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Building liquidity

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This is part of our December 2020 report into:

The Unstoppable Rise of Digital Assets

Although institutional interest in Bitcoin is rising, there is still the volatility conundrum to consider. Bitcoin’s market fluctuations, however, make it a poor store of value. But, at the same time, there is an advantage to keeping capital stored in crypto: cashing out crypto into fiat is almost always a taxable event and not ideal unless the investor intends to withdraw from the market. 

In the search for functionality and the need for a stable, liquid digital asset, investors have traded their fiat currency “on-ramp” for stablecoins. Dubbed as the “holy grail” of cryptocurrency, these digital tokens, like USDC and Tether (USDT), have emerged as the alternative to gold and Bitcoin in response to the looming crisis. These are digital assets that offer the same benefits of cryptocurrency, but are backed by a reserved asset (either fiat money or a collateralized asset like gold or crypto) that allows convenient transactions without the extreme volatility of cryptocurrencies.

The advantage of stablecoins is found in its infrastructure, which leverages a non-inflationary value to balance volatility, combining it with a “two-token model” for price regulation. This provides better stability in comparison with traditional cryptocurrencies, making it an ideal “safe haven” during an economic crisis. While speculative investing in cryptocurrency may be far from over, those who are looking for functionality and use cases for cryptocurrency may find what they are looking for in stablecoins.

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Stability without USD

While the majority of stablecoins in the market are denominated in USD, according to AHKD (a subsidiary of AAX’s parent company, Atom Group), there is demand for a HKD-denominated stablecoin, which it plans to launch later this year. 

AHKD has partnered with Hong Kong-registered First Digital Trust, a regulated entity under the HKSAR Trustee Ordinance. The firm acts as a custodian of the cash reserves that back the stablecoin in a segregated client account. Having a regulated trustee that is subject to audit requirements controlling custody of the assets that back the stablecoin helps build a level of confidence in the product. Tether, for instance, has been dogged by allegations that it’s undercollateralized. The use of regulated custodians would be an easy way for a firm to refute these allegations. 

The Hong Kong dollar itself is a compelling choice given the currency’s role in the region. The HKD is pegged to the USD and allowed to trade in controlled band as part of a plan called the “currency board”. Although it is pegged, the HKD has served as an on-ramp and off-ramp for Mainland China’s renminbi. Hong Kong is home to the largest off-shore liquidity pool of RMB, and with the HKD’s international liquidity, the city can act as a pipeline for EUR/USD-HKD-RMB settlement. Thus, a HKD-denominated stablecoin is more likely to capture interest from Mainland China than a stablecoin denominated in an alternative currency. 

State-backed liquidity: the central bank digital currency race

“Liquidity is the new boss in town” could be the theme for the last year in fintech development. The explosive growth of stablecoins led the charge in blockchain-based liquidity as investors sought efficiency in on-ramps and off-ramps.

Almost in parallel to all of this, a number of the world’s central banks are developing central bank digital currencies—digital money (not digitized from the existing supply) that exists on a digital ledger. A digital ledger is a decentralized ledger that requires multiple verifications to authenticate transactions. Blockchain is a type of digital ledger technology, but not all digital ledgers are blockchain.

China’s CBDC ambitions

It’s of great annoyance to Beijing that despite China’s rise to the status of the world’s second-largest economy, most of the world’s transactions are settled in USD. A businessman in Chengdu trying to settle a transaction with a vendor in Lahore, Pakistan, would likely do so in USD as it’s the most liquid currency for both parties. That’s not Beijing’s only problem: with the near-ubiquitous nature of WeChat Pay and AliPay, China has a money supply problem on its hands. Can China’s national digital currency DCEP (Digital Currency Electronic Payment) be a solution for this?

From Forkast’s China Blockchain Report:

The central bank’s digital currency efforts, ironically, would give it more control over the economy. According to reports and the PBOC’s statements, the digital currency would replace M0, or the money in circulation, of which central banks generally have the most control. For China, this is important considering how private companies are digitizing currency through popular mobile payment platforms WeChat Pay and Alipay.

A substantial portion of the payments that drive the consumer economy has shifted to these platforms, which means they have moved from M0 to M2, of which central banks have less control. While M2 includes M0 (in addition to M1, the amount of cash held in checking accounts), it largely refers to the funds and credit in commercial bank accounts—where WeChat Pay and Alipay currency is held.

Central bankers back digital currency

Central bankers around the world, from London to Brazil and Jakarta, have expressed interest in exploring the potential of CBDCs. Indonesia’s economy is heavily dependent on remittances, and the majority of this occurs through privately owned payment rails with high friction costs. In order to boost adoption of the real and break down barriers in regional remittances, Brazil is said to be exploring a CBDC.

“We are in the middle of a revolution in payments,” writes former Bank of England Governor Mark Carney in an early 2020 discussion paper on the topic. The use of banknotes—the Bank’s most accessible form of money—is declining, and use of privately issued money continues to increase, with technological changes driving innovation.”

Stablecoins would be part of the category that Carney defines as “privately issued money.” The inherent problem with such privately issued money is that it expands the supply of M2 – as the PBOC has recognized – giving the central bank less control over the economy through monetary policy. And the issue of risk always remains. For example, Tether currently has just over US$15 billion in circulation, while USDC has just over US$2.4 billion in circulation. Regulators have taken an interest in both. Should Tether or UDSC fail and wipe out investors, it would have a detrimental impact on the crypto-economy and likely cascade into the broader economy, as Tether will soon have sufficient capital under its control sufficient capital under its control sufficient to it in the list of top-100 US banks by assets.

The rise of digital money, particularly stablecoins, has forced central bankers to act. It’s unlikely that the rise of CBDCs would have a broad impact on the demand for stablecoins since these are primarily used for on-ramps and off-ramps for crypto.