By Max Bronstein and Avi Felman
While Bitcoin is rapidly assimilating into the global monetary picture, the dollar is unequivocally the world’s reserve currency given its dominance in world trade and the scale of the global demand that exists for dollar denominated debt. Furthermore, there is a massive supply demand imbalance in the dollar market today, particularly exacerbated by foreign entities who need dollar liquidity to service their debts and to trade with other countries. Crypto dollars, namely stablecoins and synthetic dollars created through derivative contracts, are uniquely positioned to help service the world’s dollar demand and will likely see immense growth in market capitalization as the world looks for easier and more programmable ways of storing, transacting, and financing in dollars. For a technology lauded by enthusiasts as a way to escape the dollar, cryptocurrency might actually do more in the near term to strengthen the dollar rather than to weaken it. In this paper, we explain why.
The Dollar’s Ascent
One of the more interesting (and before the recent collapse, non-consensus) macroeconomic theories pertaining to today’s monetary system is the “Dollar Milkshake Theory.” Popularized by Brent Johnson of Santiago Capital, the theory states that since the dollar is far and away the strongest and most demanded world currency, the flood of liquidity that was created by central banks starting in 2008 will inevitably be sucked up by the U.S. dollar and the U.S. economy. The core of the argument is that a global marketplace renders the source of liquidity irrelevant. In the end liquidity will always make its way to its most productive use, to the place where that liquidity generates the highest return. In this way, the dollar and the US economy are acting like a large milkshake straw through which the world’s liquidity is currently being sucked up and re-allocated.
To accept this theory first one must believe that the dollar is indeed the world’s most dominant currency. To convince yourself of dollar superiority, let’s examine the most important demand inputs.
First, while the fed funds rate in the US is at record lows, the central banks of most other developed economies have pegged rates much lower, with countries like Japan and Switzerland currently flashing negative yielding interest rates. Higher relative yields translate into more demand for US debt, which in turn increases future demand for the dollar as those debts need to be serviced. This trend was particularly exacerbated over the last decade because of how crowded most yield earning strategies became. To contextualize just how desperate investors are today, as of March 2020, there was $11.6 trillion in negative yielding debt globally.
Second, the US has a much stronger economy than almost all global peers. The US has been home to most of the wealth generated from the recent secular growth period fueled by software and computing innovation, a fact you can confirm by looking at the deviation between the S&P500 and all other global indices over the last 30 years.
Strong returns create demand for the dollar as these assets are primarily traded against the dollar. It’s hard to invest in the newest AI startups posting 250x revenue multiples with Renminbi or the Canadian Dollar. Similarly, dollars are the only currency that can be transacted for US treasuries, which are at times one of the most in-demand risk-off assets in the world.
Third, much of the world trade is denominated in dollars. Companies in countries abroad will often invoice in dollars, even when dealing with non-US entities because they find it valuable to transact with the stability of USD. According to Gita Gopinath, the dollar accounts for 4.7 times its share in world imports and 3.1 times its share in world exports, as depicted in the figure below:
Lastly, and most importantly, the world’s debt is by and large denominated in US dollars. With nearly $60 trillion in dollar denominated debt globally, there is immense demand to service dollar debt. When it comes to borrowers outside the United States, the dollar debt burden of foreign entities reached $12.07 trillion in Q3 2019 according to the Bank of International Settlements. While rates were just recently moved to near 0%, an annual interest rate of 1.5% (the rate we had just weeks ago!) generates over $1 trillion in annual US dollar buying demand since by borrowing USD, the borrower is effectively short dollars, meaning they will have to buy back the principal and pay down interest with USD.
Since the dollar is so disproportionately used as the world’s primary form of debt, any deflationary pressure in the system can quickly cascade. This is exactly what we’re seeing now. Dollar debt is now four times larger than Euro debt and twenty four times larger than Yen debt which gives foreign currencies little breathing room when they begin to depreciate relative to the dollar.
Alongside ubiquitous use of the dollar to purchase oil within the petrodollar system, the need to hold USD to service debt is one of the largest drivers of dollar demand. According to the IMF, global central banks hold around $6.75 trillion in dollar claims, over half of all of their currency reserves. Assuming the trajectory US dollar debt grows, central banks will need to buy even more USD to pad their reserves.
Over time, all of this culminates in a global short squeeze on the dollar. If this theory is to play out as described, it would be one of the most destabilizing forces in monetary history. The dollar’s strength would cripple capital markets and cause foreign currencies to collapse, which in turn would lead to debt defaults and subsequent money printing. The only way for politicians to dig themselves out of a mess that calamitous would be to restructure global order, similar to the introduction of the Bretton Woods system and the Plaza Accords. In the former, the world’s most powerful governments attempted to stabilize the international monetary system by pegging foreign currencies to the dollar, and the dollar to gold. In the latter, G5 countries came together to devalue the dollar in an effort to stabilize foreign trade and make US exports more enticing. If history is any indication, a global monetary restructuring will likely come with both currency and institutional debasement.
Now, we don’t have a crystal ball for the future of global order, so the rest of this discussion will focus on the world’s immediate demand for US dollars, how that demand is serviced, and how those services might change over time. This demand spans the entire spectrum of economic actors, from workers in developing countries to the world’s largest central banks — everyone wants (needs) dollars! And getting access to the dollar isn’t always easy, it usually involves obstacles imposed by either the US government or foreign governments enforcing capital controls. With greater debt deflation abroad and geopolitical tensions, there’s a sizable amount of pent up demand for more seamless dollar distribution sources.
Enter crypto dollars.
As we’ll discuss, it’s very likely that growth for cryptocurrencies in the short term is fueled by global economic actors using them as rails to access the dollar, rather than demand for the dominant underlying assets, bitcoin and ether.
Eurodollars and the Shadow Banking System
To understand the importance of cryptocurrencies as a conduit to access and move around dollars, it’s important to first lay out how dollars move throughout the world today. More specifically, how dollars move around outside of the US financial system. There are many pieces of infrastructure that encompass offshore USD banking, but this piece will focus on two elements: the shadow banking system and eurodollars.
The shadow banking system involves what its name implies — the facilitation of banking services (primarily the creation of credit) outside the realm of a regulated financial system. Despite the ominous name, shadow banking isn’t all that sinister. The “shadow” refers more to the general lack of insight and transparency than to allusions of illegality.
Like traditional banks, entities in the shadow banking system issue credit to counterparties who want liquidity, with the main difference being that they lend against securities rather than commercial deposits. Using securities as collateral dramatically expands the total available collateral as the market sizes of corporate debt and federal government debt far exceed the total size of commercial bank deposits. In fact, the ratio of corporate debt and federal debt relative to total commercial bank deposits is 2.26 to 1.
Since shadow banks aren’t lending against commercial deposits, they’re not beholden to the Fed’s liquidity and capital requirements, giving them the leeway to use more leverage than a traditional bank. Coupled with the fact that the collateral base against which they can lend is also larger, the shadow banking system has become a massive source of dollar funding in the world.
The growth of the shadow banking sector took off in the early 2000’s and reached a climax in 2007, with an estimated $60 trillion in assets. Since then, it’s been estimated that the system has shrunk in size, but the innate lack of visibility into the market makes it hard to size with precision. At the high end of the range, the Financial Stability Board has estimated a market size of nearly $100 trillion in 2016.
Given the size and liquidity of the shadow banking system, it serves as a good barometer for how much demand there is for the US dollar. The primary use of the shadow banking system is to access dollar liquidity, and the sustained growth of the system shows that dollar demand is steadily increasing. According to the Financial Stability Board, the shadow banking system (OFIs) was the fastest growing in terms of financial assets held.
Recent rumblings in the repo markets show both how strong the imbalance is between supply and demand for the dollar as well as the importance of the shadow banking system within the global economy. For context, repo markets are a massive source of dollar funding where financial institutions can collateralize securities, more specifically high-quality liquid assets (HQLAs), to get short term loans. The repo market is crucial to capital markets because it provides a cheaper and more efficient way for financial institutions to get access to dollar liquidity relative to borrowing from commercial banks. In theory, greater liquidity acts as a lubricant, enabling market participants to more efficiently engage in price discovery, settle transactions quicker, and collateralize derivative exposure.
In the fall of 2019, the Federal Reserve had to directly intervene in the repo market as the collateral repo rate shot up to ~8% apr. Typically, banks act as lenders in repo transactions, but due to a multitude of factors, banks had no cash to supply. For one, banks had deployed a lot of their idle cash to purchase government bonds over the previous two years. The Fed unwinding their balance in 2017, the Trump tax cuts in 2018, and an escalating trade war in 2019 flooded the market with treasuries that banks were forced to purchase. Coupled with the strict reserve requirements enacted post GFC, banks were so depleted that they couldn’t take advantage of an interest rate over 5x what they’re earning in the market. Since then, the Fed has continued to try and ease the world’s dollar crunch by offering up liquidity to repo markets on the order of $500 billion a day.
On to concept number two: Eurodollars.
Eurodollars are dollar-like liabilities that are issued by entities outside of the United States, which includes, you guessed it, shadow banks. Eurodollars can also mean dollars held by US regulated entities located in foreign countries. For example, when Banco Stantander, Credit Suisse, or Bank of Cairo issue dollar loans or store dollar deposits, they are considered to be dealing in eurodollars. Eurodollars play the critical role of allowing non US entities to bank in the dollar without having to deal directly with the Fed or commercial banks.
Given the size of Eurodollar deposits, it’s quite easy to see how much foreign entities actually want the dollar. According to BIS, there were $4.5 trillion in off-shore dollar deposits by the start of Q4 2016, nearly 33% of all M2 Money Stock at the time. The Eurodollar market is actually so big that the Fed recently began closely monitoring offshore interest rates, with the understanding that foreign funding has a material effect on the fed funds rate. This similarity in funding costs has only increased demand for Eurodollars as foreign entities can lend at the same rate as the Fed does, they don’t have to be regulated by the US government. The system has gotten so large and liquid that derivatives on Eurodollar lending rates have become the de facto way for global investors to speculate on and hedge changes in the fed funds rate. The rampant demand for dollar exposure has catapulted Eurodollar derivatives to be the largest products traded on the CME by volume and total open interest.
Dollarization and Weaponization
The strength of the dollar is a delicate dance for the United States. A strong dollar can cause consternation for internal U.S industries that export services and goods to other countries. Some countries (such as China) intentionally depreciate their currencies in order to increase the attractiveness of exports and jumpstart industries. In fact, China is a large holder of U.S debt, and a huge source of dollar demand for the sole reason that they wish to keep their currency low against the dollar to increase exports. From this angle, it may seem that the U.S would not want a strong dollar to compete in the global marketplace. Viewed through a different lense, a strong dollar allows the US to issue debt more cheaply than other countries since it is the only currency accepted in exchange for treasury bills, one of the world’s most in demand assets.
The other side of the issue is political in nature. A strong dollar gives the US a great deal of leverage. Without access to dollar financing, people and governments lose the ability to freely trade with the rest of the world and are forced to incur high transaction costs trying to convert assets between weaker currencies.
Throughout history, the US government has harnessed this economic power to punish foreign enemies, sanctions and tariffs being the most common tools. But more recently, Trump has escalated economic warfare to never before seen levels, with sanctions being imposed on Russia, Iran, North Korea, and Venezuela, alongside thousands of other economic actors. The US has also begun imposing sanctions through the SWIFT payment system, a linchpin in global trade today.
The exorbitant privileges endowed by the dollar has pushed many global powers to attempt “dedollarization.” It’s not that the United States could use the dollar as a weapon, it’s that they actively use the dollar as a weapon, and as geopolitical tensions rise and the dollar strengthens, the leverage the United States wields grows even more.
Foreign governments on the other hand have separate reasons to pay attention closely to the dollar. Citizens of countries with failing currencies do all they can to exchange their local currency into the dollar, a phenomenon referred to as “dollarization.” This can sometimes come from the government in a top-down fashion, as has happened in Panama and El Salvador, where the dollar becomes legal tender, or through more grass root movements like in Cambodia and Costa Rica, where citizens elect to exchange dollars for a majority of goods and services. The latter is more contentious because citizens fleeing their local currency destabilizes the government's ability to control economic activity and dampens the currencies network effect. Similarly, dollarization completely destabilizes the monetary discretion of the local state that is being dollarized. Governments have every motivation to stop this from happening and they do so through a variety of capital controls.
While foreign governments have tried to create alternative payment systems or find substitutes like swapping their dollar reserves for gold, the relative value of the dollar continues to grow stronger. Similarly, if we fast forward to a future in which central bank digital currencies are the norm globally, it’s easy to imagine that technology will only act as a stronger distributor of dollars to those who demand it.
There’s a massive supply demand imbalance in the dollar market today, driven in large part by foreign entities without access to the US financial system. The world increasingly needs dollars to trade and to service massive debt payments, but governments have strong incentives to stymie dollar flows. There’s currently a strong worldwide demand for dollars – but it’s difficult for individuals to source these dollars. So where do they go?
Now, they can turn to networks like Bitcoin and Ethereum which enable novel ways to acquire dollar exposure that are natively digital, globally accessible, and relatively more seizure resistant. Furthermore, financial services and networks built on top of these crypto dollars give them global distribution and make holding them competitive traditional fiat methods. In a world searching for more free access to capital, crypto dollars are a unique solution that help service a lot of this pent up demand. As such, stablecoins and crypto-backed synthetic dollars should see massive near term growth as the world scrambles for dollar exposure.
Broadly speaking, we can group the different types of crypto dollars into three buckets, two of which are fungible stablecoins:
- Centralized dollar backed currencies
- Decentralized collateral backed currencies
- Derivative Backed Synthetic Dollars
The most direct way that crypto networks enable dollar exposure is through stablecoins, crypto powered currencies designed to peg their value to the dollar. The stability of the peg and censorship resistance are for the most part inversely correlated. Stablecoins backed 1:1 with dollar collateral held in banks are much more stable, but of course, holders are trusting that the government won’t unilaterally seize or tamper with those funds. Tether (USDT) is an interesting case study because even though news broke that it was likely backed by 77 cents on the dollar, it’s market capitalization continued to grow, albeit it’s exchange reacted with volatility. This is a result of the fact that the dollars backing USDT are held in offshore bank accounts and the issuing company operates through a very loose corporate structure. At this point, traders have signaled that they believe the operators of Tether are less likely to comply with federal intervention. On the other side of the court are stablecoins like USDC which operate in a much more federally compliant way. These stablecoins have de minimis volatility which makes them more suitable for use cases like lending and payroll.
The other flavor of stablecoins are backed by crypto collateral, usually in excess of 1:1, and rely on external stakeholders to keep their price stable relative to some pricefeed. This version is less stable because it’s susceptible to large credit shocks, but on the flip side, it could be harder for a centralized party to co-opt or shut down.
Tether, which was the first rendition of a stablecoin, was created in 2014 so exchanges could decrease their reliance on traditional banking infrastructure. Back then, moving fiat in and out of the crypto ecosystem was extremely burdensome as few, if any, banks wanted to take the risk of serving a regulatory grey sector. Tether didn’t take off until the 2017 boom when traders and firms began holding USDT on their balance sheets to take advantage of mispricings between exchanges. Over the course of that year, the total market cap of Tether grew from $10 million to $1.4 billion, a 140x multiple.
After it was clear that stablecoins had reached product market fit, new competitors emerged. Dai was next in line and actually took the BitUSD model to market. To issue Dai, users put up collateral at least 1.5x the value of the stablecoin they wanted to issue. The collateral is escrowed in a smart contract that should be theoretically impossible to corrupt, meaning Dai was more seizure resistant than a Tether-like stablecoin. However, the downside is that the overcollateralization burden made it intrinsically difficult, if not impossible, to scale.
Later in 2018, a flurry of USD backed stablecoins including USDC, PAX, GUSD, and TUSD came to market and competed with Tether in terms of solvency, trust, and with Dai in terms of scalability. At present day, the total market capitalization of all stablecoins stands at roughly $8.2 billion USD, roughly .45% of the US dollar monetary base (currency in circulation) and 6.5% of Bitcoin’s market capitalization.
These stablecoins were able to gain such traction for a number of reasons:
- Their digital nature makes it easy to issue and send them around the world at low cost
- Existing exchange infrastructure already had a network effect of users
- A new class of financial services was created so that stablecoins could borrowed, lent, and used as derivatives collateral
Setting up a crypto wallet to send and receive stablecoins is far easier than setting up a bank account, especially for entities outside the US. Similarly, a new breed of blockchain-based financial services has created incentives to convert traditional dollars to crypto dollars for more than just trading — the main incentive unequivocally being dollar yield. Crypto dollars can be lent to money market protocols like Compound, lent to margin exchanges like dy/dx, and then used in peer to peer to payment applications like Dharma (all while still earning a yield). Stablecoin yields have historically been multiples higher than the fed funds rate, with USDC yields hovering between 4% - 10% apr for most of 2019.
It’s also worth noting that crypto dollars themselves are beholden to network effects. As the ecosystem progresses, it’s likely that only a handful will grow their monetary bases. Outside of Tether, USDC has become the most dominant stablecoin.
Derivative Backed Synthetic Dollars
For most people, Bitcoin is synonymous with a few ideals. Many think of it as non-sovereign hard money, a fixed issuance currency that has value because it can’t be debased. Others see and use it as a speculative tool, a 24/7 global trading market with enthralling volatility. A side of Bitcoin that many don’t see is its ability to be used as collateral backing synthetic dollars, financial instruments outside the purview of the traditional system that hold the purchasing power of the dollar. Phrased another way, “Eurodollars.”
One of the easiest ways to transform Bitcoin into dollar exposure is through futures, particularly the perpetual swap contracts offered by a number of cryptocurrency derivative exchanges, which give speculators the ability to trade BTC/USD margined in BTC. This perpetual swap contract is structured like non-linear inverse future contracts, meaning the contract value is measured in one currency, USD, but the position is margined and settled in a different currency, BTC.
As the name suggests, these derivatives have non-linear payout structures given the value of the collateral is always changing while the position value remains constant. With a linear contract, for every % change in price, the same % is reflected in the PnL, but with inverse BTC contracts, convexity is relative whether it’s a long or short position.
Long positions make less BTC when the price goes up, and lose more BTC positions when the price goes down. Borrowing from BitMex’s explainer, the following chart shows this relationship.
On the other hand, short positions make more BTC when the price goes down, and less BTC when the price goes up. It’s the dollar value that remains constant. This is how synthetic USD positions are created.
Let’s walk through a brief example. We assume 1 BTC is equal to $10,000 USD. An investor in possession of 1 BTC decides that they don’t want to take on market risk any longer, they want to lock in the value of that Bitcoin without selling it for fiat on the spot market. The investor shorts 10,000 contracts through the perpetual swap, putting up his 1 BTC as collateral. Fast forward 1 month and the price of 1 BTC is equal to $9,000 USD. The value of the investor’s short position is still $10,000 USD because he has gained .111 BTC. Now, let’s say the price of BTC has actually moved against him and is now at $11,000 USD. Luckily for the investor, his position is still worth $10,000 USD, he just now owns .909 BTC.
Not only can users create synthetic dollar exposure without incurring the tax penalty of selling Bitcoin for fiat, these synthetic dollar positions often earn a high yield because the Bitcoin market is usually in a state of contango. As soon as the synthetic dollar position is created, the user locks in a rate of return equal to the annualized futures premium. From the start of 2019 to today, holders of synthetic dollars have earned a 6.3% rate of return. Yields are going to be a strong “pull mechanism” for crypto dollars, more on this below.
Derivatives are still a hot button issue in the space because of their unregulated nature. On the one hand, regulatory arbitrage helps them reach larger scale, and on the other hand, it can act as a magnet for illicit activities. Still, Bitcoin derivatives provide each side of the transaction with a crucial financial service, the long side gets increased exposure to the underlying, and the short side gets a high yielding synthetic dollar that can be accessed anywhere.
Using cryptocurrencies to get exposure to the dollar has been the untold story of the space since 2018. Fast forward to today, billions in crypto dollar loans have been originated, and billions of crypto dollars are earning an interest that far exceeds the yields available at the world’s premier financial institutions. Better yet, crypto dollars are far easier to onboard and transact in compared to traditional financial infrastructure. With such rampant global demand for the dollar, it’s very likely that cryptocurrencies actually further entrench its strength, ushering in a world of “HyperCryptoDollarization.”
What does this future look like which use cases will be cryptodollarized the most?
Crypto dollars will grow the most from use cases that actively “pull” people into the ecosystem, away from the traditional world. This generally means use cases that are fraught with high costs, both transactional fees and opportunity cost of holding a different currency, or use cases with a lot of counterparty risk exposure to the government.
In more developed economies, yields are positioned to be the strongest driver of demand. While stablecoin lending markets are not completely immune to global monetary policy, continued price appreciation should result in higher stablecoin yields as it’s still relatively difficult to move fiat dollars into the crypto world. Price increases typically result in a forward sloping futures curve, which is one of the largest demand drivers for stablecoin loans as it creates the most liquid arbitrage opportunities. Even with crypto markets selling off more recently, stablecoin yields are multiples above short term US treasury bills. Yields become an even stronger accelerant if crypto markets can actually perform well in the midst of a global deleveraging, and stablecoin yields return to ~5% apr.
Another use case ripe for disruption is remittances, primarily in countries with strict capital controls. Using Tether as a proxy for the dollar is already becoming commonplace in China, where purchasing more than $50,000 of a foreign currency is illegal. Many OTC deals who initially began servicing crypto to crypto transactions are largely moving their business to support both crypto to Tether transactions as well as fiat to Tether transactions. The remittance market as a whole processed roughly $689 billion USD in 2019, but even more important, it overtook foreign direct investment as the largest source foreign capital inflow. On average, roughly 5% of transaction value is captured in fees and fx exchange margin, meaning $30 billion USD is captured by intermediaries. With enough infrastructure, crypto dollars are more than capable of eating into the margins enjoyed by today’s remittance providers.
When dollar debts come to roost and global currencies begin devaluing against the dollar, it’s very likely that governments will do everything they can in an attempt to keep capital from fleeing their countries. Take for example Lebanon, where banks began restricting withdrawals and citizens were forced to sell banker’s checks at 30% discounts. To skirt around withdrawal controls, citizens began converting whatever cash they can into Bitcoin and Tether. Similarly, the Central Bank of Argentina began imposing strict restrictions on how much USD citizens could purchase just last year after the Argentine stock market and the peso fell precipitously. Since some crypto dollars are much more seizure resistant than traditional fiat notes, it’s likely that they’re used by citizens to flee their weaking home currency.
Counter to prevailing mainstream narratives, the new alternative financial system being created on top of crypto rails is increasingly assimilating into, if not starting to eat, parts of the traditional world. The unique aspect is that the assimilation doesn’t resemble what everyone previously imagined. Dreams of the world ditching their fiat en masse in exchange for cryptocurrencies have been met with the same stark reality facing the entire global monetary system: everybody wants dollars. Rather than squander the opportunity for ideological reasons, the crypto industry should rally around this dollar scramble to onboard new users. Unironically, it is demand that spurs growth and that’s one area the crypto space has been lacking.
What does a strong dollar and increased crypto dollar usage mean for Bitcoin?
From a macro perspective, there’s the argument that deflation induced by a strong dollar will be damaging to Bitcoin because the world perceives it as a risk-on asset. That may be true, but it’s important to conceptualize that a strong dollar likely leads to widespread currency debasement, and while the dollar is one refuge, there will likely be increased demand in general for fiat hedges. Even more, servicing this demand will only further prove that financial alternatives exist for everyone as Bitcoin has all of the features necessary to be the most democratized store of value asset.
There’s also a strong argument for inflation in the United States. A strong dollar undermines the federal reserve’s ability to keep the global monetary system stable, which in turn pushes interest rates lower to combat deflation. As MMT takes hold and the US government prepares to play a more dominant role in labor markets, labor costs could rise at the same time assets are buoyed by extra liquidity and foreign asset flows. Additionally, passive investing has seemingly distorted the structures that help keep markets and reality closely tied, making asset inflows the primary determinant of demand. If the government can issue debt to make sure 401k deposits continue unabated, there's real potential for higher asset prices. In the case we do see inflation, expect crypto dollars to be used as a seamless bridge to non debase-able assets like Bitcoin.
A big thank you to Brent Johnson, Nic Carter, Mike Cohen, Derek Hsue, and Hasu for taking time to discuss the concepts presented in the piece as well as their feedback.