This part explores three of the primary ways organizations are implementing stablecoin systems. The purpose of this part is to reveal the breadth of stablecoin technology by identifying the technical specifications of live systems and how they work. This part serves as a foundation to Part 5 on evaluating stablecoins, which explores how legal and economic considerations of stablecoins will vary in accordance with system design. The case studies included in this part are for Tether1, Libra and Maker Dai.
Case study 1: Tether
Founded in 2014, by Tether Limited, Tethers (with the symbol USDT), were designed to be the bridge between fiat currencies and cryptocurrencies and offer stability, transparency and minimal transaction charges to users . Each Tether issued into circulation is at a 1-to-1 value ratio with the US dollar, and was said to be backed in a 1-to-1 ratio of fiat currency held in reserves. Tethers may be redeemable for the underlying fiat currency, or if the holder prefers, the equivalent spot value in Bitcoin.
The issuer and custodian of Tethers is Tether Limited, which safeguards the reserve of fiat that backs Tethers and acts as a trusted third party responsible for the asset. The technology that facilitates issuance, redemption and transfer of Tethers is built in three layers. The first layer is the bitcoin blockchain, which the Tether transactional ledger is embedded in. The second layer is the Omni Layer protocol. The protocol is the technological manifestation of the rules that facilitate the Tether network. Rules include how Tether tokens are granted and revoked, tracked and reported (once they are in circulation), and transferred and stored. The third layer is Tether Limited, the primary business entity that coordinates activities related to the off-chain collateral. Tether Limited is responsible for accepting fiat deposits and issuing corresponding Tethers, sending fiat withdrawals and revoking the corresponding Tethers (i.e. destroying them to maintain supply), maintaining custody of the fiat reserves, auditing and publicly reporting proof of reserves to instill trust, managing integrations with bitcoin compliant wallets, exchanges and merchants.
Tether is issued to a user when the user transfers funds (in either fiat or cryptocurrency) through a cryptocurrency exchange to a designated smart contract established by Tether Limited. Once confirmation of the transfer is established, the issuer “mints” (creates) and allocates an equivalent amount of Tether through the smart contract it maintains, to the user. The process of redeeming tokenized funds works in the reverse of issuance. A user sends Tether to a smart contract address specified by the issuer, which automatically withdraws Tether from circulation (burns them), and transfers an equal amount of fiat from the store of tokenized funds back to the user.
Case study 2: Libra
Introduced by Facebook in 2018, Libra is a cryptocurrency built on the Libra blockchain and governed by the Libra Association (the Association). The purpose of Libra is to serve as a low-volatility, low-friction medium of exchange and store of value for users to make payments domestically and internationally. Unlike Tether, the Libra blockchain is a “permissioned blockchain” , which means that access to run a validator node is granted to pre-approved administrators; in this case, administrators of the Libra blockchain will be members of the Association. As mentioned earlier, validator nodes are responsible for ensuring the integrity of the blockchain.
The Libra Association’s July 2019 whitepaper presented a plan for one global “Libra coin” (LBR) that would be backed 1-to-1 by a basket of digital fiat currencies and short-term government securities, held in a reserve (the Libra Reserve), and distributed amongst a network of custodians that are tasked with developing and operating the payment system. Considering that Libra would be backed by a basket of fiat currencies, the volatility of one single currency should be mitigated. Appreciation or depreciation of Libra’s value will result from FX market movements. Due to immense regulatory pressure, the Association revamped its 2019 plans to ensure that the Libra payment system supports two layers of stablecoins. As of April 2020, the Libra payment system proclaims that it will support single currency stablecoins (ex. digital versions of USD, GBP, EUR, etc.) and the multi-currency coin, LBR, as described above.
With respect to the issuance and redemption of LBR, users will interact with resellers who are authorized by the association to transact fiat and Libra in and out of the reserve. These resellers will integrate with the exchanges and institutions that enable the trading of cryptocurrencies with users, and will provide these entities with liquidity for users who wish to convert cash to LBR and vice versa.
The Association will mint and burn Libra in response to demand from authorized resellers. In other words, new LBR is only created when the resellers transfer a commensurate amount of fiat into the reserve, and LBR is only destroyed when resellers withdraw fiat from the reserve to transfer to users who want cash. The Association compares this process to the way in which currency boards have operated. Whereas central banks have the discretion to print money, in accordance with regulations, the Libra Association responds to supply and demand to control money supply.
Case study 3: Maker Dai
Dai token is a fully decentralized on-chain stablecoin created by Maker. At its core, the Dai system works by incentivizing individual users to lock up cryptocurrency that they own (in this case, ether to be specific) as collateral, on-chain, in order to issue Dai tokens to themselves.
Users who want to create Dai send their ether to a “collateralized debt position” (CDP), which is a smart contract that runs on the ethereum blockchain. In exchange for ether, CDPs let you take out a loan in Dai while the CDP holds the ether in escrow until the Dai is returned. The terms of the loan are such that if the value of ether goes below a certain threshold, the user will either have to pay back the CDP (as you would a bank), or the CDPs protocol will automatically auction off your ether to the highest bidder. This is Dai’s core mechanism for issuing, backing and burning Dai. The amount of Dai a user creates is relative to how much ether the user puts into the CDP (this is known as the collateralization rate). CDP owners are incentivized by the opportunity to leverage their crypto-assets and the opportunity to obtain cheap credit in the form of Dai.
In order to account for instances where the price of ether, which collateralizes Dai, drops so fast that there is insufficient time for the auctions to take place, Maker created a second token called makercoin (MKR). MKR provides its owners with rights over the governance of Maker smart contracts. Such rights allow MKR holders to vote on the collateralization rate of CDPs. MKR holders are incentivized to protect the stability of Dai because they are rewarded interest from CDP debts and auto-liquidation fees (i.e., they are incentivized to maintain Dai stability because they benefit financially from Dai stability). However, in an instance where the collateral in the system is not enough to cover the amount of Dai in existence, new MKR is issued to the open market in an effort to re-collateralize Dai. Therefore, MKR holders are like equity holders in that they have decision-making power over Dai, but also insurance providers in that the value of their shares will be diluted in circumstances where new MKR must be issued.
As an additional layer of defense against a potential system crash, Maker has added a process called global settlement. If global settlement is triggered, the entire system freezes and all holders of Dai and CDPs are returned their underlying collateral. Therefore, if I hold 100 Dai when global settlement is triggered, and one ether is worth 100 Dai, I can exchange my 100 Dai directly for one ether right through a smart contract. The collateral held in CDPs will be similarly released to its owners. A global settlement can only be triggered by a select group of trusted individuals who hold the global settlement keys .
The next part to this series will focus on central bank digital currency systems as the other primary alternative to the contemporary fiat model. Unlike stablecoins, the CBDC philosophy challenges the role of commercial banks by expanding the functions of the central bank. However, the basis of trust in a CBDC system is left relatively unchanged – central banks are still the issuers of money.
- Jake Frankenfield, “Tether (USDT)” Investopedia, online: https://www.investopedia.com/terms/t/tether-usdt.asp↩
- Tether Limited, “Tether: Fiat Currencies on the Bitcoin Blockchain”, (whitepaper) online: https://tether.to/wp-content/uploads/2016/06/TetherWhitePaper.pdf at 4. [Tether Whitepaper]. In April 2019, Tether’s general counsel Stuart Hoegner wrote in an affidavit that USDT was backed by “cash and cash equivalents … representing approximately 74% of the current outstanding Tethers”. Tethers original whitepaper claimed that USDT was 100% backed by fiat currency. Tether is now the subject of an inquiry by the New York Attorney General’s office. See: Nikhilesh De, “Tether Says its Stablecoin is ‘Fully Backed’ Again” (November 8, 2019) Coindesk, online: https://www.coindesk.com/tether-says-its-stablecoin-is-fully-backed-again↩
- This enables the blockchain-based payment properties discussed above.↩
- Tether Whitepaper supra note 33 at 6. ↩
- In the case of fiat currency, the user wires money to the cryptocurrency exchange, which first exchanges the fiat currency to cryptocurrency and then the cryptocurrency to USDT.↩
- The Libra Association is an independent, not-for-profit membership organization, headquartered in Switzerland, founded by leading technology firms in the payments, telecommunications, blockchain and venture capital industries. See: https://libra.org/en-US/association/?noredirect=en-US#founding_members.↩
- In response to state regulatory authority criticisms of Libra, the Association published an updated Libra whitepaper in April 2020 to address regulatory concerns. Four key changes were implemented:
- Offering single-currency stablecoins in addition to the multi-currency coin.
- Enhancing the safety of the Libra payment system with a robust compliance framework.
- Forgoing the future transition to a permissionless system while maintaining its key economic properties.
- Building strong protections into the design of the Libra Reserve.
See: Libra Association, “Whitepaper”, online: https://libra.org/en-US/white-paper/#the-libra-payment-system at Section 02 The Libra Payment System. ↩
- In a “permissionless blockchain,” anyone who meets the technical requirements can run a validator node. ↩
- Christian Catalini et al (authors at Calibra), “The Libra Reserve”, online: https://libra.org/en-US/about-currency-reserve/#the_reserve.↩
- With a currency board, a country’s monetary policy is not influenced by the monetary authority’s decisions (per the practice in a central banking system), but rather is determined by supply and demand. The currency board simply issues notes and coins, and offers the service of converting local currency into the anchor currency at a fixed rate of exchange.↩
- If the value of ether held as collateral is worth less than the amount of Dai it’s supposed to be backing, then Dai would not be worth one dollar and the system could collapse. Maker combats this by liquidating CDPs and auctioning off the ether inside before the value of the ether is less than the amount of Dai it is backing. Basically, if the price feed into the CDP indicates that the value of ether has gone below a certain threshold (let’s use 125% of created Dai), then the CDP is “liquidated” and the ether inside the CDP is auctioned off for Dai until there is enough Dai to pay back what was extracted from the CDP. See: Gegory Diprisco, “Maker for Dummies: A Plain English Explanation of the Dai Stablecoin” (2017), online: https://medium.com/cryptolinks/maker-for-dummies-a-plain-english-explanation-of-the-dai-stablecoin-e4481d79b90.↩
- Reserve Research Team, “Reserve’s Analysis of the MakerDAO Protocol” (2018), online: https://medium.com/reserve-currency/our-analysis-of-the-makerdao-protocol-4a9872c1a824↩
- Bullman et al, 2019 supra note 25 at 26.↩
- One of the greatest problems with this mechanism is that it is only effective to the extent that some buyer is prepared to purchase the newly minted MKR. Existing MKR holders are not forced to do so. In fact, MKR holders may even be detrimental to this process because they could front run the system by selling before Maker issues new tokens. Proponents of the Maker system assume that the penalty of dilution is sufficient to incentivize MKR holders to be good stewards of the system. This scenario is yet to be tested in the real world.↩
- The MakerDao whitepaper and subsequent summaries do not identify any specific criteria that may trigger global settlement.↩
- It is important to note that the safeguards Maker put in place are under immense scrutiny following the events of March 12, 2020, or “Black Thursday”, whereby a sudden drop in the price of ether led to the liquidation of thousands of CDPs held by investors. The event did not trigger global settlement, and numerous CDP holders lost 100% of their position, which during this period of liquidation accounted for $8.325 million. A class action lawsuit was filed against the Maker Foundation on behalf of the investors who lost their funds.
See William Foxley, “MakerDAO Users Sue Stablecoin Issuer Following ‘Black Thursday’ Losses” (April 14, 2020), online: https://www.coindesk.com/makerdao-users-sue-stablecoin-issuer-following-black-thursday-losses.↩