How Does a Stablecoin Make Money?

Note: This is an old post with some minor flaws, I am posting it here in protest of Medium.

This post is prompted by something interesting I have noted in the cryptocurrency space, namely that there has been a significant proliferation of so called “stablecoins.” Besides the proliferation there has also been recent VC investment into some of them, making me wonder, “how does a stable coin make money for a VC?” Let’s look into this and make sure everything adds up.

Update: I published a deep look at the Basis protocol here.

Let’s start with Basecoin, oh wait I mean Basis Protocol. This “stablecoin” has raised well over $100 million dollars from VC investors. I’m worried about these investors, many coming from top firms after looking at the economics of this BitShares 2.0 (Worry anyone else that the founder of that project is the founder of the new $4,000,000,000 darling EOS?). The way it works as best as I understand is using a three-token system. The tokens are as follows:

  1. Base Shares
  2. Base Coins
  3. Base Bonds

The base shares are created in the genesis block and all new base coins go to them as “dividends” (holy shit I hope they spent some of that $100 million on Securities lawyers). The base coins are a separate coin that is issued to holders of the base shares when the price of the base coin exceeds peg, in theory diluting their value and bringing the value back to peg. Base bonds are issued when the value falls below peg. When this happens you can purchase a Base bond for the current value so say $.80 and then redeem it for $1.

Now where this gets even trickier is when it comes time to issue new coins is that it goes first in, first out. So it goes to the oldest bond holder first, and then continues down the line, and if there are in theory no bond holders then the coins are issued to the share holders.

Now what is the issue with this system? Economics mostly. Let’s start with what is the most obvious to me, my incentive if I am a whale and if this is liquidity is to become a large share holder, and then whenever I get a dividend to immediately sell it, purchase bonds, wait for them to redeem, and then dump again. If the market gets too big for me to do this alone, I do what all the whales are already doing in crypto and organize this process with a few other people.

The second problem and the more troubling one, where this needs more investors always coming in (gotta maintain the stability fund they talk about) is better captured by Preston Byrne than I could: “It seems to me on this very cursory review that Basecoin depends on

  • Printing free money and giving it to crypto-investors who are inclined to hold it and thus restrict supply;
  • Providing financial incentives to subsequent investors to introduce money into the scheme and subsidize the price of the scheme if the price of a coin should fall below a certain level (say, $1);
  • Vulnerable to a not-at-all-decentralized reliance on price indicators provided by unsupervised, unregulated third-party trading venues already suspected of serious shenanigans;
  • Granting primary benefits of the scheme to early buyers in an unregulated ICO;
  • Where every participant is betting on the price of their assets rising;
  • Which cannot sustain itself without finding new buyers for $BASE.”

Now the question that is blowing my mind is why the investment in this from VC firms? And then I figured it out. The reason this stablecoin has gotten so much investment is because of the structure of the shares. When they buy their shares they are trying to basically buy money printing machines they will continue to issue them dividends, as they accumulate the follies of every retail investor who purchases the coin to use to trade in the crypto world. They’re trying to profit of a couple really nice facts.

  1. Many cryptocurrencies banks have no strong fiat on-ramp and thus depend on stablecoins like Basis protocol for people to trade, creating built in buy pressure.
  2. The initial purchase of shares will allow for the stability fund to maintain the peg long enough for them to cash out their investment.
  3. Plus, if the price of cryptocurrencies continue to rise and more people are purchasing then they can continue to print money for longer.

Not exactly a great product for all of us.

Update: I wrote an in depth look at MakerDAO, Dai, and MKR here.

So let’s look briefly at another stablecoin. This time MakerDAO.

MakerDAO which issues DAI confuses me because I cannot figure out the advantage to using it. Basically you put up about a whole bunch more money than you want in Ether. They then issue the Dai. So say you wanted $1,000 worth of Dai, you need to overcollaterize and put up let’s say $1,500. Now why would you do this instead of trading into the much more stable USD? Good question. I cannot for the life of me figure it out.

Best part is though how vulnerable this system is. Let’s say that tomorrow there is a another horrible event on Ethereum. Think like the DAO hack, but larger, and they are unable to achieve consensus to roll the chain back. The value of Ethereum plummets and then you are not overcollaterized, you are undercollaterized and the value plummets.

There is also a bunch of the same algorithmic BS that Basis Protocol and BitShares try to use to maintain their value thrown in for good measure.

Oh and the best part if they do end up undercollaterized? They dilute the pooled Ethereum so you can no longer claim back the same amount of Ethereum you put in. How’s that for a fun little twist?

So well I’m confused about this, at least it’s clear how they make money. To pay back their “Stability fee” you need to use their MKR token.

Worst of all? It hasn’t maintained it’s peg.

Finally, we need to discuss the elephant in the room. The one who’s imminent collapse will also be the black swan event that destroys MakerDao and wipes out a ton of value in the crypto ecosystem. Tether. I am not going to go back over ground that has been thoroughly covered, so just read everything Bitfinex’ed said. But more than that, it is supposedly backed, with no audits, and no convertibility yet trades with no counterparty or insolvency risk even when bank accounts get seized.

Plus, it’s linked to Bitfinex, which has also been linked to the delightful market makers over at Cumberland mining as Spoofy McSpoofface detailed already. Namely bad.

Though if you want me to answer how does Tether make money, again I’m not exactly sure, best guess I have is they don’t and it’s all used for money laundering. (Remember Kraken let’s you trade fiat into Tether with no fees, but won’t let you trade using Tether).

Update: I wrote a piece discussing recent developments in Tether here.

Update: Okay so Tether makes money in two ways, 1. a ten basis points charge on Tether purchases, and 2. Interest on the money held. However, it is still an open question as to whether or not they are actually earning interest due to the complexity of their current banking situation.

That’s the secret behind all of these stablecoins. They hide behind their algorithms and everything else, but they all rely on market-making bots in order to maintain their pegs. Some even outright admit it, like Basis with their “Stability Fund” or this one which is just beautiful: https://twitter.com/prestonjbyrne/status/953769228238286848

If you still are in doubt, ask George Soros about what happens when someone tries to peg something. In his case he got rich. For many people in this case they will get caught holding a bag. If you are going to trade crypto, then trade responsibly and do it with real fiat on ramps not magic pegged currencies. And as always nothing I say is legal or financial advice, I’m just an angry guy on the internet.

Update: Added clarifying comment about nature of Cumberland mining.

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A Bear’s Perspective on REP

A Bear’s Perspective on Augur

Myles Snider has already written an excellent introduction to Augur and Prediction markets and for the sake of brevity I will not rehash it here. I highly recommend reading his piece before considering my piece: here. In this I will present a different perspective on the coin, focusing on potential regulatory risk, but not on the normal worry of the SEC treating the coin as a security.

CFTC Risk

In the United States the Commodity Futures Trading Commission (CFTC) has previously cracked down on other prediction markets. Most visibly and noticeably on Ireland based Intrade. Despite its international basis it was still able to be shut down by the United States based CFTC. Even DARPA and the CIA experimented with a prediction market, that was shut down due to Congressional pressure. (Interesting read about it here) These and other examples of various prediction markets being shut down thanks to regulatory pressure, seem to suggest that the United States is not ready for a prediction market. The common argument given defending Augur is that because it is decentralized it is protected from this kind of intervention. However, several issues arise when you consider that argument. First and foremost there needs to be a way to get your fiat money (think USD) into and out of the currencies being used for Augur. I would not expect a significant crackdown on the Ethereum that is used to trade (though it is possible with the SEC comment about coins being security, and the fact that there was an initial sale). The greater issue here is that the market makers need to hold the REP coin associated with this platform. That means they must have a way to get into and out of this coin. In the Intrade shutdown it was possible because there was cooperation between the CFTC and the bank associated with Intrade. It is possible that any exchanges that offer trading from fiat to REP or vice versa will have difficulty finding banks that will accept their business, or if a bank is found it is also possible that individual holders of REP could become a target of investigations. We have already seen many cryptocurrencies including Binance and Bitfinex having trouble finding banking and I do not see that being an issue that will be easily solved soon. Carrying coins like this will make it that much more difficult for exchanges to find banking.

The second major CFTC risk I see associated with Augur is the ability for anyone to make a market on anything, and then collect trading fees on it. This potentially could mean that the real risk here is that these individuals market makers could end up sanctioned by the CFTC. Especially since they are receiving a portion of the fees associated with the market, meaning that they are receiving a direct and trackable benefit from this platform. This is especially worrisome in light of some of the specific complaints that were levied against Intrade that led to its closure. In 2005 Intrade was found to be in violation and they were then required to inform US customers with a pop-up on the exchange that told US customers they were not allowed to trade these options, and to try to ensure that US based customers could not trade these options. My fear with Augur here is two-fold, one the Augur trading platform will need to make sure that US customers are told that they cannot trade these options, and that individual market makers will become liable for US customers who do trade their options.

Insider Trading Risk

There is another risk that is neglected, but in my opinion represents a smaller overall risk to Augur as a whole, however, it does represent a risk to people using Augur. Every single market participant on the Augur platform needs to understand that they are liable for insider trading regulations in their countries. Many of these options, especially if they are tied to the price or performance of “real” securities, are ones where anyone trading in the market need to ensure that they are not in violation of insider trading laws. Failure to appropriately recognize this risk, by any market participant increases their legal liability.

Manipulating market to affect real world

Augur has described the potential for these prediction markets to serve as a more accurate way to predict various real life events. However, what I have not seen described yet is the fact that if these markets are being used to predict various real life events, they are open to manipulation. For example, consider a prediction market in Augur that is predicting the price of oil a month later. The market on Augur is likely going to be much smaller than the equivalent futures contract. This means that a sufficiently large enough whale could potentially make large enough bets to manipulate the Augur market, which could then potentially change either the futures market or the actual price of oil. This is in my opinion is one of the smallest risks to the price of REP and to Augur in general because it requires several things to happen:

  1. Augur needs to become a large enough platform that its predictions are used in securities trading.
  2. The market needs to be small enough that a single or a team of whales can manipulate the market.
  3. The whales need to be able to make these manipulations, while hiding that these manipulations are occuring.

As such this seems to be the smallest risk in my opinion to Augur as a platform or REP’s price.

Conclusion:

In conclusion, while I feel that Augur is a fascinating platform, and the way REP is used to adjudicate disputes in the prediction market is innovative, I worry the regulatory risks are being underestimated. There is a history of these kind of markets coming under regulatory investigation and that is neglecting the fact that it is possible that the REP ICO may have also been an illegal security sale (based on the recent comments suggesting most ICO’s were illegal). This suggests to me that REP may initially gain value, it is likely to fall under regulatory scrutiny that will significantly depress its value, and may permanently prevent Augur from flourishing, which is disappointing because I find prediction markets fascinating.

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