Gold-On-A-Block: Stablecoins (Part 2)

The usage of the universal symbol of value, gold, as an asset backing cryptocurrencies is not a new idea in the industry. Together with gold and other precious and industrial metals, exchange-traded commodities have found their application in cryptocurrency design. While quite similar in design and features to their fiat-backed relatives (described in part 1), the stability of the value of commodity-backed cryptocurrencies is expected to arise from an asset fundamentally different to fiat currencies.

Commodities are fungible assets which are traded on organized markets. Unlike fiat currencies, the supply of which is regulated by central banks, and is theoretically unlimited, commodities are real-world assets with limited supply due to their nature. The limited supply of commodities comes from their natural scarcity (e.g. gold, diamonds, platinum) or from (international) production and trading agreements (such as the supply of oil). For a commodity to be of interest as a collateral or a backing asset of another financial instrument, it is also important that it is regularly traded in organized markets. Continuous trading of an asset allows for the price to be known — as one of the major tasks of organized markets and exchanges is the price discovery and is an indicator of asset liquidity.

The scarcity and the limited supply of exchange-traded commodities are why it is thought that their value cannot drop to zero. While their price may fluctuate, depending on market demand and offer, production or industrial usage, it is really hard to imagine a situation in the foreseeable future when e.g. the value of gold or platinum would decrease to zero.

Looking at the 5-year price chart of gold it becomes quite clear why is it the favorite commodity used for backing stablecoins of this class.

Chart: https://www.bloomberg.com/quote/XAU:CUR (2018–11–09)

Stablecoins backed by exchange-traded commodities

The distinct feature of this class of stablecoins is that they are backed by one or more exchange-traded commodities in a fixed ratio. The concept of issuing commodity backed stablecoins is analogous to the process of issuing fiat-backed stablecoins: the customer deposits an amount to the issuer, the issuer buys the required quantity of the commodity from their vendor. The commodity is stored by the custodian, which vouches, together with the issuer the quantity of the commodity is adequate to the amount paid by the customer — and with that, the stablecoin is minted and transferred to customer’s account. Regular audits ensure that the commodity used as the backing asset of the stablecoin is of adequate quality and quantity to reflect the total supply of the coin. In case of redemption, the customer is able to obtain the backing asset from the issuer of the coin (or it’s financial equivalent in some cases), while the coin is withdrawn from the supply (burning).

Governance

Similarly to fiat backed stablecoins, commodity-backed stablecoins are highly centralized crypto assets, as their value is dependent, not only on the value of the backing asset, but on the trust in the issuer, custodian and auditor. Failure in compliance with any of the parties involved in the process of minting and backing asset custody may lead to the breaking of the peg and loss of price stability.

The cost of maintaining the peg with these stablecoins, due to the number of participants in the system is considerable, as it includes the cost of storage of the stablecoin collateral and cost of audits. Some of these costs may be transferred to the holders of the stablecoin through periodic demurrage fees.

The Petro experiment

One of the most prominent attempts to issue a commodity backed cryptocurrency is the case of the Venezuelan Petro. Venezuela has been lingering in an economic and financial crisis for years now, which their government is trying to solve through issuing a national commodity-backed cryptocurrency. The first attempt to issue the Petro backed by oil reserves of the country failed, and they extended the basket of commodities to include mineral reserves and diamonds. Due to lack of consistent white paper, which was changed even during the public sale of the coins, and lack of clarity in the entire process and valuation of the collateral, the Petro still isn’t an operating cryptocurrency. Nevertheless, it has a relevance in the story of this class of stablecoins, as an illustration of the significance of trust in the participants of the process involved in the issuing and maintaining the stability of the value of the coin.

Tiberius coin

The Tiberius coin is an interesting commodity backed stablecoin, because of its’ basket of backing assets, which includes industrial and precious metals.

The Tiberius coin backing assets basket includes:

  • Technology metals: 25g copper, 5g tin
  • Electric Vehicle metals: 25g aluminium, 6g nickel, 1g cobalt
  • Stability metals: 3mg gold, 1.5mg platinum

According to the authors of the project, all metals included in the basket except gold have industrial uses, and they will always command some intrinsic value. Tiberius also offers delivery of the actual assets to holders of their token, which holders can initiate by “canceling the token” — which is essentially the process of redemption and burning, executed via smart contracts. Given that industrial metals are normally traded in lots of tons rather than grams, in order to actually get the physical asset, holders of Tiberius coin should be ready to pay a fee of USD 10.000.

The Digix Gold Token

The DGX token is conceived to be “digitalized gold”. Backed with gold of 99.9% purity, it is a textbook case of a stablecoin backed by an exchange-traded commodity. The token is issued by buying gold from authorized vendors, which is stored with a trusted storage provider. Once the vendor and custodian provide their signatures, the “Digital card” is passed on to the smart contract that issues the gold backed coin. The ownership and custody chain of the backing asset is also tracked on a blockchain. The redemption process is straightforward — holders of the Digix Gold Token can redeem 1 gram of gold for each token they own. Audits of the quality and the amount of the backing asset are completed once every three months by reputable auditors. Quite unusual in the world of stablecoins, especially having in mind the controversies surrounding the Tether, the fiat backed stablecoin.

Commodity backed cryptocurrencies are, in spite of the sound reasoning behind choosing the backing assets, nowhere near as used as fiat-backed stablecoins. The reason for this may be in the redemption of physical assets — owning tons of industrial metals or crude oil is of interest to specialized businesses rather than to a individual investor speculating on the cryptocurrency market.

This class of stablecoins is, similarly to fiat-backed cryptocurrencies, neither trustless nor decentralized. A lot in the process of issuance and maintenance of the price stability depends on the trustworthiness of parties involved in the process. What is a great step forward in this setting is that there is at least one stablecoin project that operates flawlessly — delivering audits in time and without raising doubts.

The views expressed in this article are not investment advice nor recommendations. The facts contained herein are not necessarily complete and readers of this article should do their own due diligence, including seeking independent financial advice, before investing. This article is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.

The text of the article is available on the Burst blockchain, and is retrievable using the CLOUD-PKFV-LKFH-WYJT-GB3ED CloudBurst ID.


Gold-On-A-Block: Stablecoins (Part 2) was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.