The Delicate Psychology of Stablecoins
Michael J. Casey is the chairman of CoinDesk's advisory board and a senior advisor for blockchain research at MIT's Digital Currency Initiative.
The following article originally appeared in CoinDesk Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.
There's an early scene in "It's a Wonderful Life," that stalwart of holiday season TV viewing, that provides one of the most insightful on-screen depictions of the core challenge of banking: maintaining trust.
It's where Jimmy Stewart's character, George Bailey, desperately trying to stave off a run on Bailey Building and Loan, tries to convince a horde of nervous customers not to withdraw their funds. Failing to win them over, he eventually reaches for his checkbook and, drawing on personal savings earmarked for his honeymoon, writes personal loans to each of them to keep his small-town lender afloat.
This scene is worth contemplating amid this month's intensified competition among stablecoins as confidence in tether (USDT), the widely used one-to-one dollar-pegged crypto asset, has waned drastically.
Stablecoins, which promise that their token will trade at a fixed value relative to another asset such as the U.S. dollar or gold, face similar challenges in terms of building community-wide trust in their operations.
Bailey found the task to be more art than science. In the end, he had to put his own capital on the line to demonstrate that the self-interest of the bank's owner didn't trump those of its customers. We learn from this Hollywood classic that, in finance, trust is generated by more than just rules and technical specifications. It's contingent upon a complex, multifaceted array of signals that, often, come down to a sense of character, a concept that, in the corporate world of today, we could define as "a trusted brand."
At first glance tether's trust challenge seems different from that of old-fashioned savings and loans like the fictional one in Frank Capra's film. The latter is a commercial bank operating under a traditional fractional reserve banking model, where depositors' funds aren't held in full but lent out to borrowers. By contrast, Tether Ltd., as with other stablecoin issuers, asserts that it maintains a full reserve of deposited dollars to back every USDT token in circulation and that, because of that, it will always facilitate redemptions of those tokens at a fixed exchange rate – in this case, one-to-one.
The similarity emerges when we consider that a stablecoin's value proposition goes beyond a redemption commitment to existing token holders to encompass prospective token buyers. For a stablecoin to consistently trade at par, its issuer must, in effect, convince a wide a community of future tokenholders of its future solvency. And that degree of trust can be hard to maintain, as it involves the psychology of the market, which can shift significantly over time.
Just as Bailey found that his community's beliefs about him and his bank could be undermined by swirling stories and rumors and by a wider economic context that fueled fearful herd behavior, so too must stablecoin issuers consider a wide array of external forces that can shape trust. In the parlance of Wall Street, their quota of trust must be able to withstand a "stress test."
Managing market psychology
Consider Tether's predicament. Whether it has the funds it says it has isn't the only question. The other, perhaps even more important, is whether the market believes those commitments will hold up against a wider environment of waning confidence.
It's no coincidence that when USDT dropped to a low of $0.9253, or more than seven cents below par on Monday last week (on one exchange, Kraken, it fell even lower, to $0.85), it came on the heels of Wall Street's worst week in seven months. In that broader, shaky financial climate, where fear started to trump greed, news that Bitfinex – the exchange that has overlapping ownership and management with Tether – had temporarily suspended certain fiat deposits because of "processing complications," didn't help matters.
Adding to the mix was the constant rumors and doubts over Tether's banking relationships (to say nothing of its reserves). Investors understand that, at the end of the day, a bet on a reserve-backed stablecoin is a bet on the counterparty risk of the controlling entity's banker. So all of this – the rumors, the glitches in deposits, and the market conditions -- produced a perfect storm to trigger an investor fire sale of USDT.
The new dollar-pegged tokens competing for USDT's sliding market share must now prove they can avoid such missteps. To do so, they must address this wider concept of trust, which means contending with the fickle, herd-like beliefs of human beings.
That goes for both those that employ Tether's reserves-backed model, such as Gemini's GUSD, Paxos' PAX, Circle's USDC and Trust Token's TrueUSD (TUSD), and the algorithm-based approach of offerings like basecoin, which despite their fancy math, will be subject to sophisticated attacks by bots seeking to "break the peg."
And, importantly, the real test of trust can't be judged on current circumstances, at a time when many of these new stablecoins are enjoying such an influx of tether refugees that their market price has, from time to time, actually traded above par. It will come at a moment of crisis.
As the Argentine government learned in 2001, when it had to abandon the peso's decade-long peg to the dollar with disastrous consequences for its economy, the ultimate test of a pegged-currency regime is always whether it can survive a moment in which market psychology is consumed by fear and mistrust. (The same goes for confidence in the banking system, by the way: it was the experience of the Great Depression that led the U.S. government to create the Federal Deposit Insurance Corporation and take aim the kind of corrosive, self-fulfilling psychology of fear that George Bailey had to contend with.)
A multifaceted approach to trust
So, how can these stablecoins survive such a stress test? The first step is to recognize that building lasting confidence in their brand requires a multifaceted approach and a special obsession with transparency.
For reserves-backed stablecoins, this includes practices such as: naming the banking relationship so that users can properly assess the underlying counterparty risk; committing to independent security audits of the underlying code to show that tokens are destroyed when funds are redeemed; holding regular attestations of the firms' balances by trusted third-party auditors. (Note: this does not mean a full "audit" per se. Calls for an audit of Tether were misleading; there is no way that a crypto system's past transactions can be audited in the traditional sense. Instead, proofs rely on attestations as to the accuracy of the firm's claims about its balances at a point in time.)
And indeed, many of the new kids on the block are employing this multifaceted approach, using an abundance of transparency and proofs of solvency. Gemini and Paxos, moreover, have incorporated themselves as New York trust companies, imposing a fiduciary responsibility on themselves. These multiple measures are necessary, says the white paper released by the Gemini Trust Company – led by Tyler and Cameron Winklevoss – because "[b]uilding a viable stablecoin is as much of a trust problem as it is a computer science one."
Still, the fact that trust is hard to establish and easy to lose means that considerations must go beyond even these seemingly robust measures.
The core problem is that an owner/issuer's interests in any financial operation are not intrinsically aligned with those of their investors. To assure people that this misalignment won't lead to unfavorable results requires consistent, sometimes overboard attention to a brand of trust. In Bailey's case, it came down to pulling out his checkbook to show his character.
This is where the new stablecoins must walk a fine line in dealing with the tether fallout. They must, of course, differentiate and distinguish themselves from that failure, showing why they are more secure, more trustworthy.
However, if the messaging, whether on Twitter or elsewhere, comes across too strongly as a bid to grab market share, to profit from Tether's woes, one can imagine users imputing corporate motives that don't align with theirs. That could hurt the brand and cause its nebulous pool of trust to run dry.
This is not to wish ill upon these new offerings. We should all wish for their success. A successful stablecoin could not only serve the needs of crypto exchanges as Tether has done but also integrate reliable real-time digital payments in fiat-dominated tokens into a host of other blockchain uses cases such as supply chains and cross-border remittances.
The problem is that they'll have to face another crisis if we're to know whether they've succeeded.
U.S. dollars image via Shutterstock.
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