist only on the fringes outside US law. Larry's analysis is greatly appreciated, informative and instructive, but given the restrictions on competition, is it perhaps too early to gauge success, or not?

    Personally I believe the success of Bitcoin and other "off-the-grid" crypto currencies, as well as companies like Panera being sold at over a 50 GAAP PE ratio for that matter, are only viable under a complete destruction of the current state global monopoly monetary system – which, of course, is exactly what is happening. The major central banks and their state government sponsors are sewing the seeds of their own destruction. The success of Bitcoin and its current price, in particular, should be a complete embarrassment to the Fed and others, and a massive wake-up call. I may be wrong in this analysis, but the only way to tell is for each state monopoly money producer to open themselves to competition so we can find out.

  • Mattyoung

    Tether works when you exchange between trusted parties, then it is just like cash. Bitcoins can be passed between trusted parties without calling the ledger service. So, the idea is to put a trusted party in everyone's hand, a handheld cash device that guarantees against double spending. With the secure device, then, any currency can be traded many times before calling any clearing house or updating an S&L account.

  • JP Koning

    Good post.

    "And perhaps the important test of trustworthiness is that Tethers have
    in practice been redeemed every day at par for about two years."

    A time series of the deposits issued by a bank like Citigroup would show quite a lot of volatility as deposits are issued and redeemed at par. The Tether chart you use is odd since it the market cap implies that while Tethers are being created, they aren't being destroyed. Now maybe Tether is indeed redeeming tokens at par on a daily basis, and it is keeping those tokens in treasury rather than cancelling them. Thus we don't see any declines in market cap. The other explanation is that the redemption promise has never actually been tested. Since we don't know the answer, I'm not convinced Tether has passed your trustworthiness test.

    • whowhatwhywhen

      today, the price of a tether is 0.92cents. that's an 8% decrease in one day. Not so successful after all. I'd recommend sticking to Bitcoin, Ether, Ether Classic, Ripple, and maybe a couple others (Zcash, Dash, Monero)

  • Andrew_FL

    If you can program a cryptocurrency to peg to the US Dollar, in principle you could program a cryptocurrency to stablize the nominal volume of cryptocurrency payments. Right?

    • George Selgin

      That has been my belief.

  • Professor White, how does Tether make money? You mentioned that it "can earn interest income by holding some of its dollar-denominated assets in interest-bearing form." However, they can do that regardless, without issuing a cryptocurrency and so forth. Earning interest on one's own deposits isn't really a business model – it's just an incidental source of income available to any and all businesses and persons.

    Backing a currency 100% with another currency seems pointless. What's the benefit there? I don't see a business model. Smart people aren't going to invest time or money in such a business – a McDonald's franchise or a stapler factory would be more interesting and lucrative, not to mention the really groundbreaking things they could be doing with cryptocurrencies.

    A cryptocurrency that could reliably peg itself to something useful might be very attractive. How to achieve a reliable peg is the hard part. First, I think the currency would have to be at least as good as the leading cryptocurrencies regardless of the pegging feature. It would need to be able to create value on its own the way that Bitcoin, Litecoin, Dash, Ethereum, and Monero have done (these seem to be the leading cryptocurrencies, with good market caps and unit prices of many dollars).

    It would need to be able to quickly ramp up in value/price to the ballpark of its intended long-term peg-based value. It would need to do this by market action alone, like the other currencies, or by some prop like backing or reserves (possibly a temporary mechanism). Once there, it would need to be able to then settle into its pegging mechanism.

    I think it's probably a mistake to declare that a currency be pegged to something in real-time, 24/7, if it's something like a fiat currency or gold. There's going to be a lot of fluctuation and attack vectors that will be hard to manage with an algorithm or some other mechanism.

    Better would be peg to a running average. For example, I e-mailed George Selgin once about my idea for a gold-backed currency pegged to 1-year running average (daily) of the gold price in dollars or whatever (the reference currency wouldn't matter much). So say we define Joe Bucks as 1,000 Joe Bucks = the 1-year running average price of 1 oz t of gold. They'd be redeemable for that dollar or Euro amount. (There's no point in physical gold redemption – if people want physical gold they can just buy it.) That gives you some long term stability and predictability, retains the value of the currency over the long run as dollars and fiat steadily lose their value relative to gold and everything else, which seems like some nice properties to have in a currency. The running average bit gives the issuer some flexibility, buffering, and planning opportunities, in order to best manage positions and reserves and so forth.

    If someone could figure out a way to peg a cryptocurrency to gold in a similar fashion, on autopilot to some extent, that would be interesting. 1 year might be too short. Maybe 3 or 5 year averages would be best. Or maybe a fundamentally different gold price-related algorithm would be better. In any case, it would have to have the kind of appeal that Bitcoin, Ethereum, Dash and others have, with the added draw of its pegging mechanism. Pegs are incompatible with a free market unless and until someone comes up with the right kind of peg.

  • Professor the timing of this article is quite interesting. First your assessment of BitShares and its bitUSD is not accurate.

    BitShares Market Cap is over $30,000,000 and steadily growing purely from organic adoption; in spite of several representatives from competing platforms, commodities, currencies and blockchains repeatedly stating that it is a flop. A bitUSD bought when BTS was half the value is still worth the same today with regard to its USD buying power and if it had been the opposite direction (BTS decreasing in value) then it still has the same buying power. Here is a link that includes graphs showing the smartcoin (stablecoins) bitUSD and others: https://steemit.com/bitshares/@steempower/bitshares-state-of-the-network-18th-april-2017

    Secondly with timely events of US banks closing all USD wires from centralized exchanges, this exemplifies the limitations of centralist solutions for decentralization. Tender (USDT) and all future attempts dependent on centralization of digital fiat paired asset ownership will ultimately fail. The failure of USDT at this point isn't even because of the collateral being seized or stolen (all though that is another possibility), but because all of the control, value, fungibility USDT offered was at the mercy of central banking. How on earth would anyone ever think that central banking or nations/businesses controlled by fiat would contribute to increasing the rate of making their irrelevance?

    bitUSD may have been ahead of its time when it was first introduced, but hopefully with this newest hyped USDT debacle people will realize the time for decentralized stable digital fiats is now. The sooner people start utilizing decentralized exchanges and maybe for the beginner centralized exchanges that utilize USD pairs with bitUSD:**** assets.