Until 1971, the U.S. economy was governed by the gold standard, meaning each dollar in circulation was supported by gold in the Federal Reserve. However, this standard was fictitious since, as the U.S. economy expanded, the government began to issue more dollars beyond the capacity of its reserves.
This discrepancy of collateral value against the circulating monetary asset, the dollar, caused the U.S. government to abandon the gold standard because it couldn’t afford to pay for what it represented in gold with its reserves.
One dynamic that gradually eroded the parity against gold was seigniorage. This term has to do with the issuance of money without backing, which has a temporary wealth effect for the issuer, i.e. the government. At first stage, the creation of money beyond reserves in a parity scheme has positive effects as the credibility gained is maintained for a while. Once that credibility erodes, seigniorage is transformed into a rise in prices resulting in the inflationary tax paid by all holders of the money for its loss in purchasing power.
This event known as “the closing of the Gold Window” marked a turning point for the world economy. This mismatch of reserves against money supply is a pattern that occurred several times throughout the world history and from which most large governments have not been able to recover quickly.
However, the U.S managed to impose its currency as the best instrument of global value transmission successfully.
But, what made the dollar take on the role and importance it has achieved? What new instruments are emerging around the world to compete with it?
What followed after the closing of the gold window was dollar issuance that caused inflation to rise and also caused the value of the dollar to fall against stocks, commodities and gold that the public was buying at that time.
As the dollar supply expanded sharply, inflation began to rise, reaching a peak in 1973 of 13% and then retreating again until it reached a peak of almost 14.75% in 1980 and then began to fall. This inflationary and issuance trend generated a devaluation of the dollar and an appreciation of financial assets, gold and commodities against it.
Despite the fact that increasing money supply could end up being a terrible thing for any economy of any large country, the dollar came out stronger and during the 80s and 2010s was able to monopolize international trade. The first thing to keep in mind is that the dollar, beyond a banknote, is a technological tool, in all its versions, whether digital or physical, it is a means of payment that can be accepted worldwide and can be used in almost any service of the great new digital economy.
Although the dollar is not supported by gold, it has certain values that reserve currencies must have, ranging from political to technological characteristics.
From the political and economic point of view, the great GDP of the United States in the global economy made it an inevitable player in the global order. In this way, over time, the United States managed to make its currency the currency with which major international business is conducted, focusing on another of the major points that a reserve currency of value needs, a collateral.
Even though the dollar lost its window with gold, it silently gained a position in the oil market that made it an asset that is directly linked to the demand for energy in the world, thus giving birth to the petrodollar since 1973 when the agreement to buy oil with dollars was closed with Saudi Arabia. As the agreements for gas and oil have to be made with dollars, the pressure on the demand for it is always maintained.
Having an attachment to commodities through energy deals gave the dollar the leg up it needed. But none of this can be possible to do efficiently without a system that can transmit that value, and that was another of the main points on which the American financial infrastructure excelled, the creation and implementation of SWIFT and its evolution with new technologies allowed the dollar to be a more than interesting product for a long time.
Despite the fact that the world economy suffered inflationary cycles, slowly and thanks to these three tools, political, economic and technological, the dollar managed to emerge stronger.
Since the inflation peak of the early 1980s, the U.S managed to lower its inflation to values close to 0.5% and kept it contained in a macroeconomic context in which world markets were highly volatile.
During the 1990s, several emerging economies suffered balance of payments crises in their most classic form. That is, the loss of international reserves by the central bank, forcing a devaluation of the local currency. These were the cases experienced by Mexico with its Tequila crisis, Russia with the Vodka Effect, Thailand and a group of Asian countries and finally Argentina with the exit from convertibility in the early 2000s. The common denominator of these crises, in addition to the fall in commodity prices, was the loss of confidence in the local currency, causing devaluations and high levels of inflation.
In addition, the fall of the Berlin Wall in 1990 and the subsequent fall of the Russian Communist Party caused the dollar to expand to new markets and globalization and new technologies quickly reached the entire world.
Having a robust technological infrastructure for exchange, being a globally accepted means of payment and having purchasing pressure tied to the expansion of energy made the dollar as a technological product unstoppable.
The expansion of the financial market and its evolution with globalization saw the birth of large international stock exchanges with global financial products that began to be used worldwide with the advent of the Internet in 1990.
After a long period of grace, the dollar is beginning to be rivaled in its global order by the growing power of China, mainly in Asia.
There are 5 events that are beginning to occur nowadays:
Central banks lowered their interest rates to zero and even then they can’t pay their debts, which leads to them having to print generating inflation
Inflation leads holders of assets other than banknotes to accumulate more wealth naturally generating a gap in the distribution of income which leads to polarizations in society
The growth of China’s GDP, which is beginning to position it as a new focus of power at a global level and seeks to impose the digital yuan
The withdrawal of Russia, one of the world’s largest commodity producers, and Ukraine from the market, causing a shock in the commodity supply chain
The emergence of new technologies for the transmission of value puts currencies issued by central banks in competition with currencies issued by decentralized technological entities
These situations in which the world order begins to be in dispute have happened hundreds of times in the history of the world. And they usually result in the major economies competing to impose their currency as the international store of value.
From 2008 onwards, the international economy has suffered several setbacks, the main ones being the 2008 subprime crisis and the onset of the pandemic in 2020.
After the 2008 crisis and seeking to stimulate the market, the Fed reduced the interest rate to almost 0% to stimulate the domestic market. In doing so, the cost of money became zero, with very low incentives to save. All the focus was on stimulating investment and risk taking, seeking to reactivate economic activity.
From 2016 onwards interest rates started to rise gradually but the shock of the global pandemic in 2020 again forced the fed and governments around the world to lower their interest rates, putting rates back to zero.
This action generates a greater issuance and demand for dollars from shareholders who seek to get hold of this free money to buy assets that increase their value in inflationary periods (such as bonds, stocks and gold), and that in turn. In order to avoid the increase in inflation, the Fed starts to anticipate the rise in interest rates to stop monetary issuance and control core inflation, which is measured through the CPI (which doesn’t take energy into account).
The dollar, which today is the financial instrument that functions as the flow of all international trade, is beginning to be challenged by other currencies, especially those that also seek to position themselves as assets for natural resources, such as the yuan, the euro or the ruble.
Since the 1990s or so, China has been growing in GDP at an impressive rate, to such an extent that it now accounts for 14% in global GDP, behind the United States, which has 24%.
This increase in economic power is seen in China’s trade links, which today is also the largest partner of most countries in the world. A position that only 20 years ago was dominated by the USA.
This growth and integration in global markets means that China is beginning to see how its political and economic influence allows it to negotiate other terms in trade relations and positions it as a rival in economic terms in certain regions of the world such as the South China Sea.
Finally, the war between Ukraine and Russia took out of the market two major players in the commodities market, while Ukraine has ample agro-cultural capacities and an economy halted by the war, Russia is the main exporter of Commodities in the world, with large reserves of gas and oil that due to the sanctions against Russia were left at a subprime value while the prices of other markets increased due to the shock in the stock.
Both oil and wheat prices have risen significantly since the beginning of the war. These events will have an impact on the food and energy supply chain, the prices of these commodities will increase, and this will cause inflation to rise in both Europe and the United States.
Both energy and commodity prices are set in the international market. This presents a challenge for central banks, including the Fed, in terms of their measures to lower inflation. The Fed’s tools are mainly twofold. On the one hand, it can determine the benchmark Fed Funds overnight rate. On the other hand, it can use its balance sheet to buy or sell longer-term bonds, affecting longer-term interest rates. These measures have an effect on the cost of financing for businesses, mortgages and investment decisions. That is why the Fed looks closely at Core Inflation, which excludes volatile prices such as energy and food that are mostly fixed in the international market. Controlling core inflation is the most direct reach central banks can have even though they have no control over headline inflation.
This brings us to a scenario in which, in order to protect against domestic inflation, the Fed’s measures to raise interest rates generate an appreciation of the dollar, while the macro context of rising commodity prices, especially energy, and the dragging effect of the expansion of the money supply in recent years drive inflation around the world.
And as dollar inflation rises and the dollar appreciates, other new instruments are expected to emerge and appreciate markedly above the rest that will face increasing volatility problems.
With the cut of Russia’s commodities market economy due to the sanctions, hundreds of thousands of commodities remain unused in Russia, which needs a buyer large enough to be able to absorb such demand. China, due to its geographic proximity and its internal demand and political weight, seems to be the only one that can make use of this market, closing agreements to trade commodities in Yen or Rubles, which would start to increase the value of these currencies by associating them with the demand for energy.
In this competition to become a reserve currency, China started to create its own payment systems that are currently being tested in South China. These new technological systems that are new and more efficient than the traditional system for the exchange of capital are beginning to appear and among them, a new trend is starting to appear. The electronic yuan is starting to become a reality, and this is something that is driving a new technological race, this time for the global economic infrastructure.
In parallel to these events, the rapid evolution of technology represented through the advent of the Internet and new technological tools began to take off and create new systems that govern today’s social interactions.
Different technological companies and the people who settled there began to create their own tech culture, and within that culture there was a growing concern about the centralized capacity to control that these systems could have if they were not decentralized led to the creation of new groups of thought, among them the cypherpunks who were characterized by the belief that in order to live in freedom societies needed cryptographic systems that allow people to communicate and exchange value without the possibility of an entity controlling that.
Since its manifesto in the early 90s and through this culture that represented the values of open source and cryptography as main pillars, the technological base that would later lead to the birth of Bitcoin in 2008 and then Ethereum in 2015 began to take shape. These think tanks were clear about the need for an infrastructure capable of transmitting value, an asset that functions as a store of value and “that is stable”.
Without getting into too much discussion of what is stable or not, what these thoughts expressed is that in order to have a good economy, one needs stability. Something in which regardless of the function or roles that assets such as ETH or BTC take, they do not possess. In the search for this stability is that certain companies began to create algorithms for stablecoins with different designs.
The creation of Blockchains put on the map new pieces of electronic and public architecture that enable the creation of new financial instruments that make use of these new mechanisms for the transmission of value, and even more importantly, their programming.
As the evolution of the crypto story progresses internally, assets such as BTC or ETH begin to be taken as commodities whose value depends on the use of the network and speculation with the entry of new participants who begin to see the disruption of value that this type of technology brings.
The natural evolution of these decentralized economic networks began to push their users towards the search for new financial instruments that would allow them to gain a certain stability in a highly volatile environment.
Since the emergence of Bitcoin and the blockchain as a concept, different teams started experimenting with how to assemble tokens with a value that remains stable from market fluctuations.
Looking how to offer this stable asset that is necessary for the growth of any economy, then brought the appearence of systems that worked with blockchain infrastructure to place fiat currencies on the blockchain, such as Tether with its USDT and in turn began to appear new algorithmic models that used the technology to work as a basis for doing things without the need for collateral from the traditional world.
Nubits for example, a project born in 2014, laid the foundations for the design of the stablecoins that would later dominate the market. NuBits works as a system of seigniorage shares that uses smart contracts to perform the function of a central bank, which is allowed according to supply and demand, to increase or decrease the supply of money on the blockchain. An action that stabilizes the value of the token in the market.
The NuBits case served as a learning curve for future algorithmic stablecoins, in 2016 the NuBits peg broke for a period of over three months. The initial price crash occurred between May 26 and June 20, around the same time that the Bitcoin price suddenly spiked after 6 months of relative stability. It is notable that the drop occurred because people who had NuBits saw Bitcoin’s price appreciating, so they sold their NuBits in large quantities to buy Bitcoin. The NuBits parity could not withstand the large sales and broke down. The price plummeted and the parity remained broken for a long period.
It seems that when Bitcoin and volatile cryptoassets prices soar, investors with capital in stablecoins will want to sell them to participate in the rally. This causes strong downward pressure on the price of stablecoins.
It is from these experiments that later many projects began to emerge, among them, Maker DAO, the company that with the introduction of DAI in 2018/2019 was one of the main reasons for the success of DeFi.
From their birth to the present day stablecoins already carry a circulation that since 2020 exploded reaching almost 150 billion USD, a 15x increase in two years.
During these years we have seen the emergence of three types of designs. Fiat collateralized, Crypto collateralized and uncollateralized.
Fiat collateralized are those that are collateralized by dollars in a bank, the main competitors being USDC and USDT, the latter with great scrutiny for its actions in not being so clear.
Crypto Collateralized are those that use only digital assets as collateral, which can also be other fiat stablecoins, although most of them have assets that are registered in the form of tokens on the network in which they operate. Its main exponent is Maker DAO, although other players such as RAI and Liquity are also part of this model.
Uncollateralized stablecoins are those that use an algorithm and a collateral that they themselves issue, which is used in the system as collateral. These are the riskiest with examples such as Terra, Basis Cash, among others.
This type of stablecoins, which currently follows the dollar, has the particularity that since all its circulant is natively digital, the control and levers it has are much clearer and more precise. The fact that everything is digital makes it possible to understand the circulant that exists.
However, the most interesting in this case are the last two, which are collateralized by natively digital assets, or without collateral, since their design must include algorithms that regulate the issuance of the stable asset.
In order to understand the different forms of operation, we will take property mortgages as a reference.
A mortgage of a property consists of making a loan against your asset, which is the property we own, in exchange for dollars. Since the bank knows that the loan is secured against a higher value asset, it is assured that in case of a problem the property will be “liquidated” and its market value will be higher than when the loan was taken out and will be able to cover the “bad” debt that one has.
In a more abstract understanding of this concept, what one is doing is holding a position on a volatile asset that one wants to continue to hold and against that taking out a loan on a stable asset that allows one to speculate on the volatility of another asset in order to make a profit.
Algorithmic stablecoins follow certain design patterns that became clearer as the market evolved. Within these designs the most important points are collateralization, decentralization and the efficiency using the capital they have.
The collateral is the asset against which the stable asset will be issued. The idea of this collateral is they are assets whose value, although volatile, has a fundamental for which an investor will always want to buy or sell it.
Collateral in stablecoins can be of two types, FIAT or Crypto. The difference between them is whether the asset used as collateral has its deposits in traditional finance, fiat, or whether it uses a decentralized cryptographic system for such deposits.
Fiat-collateralized currencies are currently the largest stablecoins. Even though not being fully decentralized, they are generating a collateralized system with an efficient use of capital.
This is how currencies like USDC and USDT work, which is almost like a full reserve bank where every debt issued is backed by a dollar in a bank (in theory).
Although it is often said that its reserves are all in dollars, the reality is that most of its assets are U.S. Treasury T Bills, the most liquid and most stable rate product in the world. Thus, part of its reserves are in bonds issued by the fed.
This type of stablecoin i the most widely circulating today, dominating the stablecoins market with 130 billion USD in circulation.
It is in these types of currencies against fiat collateral that central banks will seek to compete or regulate. In the case of USDC or USDT, the US government could seek to regulate these assets that are offering representations of the dollar, which are actually T bills, by regulating the wallets that can access these products, or it could also seek to create its own CBDC, leaving these instruments with little legitimacy. In the case of China, the Digital Yuan will work with a structure that is not blockchain but will surely seek to replicate the scale effect that such applications can have.
On the other hand, crypto collaterals are digital assets such as Bitcoin and Ethereum among others, depending on the project and its governance is that different tokens will be accepted. Each asset that is taken has a different risk profile and the stability mechanism of the protocol has to be good enough to withstand large movements in volatility, which is achieved by having a good margin for each product. By margin we mean the amount of collateral/debt that one can withdraw. Unlike their fiat counterparts, these models tend to be less capital efficient in exchange for being decentralized.
The leading example of this type of design is Maker DAO which has $7.5 billion in DAI circulating. It is interesting to note that as of today almost 50% of the collateral used is USDC, which is a fiat collateralized stablecoin but being over the ethereum network as an ERC20 operates as a digital asset.
Another collateralized design are those collateralized with their own token, which means that a synthetic is allowed to be issued against the same equity of the company. The main exponent of this riskier model is Synthetix, which uses a collateral ratio of 600% to allow the issuance of its synthetic, sUSD.
Both MakerDAO and Synthetix share a system that are analogous to that of a bank with a reserve requirement. On collateralized capital, some debt is issued and then repaid. Their system is reputable because investors are confident that they can recover their underlying assets if the system is healthy. In the case of these crypto models, it is also true that since the whole system is built on smart contracts, the mechanisms that keeps the system free of bad debt are all levers that are activated automatically mainly.
There is also another type of uncollateralized currency, known as “Algorithmic central banks”, this type of currency does not allow the depositor to withdraw collateral in exchange for its circulating currency, nor does it have depositors per se. This makes them less like a commercial bank and more like a central bank, since central banks use methods other than redeemability to keep prices stable.
Each of these stablecoins works in a slightly different way, depending on their behavior when the peg is above or below the target value.
These designs seek to have market making algorithms that are constantly willing to buy and sell to maintain the peg, which in practice if they are sufficiently liquid is almost the same as allowing to mine or redeem.
Among these designs, the most popular, due to its infamous ending, is UST. It was collateralized by LUNA, the native token of its blockchain, Terra. Terra’s protocol functioned as a market maker for its own stable coin, and if the system ran out of collateral assets it would start issuing more Luna (creating inflation) to get it back.
This type of stablecoins has a turnover of almost 15 billion USD, which is considerably smaller than that of the fiat collateralized ones, but at the same time they are more experimental projects that bring something else to the market and that can continue to show exponential growth.
Decentralization means how immutable the system is, in this spectrum it is easy to place the fiat collateralized entities as the least collateralized. These are entities that receive dollars and are subject to the regulations of the currency they are working against, and the control of the issuance of the circulating currency is done by that entity.
Just using a blockchain is not enough to be considered a decentralized project, to be decentralized a project must also have a form of emission that is not controlled by any entity in a centralized way and control the emission in the most programmatic way possible.
The governance of well decentralized blockchain projects, such as Maker DAO, are realized through DAOs, which however often fall into the trap that the power remains within the primary holders of the token controlling the DAO, in the case of Maker DAO, its governance token MKR.
The type of governance through tokens is one of the points that are being worked on in the different DAOs and it is a type of problem that blockchains should be solving.
It is important not to forget that a system is only as decentralized as its most centralized point. If the project operates as a DAO but the blockchain on which it operates is highly centralized, at the end of the day it will be a centralized project, as for example was the case with Terra.
By capital efficiency we mean how efficient the currency design is with capital, which is represented by how much capital it needs to immobilize in order to be able to issue its debt, i.e. its stable.
In this range of design the most inefficient form is the most successful in the crypto market, which is over-collateralization. Basically you tie up far more collateral in value than you take out. This form is robust to withstand volatility but it is still a weak point of the design.
In the case of fiat stablecoins, we are talking about a one-to-one relationship, where each dollar has a token as a counterpart, these are much more efficient with capital than a currency such as DAI.
In a more intermediate step between these and the others are projects like FRAX, which takes as collateral only stablecoins, and against that issues its stable FRAX token, which over time as the system proves robust also collateralizes a portion with its own FXS token of which it issues more or less as needed.
Finally and at the top of this type of design are the stablecoins that do not use collateral, and therefore are extremely efficient because they do not need reserves to issue a stable currency. The current design of stablecoins came from Basis, a project that never saw the light of day but whose ideas were taken and implemented by Basis Cash.
These types of designs fall into the final spectrum of capital efficiency since with zero collateral they generate a debt that the seigniorage algorithm will then seek to stabilize.
Basis cash worked in two phases and with two tokens:
Expansion cycle: when the token is above peg, more Stablecoin is issued which goes to the holders of BAS project equity tokens (basis shares). As the supply expands, the holders have more stable and the price goes down again due to inflation.
Contraction Cycle: in this stage the protocol is more complex, to reduce the stablecoin supply circulating, bonds are issued, BAB (basis bonds) that are sold for BAC (the stablecoin) and that the protocol burns when it receives it, eliminating it from the circulating and thus raising the price. Now those Bonds that were sold are the ones that will have the priority to receive the issuance once the price rises above the shareholders.
The new issue of Basis Cash is known as seigniorage, the profit that central banks make by issuing a new currency.
Normal central banks keep the seigniorage in their own balance sheets for difficult days, while Basis Cash distributes it among its shareholders.
This model, whose maximum exponent is Basis, also gave rise to projects such as ESD and DSD, all of which were highly risky and lost their peg.
These models together with the algorithmic central banks are the riskiest models and have the highest failure rate. However, it is interesting how they open up new design patterns.
The general macro context seems to tend towards a context of high volatility, where the dollar will begin to appreciate against other world currencies due to the demand for it at a global level, given that it is the main asset of the economy.
In this same context, the dollar faces global and local causes that will generate inflation. On the local level, the monetary expansion resulting from the lowering of interest rates to zero to stimulate the economy will increase Core inflation, something that is seen not only in the dollar but also in other central banks around the world, and this type of inflation is being controlled through the instruments available to the Fed. Globally, the increase in commodity prices, especially food and energy related prices, will produce a generalized price increase that could generate a volatile and inflationary regime around the world.
In a world where stability in an asset is a scarce commodity, those instruments that offer it will have the attention of users. **
Today it seems clear that the main economic powers will start experimenting with CBDCs (Central Bank Digital Currencies), currencies officially issued by governments and that could replace currencies such as USDC or USDT, as they have more legitimacy than these. A digital currency that represents the dollar, and that competes with a digital yuan that is slowly beginning to establish itself, is something that the Fed has to think about strategically.
Central bank’s digital currencies could compete against stable assets that operate on the basis of today’s stablecoins and seek to position themselves as competition against such assets by ensuring stability with their algorithmic mechanisms.
Regulations that emerge during this stage will be key to the evolution and integration of these new types of stability mechanisms in the economy. Measures regarding the privacy with which certain instruments can be used will bring discrepancies between those who see the need to expand regulation and those who seek to preserve the openness of the systems.
Within Stablecoins designs after the experiences of the last few years and the exponential growth of projects like MakerDAO with DAI, probably a new wave of expansion will occur in these products, which are still too small to compete even against their counterparts with fiat collateral (which have a circulating supply approximately 10x larger).
This type of stablecoins will have a greater or lesser extent to the digital currencies of central banks, the CBDCs, with some projects seeking to have only crypto assets so as not to have exposure to the regulations that such assets could request. Among them MakerDAO, who already communicated that USDC vaults will be closed and that it will seek the greatest decentralization in DAI.
As inflation progresses, traditional systems will begin to look at these new mechanisms with different eyes and seek to use them as tools in their monetary policies. Stablecoins issued against commodities such as collateral or bonds may become something to watch out for. In a context of high volatility making a digital system to control the issuance against an asset such as Lithium or Oil can be an interesting way to mix a digital control of a real asset.
In a highly volatile and uncertain world, stability is a scarce resource, and the search for it will drive new experiments.
Lucas Palomeque — COO CTF Capital
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