By: Barbara Hendrickson and Ray Luckiram[1]
March 19, 2019
Introduction
Stablecoins have become increasingly popular over the last few years. Stablecoins differ from other cryptocurrencies and digital assets because they are ‘pegged’ to an underlying asset. When a cryptocurrency is said to be ‘pegged,’ it means the underlying asset is purchased by the issuer and held by a third party on behalf of the investor. By pegging their value to an underlying asset, stablecoins are considered by some to be less volatile than other cryptoassets.[2]
According to the cryptocurrency exchange Coinbase, most stablecoins use either a fiat-collateralized, crypto-collateralized, or follow an algorithmic model. Fiat-collateralized stablecoins are backed by actual fiat currencies held in reserve by the stablecoins’ issuers, such as central banks (centralized), whereas crypto-collateralized stablecoins are backed by digital assets locked in smart contracts (decentralized). Algorithmic stablecoins, by contrast, aren’t backed by collateral. Instead, they use various mechanisms to expand or contract their circulating supply as necessary to maintain a stable value.[3]
Fiat Collaterized Stablecoin
The most common form of stablecoins are those that are backed by fiat currencies such as the USD, CAD, Euro, or Swiss Franc. Generally, fiat-backed stablecoins are held at a 1:1 redemption ratio, that is $1 of stablecoin is equal to $1 of fiat currency.[4] The theory is that a portion, at least, of the general risk associated with cryptoassets is mitigated in the case of fiat-based stablecoins because the fiat currency underlying the coin are held in reserves So that in the instance where the crypto asset is compromised due to technical error or fraud, the owner of the stablecoin may still exchange the cryptocurrency for the fiat currency.[5] Issuers of stablecoins face certain challenges. Developers must fundraise to finance the creation of the digital asset. They must also find trusted custodians to hold large amounts of fiat currency.[6] As a consequence, the ability of the larger stablecoin issuers to hold reserves equal to the amount of circulating coins has previously been called into question.[7]
Most fiat currency-backed stablecoins are created in roughly the same way: purchasers deposit dollars with a stablecoin issuer, and in exchange, the issuer mints and returns an equivalent amount of the stablecoin. The process also works in reverse: stablecoin-holders can send a stablecoin back to its issuer in exchange for an equivalent amount of dollars.[8]
Currently, the world’s dominant fiat-backed stablecoin is Tether, which issues Tether Coins. Each Tether Coin is said to be 100% backed by reserves, which include traditional fiat currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities. According to Tether, every Tether is 1-to-1 pegged to the dollar, so 1 USD₮ is valued at 1 USD. Tether is registered as a Money Services Business with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury. [9]
Commodity Collateralized Stablecoin
Commodity-backed stablecoins are linked to an underlying precious or industrial metal which is traded on a commodity exchange. The commodity-backed stablecoin is backed by a physical asset. Another important element of commodity-backed stablecoins is a mandated baseline. As a rule, the minimum value of the coin will be based on the specific value of the underlying commodities. The commodity itself normally trades on an organized commodity market.[10]
The stablecoin normally has a fixed redemption ratio of coin to weight. For example, one coin would be equal to one gram of gold.[11] Again, the issuer is required to hold the commodity in reserve on behalf of the investor, often done through a third-party custodian.[12]
One of the most popular commodity-backed stablecoins is the Digix Gold Token, which is redeemable at a ratio of 1 token to 1 gram of gold. According to Digix, which is based in Singapore, its digital token is backed by 99.99% gold cast bars.[13] An example of a Canadian commodity-backed stablecoin is one issued by Canamex Gold Corp. (“Canamex”) a CSE-listed company. On May 9, 2018 Canamex announced a non-brokered private placement to accredited investors, of GOLDUSA Ethereum ERC20 Crypto Tokens via a Security Token Offering (“STO”). Each GOLDUSA token purchased at $US 4.00 per token represents 1/200 oz. gold. On September 28, 2018 Canamex announced the launch of the Silver STO. Each SILVERUSA is an interest in ½ oz. silver at an initial token price of $US 5.00 per token.
On October 29, 2018, Canamex announced that it has executed a MOU with MDXH, a public company incorporated in Malta. Canamex is now exploring the possibility of listing and admitting to trade these GOLDUSA Tokens and SILVERUSA Tokens on the MDX. MDXH intends to establish and operate a Multilateral Trading Facility, the Malta Digital Exchange (“MDX”), a secondary market exchange platform which would allow the trading of tokens. According to the press release, MDX will be a multi-asset digital exchange, which focuses on virtual financial assets and security tokens.
Crypto Collaterized Stablecoins
Crypto collaterized stablecoins, which are backed by crypto assets and are decentralized in nature, rely on trustless issuance, which is also referred to as on-chain issuance. This type of stablecoin maintains its 1:1 peg against assets via overcollateralization, incentives, and other methods. Crypto collateralized stablecoins provide the opportunity to use crypto assets as debt collateral. These stablecoins attempt to counteract price volatility by providing that each coin is fully backed with this reserve. Collateral is held in a smart contract and accessible only by clearing the stablecoin debt. Alternatively, the smart contract can be closed and the collateral sold by the stablecoin system if excess collateral falls below a certain predetermined level. [14]
The DAI Stablecoin, by MakerDAO, is an example of a crypto-collateralized stablecoin. According to the Dai website, Dai is a decentralized, asset-backed currency whose value is stable relative to the USD. Price is maintained through a system of smart contracts, designed to respond to varying market dynamics. Each Dai is fully backed by an asset held in the secure MakerDAO smart contract platform. Anyone can lock their tokens up as collateral and issue Dai against them.
In much the same way, any user can create Dai by opening a Collateralized Debt Position (“CDP”) on the MakerDAO platform. A CDP is a smart contract which gives users Dai in exchange for locking up valuable collateral. The assets are held in escrow until the borrowed Dai is returned by the user. Put another way, Dai is created when users lock up collateral and Dai is removed from circulation when users free up their collateralized assets. Third-party network participants, known as “keepers” help maintain the price of Dai. Keepers are generally automated programs that take advantage of arbitrage opportunities to keep Dai near its peg. They also participate in CDP auctions ensuring the orderly wind-down of liquidated contracts.[15]
Algorithmic Model
Algorithmic stablecoins, also referred to as “Seigniorage Shares” and “Future Growth-Backed stablecoins,” are algorithmically-backed with expansion and reduction of coin supply mathematically determined. There is no collateral backing issuance. In the case of algorithmic stablecoins, increased demand causes the system to issue new coins, thus increasing supply and lowering price back to the peg.
Seigniorage is the revenue earned from the issue of money. Historically, this revenue accrued to the “seigneur” or ruler. In Canada today, seigniorage can be calculated as the difference between the interest the Bank of Canada earns on a portfolio of Government of Canada securities—in which it invests the total value of all bank notes in circulation—and the cost of issuing, distributing, and replacing those notes.[16]
Anytime the price of the stablecoin is less than USD$1, the system starts offering “shares.” In order to buy the shares, though, stablecoins are needed. Essentially, speculators are offered a small portion of future growth in the stablecoin’s market cap in exchange for providing the capital to peg the fiat currency. This is why non-collateralized stablecoins are often referred to as “Seigniorage Shares”, as seignorage is the profit made by a government through issuing fiat currency, especially the difference between the face value of coins and production costs.[17]
Basis is an example of an algorithmic stablecoin. In April 2018, Basis made headlines when its promoters raised $133 million from several prominent venture firms. But, only eight months later, Basis shut down unexpectedly and returned its remaining capital to investors. The reason for the shuttering, according to Basis CEO Nader Al-Naji: “We met with the SEC to clarify a lot of our thinking [and] got the impression that we would not be able to avoid securities classification.”
Looking Forward
Stablecoins have not been the subject of extensive discussion by securities regulators in Canada and nor the U.S. to date. However, when Valerie A. Szczepanik, Associate Director of the SEC’s Division of Corporation Finance and the SEC’s Senior Advisor for Digital Assets and Innovation, was recently asked her view on stablecoins, she made the following cautionary remark in reference to two types of stablecoins: those that maintains a fixed price and those whose value fluctuates in order to help the first token’s price stay fixed (algorithmic stablecoins): “You might be getting into the land of security.”[18] Securities regulators in Canada might say the same thing.
For more information, please call Barbara Hendrickson at BAX Securities Law (416) 601 -1004 or Ray Luckiram (416) 601-0591.
This publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.
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[1] We are grateful to Addison Cameron-Huff for his review of this piece.
[2] https://masterthecrypto.com/guide-to-stablecoin-types-of-stablecoins/ accessed on March 19, 2019.
[3] https://masterthecrypto.com/guide-to-stablecoin-types-of-stablecoins/ accessed on March 19, 2019.
[4] https://masterthecrypto.com/guide-to-stablecoin-types-of-stablecoins/ accessed on March 19, 2019.
[5] https://medium.com/datadriveninvestor/the-power-of-code-stablecoins-part-4-5c18cc5b7f7 accessed on March 19, 2019.
[6] https://loopring.org/resources/pwc-loopring-stablecoin-paper.pdf accessed on March 19, 2019.
[7] https://medium.com/datadriveninvestor/the-power-of-code-stablecoins-part-4-5c18cc5b7f7
[8] https://medium.com/datadriveninvestor/the-power-of-code-stablecoins-part-4-5c18cc5b7f7; accessed on March 19, 2019
[9] https://tether.to/; accessed on March 19, 2019.
[10] https://medium.com/datadriveninvestor/the-power-of-code-stablecoins-part-4-5c18cc5b7f7; accessed on March 19, 2019.
[11] N. https://loopring.org/resources/pwc-loopring-stablecoin-paper.pdf
[12] https://medium.com/datadriveninvestor/the-power-of-code-stablecoins-part-4-5c18cc5b7f7; accessed on March 19, 2019.
[13] https://digix.global/dgx/, accessed on March 19, 2019; accessed on March 19, 2019.
[14] https://medium.com/makerdao/stablecoins-collateralization-types-2a860624dcd3; accessed on March 19, 2019.
[15] https://medium.com/makerdao/stablecoins-collateralization-types-2a860624dcd3; accessed on March 19, 2019.
[16] https://www.bankofcanada.ca/wp-content/uploads/2010/11/seigniorage.pdf; accessed on March 19, 2019.
[17], https://medium.com/makerdao/stablecoins-collateralization-types-2a860624dcd3; accessed on March 19, 2019.
[18]https://www.coindesk.com/secs-valerie-szczepanik-at-sxsw-crypto-spring-is-going-to-come; accessed on March 19, 2019. https://www.coindesk.com/will-fiat-backed-stablecoins-pass-legal-muster-with-the-sec-and-cftc;
