Digital Currencies and their role in transforming corporate financing
They are inevitable: digital currencies are here to stay.
Digitalization of the world economy is a fact. This has imposed challenges and novel solutions for the financial sector, which is increasing its offerings to meet the growing interest of consumers, both individual and corporate.
Data from American Market Intelligence suggests that at least 18% of people in Latin America have an interest in crypto assets, which increases the need to amplify the scale, security and value offerings to strengthen their acceptance.
In that sense, it is useful to understand some of their basic components and begin to explore their role in the current economic context, as well as their potential to transform corporate finance.
Tokens: what are they and how do they work?
Tokens are the digital currencies entered into the ledger of each blockchain. In other words: tokens are all those crypto assets that represent a good, fungible, or non-fungible, on the same blockchain.
However, it is the technology that validates them that makes it possible to carry out transactions, investments, or even purchases in the real world with tokens. Thus, linking an asset to a blockchain, and transforming it into code through encryption, is what is known as tokenization.
This is where the value of tokens comes from: it is the security provided by the decentralized model of the blockchain that they can be considered assets with exchange value.
With this terminology in mind, let's analyze the different types of tokens that exist, as well as their main functions.
Under the premise that any taxonomy will be insufficient in the future, here is a description of the four main categories into which tokens are classified.
Simply put, these are digitized versions of assets and securities. When an asset –such as debt securities, bonds, options, or commodities, among others– or an asset is "tokenized", it means that it becomes compatible with a blockchain on which it can begin to be traded.
They represent rights to financial and non-financial assets, which are exchanged between parties on the same blockchain to ensure the security of transactions with no need for intermediaries.
In other words, it is the incursion of tokens and cryptocurrencies into the "real world". From real estate, through gold and company shares, to soybeans and oil.
In this way cryptocurrencies are intended to be given stability.
Also known as app tokens, these are tokens that provide the holder with a product, service, or even both. They usually serve as a way of accessing a limited-access network or platform.
Utility tokens are usually not subject to any type of regulation, with the aim of helping the creation of an internal economy to a project structured on a blockchain.
Now that we know the three main categories that group tokens, it is worth addressing their functions.
The benefits of tokenization in the financial sector
Tokenization attempts in a host of sectors are definitely transforming the way companies raise finance. Especially because they provide a means to strengthen transparency, accessibility, and liquidity readiness.
A study by Brown Brothers Harriman found that there are at least five benefits to issuing digital assets as an investment vehicle.
- Fractional ownership: Traditional assets, such as real estate and artwork, trade at restrictive price points for most. Tokenization makes way for fractionalization of their value, creating a much more accessible avenue in which the price threshold is lowered.
- Increased liquidity: Due to fractional ownership, tokens have the ability to increase the liquidity of their issuers, as they broaden the investor base of "small ticket" investors.
- Strengthen trust: The decentralized model favored in the blockchain structure reduces dependence on a central regulatory authority, thus mitigating the risk of security breaches.
- Programmability: Perhaps your company's main objective for tokenizing its assets is not to finance a project or initiative, but to automate and streamline governance processes. The tokens' interchangeability feature makes them ideal for, e.g., monitoring KYC or AML processes, thus strengthening compliance processes in your business.
- Accessibility: This is the main point that tokens seem to address. It breaks down the barriers imposed by transactions that require a physical intermediary (document, machine, or person).
In short, companies see in the tokenization of their assets the possibility of being able to repackage the different assets that compose them into smaller units, making it much easier to obtain liquidity to finance themselves or to optimize their processes.
Blockchain and payment networks
According to IBM, a blockchain is a public and immutable ledger in which transactions, asset traceability, and trust protocols are recorded.
Simply put, it is a database that stores information on multiple servers, in order to strengthen security against fraud or hacking attempts.
Each person involved in a blockchain has a copy of the ledger, which is updated simultaneously whenever a transaction occurs. In this way, all movements are recorded in the ledger, allowing each node in the blockchain network to have a snapshot of the system in real-time.
Not only does blockchain technology offer answers that previous network models have not been able to solve, but it also opens the door to new possibilities that have a direct impact on business strategies.
Overall, three native benefits of blockchain technology can be mentioned, which, when applied in the context of financial services, have the capacity to transform the different sectors that comprise it.
More specifically, as far as the digital payments sector is concerned, these three benefits of blockchain translate into the following advantages for its users..
1. Reduces middlemen in each transaction
Currently, one of the biggest problems in the digital payments industry is the number of intermediaries involved in a single transaction.
When the approval of numerous intermediaries is needed to process the transaction, the time it takes for each transaction increases. For instance, according to Western Union, a cross-border money transfer can take between 1 and 5 days to arrive.
A common transaction like the one we described would be different with blockchain due to the fact that this technology acts as a reference of truth for the same transaction.
That is, since both sender and receiver have access to the same ledger - as do all users of the blockchain - it can be validated and made transparent to ensure that the sender does indeed have the necessary funds to make the transfer in question.
In short, blockchain guarantees that data is accurate and authentic without the need for an intermediary, thanks to the open nature of its records.
2. Strengthens system security
Although traditional financial institutions have complex security protocols in place, there have been documented instances where they have failed.
This highlights that the centralized security model is susceptible to failure, jeopardizing the finances of millions of people and businesses.
In contrast, blockchain technology is built on a decentralized model, which allows banks and other financial institutions to protect their information and that of their customers in different ways.
As a parameter, due to the fact that it is a model in which it is not a single computer that has full control of the network, hacking a blockchain would require intervening in at least 51% of the servers or computers involved.
Likewise, the integrity of the ledger certifies the validity of each transaction, since each person has a copy of the ledger where each movement is recorded in real-time.
3. Reduces transaction costs
Above we drew attention to the high cost of an international transaction through traditional intermediaries.
With blockchain technology, the amount of intermediaries is reduced and therefore all available resources for transactions are optimized, both because commissions are no longer paid, and because transfers occur faster.
A notable example of a blockchain that enables fast and cheap transfers between parties would be Stellar, whose particular focus is on cross-border payments.
Transfers over the Stellar network occur in 4 seconds, costing less than $0.0001 USD for each transaction. Stellar's numerous benefits have enabled it to partner with several traditional players in the payments industry, such as Moneygram.
How is blockchain reshaping financial services?
Even though to this day, no piece of technology or innovation is not perfectible, in the specific case of the global payment system its problems have to do with the fact that users have no visibility on the actual volume their service provider is benefiting from.
According to a study published by Capital Monitor and Corpay, the average commission per international transaction for companies is 3.39%. Developing regions, such as Latin America, are disproportionately affected by this situation, where banks charge an average of 5% commission on each transaction made by companies.
As the global economy appears to be heading into a recession, these fees create costs that businesses cannot bear. Blockchain-based payment networks are looking to offer an alternative to their diverse applications.
Stablecoins: the opportunity to do better business
Stablecoins are tokens linked to a fiat currency, such as USD or EUR; or to some commodity, such as oil or gold. This yields an asset with greater stability than a conventional crypto asset or fiat currencies with high volatility rates, such as the Argentine peso.
In contrast to other crypto assets, such as Bitcoin or Ether, stablecoins are considerably less volatile, as they remain linked to stable assets. This, in addition to providing stability, renders them reliable and traceable thanks to blockchain technology.
To further understand this dynamic, it is relevant to analyze the various types of stablecoins available, as their functionality is often linked to the type of assets backing them.
Backed by fiat currencies
Fiat-backed stablecoins are those that hold a reserve of traditional currencies as collateral, securing their value. Usually, companies that use stablecoins issue regular and auditor-verified reports.
The purpose of this is to ensure that they do indeed have the foreign exchange reserves in their accounts that back up each unit of digital currency: there is one dollar of backing in the issuer's account for each asset issued.
One of the most important and reliable stablecoins is USD Coin (USDC), which is backed by the US dollar and is used by Visa, Mastercard, and other renowned financial institutions.
Currently, USDC has a stake of ~$55 billion USD. Its users can use the token in exchange for USD that they deposit in their account, through which they can perform exchanges and transfers at authorized merchants.
Simplicity: for users, it implies a lower degree of complexity in understanding the dynamics of exchanges that fiat stablecoins provide. As long as it works, its ratio is 1:1 with its respective currency.
Centralization: what for some is a disadvantage, for the users of these stablecoins is a sign of trust. Accountability, both for users and service providers, is controlled by the same entity. Likewise, their adaptability to the market environment increases through centralized decision-making.
Centralization: on the flip side of the last benefit, it is argued that a weak link can jeopardize the entire chain; similarly, it can be the source of corruption within the system (as has happened to Tether itself).
Lack of regulation: in contrast to bank deposits, which are normally guaranteed by the government, stablecoins are not regulated by any national administration. Hence, care should be taken in selecting a stablecoin that has a good reputation/compliance.
Capital flight: any centralized securities pooling system is subject to a loss of confidence causing investors to liquidate their assets. This could create difficulties for the management company, as its declared solvency would then have to be checked in fact.
Backed with crypto-assets
The stablecoins collateralized by other digital assets use reserves of these assets to keep their value stable. The most important example of this kind of stablecoin would be DAI, which has a stake of ~$6 billion USD.
These stablecoins use crypto assets such as Ether (ETH) as a reserve. However, stablecoins collateralized by other digital assets require an extra amount to back them; i.e., the reserve value has to exceed that of the coins in circulation.
This is one way to deal with a possible collapse in the value of the backing crypto asset. If, for instance, you had an ETH reserve worth $2 million USD, by having tokens equivalent to $1 million USD in circulation, you would be protecting the stablecoin from a drop of up to 50% in the value of its backing.
These stablecoins have the advantage of not having a direct link to the U.S. financial system, which can be attractive to people who choose not to follow U.S. monetary policies.
In addition, it offers users a level of decentralization such that there is no longer a need for a central issuing institution (which may be acting in its own interests, and not necessarily those of the rest of the network).
However, this particular type of stablecoin does not avoid the risk of volatility that other cryptocurrencies present: if the prices of crypto-assets in reserve fall, the backing can break.
Backed by algorythms
Perhaps the most divisive type of stablecoin. These are tokens whose backing is contingent: the way they are intended to be stabilized is by controlling the supply with an algorithm. They have no assets in reserve to maintain that fixed price.
Advocates argue that this practice is not entirely dissimilar to that carried out by central banks, which do not require reserve assets to stabilize their currency. The counter-argument is that central banks and federal reserves issue monetary policies that are issued under standard parameters, which ultimately makes them reliable in a crisis event.
Theoretically, two of its benefits are autonomy, as it incurs less centralization; the other is its scalability, as an algorithm-backed stablecoin can cover virtually any demand. In short, algorithmic stablecoins have proven to be very risky.
Unlike the other two types of stablecoins, with algorithmic stablecoins we have just had hard proof of one of their disadvantages: the evidence is what happened in May of this year with TerraUSD (UST), which lost 100% of its value because it lost the link to its backer.
Ideal Opportunity Areas for Stablecoins: 3 Practical Applications
Stablecoins are proving to have concrete benefits for use cases in the global economy. Here, we identify 3 areas of opportunity that may be attractive for any company to implement the use of stablecoins.
Transactions through stablecoins may cost fractions of a cent, regardless of the amount sent. In contrast, a traditional provider can charge up to 3% of the total for each transaction.
By reducing middlemen, blockchain technology ensures less risk for third parties. When the only parties involved in the transaction are the sender and the receiver, speed is increased and the cost is reduced.
Under these two arguments, stablecoins can serve as an alternative to systems such as SWIFT. A company can send a payment to its suppliers abroad in seconds and at a low cost, or receive payments from its customers that are automatically reflected in its account, no matter where they are made from.
B2C companies can also use stablecoins to their advantage since they reduce the volatility of assets and their commissions have a significantly lower impact on consumers' pockets.
Remittances are a paradigmatic example since according to World Bank data, the average commission percentage is 6% of the remittance. For instance, if a consumer transfers $200 USD from the US, the recipient in Mexico would receive approximately $188 USD.
Different companies could benefit from enabling a remittance infrastructure based on stablecoins, as they could alleviate the uncertainty of consumers who perceive a significant decrease between the amount they send and the one they receive when sending their money.
As mentioned above, since the beginning of the pandemic to date, some countries in Latin America have seen a double-digit decline in the purchasing power of their currencies.
Therefore, converting a local currency into stablecoins can be a security measure to protect income and savings from the risk of hyperinflation, which erodes the purchasing power of fiat money.
In contrast, in European Union countries, where inflation is not as severe, converting euros into stablecoins allows for avoiding account management fees charged by traditional banks.
Tribal and the digital currencies world
At Tribal, we recognize the benefits of this technology, so we are developing blockchain-based products with the goal of bringing cutting-edge financial solutions to emerging markets.
In December 2021, Tribal established partnerships with the Stellar network and Bitso to streamline its transfers with blockchain technology.
Recently, we joined the Blockchain Association as a member, with the aim of engaging in conversations for a fair regulation of the market
This way, we are moving towards building a comprehensive offering that will significantly improve the supply of financial services for companies.