INTERMEDIARIES - MAKING OR BREAKING THE (STABLECOIN) MARKET - PART 3
By Nadiem Sissouno, Head of Economics at Mento Labs.
The previous sections of this series dissected the complex landscape of stablecoin distribution, examining how intermediaries shape market efficiency and trust while acknowledging the significant challenges and risks they introduce. It was concluded in Part 2 that externally distributed stablecoins, despite their reliance on intermediaries, dominate the market. While robust ties with fiat systems and superior user experience are significant factors, the cornerstone is the economic trust that intermediaries foster through enhanced market efficiency.
Two Dominant Approaches in Crypto: Idealism vs. Pragmatism
In the evolving landscape of cryptocurrency, particularly within the realm of stablecoins, two distinct approaches have emerged in addressing market efficiency and the crucial services that underpin the financial systems we envision.
The first approach is grounded in idealism, advocating for a fully decentralized blockchain solution for every functional requirement. Proponents of this view strive to eliminate traditional intermediaries entirely, replacing them with decentralized exchanges (DEXs) and other blockchain-based mechanisms. However, this approach encounters significant practical limitations. A DEX, for instance, cannot fully substitute for a centralized exchange because it lacks the ability to act as a fiat price maker. This critical function, intrinsic to centralized exchanges, is indispensable in maintaining the link between digital assets and traditional fiat currencies.
Conversely, the second approach can be seen as pragmatic but perhaps myopic. It involves reintroducing traditional, centralized, and often opaque intermediaries whenever a challenge related to market efficiency arises. This method might offer a temporary fix by leveraging existing financial structures, yet it often does so at the expense of the transparency and trust that blockchain technology aims to foster. By lightheartedly handing over essential services to these intermediaries—or in some cases, removing intermediaries without adequate decentralized alternatives—what results is a potentially compromised market. This is evident in the struggles faced by Mento stablecoins, where the removal of intermediaries has led to a market that many perceive as broken.
Necessary Innovations in Stablecoin Infrastructure
What must be changed to improve our stablecoin systems? While numerous areas could benefit from enhancement, certain key developments are crucial, and these must be undertaken collaboratively by the stablecoin and infrastructure-building communities. Foremost among these is the creation of advanced supply chain tooling. If we aim to establish a direct distribution model, it's essential to provide tools that enable seamless fiat-to-stablecoin conversions directly within users' applications.
Stabletoken Supply Chains
Currently, the process to convert fiat into stablecoins is cumbersome and inefficient. For example, a user might deposit funds into Binance, execute a transfer to Balancer exchange, swap for a different token, and only then manage to bring it into their intended wallet. This convoluted process is far from ideal. To address this, we need to develop a user interface that is not only seamless but intuitive, alongside software development kits (SDKs) that facilitate direct and straightforward swaps from fiat to the desired stablecoin.
Stable Value Transfer Protocol (VTCP): Unifying the Diverse Payments Landscape
In the early days of the internet, multiple data networks operated on different standards, causing inefficiencies and limiting connectivity. The advent of TCP (Transmission Control Protocol) revolutionized this landscape by unifying disparate networks under a single, standardized protocol, enabling seamless data transfer across the globe. Today, the payments industry finds itself in a similar situation, where various systems such as Apple Pay, Google Pay, Circle's USDC, and Tether's USDT operate with different standards.
To transcend these limitations, stablecoins require a Value Transmission Control Protocol (VTCP) that unites these diverse payment systems, providing a universal protocol for transferring value. A VTCP for stablecoins aims to deliver stable, reliable, and transparent transfers of digital assets, akin to TCP’s function for data transmission. By standardizing value transfers across different chains and systems, the VTCP can absorb market risks and ensure seamless transactions, just as TCP harmonized data transmission across disparate networks.
The establishment of a VTCP is critical for the long-term success and adoption of stablecoins, as it will reduce friction and deviations from stability in the process, foster user trust, and empower stablecoins to fulfill their potential in transforming the digital economy.
Enhancing the VTCP with Insights from Existing Payment Networks
As the development of a Value Transmission Control Protocol (VTCP) for stablecoins is proposed, it is insightful to consider the current landscape of digital payments, particularly through systems like Apple Pay and Google Pay. These systems operate in a manner akin to using a stablecoin within a private, permissioned, and opaque network owned by the payment provider. Each transaction executed through these platforms effectively moves a digital representation of money—mirroring the essential function of a stablecoin, but within a closed and controlled ecosystem.
This analogy highlights a key aspect of current financial interactions—consumers are already accustomed to using digital value transfer systems that resemble stablecoins, albeit under the governance of corporate entities rather than decentralized networks. These systems enjoy widespread acceptance and use, but they lack the open, interoperable standards that a VTCP for stablecoins aims to establish.
Incorporating a VTCP could transform this landscape by replacing these isolated systems with a unified, open network that provides the same ease of use and reliability as existing payment apps but with greater transparency and without proprietary restrictions. This shift would not only democratize access to digital money but also enhance cross-platform interoperability, ensuring that value can be transferred as seamlessly as data packets across the internet in the early days of TCP.
By adopting a VTCP, the stablecoin industry can learn from and improve upon the existing models provided by private payment systems, aiming to create a universally accessible, stable, and reliable digital currency system that supports a broader range of financial activities with enhanced trust and security.
The Importance of Real-World Asset Tokenization in Fiat-Backed Stablecoins
Real-world asset tokenization plays a pivotal role in the ecosystem of fiat-backed stablecoins, primarily because it bridges the gap between traditional financial systems and the digital currency world. For stablecoins that claim to be backed by fiat currencies or other real-world assets, tokenization is not just a technical process; it's fundamental to their credibility and functional stability.
Ensuring Credibility and Trust: The core appeal of fiat-backed stablecoins lies in their promise to offer a stable digital counterpart to real-world currencies, underpinned by tangible and verifiable assets. Tokenization makes this promise tangible by providing a digital representation of real-world assets on the blockchain. This visibility is crucial for users who need assurance that the digital tokens they hold are indeed backed by actual assets held in reserve. If these tokens can be directly linked through blockchain technology to real-world assets that are verifiable, it significantly boosts user trust and confidence in the stablecoin.
Facilitating Auditability and Compliance: By tokenizing real-world assets, stablecoin issuers can offer a clear and auditable trail of the backing assets. This transparency is essential not only for user trust but also for regulatory compliance. Regulators and auditors can verify that the assets purported to back the stablecoins are present and accounted for, which is crucial in environments where regulatory scrutiny is increasing.
Enhancing Liquidity and Reducing Volatility: Tokenization can also enhance the liquidity of stablecoins by making it easier to trade these digital assets against their real-world counterparts. With clear, tokenized assets, the process of redeeming or exchanging stablecoins for their underlying assets becomes more straightforward, thus reducing potential volatility due to liquidity issues.
Adapting to Real-World Changes: In a dynamic financial environment, the value and state of real-world assets can frequently change. Tokenization allows for real-time adjustments in the digital representation of these assets, ensuring that the stablecoin's value remains closely aligned with its real-world backing. This responsiveness is critical for maintaining the stability of fiat-backed stablecoins, especially in fluctuating markets.
Enhancing Stablecoin Systems: Transparency, Synchronization, and Tokenization
Transparency through Improved Oracles: To elevate transparency in stablecoin ecosystems, there's a pressing need for oracles that do more than just report prices. They should provide a certainty score that reflects the reliability of data, particularly in the face of inconsistencies between different platforms such as Binance and Coinbase. More critically, these enhanced oracles should be capable of assessing and reporting the certainty of off-chain states, which often cannot be categorized simply as true or false. Financial and legal states, for example, are frequently evaluated by experts like courts or notaries, and even the most authoritative assessments are subject to a degree of uncertainty. Standardized oracles equipped to handle this complexity would help users navigate the ambiguities inherent in linking digital assets with real-world conditions.
Synchronization of Off-Chain and On-Chain Assets: Effective synchronization between off-chain and on-chain assets is vital for maintaining stablecoin integrity. It's essential that state changes of real-world assets, which back digital tokens, are accurately reflected on the blockchain. If a real-world asset used as collateral is altered or sold, the corresponding digital tokens should be adjusted—ideally burned—to reflect this change. Developing a framework where the state of real-world assets and their on-chain representations are closely linked will ensure that the digital tokens remain a true and stable reflection of their physical counterparts.
Oracles have traditionally been viewed primarily as mechanisms for importing off-chain data into blockchain environments. However, equally critical—yet more complex—is the task of ensuring that on-chain states effectively influence off-chain realities. This bidirectional interaction is essential, especially when it comes to assets that are represented both on-chain and off-chain.
One of the most significant challenges in this area is the enforcement of on-chain decisions in the off-chain world. For example, consider assets that are tokenized on a blockchain but also exist as tangible property, such as real estate or physical commodities. If such an asset is used as collateral for a stablecoin or any other on-chain financial instrument, it is crucial that the asset cannot be sold or otherwise compromised off-chain while it remains encumbered on-chain.
This situation parallels mechanisms like those found in traditional property registries, where a notary or legal system can prevent the sale of a property if there are outstanding claims or liens against it. Translating this concept to blockchain requires a robust system of oracles that not only communicate asset status updates from the off-chain world to on-chain systems but also enforce on-chain contractual stipulations in the off-chain legal environment.
To address this, oracles could be designed to interact with legal and regulatory frameworks, effectively acting as automated agents that can register claims or restrictions in off-chain registries based on on-chain data. This would involve creating legal agreements that recognize and enforce blockchain-based decisions, possibly by integrating blockchain technology with existing legal databases or creating new, blockchain-compatible legal structures.
This enhanced role for oracles would not only secure the integrity of collateralized assets but also expand the potential for blockchain to interface effectively with traditional legal and financial systems. By ensuring that on-chain conditions have binding off-chain consequences, oracles can help bridge the gap between digital and physical asset management, fostering trust and stability in blockchain transactions that involve real-world assets.
Tokenization of Real-World Assets: The tokenization process involves converting real-world assets into digital tokens, but it's crucial that these tokens accurately mirror the status and availability of the underlying assets. To achieve this, the system must be capable of dynamic adjustments based on verified changes in the real-world assets. Implementing bidirectional oracles that provide ongoing verification of asset status, and adjust the token supply accordingly, will be fundamental. Such mechanisms ensure transparency and trust by making sure that any change in the physical asset's status is promptly and accurately reflected in its digital counterpart.
Enhancing Market Efficiency through Community Engagement and Incentivization
In the cryptocurrency ecosystem, engaging community members to take on roles typically held by traditional financial institutions is crucial for decentralization and market efficiency. However, two main challenges hinder this engagement: the loose commitment to perform essential services and the lack of infrastructure that enables individuals to assume these responsibilities effectively.
Firstly, apart from consensus mechanisms, which are well-incentivized and integral to blockchain operations, other crucial services often rely on less formal incentivization structures, such as arbitrage opportunities. While these can be effective, they depend heavily on the presence of immediate financial benefits and do not necessarily promote long-term commitment to maintaining system integrity or market efficiency.
To address these challenges, the crypto community needs tools that empower users to become service providers in their own right. This involves providing accessible, user-friendly infrastructure that enables experienced community members to take on significant roles, from liquidity provision to price stabilization and arbitrage. For instance, while traditional finance companies are equipped and licensed to perform these roles, decentralizing these activities requires reducing technical hurdles and possibly rethinking how licensing is handled within the crypto space.
Moreover, there's a need to embed these roles within the blockchain's incentive structures. By creating schemes that not only reward but require participation in these crucial services, the ecosystem can ensure that these functions are consistently performed, not just when they are the most lucrative. For example, integrating service roles into the blockchain protocol, where actors are rewarded through tokens or other benefits tied to their performance and reliability, can help solidify commitment and ensure that these roles are not neglected.
In sum, by enhancing the tools available to community members and rethinking incentivization beyond loose commitments, the crypto ecosystem can foster a more robust and efficient market. This requires not only technical solutions but also a cultural shift towards recognizing and institutionalizing these roles as essential components of the blockchain infrastructure.
Summary: Establishing Industry-Wide Standards for the Future of Stablecoins
To encapsulate, it is clear that the path forward for stablecoins involves much more than just technological innovations and legal frameworks. What is crucially needed are comprehensive standards—standards that the industry must develop collaboratively. These standards should encompass all critical aspects of the stablecoin ecosystem:
Stable Value: Ensuring that stablecoins maintain a reliable and predictable value relative to their underlying assets.
Collateral: Defining and maintaining robust protocols for the management and verification of assets that back stablecoins.
Oracles: Developing reliable and standardized methods for oracles to provide accurate, timely, and transparent data both from off-chain sources to on-chain and vice versa.
Tokenization: Creating clear guidelines for the tokenization process that ensure it accurately reflects the real-world assets it represents, with enforceable legal standing.
Intermediaries: Standardizing the role and responsibilities of intermediaries to balance the benefits of decentralization with the necessity of trusted entities in certain roles.
By addressing these areas, the industry can not only improve the functionality and reliability of stablecoins but also enhance their acceptance and integration into broader financial systems. Such standards are not merely beneficial; they are a necessity for the stablecoin sector to mature and for blockchain technology to achieve its full potential in reshaping financial landscapes.
Final Discussion: Defining the Role and Evolution of Decentralized Intermediaries
As we explore the future of stablecoins and blockchain technology, the concept of decentralized intermediaries stands out as a pivotal innovation. These entities are crafted to effectively bridge the on-chain and off-chain worlds, fostering a robust ecosystem where digital and real-world systems interact seamlessly and transparently.
Phase One: Establishing the Foundation
In the initial phase, a decentralized intermediary acts as a hybrid entity designed to log and verify off-chain events on the blockchain, enhancing on-chain compatibility. This setup allows for effective community or protocol governance of its operations. The intermediary's actions are governed through a system of rewards and penalties, along with the possibility of exclusion from the network, ensuring that service providers are committed and adhere to established standards.
Phase Two: Creating Bidirectional Links
As the system matures, the role of the decentralized intermediary evolves to establish 'inextricable hooks' that facilitate bidirectional enforcement of state changes. This advanced stage aims to create a legal and operational framework where changes in on-chain states can enforce changes off-chain and vice versa. This mechanism ensures that actions taken within the blockchain have tangible effects in the real world, and that real-world events are accurately reflected and actionable on-chain.
Potential Enhancement by Intent-Based Architecture
While the foundational definitions of decentralized intermediaries remain firm, the potential enhancements offered by emerging technologies such as intent-based architecture could significantly elevate their functionality. Intent-based architecture, created to utilized to automate and optimize on-chain operations, could enable decentralized intermediaries to dynamically adjust their operations to meet predefined objectives. There are compelling parallels between the intent-based architectures applied to purely on-chain services and the integration of intermediaries into decentralized structures. By leveraging intent-based architecture, decentralized intermediaries could more effectively align their actions with the evolving needs and intents of the blockchain network and its stakeholders, enhancing their responsiveness and adaptability.
Legal and Trust Frameworks
Implementing phase two requires robust legal frameworks that recognize and integrate blockchain operations into the broader legal and financial systems. This may involve setting up trusts where real-world assets are managed by trustees who ensure that these assets are not inappropriately used as collateral on the blockchain without proper authorization. These frameworks ensure that the digital representation of assets is not only accurate but also legally binding and enforceable.
Conclusion
Decentralized intermediaries represent a significant step forward in the integration of blockchain technology with traditional financial systems. By establishing standards and frameworks that enhance transparency, accountability, and enforceability, and potentially incorporating intent-based architecture, these intermediaries promise to transform how we interact with and trust blockchain technology, providing a reliable foundation for the future growth and adoption of blockchain applications.
