QIAN V1: crypto-assets backed stablecoin protocol

1. Background

With the popularity of blockchain technology and cryptocurrencies, a whole new form of currency has emerged.

However, the immense price volatility of cryptocurrencies makes it impossible to use them as a medium of trading, or as a tool of deferred payments, or as a unit of account. Based on the need for stability, the stablecoin Tether (USDT), has rapidly emerged, with the circulating supply already approaching $10 billion.

In the cryptocurrency industry, there are currently three main types of stablecoins: fiat-backed, cryptocurrency-backed and algorithmic stablecoins.

Fiat-backed stablecoins, currently represented by USDT, BUSD, HUSD, USDC, PAX, TUSD, etc., has the largest market share among all the stablecoins.

The most common representative of cryptocurrency-backed stablecoins is the DAI launched by MakerDAO. Market share of this type of stablecoin is second to the fiat-backed USDT. Due to the high level of decentralization, cryptocurrency-backed stablecoins are developing rapidly and are more widely embraced by the open source community.

The algorithmic stablecoin, which is represented by project Ampleforth, which the stability adjustment mechanism is based on the automatic adjustment of the total supply of tokens. Algorithmic stablecoins has been widely doubted due to their rudimentary mechanism and their inability to maintain currency price stability and thus far have little market share.

2. Problems

The stablecoin DAI is designed following BitUSD in BitShares, using cryptocurrencies as collateral to secure the intrinsic value of the stablecoin. Both BitUSD and DAI are experimental products that have a lot of room for improvement.

Take the issuance mechanism of the United States dollar as an example, a system of "issue collateral" is in place whereby Federal Reserve banks are required to provide the Fed with qualified collaterals, together with additional collaterals, which are equal to or greater than 100% of the amount of currency issued and in circulation when they receive additional dollars. Most of these collaterals are U.S. Treasury securities owned by the Federal Reserve Banks, in addition to gold securities, qualified commercial paper, mortgage notes, bank promissory notes, and qualified state and local government bonds.

All cash in use is issued by the Federal Reserve and the dollar is actually a type of Federal Reserve note which is fully secured at the time of issuance. The collateral is primarily U.S. Treasury securities, the value of which in turn is backed by the credit of the U.S. government. Hence, the issuance of the U.S. dollar is backed by U.S. government credit.

For the U.S. government, the cost to issue the dollar is only about 2% per year of interest on the U.S. Treasury securities, and the dollar is issued without the issuer (the Federal Reserve) having to prepare any more assets in advance, otherwise, the cost of issuing the dollar would be much higher and the dollar's ability to stimulate economic activity in the United States would be weaker.

Based on the national background of the MakerDAO team, they clearly refer to the currency issuance mechanism of the US dollar at the beginning of their product design, and the DAI is the collateral note of the MakerDAO system. The issuance of DAI is dependent on CDPs, and the holders of CDPs not only need to spend real money in advance to purchase cryptocurrencies such as ETH but also need to bear the stabilization fee of DAI. This is the equivalent of issuing U.S. Treasury securities with gold reserves which require the United States government to buy gold in advance, then using these gold reserved U.S. Treasury as the issuing guarantee of the dollar. It is clearly a losing business for stablecoin issuers, and this design fundamentally constrains the volume of DAI issuance.

Therefore, without a breakthrough in the underlying design, the supply of stablecoins like DAI will not be able to grow a huge amount. Under the squeeze of fiat-backed stablecoins, the impact of cryptocurrency-reserved stablecoins will gradually decline, eventually confined to a small market as an alternative asset. Following the pattern of technology’s development, stablecoins like DAI may be replaced by cryptocurrency-backed stablecoins with more reasonable mechanisms.

3. Issuance mechanism of the Hong Kong dollar

The United States dollar is a classic example of currency issuance through government credit, and only a government with a strong and consistent credit history that is able to repay the principal and interest on the national debt on time can guarantee the sustainability of this currency issuance mechanism. Another dominant international currency issuance mechanism is the issuance of national/regional currencies secured by the mainstream foreign exchange. For example, a currency maintains a fixed exchange rate with the United States dollar and thus indirectly maintains its own currency stability, which is known as a fixed exchange rate regime. In the fixed exchange rate regime, a monetary authority pegs its currency's exchange rate to another currency, a basket of other currencies, or to another measure of value (such as gold), and may allow the rate to fluctuate within a narrow range. To maintain the exchange rate within that range, a country's monetary authority usually needs to intervene in the foreign exchange market to maintain value stability in its currency. One representative of the fixed exchange rate regime is the Hong Kong dollar and its currency board system.

One of the features of the Hong Kong dollar issuance system is that it provides for the HKD issuance of at least 100% of United States dollar foreign exchange, specifically, the issuing bank delivers the United States dollar to the Foreign Exchange Fund managed by the Hong Kong Government in exchange for a certificate of indebtedness equivalent at a fixed exchange rate, and then bank issues the banknotes of the Hong Kong dollar equivalent to the amount on the certificate. If the issuing bank wishes to reduce the volume of Hong Kong dollars issued, it submits the according certificate of indebtedness and Hong Kong dollars at a fixed rate to the Exchange Fund, in exchange for the equivalent United States dollars.

The Hong Kong dollar insurance was overcollateralized based on foreign exchange. According to reported data in January 2020, Hong Kong's foreign exchange reserves reached 445.8 billion US dollars. Correspondingly, the issued Hong Kong Dollar M1 reached 206,626.864 million on January 1, 2020 (206,626,864 million) US dollars. The ratio of foreign exchange reserves to the base currency is more than twice as high, and the Hong Kong dollar thus has a very high safety cushion.

If the demand for US dollars in the market rises and the Hong Kong dollar depreciates, e.g. the market price becomes 1:7.9, the issuing bank will use 1 US dollar to buy 7.9 Hong Kong dollars in the market and redeem 1 US dollar from the Exchange Fund with 7.8 Hong Kong dollars, getting 0.1 Hong Kong dollar difference, completing the arbitrage process. In this transaction, the Hong Kong dollar is recalled, the amount of Hong Kong dollar in circulation on the market decreases, demand increases and the exchange rate rises accordingly.

If the demand for HKD in the market goes up, say to 1:7.7, the issuing bank will use the HKD 7.7 to buy $1 and then use the $1 to buy HKD 7.8 from the Exchange Fund (the right to issue the HKD 7.8 to be exact), from which it gets a spread of HKD 0.1. This transaction process has seen a decrease in the volume of the dollar, an increase in the volume of the Hong Kong dollar, a decrease in demand, and a fall in the exchange rate.

The above process depicts the pegged exchange rate mechanism of the Hong Kong dollar, which ensures the widest acceptance precisely because the Hong Kong dollar uses the US dollar as the collateral currency. This has been fundamental in keeping Hong Kong's economy open to the world and thus becoming the financial center of Asia.