Perspective Chapter: Stable Coins Backed by Real-World Assets – The Best of both Worlds

Abstract

Stable coins can bring stability in volatile crypto markets and during uncertain times. To examine their well-functioning, we assess the degree to which they fulfill the three main functions of a currency: means of payment, unit of account, and store of value. The true benefits of digital money will only materialize when living up to the key principles of peer-to-peer, trustless, and cryptographically secured electronic cash, as proposed in the original bitcoin whitepaper. We conclude that tokenized real-world assets, such as gold, can form an attractive reserve for stable coins. By combining the convenience, portability, and security enabled by blockchain technology with the proven reserve value of gold, it brings the best of both worlds.

1. Introduction

Over the past decade, the benefits of decentralized systems, the innovation of smart contracts, and blockchain technology have become obvious across different industries and user segments. However, recent volatility and turbulence in crypto markets have instilled fear and uncertainty. The sharp value depletion of cryptocurrencies over the past 2 years has further diminished confidence, as almost all top 30 cryptocurrencies have lost between 60 and 95% of their value. It coincided with fraudulent actions by prominent “trusted parties”, who turned out to be bad actors. Rather than being isolated events, bad conduct has manifested itself across the industry, including exchanges, market makers, decentralized finance platforms, intermediaries, and even protocols.

Faced with such turbulence, anything or anyone bringing stability seems like a god’s gift. Does this lead us to “stable coins”¹?

Stable coins are digital currencies that combine the innovation of blockchain technology with the stability, guarantee, and simplicity of traditional currencies. They are a subset of crypto assets, which, under MiCA² regulation, are defined as “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”. Stable coins minimize volatility by being pegged to a stable asset or a group of assets, often reserve-backed currencies like the US dollar or other commodities such as gold. Under the same MiCA regulation, they are “E-money tokens” whose main purpose is to be used as a means of exchange and that purports to maintain a stable value by being denominated in (units of) a fiat currency. The term “fiat” is a Latin word meaning “it shall be”. Thus, fiat currencies have no utility, nor value other than the one that a government maintains.

As the term suggests, stable coins are stable, meaning that they are worth exactly as much as the real-world commodity or currency to which they are pegged, which reduces volatility. The most known examples are USDT and USDC, which are pegged to the US Dollar. Like the traditional banking system, where electronic money circulates and is backed by real deposits on bank accounts, stable coins need institutions who guarantee and transparently report the proof of reserves that back up the digital money that is issued on-chain. Tether and Circle play that role for USDT and USDC, respectively. For every “real” dollar deposited with them, they will issue (or “mint”) a digital twin version minus a fee. Converting the digital twin back into a “real” dollar triggers the reverse process.

The market appreciates the features of stable coins, the “24/7” accessibility, efficiency to scale, lower transaction cost, and programmability of running on the blockchain, combined with the stability and trust that comes with a regular currency. They provide the cash leg for crypto traders as evidenced by the fact that the largest trading pairs of leading cryptocurrencies are with stable coins.

However, is this value proposition really living up to the vision of providing peer-to-peer digital money transfer without dependency on a central trusted party? To examine this, we consider the key functions of a currency: means of payment, unit of account, and store of value.

2. Methodology

The chapter employs an analytical and evaluative methodology to examine the functions and potential of stable coins backed by real-world assets. The absence of primary qualitative research methods such as interviews, observations, or case studies—typically associated with qualitative research—is noted. Instead, the authors engage in a multi-faceted analysis utilizing theoretical and conceptual evaluations. This approach encompasses:

Comparative analysis: Various stable coin types are contrasted to evaluate their risks and their adherence to the functions of currency, thereby assessing their stability and efficacy.

Risk assessment: Idiosyncratic and systematic risks associated with different stable coin models are assessed, drawing on financial data and historical events.

Market analysis: Market dynamics, including adoption rates and performance metrics of stable coins, are compared to those of traditional currencies.

Regulatory analysis: The chapter engages with the regulatory landscape impacting stable coins, with specific attention given to regulations such as the Markets in Crypto-Assets Regulation (MiCA).

Economic analysis: The chapter presents an economic perspective, appraising stable coins concerning inflation, purchasing power, and their role within the broader monetary system.

Conceptual discussion: The proposition of stable coins backed by real-world assets, such as gold, is advanced, with a discourse on the prospective advantages of this approach.

The study conducts a macroeconomic analysis of stable coins, applying established economic theory to dissect their role concerning the tripartite functions of currency: as a medium of exchange, a unit of account, and a store of value. It identifies and explicates the discrepancies between contemporary stable coins and the decentralized, trustless, and cryptographically secure vision of digital cash initially outlined in Satoshi Nakamoto’s Bitcoin whitepaper [2]. The research forwards a conceptual framework for the evolution of stable coins backed by real-world assets. It details a systematic procedure encompassing tokenization, fractionalization, fungibility, collateralization, and decentralization, culminating in the creation of a stable coin underpinned by real-world assets, with gold serving as a paradigmatic example.

3. Means of payment

This is arguably the strongest feature of stable coins. Most business transactions or asset transfers require a cash settlement in a generally accepted or “fiat” currency. Fiscal and accounting policies require or prefer that business transactions and assets are settled and valued in regular currencies. Most goods and services in the global economy are still being paid for with fiat currency. Bitcoin is increasingly accepted as a means of payment or legal tender, by regulators, tax authorities, merchants, and businesses. However, most parties tend to mainly hold their cash and cash equivalents in regular “fiat” currencies. Since a stable coin is like a mirror image or proxy of such regular currency, for example USD or EUR, it is much easier to use in regular commercial transactions or employee remuneration, and to process in accounting and financial reporting.

Since stable coin payments run on the blockchain, they have multiple advantages compared to the normal banking system. Transactions are not limited to banking hours and can be executed 24/7, in a quite rapid and cost-efficient manner. They are also programmable by linking them to smart contracts that can be transparently monitored on-chain. The recipient can always redeem the stable coin to its fiat equivalent, guaranteed by a proof of the reserves of the issuing institution, such as Tether for USDT and Circle for USDC. Since their introduction, there have been no significant shortfalls in reserves of these currencies. With a few short-lived exceptions, their market value has been equal to 1 USD. Admittedly, the governance and regulation of such institutions can significantly differ, for example in the way they are regulated or the extent to which they transparently publish audited proof of reserves³.

However, stable coins are far from a perfect means of payment. To fully deliver on the promise of efficient, truly peer-to-peer digital money, much can be improved to further reduce cost, latency, and complexity. Sending money globally is not yet as straightforward and cost-effective as sending secure email or short messages. It highly depends on the medium of exchange used for the transfer, as well as on the blockchain network that the stable coin lives on. To make progress in “banking the unbanked”, the security and convenience is insufficient. It clearly manifests itself in today’s retail payment world and the deficiency will become even more apparent as the future of payments evolves. Beyond micropayments of workers sending small amounts to family overseas or donations to charity programs or victims of war, the world will move to streaming payments, where online consumption of audio, video, and games will require “on-the-go” micropayments, by the minute or even second for usage, tipping, or rewards. The high fees (including “gas fee”) and high latency (in part caused by network congestion) of current stable coin transactions limit the ability to handle such processes, further burdened by additional fees depending on the exchange or platform used. Bitcoin shares similar constraints. Workarounds (such as Bitcoin Lightning) have been introduced but still do not offer the convenience to become mainstream. They are a good current fix but are clearly not built for the future.

A final consideration is foreign exchange (fx). The current offering of stable coins is almost exclusively in USD, without a strong multi-currency offering. This is essential for the young generation of internet native users. They have learned to avoid the high fx fees imposed by financial institutions, especially in Europe, and fled to alternative providers such as Revolut and Wise. Unlike regular banking or credit card providers, they provide users with fair fx rates closer to the mid-market spot rate. For wholesale transactions, the introduction of the SEPA regime has made payments frictionless within the EURO banking zone, meaning quasi free and instantaneous.

These improvements in cross-border payments have largely solved the international money problem for both retail and commercial users. Hence, for non-crypto specialists, there is an insufficient incentive to leave the traditional banking world in favor of stable coins. Launching EURO denominated stable coins has so far seen minimal adoption. As of November 2023, more than 1 year after its introduction, Circle’s EURO Coin (EURC) represented only 0,2% of USDC: EURC had 51.5 million reserves, compared to USDC 24.2 billion. European regulation, such as MiCA, might present some compliance hurdles, but it cannot be the only reason for this large gap. Unlike the stable coin world, in the real economy, the USD is the most used currency for international trade, but it does not have a 99% dominance. To date, stable coins have not yet offered an attractive alternative in the non-USD economy.

In commercial banking, stable coins have yet to enter most operational treasury systems. While many vendors offer the option to pay in a fiat or stable coin—mostly limited to USD—banking, treasury, and accounting systems are seldom equipped to properly handle stable coin payment rails. Reconciling stable coin banking transactions with accounting books and records remains largely patchwork.

4. Unit of account

This function of a currency is obvious but easily overlooked. Every expression of monetary value needs a unit: prices of a product, value of an asset, or financial strength of a company. People make consumption, business, or investment decisions, by applying comparative, profit, or return calculations. This obviously requires a unit of account. Historically, the currency world has been much more diverse. Going back in history, we will find that local cities, regions, provinces all had their own currency. Even in a small country like Switzerland, with its robust Swiss franc, not so long-ago, municipalities or cantons had their own currency. In the last 30 years, Europe’s currency landscape has been much simplified with the introduction of the EURO. Consumers and businesses now enjoy this simplicity as they travel and do business around Europe. It is unlikely that they want to revert to more diverse currencies. The promise of peer-to-peer bitcoin payments is attractive but the notion of having to pay a restaurant bill with 0.002 BTC is quite impractical. Some systems are even unable to handle more than 2 decimal places behind the comma. We will neither see companies publish their financial statements nor citizens report their tax return in bitcoin, ethereum, or a stable coin of other denomination than their domestic currency. Certain authorities, such as the small canton of Zug in Switzerland, allow citizens to pay taxes in bitcoin. However, since the authorities do not want to hold any crypto exposure, the Swiss Franc tax liability is simply settled in bitcoin at the prevailing spot market price.

Hence, this explains an advantage of stable coins. They are expressed in an underlying currency that people recognize and find easy to report, so that it conveniently co-exists with regular fiat currencies. Expressed in the accountant’s terminology: people and especially businesses see a strong relationship between the currency they do business in (“functional currency”) and the one they use to publish their financial statements (“reporting currency”).

All combined, the adoption of stable coins has therefore strongly benefited from the simplicity to account for it in a unit that is commonly used. However, adoption could grow much further, if more stable coins would be available in addition to the USD.

Countries where the local currency devalues so rapidly and prices inflate exponentially have a different challenge. Their citizens have lost trust in their domestic currency and rather prefer an alternative currency. That, however, is primarily motivated by a desire to store and safeguard value, which brings us to the final function of a currency.

5. Store of value

Keeping the value of financial assets intact requires a way to store them securely and to preserve their real economic value, relative to the chosen market benchmark and protected against inflation and fluctuation of economic cycles. Since the 1970s, currency rates have been permitted to “float” in the global foreign exchange markets relative to other fiat currencies. Trust in scarcity of an asset backing up the currency was replaced by trust in the economic stewardship of national monetary authorities. Hence, let us examine how stable coins can become stable stores of value.

Stability is a challenge for most stable coins, which are USD pegged, as they represent both idiosyncratic as well as systematic risks.

The fiat-backed stable coin is, in essence, an IOU (“I owe you”), where users transfer fiat currency to a centralized institution and receive stable coins as digital receipts. These stable coins represent claims on the corresponding fiat deposits held by the institution, effectively tokenizing the fiat currency.

A primary risk associated with fiat-backed stable coins is counterparty risk, as the issuance of stable coins is controlled by a centralized institution. There is a possibility that the issuer may print excessive stable coins or abscond with the underlying bank deposit. Additionally, third-party risk arises from the potential default of banks or the freezing/confiscation of funds by governmental authorities. An illustration of this is when USDC was detached from its peg to USD due to the imminent risk of banking default at Silicon Valley Bank in March of 2023, a custodian bank used by Circle. Following that event, USDC saw a significant decrease in volume, down 62% from Q1 to Q3 2023⁴.

To maintain the functionality and reliability of fiat-backed stable coins, users must place trust in both the issuer and the custodian banking institution. To address these risks and improve transparency, various fees are incurred, ultimately borne by users. These fees cover expenses such as auditors, custodian banks, financial firms, regulators, and legal services.

Alternatively, users have the option to collateralize their crypto assets in a smart contract (i.e., an autonomous bank on the blockchain). Through this method, stable coins (i.e., crypto fiat loans) are generated automatically against the collateralized assets. Given the volatile nature of crypto collateral, stable coins are over-collateralized to mitigate potential price swings. This decentralized approach reduces reliance on traditional banks, simplifies administrative processes, and eliminates the need for middleman fees. Users can easily create stable coins at any time simply by utilizing their idle crypto assets. Unlike fiat-backed stable coins, crypto-backed stable coins offer decentralization, transparency, and traceability. Users’ collateral remains locked within the smart contract, and the issuance and verification of stable coins can be publicly tracked. Furthermore, the liquidation of crypto-backed stable coins is instantaneous, allowing users to withdraw their crypto assets within seconds by returning the stable coins to the smart contract. However, inherent risks exist, such as the stability of the underlying crypto collateral. If its value plummets rapidly, the stable coin may become under-collateralized and liquidated. Additionally, a cascade effect can occur when a collateral price drop leads to under-collateralization of certain stable coin loans. The smart contract automatically triggers collateral liquidation to repurchase the stable coins, causing a fire sale that further drives down the collateral’s price. This situation can trigger a chain reaction of non-performing loans and result in a crash of the underlying collateral. To mitigate these risks, it is advisable to diversify the crypto collateral by adopting multiple assets. It is important to note that the system is also vulnerable to hacks, if the code governing the locked crypto assets is not well-written, leading to the near impossibility of collateral recourse.

Algorithmic stable coins, though still in the early stages of development, also face numerous challenges. One notable example is Basecoin, which employs bond sales to contract the money supply. Stable coin holders can exchange their stable coins for bonds, entitling them to receive future stable coins as the monetary expansion progresses. The bond buyers effectively sell their stable coins to the system, gaining more stable coins over time. During periods of money contraction or black swan events, users may lose confidence in the stable coin. This can trigger a death spiral in which the bond prices rapidly decline due to increased risk perception. Consequently, the system needs to issue more bonds to purchase stable coins, further reducing bond prices. This death spiraling effect can eventually render the bonds worthless, destabilizing the stable coin. The stability mechanism employed by algorithmic stable coins is vulnerable and cannot withstand prolonged periods of reduced demand for the stable coin. Additionally, a rumor-triggered drop in bond prices can lead to fragility in market sentiment and, subsequently, stability. Nevertheless, algorithmic stable coins represent an ambitious design that paves the way for future stable coin innovations. Notably, they differ from fiat-backed and crypto-backed stable coins as they do not rely on collateral. Instead, these coins create a new crypto asset—bonds—to maintain price stability. By shifting volatility to the bond tokens, the system attempts to uphold stability of its stable coin. However, the lack of endorsement for these bonds poses a significant concern, akin to building a stable coin on an unbacked asset—resembling a foundation built on sand.

Despite the idiosyncratic risks associated with each type of stable coin, it is essential to consider a systematic risk that is often overlooked: the fiat currency, especially the USD, to which most stable coins are pegged. This risk stems from the continuous loss of purchasing power, as major central banks target a 2% annual inflation rate. For example, over the past 30 years, the USD has experienced a steady erosion of purchasing power. Inflation has consumed more than 50% of the value of USD⁵.

The USD is supported by the US National Debt, which has been growing at a substantial and concerning rate. Pegging a stable coin to the inherently unstable nature of government-issued IOUs is deemed impractical and untenable.

Also relative to GDP (Gross domestic product), the US budget deficit has been steadily increasing over the last 20 years. In that time frame, sharp deficit increases have strongly correlated to recessions, for example, by the dot com bubble (2000) and financial crisis (2008). Even when considering the pandemic impact as an exceptional one-off event, the evolution of the last 24 months is not encouraging for the USD as a store of value⁶.

This is further worsened by concerns from recent developments in the US economy and its state of over indebtedness. The housing market is substantially down as homeowners do not want to roll over their mortgages into new rates as high as 8%. Banks have piled up assets with low interest rates, while the Fed has increased rates 22-fold in a year’s time. The weakest US banks went into bankruptcy in April of 2023, but a slow bleeding is still going on among many others. Credit default swaps have been steadily increasing. As of June 2023, subprime debt made up 21% of the $1.58 trillion in outstanding auto loans, the second-largest kind of consumer debt after mortgages and 77% higher than its 2013 level, according to the Federal Reserve Bank of New York⁷.

US companies’ earnings are also going down as they lose pricing power, combined with consumers losing purchasing power.

In the event of a hypothetical scenario where the United States defaults on its debt and experiences a significant depreciation in the value of the USD, like the occurrences witnessed with the Argentine Peso and the Turkish Lira, concerns arise regarding the potential impact on individuals who hold cryptocurrencies and choose to store their assets in USD-pegged stable coins. It prompts a critical examination of whether these individuals have effectively assessed and prepared for the associated systemic risk in such scenario. Also, in the current environment, when holding USD cash reserves, the available high yield on USD placements in the normal money market appears more attractive than relying on decentralized finance (DeFi) platforms with yield or reward.

Table 1 adeptly encapsulates the principal idiosyncratic and systematic risks that are encountered by the three distinct classifications of stable coins. This table delineates the potential vulnerabilities and uncertainties inherent in these stable coin variants, thereby providing valuable insight for risk assessment and management purposes.

Stable coin categories	Idiosyncratic risks	Systematic risk
Fiat-backed	Centralization of bank deposit	(Hyper)inflation of fiat currencies
Crypto-backed	Liquidation riska	(Hyper)inflation of fiat currencies
Algorithmic	Lack of collateral	(Hyper)inflation of fiat currencies

Table 1.

Categories of fiat-pegged stable coins and their risks.

^a

The liquidation risk is due to the volatile price of the crypto assets.

All combined, this places substantial doubt on USD denominated stable coins to provide a sustainable store of value. It was recently evidenced by several US credit ratings being lowered⁸.

6. A better alternative: Real-world assets

Scarcity drives value preservation over time, which can be embedded in real-world assets. Examples are precious metals, like gold, which are limited in supply, unlike fiat money which governments keep printing. This may, for example, explain the recent interest in gold-backed stable coins. Gold is a precious metal considered as a trusted store of value. It has always been deeply connected with humanity and desired as it is timeless, corrosion-resistant, and highly malleable. Historically, it has been associated with wealth and prestige. Its price volatility is low and uncorrelated to traditional market trends, which is particularly appreciated during times of uncertainty. Its value has grown throughout the years with its purchasing power becoming stronger as compared to the USD. There are different ways to buy and possess gold. However, traditional options have disadvantages and constraints, such as lack of transferability, that can be addressed by the symbiosis with novel blockchain technologies.

Gold as a stable coin reserve combines all the convenience and ease of digital use of stable coins with a store of value that is backed by a scarce real-world asset, rather than a promise to pay from governments and their central banks. This is particularly appreciated during times of uncertainty.

From an investor’s perspective, a clear disadvantage of gold is that it is a non-productive asset. Unlike, for example, a piece of land that produces crops, gold is mainly held in storage, except when used for jewelry and by artisans. When, however, gold can be used as a reserve to back up a stable coin with all the same functionality of digital money, as we know it today, it offers unique possibilities and potentially brings the “best of both worlds”.

To enable the creation of a gold stable coin, some essential challenges must be overcome: tokenization, fractionalization, fungibility, collateralization, and decentralization. This needs to be done in a sequential and carefully orchestrated way. It should also be governed by a decentralized autonomous governance system, as both control and profit—if any—of this monetary circuit should belong to a community that owns the currency, much in the “peer-to-peer” spirit of the original bitcoin whitepaper.

Tokenization – Minting a token produces a digital certificate of ownership of gold. The certificate points to a unique underlying gold bar, including various informational attributes valuable to the owner, such as provenance, purity, and storage custodian. These data might be quite rich, including high resolution images, and therefore require blockchain protocols with powerful and efficient data storage capability. The token is non-fungible, as every gold bar is unique with an individual serial number. Owners can effectively redeem the physical asset, which prevents the custodian from misusing or embezzling the gold bars. However, being non-fungible implies being non-fractional. To function as a payment vehicle, it would need to be fractionalized.

Fractionalization and fungibility – Gold assets, in above non-fungible token (NFT) form, can be swapped for a gold-backed stable coin, by using a fixed weight to token rate, for example, 1 gram of gold to mint 100 “gold tokens”. The minting process is administered and guaranteed by a smart contract. This generates fractionalized gold tokens, which can function as any cryptocurrency. As an illustration, at current prices, such a “gold token” would be worth approximately 0.64 USD.

Collateralization – A final step to create a fiat-pegged stable coin would be to use the above “gold token” as collateral and peg it to a fiat currency, such as, for example, the US dollar. This provides a stable coin denominated in USD, the most used currency for international trade, backed by physical gold via gold tokens by way of using it as collateral. It, therefore, creates a gold-backed and fiat-pegged stable coin. It would require a sophisticated collateralization mechanism, adjusting for market prices and collateralization requirements.

Decentralization – To function in a truly trustless, decentralized, and autonomous manner, the above steps need to be governed by a decentralized and autonomous nervous system, rather than central trusted parties or intermediaries. This allows a community of participants to vote and decide on the well-functioning of the entire “token economics”. As mentioned earlier, should any fees or rewards be created, they would also belong to the community, which functions as a decentralized autonomous organization (DAO).

The use of gold tokens as collateral within the realm of DeFi carries significant advantages. The inherent stability of the gold token’s value, which is pegged to the real-time spot price of gold, contrasts favorably with the volatility often associated with cryptocurrencies like Ether. Consequently, this characteristic notably diminishes the risk of liquidation. Additionally, beyond its price stability, the gold token acts as a hedge against inflation, conferring it with enhanced resilience as a collateral option for the creation of stable coins. Notably, when compared to fiat-pegged stable coins, which are supported by reserves and bank deposits that historically have experienced depreciation in purchasing power, the price of gold has demonstrated a threefold increase over the past 20 years, reinforcing the appeal of gold tokens as a robust choice for collateralization in the DeFi landscape.

The above example, taking gold as a “real-world asset”, is only one illustration of blockchain technology using digital authentication of the underlying asset in a tamper proof manner. Not only does it provide collateral certainty, but it also informs the owner of relevant ESG⁹ features of the asset, directly certified by the smart contract, rather than relying on a third-party reporting mechanism. Such a certificate is different from a paper certificate that relies on intermediaries, like banks, to hold custody of the asset, resulting in frictional costs and counterparty risk. This on-chain traceability can provide a proof of location of storage in a stable jurisdiction in a reliable and well insured way, fully remote from the bankruptcy of any financial intermediary. Holding a digital, on-chain certificate, like an NFT, also facilitates easier redemption or trading in the secondary market, hence providing liquidity to the investor, with low frictional costs. This offers a stable asset, a strong store of value, owned in a self-sovereign way, yet with high transferability.

7. Conclusion

If well orchestrated and governed, in the way that is described above, we propose that a gold stable coin can offer a strong currency alternative. Different to other gold investment products, a gold-backed stable coin uses blockchain technology that strongly reduces the otherwise necessary trust in intermediaries and is therefore much more efficient, transportable, transparent, and thus more secure. Altogether, this tokenization combines the advantages of an efficient and highly secure store of value with a high portability and liquidity. The choices of a gold token and a gold-backed USD stable coin and the ability to quickly and easily move between them combine the benefits of unit of account and reduction of day to day volatility.

The key assertions made by the bitcoin whitepaper, which proposed to avoid relying on a trusted third party, prevent double-spending and doing this by relying on cryptographic proof provided by an on-chain network of nodes apply well to tokenization of “real-world” tangible assets. Much of the well-functioning of a currency can be improved when backed by real-world assets.

This will be an evolution. It took some time for email to replace the fax machines. We now have the technology and the governance mechanism to renew the old payment system rails. That is exactly what well-designed stable coins can do.

Acknowledgments

The authors express their gratitude to the editor, Dr. Luyao Zhang, for her invaluable and perceptive comments. Additionally, Yulin extends appreciation to Mr. Gian Bochsler for his inspiration in the development of the gold-backed stable coin. Paul extends his gratitute to his colleagues at the DFINITY Foundation for their ground breaking work in establishing the technology that enables the innovation of digital assets.