Truly Own Your Money, Not Under Your Mattress

06/18/2020 | Blog posts

We all know someone, usually an elderly gent or lady, who stashes their money below their mattress, or any other place in their house, since they do not trust banks. From the financial crisis in 2007/2008, we learned that this mistrust is at least partially justified. 

It is also this mistrust that gave rise to cryptocurrencies, such as Bitcoin or Ether. Cryptocurrencies allow their users to truly own their money, with a digital payment system that does not require users to trust centralized institutions, such as banks or payment processors, with their money. 

Cryptocurrency also acts as a hedge against inflation, since their inflation rates are determined by programming and cannot be altered. In contrast, central banks can freely inflate the supply of their fiat currencies as they see fit. This has led to many instances of hyperinflation throughout history. Bitcoin is capped at 21 million coins, for example. There will never be more.

Cheaper and Faster Transactions

However, cryptocurrencies are notorious for their volatility. As shown multiple times, the trading value of Bitcoin has at times dropped by over 30% in a single day. This prompted the design of stablecoins. Stablecoins are cryptocurrencies with a trading value that is pegged to the value of a fiat currency, such as the US-Dollar. Pegging the stablecoin gives it less volatility, while retaining the direct ownership of assets.

Issuers of stablecoins most commonly operate by storing fiat currency in a centralized institution and handing out digital certificates. At any time these digital certificates, or tokens, can be redeemed again for the same amount of fiat. The tokens are stored on a decentralized public ledger, also known as a blockchain. 

This allows the owners of stablecoins to enjoy most of the benefits of cryptocurrencies, without the volatility risk. One of the main benefits is that transactions on the blockchain are often faster and cheaper than wire transfers, especially for cross-border transactions. All of this works completely without banks.

Stablecoins for Salary Payments and E-Commerce

Depending on the blockchain used for such transactions, transferred funds arrive at their destination in a matter of minutes or even seconds, whereas banks often require multiple days. The fees for a single transaction range from few cents to a fraction of one US-cent. For this reason, stablecoins are gaining popularity for cross-border transactions, such as salaries for digital workers. 

Recently, New Zealand has clarified its taxation rules for salary payments. This allows all New Zealand based employees to receive their salaries in the form of stablecoins, without ever having to hand over custody over their money to a bank. Also, many online shops have started to accept cryptocurrencies, especially stablecoins, as a means of payment.

This speed and the low fees of blockchain enabled transactions are also the main reason most central banks are now researching this new technology. Recently, China became one of the first countries to test a Central Bank Digital Currency (CBDC) and many more will surely follow suit. 

Centralized and Decentralized Stablecoins

As noted above, most stablecoins are digital certificates that allow their owner to redeem them for fiat currency with a centralized custodian. By far the most widely used stablecoin is Tether (USDT), which is pegged to the US-Dollar and currently has over 9 billion USDT tokens in circulation. The amount of Tether tokens in circulation has more than doubled since the start of 2020.

Tether’s popularity is mainly due to the fact that most cryptocurrency exchanges quote their exchange rates in USDT. Thus, USDT acts as a base currency for converting cryptocurrencies. Exchanges report a daily trading volume of over $30 billion, which exceeds the trading volume of Bitcoin. Alternatives to Tether are USDC, PAX and BUSD.

The problem with centralized stablecoins is again related to banking. Using a centralized stablecoin means that there is once more a custodian that you need to trust with your money. This problem is solved by decentralized stablecoins. These maintain their peg through algorithmic measures, instead of issuing redeemable certificates. 

The most popular decentralized stablecoin is DAI, with around 130 million units in circulation. While generally not quite as stable as Tether, DAI still maintains its USD-peg reasonably well.

Decentralized Finance

Stablecoins are the preferred currency for Decentralized Finance (DeFi) products. DeFi attempts to map traditional financial instruments onto the blockchain. This allows the counterparties involved in these financial transactions to interact with each other, without the involvement of a middleman, like banks or centralized exchanges. The idea behind DeFi is that, at some point, we can stop using banks altogether and interact on a peer-to-peer basis, by directly controlling our own money.

There is a steadily growing number of DeFi products available, among others derivatives, staking, and insurance. However, by far the most common and best tested use case for DeFi is decentralized lending. This allows borrowers to take out instant collateralized loans. The collateral ensures that the lender does not lose their stake in the case of credit default.

Using the various lending products and providers in the blockchain space, lenders can get an APR of up to 10% on their stablecoins, giving them protection against moderate fiat inflation, without the exchange rate risk associated with cryptocurrencies. 

While this arrangement does not put the lender under credit default risk as the loan is fully collateralized at all times, it somewhat limits usefulness for the borrower. Currently, borrowers cannot gain access to more capital through DeFi. This problem will be solved once  decentralized underwriting is fully discovered. 

Note that there are certain risks attached to DeFi lending however. Instead of handing control of your money to a centralized custodian, DeFi users lock their money up in a smart contract. The programming of these smart contracts might be faulty, which could allow hackers to steal the locked funds. Therefore DeFi users need to properly investigate if a product is reliable and has already stood the test of time.

Facebook’s Planned Stablecoin

One of the hottest topics of last year in the stablecoin market, was Facebook’s plan to issue their own stablecoin, Libra. Originally, Libra was conceived as a coin that would be pegged to a basket of underlying assets. 

This was seen as a direct attack against central banks, as this would have essentially created a new worldwide currency that undermines their monetary sovereignty. Beyond banks, the notion of a large worldwide centralized organization issuing their own cryptocurrency has been criticised by governments and the crypto community alike.

In a second attempt to gain support, the Libra Association has recently applied for a license from the Swiss financial regulators. Instead of pegging Libra to a basket of different fiat currencies and bonds, Facebook now plans to issue multiple instances of Libra that are pegged to only one fiat currency each. Since these localized Libra currencies would still be subject to the monetary policy of the currency they are pegged against, this might be seen as less risky by regulators.

Conclusion

Cryptocurrencies question what it means to truly own your money. When you deposit cash at the bank, you are giving away your ownership, instead receiving a credit through the bank. Recent history has shown that banks do not always handle your money with due diligence. 

In general, fiat money is subject to the whims of the central bank issuing the currency. While the currencies of most developed countries aim for a stable price level and low inflation, the face value of your money still decreases every year, especially when banks cannot offer you a proper interest rate. 

With stablecoins, you can truly own your money, not in cash, but in a digital form, without the need for banking. This money can instantly be used for cheap and quick global payments. Furthermore, you can invest your stablecoins in various DeFi products and earn an APR that exceeds the interest rates on bank deposits by far. Best of all, you can do all of this without ever giving away ownership of your money to a centralized custodian.