Why Facebook Chose Stablecoins as Its Path to Crypto

(Bloomberg) -- When Facebook Inc. developed Libra, its planned digital currency, it decided to focus on one version of the crypto world known as stablecoins. They’re not the biggest or best-known players in the field pioneered by Bitcoin. But to the broad range of companies partnering with Facebook on Libra, stablecoins seem promising as a possible bridge between the existing world of government-issued money and a crypto-based future. In particular, stablecoins are getting attention from banks like JPMorgan Chase Inc. as well as Facebook because they address one of the biggest hurdles facing digital currencies: their extreme volatility.

1. Why is volatility a problem?

Bitcoin once dropped from nearly $20,000 to around $6,000 in four months -- a range of price swings that makes it nearly unusable for real-life transactions. Other digital assets like Ether or Litecoin have seen similar swings. Stablecoins, by contrast, are designed to hold their value. The price of the best-known stablecoin, Tether, has been at or close to $1 since 2015.

2. How do they do that?

In one of two ways. Collateralized stablecoins are pegged to another asset, like the U.S. dollar, a basket of national currencies or commodities, and their issuers back up the value of their coin by holding on to that asset. Other stablecoins are pegged to the price of crypto assets like Ether or a group of digital currencies. Stablecoins of this sort typically employ algorithms to manage supply and demand of the coin so what’s in circulation matches what’s held in reserve.

3. Which one is Libra?

The first. Facebook says that Libra will be backed by "a collection of low-volatility assets, such as bank deposits and short-term government securities in currencies from stable and reputable central banks." Unlike Tether, though, Libra’s value will fluctuate in the same manner that the U.S. dollar varies compared with the euro or yen on any given day. A system of exchanges will be established for users to convert fiat for Libra, the company said.

4. What is JPMorgan planning?

It says it will use its JPM Coin to enable fast money transfers between its corporate customers on an internal blockchain. It will be a closed and centrally run system, in contrast to many other cryptocurrencies. JPM Coin is backed by U.S. dollars held by the bank.

5. Why are the coins popular?

Stablecoins can be a bridge between two worlds that weren’t designed with mixing in mind -- cryptocurrencies and traditional finance. That makes them useful as a way to lock in gains from crypto trading or as a safe harbor if investors think a downturn is coming. They also make it easier to transfer funds between crypto exchanges. Many digital exchanges don’t have the relationships with banks needed to offer fiat deposits or withdrawals, but can and do accept stablecoins such as Tether. Finally, stablecoins can streamline, speed up and make cheaper purchases and money transfers by using different a different technology, called blockchain, instead of the traditional payments infrastructure.

6. What are others like?

As of February, there were more than 50, of which 26 had been released and most of the rest were expected to be launched in 2019, according to research by Blockchain.com. The stablecoin market value stood at $3 billion, more than double a year ago, according to the research report. Here are some examples:

• By far the most popular stablecoin is Tether, with a $2.6 billion valuation at the time of the Blockchain research report. From 2015 to early this year, Tether said its tokens were backed 1:1 by U.S. dollars. In April, though, after the company behind Tether was accused of a cover up, it said cash and short-term securities represented only 74% of the outstanding coins. Doubts about Tether have dogged it for years, and the company has yet to publicly provide conclusive evidence of its holdings. But bank statements from late 2017 to early 2018 seen by Bloomberg News appeared to show a 1-to-1 match between dollars on deposit and the number of tokens issued.
• True USD is another collateralized stablecoin that holds greenbacks. When users turn in their True USD for dollars, which are kept in escrow accounts, the stablecoins are destroyed, which helps maintain the 1-to-1 ration with the fiat reserves. Unlike Tether, True USD is releasing monthly reports on its reserves. Yet in May 2018 its price lost the 1-to-1 peg and hit $1.39 in secondary trading after it was announced that the currency would be listed on the crypto exchange Binance, according to the Blockchain research.
• Dai is a stablecoin pegged to the value of the dollar but backed by Ether, one of the most-valuable cryptocurrencies -- yet one that is also wildly volatile like Bitcoin. Dai says that it over-collateralizes, that is, it holds more Ether than a 1-to-1 reserve would require, to provide a cushion for swings in Ether’s price. That gives it one of the more complicated price stability mechanisms in the market, as noted in the Blockchain report.
• Gemini Dollar is issued by the digital asset exchange Gemini, founded by Cameron and Tyler Winklevoss. The tokens are also backed by U.S. dollars, which are held by State Street Corp. Its dollar reserves are examined every month by San Francisco-based BPM to ensure they match, according to Tyler Winklevoss.

7. How do stablecoin companies make money?

Interest and fees. The bank statement for Tether reviewed by Bloomberg News showed how much money it was making from the cash pile. It had earned $6.6 million in interest since the beginning of the year, according to the July document. It also charges fees for deposits and withdrawals of fiat money.

8. What’s next?

Stablecoins could be the product that convinces everyday users that cryptocurrencies deserve a place next to their ATM card. In the longer run, if a national government decides to issue its fiat in digital form that would be a big leap for the stablecoin market, assuming the country has a trusted record of maintaining its national currency like the U.S. dollar. While the U.S. doesn’t seem likely to do that soon, the Federal Reserve has been urged to consider the option. The central bank in Sweden, one of the world’s most cashless societies, plans a pilot project with an "e-krona" this year.

9. What are the risks?

That depends on which stablecoin you are talking about. Those tied to digital assets like Ether could crash if it does. Collateralized stablecoins run a risk of fraud, that the reserves they claim are backing the asset are fictional. And like any asset, digital or tangible, there is the risk of secondary-market manipulation which could skew coin values and threaten to break any underlying peg. Lastly, regulators could decide that stablecoins are securities and must be registered in jurisdictions like the U.S. or EU, or be excluded from those markets. In December, Basis, a stablecoin that raised $133 million from investors, said it was closing down the project and returning the money after regulatory guidance it received made it clear it would have to register bonds and token shares as securities under U.S. law.

The Reference Shelf

• Facebook’s white paper outlined its Libra plan.
• A report on the State of Stablecoins by Blockchain.com.
• Bloomberg News reveals Tether bank statements.
• QuickTake primers on cryptocurrencies and Tether.
• The Bloomberg terminal’s cryptocurrency monitor.

To contact the reporters on this story: Matthew Leising in Los Angeles at mleising@bloomberg.net;Olga Kharif in Portland at okharif@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, John O'Neil, Dave Liedtka

©2019 Bloomberg L.P.