Fintech perspectives from a bunch of policy wonks. The views expressed herein are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board or its management.
There is a growing queue of crypto-asset exchange-traded fund (ETF) applications at the U.S. Securities and Exchange Commission (SEC). So far, the SEC hasn’t been friendly towards the concept, pointing to inadequate means to prevent market manipulation and illicit activities at the top exchanges, as it rejected Bitcoin (BTC) ETF applications starting in 2018.
With institutional and retail crypto-asset investment interest surging, three firms (Valkyrie Digital Assets, Vaneck, New York Digital Investment Group) have recently submitted BTC-based ETF filings with the SEC. However, the approval process will be a long slog, with late September being a best guess as to when it will be complete, if successful. Hopes are high this time around because of the new Presidential Administration and the possibility of longtime crypto advocate Gary Gensler as SEC chair.
Meanwhile, the Ontario Securities Commission (OSC) cleared the launch of the Purpose Bitcoin ETF, making it the first publicly-traded ETF to gain regulatory approval in North America. After about a week of trading on the Toronto Stock Exchange it had bought 10,064 Bitcoin (about $450 million at a BTC price of $45,000). Soon after, the OSC approved the Evolve Bitcoin ETF but it appears to be off to a slower start. Also, CI Global Asset Manager filed a preliminary prospectus for its CI Galaxy Bitcoin ETF.
Alternatively, there is the Grayscale Bitcoin Trust and other similar closed-end trust products coming down the pipeline. Osprey Fund’s Bitcoin Trust is now available on a private-placement basis to retail investors. Bitwise Asset Management is seeking Financial Industry Regulatory Authority approval to trade shares of its Bitwise Bitcoin Fund on New York-based OTCQX over-the-counter (OTC) marketplace. BlockFi registered its new Bitcoin Trust with the SEC late last month. Bitwise launched a DeFi Crypto Index Fund that will track companies and securities involved in decentralized finance (DeFi).
Also, tech company MicroStrategy has been selling zero-coupon convertible senior notes with the intention to use the net proceeds to buy BTC. In December 2020 they sold $650 million of notes, and then another $1,050 million in February. However, a Gartner Finance poll of finance managers found that a majority of them are not planning to hold BTC as a corporate asset. In their responses, most of the 77 finance leaders interviewed cited BTC’s volatility as “extremely difficult to mitigate.”
The last Monthly Monitor talked about how USD-pegged Empty Set Dollar (ESD) briefly held the #6 position in the stablecoin league table. The ESD launched in September 2020 and was one of the first algorithmic stablecoins to come to market. (An algorithmic stablecoin adjusts its supply to maintain its peg.) However, ESD broke its peg massively in January 2021, and is now trading down around $0.13 resulting in a drop down to #14.
However, there’s another very viable-looking USD-pegged stablecoin, TerraUSD which sits at #7 ($590 million market capitalization). The peg isn’t absolutely perfect, as it has occasionally spiked down to nearly $0.96 and up to $1.04, but since it has launched in October 2019 it has spent most of its time within a $0.98 – $1.02 band, which is better than any other algorithmic USD-pegged stablecoin I’ve seen. TerraUSD is also part of the Terra family of products that seem to be seeing real use cases (see below).
Terra is a delegated proof of stake system that uses the LUNA token as collateral for the stablecoins it issues, and it has several active use cases underway:
The South Korean CHAI decentralized app-based mobile payments system runs on Terra’s payment rail. The rail is built on two the native stablecoin of Terra for funds across the networks and the Luna token for small transaction fees for miners. CHAI has partnered with 15+ major local banks to facilitate convenient fiat on/off ramps, recently crossed 2 million monthly active users. Terra’s network also integrates with MemePay, a Mongolian e-wallet utilized by 1.5% of the online population.
Terra’s Mirror synthetic assets protocol tracks the price of U.S. stocks, futures, exchange-traded funds, and other traditional assets. The Mirror Wallet kicked off with 12 of the top American technology stocks. The target market is users outside of the United States who seek 24/7 exposure to and fractional ownership of synthetic assets.
FYI besides TerraUSD there are eleven other Terra-based stablecoins (AUD, CAD, CHF, CNY, EUR, GBP, INR, JPY, HKD, KRW, and SGD).
Bitfinex and Tether reached a $18.5 million settlement with the New York Attorney General (NYAG) over allegations that they hid the loss of commingled client and corporate funds and misrepresented the truth about the reserves backing Tether’s USDT stablecoin. The two firms also agreed to provide to the NYAG quarterly reports on the composition of Tether reserves over the next two years, starting within ninety days of the February 18, 2021 effective date of the settlement. Without admitting or denying any wrongdoing, Tether committed to publicly share these reports. However, the lawsuit did not cover the rumored role of Tether in a huge BTC pumping scheme.
According to the Financial Stability Board, stablecoins are crypto-assets that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. U.S. dollar pegged USDT is the biggest stablecoin by market capitalization.
Although USDT’s market capitalization is a small fraction of BTC’s ($35 billion versus $940 billion on February 24, 2020) in terms of trading volume it is by far number one. USDT’s main use case appears to be as a crypto-asset trading on-ramp for residents of countries where there are crypto-asset trading bans and/or capital controls, and as a “reserve currency” for unbanked exchanges.
Is USDT fully backed U.S. dollar assets?
Tether claims that USDT is always 100% backed by currency and cash equivalents, plus “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.” In an ongoing lawsuit launched in 2019 by the New York Attorney General (NYAG) against Tether parent iFinex, it came to light that Tether had loaned $850 million of USDT’s reserves to its sister company Bitfinex. Since then, Tether has been dogged by suspicions that USTD is not 100% backed by U.S. dollar assets, although Tether claims that the Bitfinex loan has been paid off.
Tether has not helped its cause with its opacity regarding USDT’s reserve holdings. Although not audited, other stablecoin issuers at least publish monthly attestations that they are fully backed. However, attestations remain very vague about what comprises the reserves. The last time Tether published anything like an attestation for USDT was in 2017., but claim full details will be released later in 2021.
What kinds of assets back USDT?
But even if USDT’s are fully backed, questions remain around what they are invested in, although the other stablecoin issuers are not paragons of transparency. The USDC attestation report only tells us the reserves are held in segregated accounts at US federally insured depository institutions and in approved investments. The BUSD and PAX reports are equally vague, telling us that the reserves are held at US depository institutions sometimes in amounts backed by debt instruments expressly guaranteed by the full faith and credit of the US Government. Gemini’s attestations seem more transparent and imply that all of the reserves are invested in US Treasury securities.
The perception that Tether’s investments aren’t exactly top-tier, is not contradicted by the redemption restrictions: “Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves.” (Crypto traders get around this by buying BTC with USDTs on an exchange that trades the BTC/USDT pair, transferring them to an exchange that trades the BTC/USD pair, and cashing them out.)
Is Tether part of a Bitcoin pumping scheme?
Some claim that USDT issuance is part of a BTC price pumping scheme. For example, a 2019 paper found that Bitcoin purchases with Tether “are timed following market downturns and result in sizable increases in Bitcoin prices. Rather than demand from cash investors, these patterns are most consistent with the supply-based hypothesis of unbacked digital money inflating cryptocurrency prices.” See also David Gerard’s succinct description of the process in this Twitter thread.
But according to Frances Coppola, USDT’s asymmetric mechanics both support and disprove this claim. An opposing theory says that what look like BTC pumps are merely Tether reacting to BTC price volatility by supplying more “lubrication” to markets. The “lubrication” idea stems from Tether’s key role as a “reserve asset” for unbanked crypto platforms. Also, a recent paper used USDT deviations from its fiat currency peg to show that USDT acts as a “safe haven” for crypto-asset investors. They found evidence of significant premiums over parity during the crash in non-stable crypto-assets in early 2018 and during the March 2020 COVID-19 crisis. Discounts were found to derive from liquidity effects and collateral concerns. For example, USTD spiked to as low as around $0.90 in April 2017 when doubts were raging about the sufficiency of Tether’s reserves.
So, if BTC’s price is falling, investors wanting to cash out is likely to increase demand for USDT, which will in turn raise its price. In normal circumstances, arbitrage is probably sufficient to maintain the peg. But when BTC is experiencing high volatility – in either direction – demand for USDT can increase far faster than arbitrageurs can bring it down. To prevent the dollar peg breaking, therefore, Tether must respond to this extra demand by issuing more USDT. And issuing more USDT increases exchange liquidity, making it easier to purchase or sell BTC and therefore feeding the price movement. So wild swings in BTC’s price might not be triggered by USDT issuance, but they… can be fed by it.
If Bitfinex and Tether follow through on their commitment to be more transparent about Tether’s reserves, rumors about USDT being backed by flaky assets may be put to bed, although questions remain around possible Tether BTC pumping. Also, it is a big if! However, the NYAG settlement does reduce a major crypto market black swan risk if, as Bryce Weiner believes, the market plumbing absolutely depends on USDT, making it effectively too big to fail.
There is a perception that decentralized finance (DeFi) and central banks are worlds apart. However, these two worlds should explore common ground that can unlock the best possible solution for the end-consumer – the transparency and efficiency of the DeFi space paired with safe and reliable liquidity and reduced compliance burden provided by central banks. After all, it should be about working towards one common goal – to provide the safest, most efficient, and reliable user experience in payments.
A lot of existing and prospective initiatives are looking into enabling faster, cheaper, more transparent and more inclusive cross-border payment services, while maintaining their safety and security. Improved cross-border payments translate into widespread benefits such as supporting economic growth, international trade, global development and financial inclusion. Cross-border payments are particularly relevant for emerging and developing economies given the central role of remittances and the large number of unbanked citizens in these countries.
The emergence of distributed ledger technology (DLT) has added new momentum to efforts to improve cross-border payments initiated both by the private and public sector. While the private sector has focused on developing decentralized peer-to-peer (P2P) solutions in the retail domain, the public sector has aimed at enabling direct exchanges between participating financial institutions through centrally operated DLT-based networks in the wholesale domain.
For the private sector, the use of DLT eliminates the need for trusted third parties and intermediaries like commercial banks for processing, clearing and settlement. DLT has spurred the growth of DeFi that recreates traditional functions of financial systems using smart contracts in place of middlemen. DeFi operates via decentralized, permissionless DLT-enabled applications called DApps. Currently, the primary DeFi platform is Ethereum, but in principle these ideas can be implemented on any smart contract platform. The main building blocks of DeFi are fiat currency-pegged stablecoins that can be exchanged seamlessly and most DApps are designed to fully interoperate with each other.
Public sector activity in the cross-border domain has focused on exploring DLT-enabled private permissioned wholesale CBDC networks as an alternative to existing real-time gross settlement (RTGS) systems. The broadcast of transactions in real-time across the network of participants eliminates the need for reconciliation or intermediation, allowing designated financial institutions to transact directly without relying on correspondent banks. The Inthanon-LionRock research project carried out in collaboration between the Hong-Kong Monetary Authority and the Bank of Thailand in 2019 created a Thai Bhat and Hong-Kong Dollar cross-border corridor network prototype, which allowed participating banks in Hong Kong and Thailand to conduct funds transfers and foreign exchange transactions on a P2P basis reducing settlement layers.
At a first glance, these two types of initiatives appear worlds apart. But the potential convergence holds promises for the best of two worlds in cross-border payments – a robust solution leveraging the competitive advantage of both. For example, DeFi relies on liquidity pools to meet its liquidity needs. Liquidity pools are crypto-assets that facilitate trading on decentralized exchanges. The tokens are locked into smart contracts and serve to provide liquidity in decentralized exchanges. Those exchange typically make use of an automatic market maker, which obviates the need for an order book and a counterparty in the traditional sense. For the buyer to compete a transaction, there does not need to be an available seller, only sufficient liquidity in the pool against which the trade is executed.
However, these pools can put the deposited funds at serious risk such as impermanent losses, smart contract exploits or malicious actions by pool administrators. Given their decentralized nature, there is no recourse when funds or data is lost as the counterparty is not easily identifiable. Instead of relying on crypto-assets in the liquidity pool, stablecoin providers could purchase central bank reserves issued “on-chain”. These reserves can be used to back the issuance of their coins in different currencies. Another advantage of linking up with central banks is that it could ease the regulatory and compliance burden of DeFi providers and participants which can be particularly heavy when working across different sectors and jurisdictions. Central banks, on the other hand, would have more regulatory oversight over DeFi providers holding their reserves.
Also, rather than having to venture out in the retail space to operate and manage their own networks, which can be time and resource intensive, central banks could benefit from the continuous enhancements of decentralized public networks. In addition, central banks would not need to run consumer-facing operations, like hosting wallets, handling consumer complaints, maintaining superior user experience and integrating with other functional applications beyond payments, which are traditionally outside their mandates. Plus, central banks would have real-time insights into how DeFi providers are using these on-chain reserves and whether they are achieving desired policy goals.
The oracle middleware of decentralized data systems provides a unique opportunity for central banks (or international regulatory and standard setting bodies) to impose technical and regulatory standards that govern the interaction with external DeFi providers. Oracles are third-party services that enable data and transaction sharing between disparate environments in a secure and authoritative manner. Information shared by oracles is digitally signed and hence is considered non‑repudiable (assurance that the signature cannot be denied by the party who signed it). For example, only parties that have completed required financial integrity checks would be authorized to purchase the central bank liability discussed above. Oracles can transmit real-time exchange rate data for DeFi cross-border payments systems and continuously validate and monitor data usage in the downstream applications. Oracles can also be used to achieve interoperability with private enterprise blockchain networks and existing legacy payment systems.
The marriage of the decentralized P2P solutions and centrally governed and organized networks can catalyze mutual benefits beyond cross-border payments. Linking central platforms with decentralized marketplaces would allow for a better integration of the retail and wholesale domains thereby unlocking a variety of use cases for DeFi providers that could be aligned with a country’s strategic policy objectives such as expanding financial inclusion. At the same time, central banks can rely on the continuous improvement of the public networks underlying DeFi while ensuring access to liquidity and regulatory compliance.
Most institutional investors participate in crypto-asset markets through investment funds like Grayscale Investment’s closed-end trusts. As publicly traded trusts that report to the U.S. Securities and Exchange Commission, they relieve investors of concerns about storage, custody and security of their holdings. Grayscale is the dominant crypto fund manager with over $37 billion assets under management. This blog explores some of the market dynamics associated with the Grayscale Bitcoin Trust (GBTC).
Although accredited investors can buy GBTC directly from Grayscale at NAV, many institutional investors cannot take this route because GBTC shares have a six-month lock up period. (According to SEC Rule 144, restricted securities issued by an SEC reporting company like GBTC are subject to a minimum holding period of 6 months.) Hence, these investors are forced to buy the shares at a premium over the native asset value (NAV) in the secondary market, and these premia can be significant:
Price premia over NAV occasionally appear on exchange-traded funds (ETFs) but they rarely exceed about 3%. When they do, authorized participants step in to arbitrage the gap away by creating or redeeming shares of the ETF.
However, some have pointed to a scheme by which the premium could be arbitraged. It involves buying GBTC directly from Grayscale at NAV and shorting free-trading GBTC. Six months later, the two positions net out leaving a risk-free profit. This glosses over risks like not being able to borrow and fund GBTC for up to six months. JP Morgan analysts have estimated the cost of this premium monetization trade at 10-15% per annum. The GBTC long position could also be hedged with BTC futures contracts. However, the fact that the premium continues to exist, implies that such arbitrage is not consistently taking place.
That same JP Morgan analysis concluded that the introduction of a U.S. Bitcoin ETF would be positive for Bitcoin over the longer term but could be short-term negative. It would erode GBTC’s effective monopoly status and could cause a cascade of GBTC outflows and a collapse of its premium. This could have negative near-term implications for Bitcoin given the flow and signaling important of GBTC. And some think that the chances of the SEC giving the green light to a Bitcoin ETF is looking good.
Meanwhile, Grayscale competitors are sprouting up. Osprey Bitcoin Trustlaunched with a 0.49% management fee (versus GBTC’s 2%). BlockFi and Bitwise have followed suit with similar offerings. However, the business models of Grayscale and all such funds hang on whether the SEC will continue to push back on crypto-asset ETFs.
As central banks advance their work on central bank digital currency (CBDC), they are faced with questions on how to ensure interoperability with other digital assets. To unravel the interoperability conundrum and provide a robust digital ecosystem for the economy, China has launched the Blockchain Service Network (BSN). Although in its early stages, the BSN remains a unique attempt to build a global interoperability network that connects digital assets both across borders and networks.
Many central banks are exploring central bank digital currency (CBDC), but China is at the cutting edge of exploring interoperating their e-CNY with other digital currencies and payment systems. The Blockchain Service Network (BSN) is a government-backed infrastructure network that bridges various distributed ledger technology-based networks. It was founded in April 2020 by Red Date Technology, a Beijing-based software company, and six other private and public sector agencies, including China UnionPay, China Mobile and the State Information Center. For regulatory compliance purposes, the governance of the BSN was split up into BSN China (for private permissioned blockchains) and BSN International (for public permissionless networks) while preserving a certain level of interoperability.
BSN China is expected to serve as a domestic public infrastructure network that will facilitate the development, deployment, operations, maintenance, and regulation of low-cost consortium blockchain applications. (Consortium blockchains grant assess only to selected participants, whereas private blockchains keep write permissions to one entity, although read permissions may be more open, whereas with public blockchains, access and interaction with the network is unrestricted and the identity of its participants is semi-anonymous.)
Rather than starting from scratch, developers can leverage the BSN to build their applications efficiently by choosing desired components from a broad menu of integrated systems. Developers would be able to deploy their distributed applications (dapps) with a single private key across different networks, while servers running on the BSN are designed to be compatible with the blockchains of any participating member.
A network of public city nodes that are linked via the internet form a nationwide (and in the future, worldwide) physical city node blockchain service network. In effect, public city nodes serve as BSN data servers that developers can deploy their applications to using a dedicated channel for transaction processing, data communication, and storage. These disparate channels are supposed to ensure “absolute privacy” of each application while allowing data allocations across multiple channels. Participants and end-users can access those applications at no cost. Currently, the BSN spans various cloud environments and portals, including 108 public city nodes, connecting over 80 cities across mainland China and eight public city nodes in other countries around the world.
Through the hub users can tap into data generated by outside applications while getting cross-chain services between blockchains adapted in the network. For example, an Ethereum-based dapp would be authorized to access real-time logistics data generated by a dapp built on Hyperledger and processed through the Interchain Hub. The BSN envisions this becoming a standard protocol for dapps from different blockchains, allowing them to call each other with just a few lines of code.
This aim of this collaboration was to provide developers outside China with a standardized development environment to build and run dapps on public blockchains. The public blockchains are supposed to be adapted to the Chinese market with public blockchain nodes that are installed on top of the BSN, so that Chinese developers can access all nodes from all public blockchains via one gateway and one simple monthly plan.
In the localized version for the Chinese market, the network will convert the decentralized public blockchains into permissioned ones, while replacing their native tokens with direct payment by the Chinese currency renminbi to cover transaction fees on these blockchains. This is considered to be the most direct and effective way to ensure regulatory and supervisory compliance and encourage adoption among users within China. Unlike the localized version, the global version of the BSN will allow public decentralized blockchains.
According to industry experts, the BSN is supposed to serve as the backbone of China’s Digital Silk Road ambitions. Others argue that the BSN will encourage the development of digital currencies, stimulate internationalization of digital assets, and expand Chinese developers’ access to the global crypto industry. Regardless of the underlying motivation, thus far, the BSN is the only large-scale network that aims for seamless interoperability between international digital assets and applications across public and private blockchain networks.