Exploring Fractional Collateral Backing for Stablecoins

What defines collateral and value? Recent insights from Caitlin Long, a Wall Street veteran and the Founder and CEO of Avanti Financial Group, took a look at the investment reserve disclosure from Tether Operations Limited, the company behind the USD-pegged stablecoin, USDT. It showed that of the assets used to back and stabilize USDT, only 3.87% are held in cash, with the remainder held in commercial paper, fiduciary deposits, reverse repo notes, and treasury bills.

The key takeaway? Despite the reserves’ composition coming as something of a surprise, the USDT to USD market has held consistently following the disclosure, even while the wider crypto market witnessed a volatile contraction. In fact, it spent more time situated marginally above peg rather than below it, a curious fact to many financial experts.

It is now apparent that despite a lower level of cash reserves or alternative collateral composition, USD-pegs can be maintained. However, since the majority of the remaining reserves are made up of credit assets, they add further credit risk to Tether, which may compel crypto hedge funds, for example, to reduce their USDT exposure accordingly, granted that centralized control of operations and reserves expose users to additional monetary risk.

While risk is certainly lower with full cash backing, it is not dissimilar to how the US fractional reserve banking system operates. However, there are several other means of tackling a digital asset’s reserve value, aiding its long-term peg.

Onomy Protocol is one such solution, but with far greater ambitions. The founders quickly realized that the $6.6T per day Forex market needs to plug into DeFi whilst leveraging an appropriate infrastructure that ensures not only the appropriate backing of minted stablecoins, but also the necessary transactional capabilities. Thus, Onomy Protocol is based on the economic assumptions that the market correctly prices the value of an asset with sufficient liquidity and asset backing, creating a self-fulfilling valuation while also recognizing the greater credibility of decentralized stablecoin models.

The Reserve-Based Migration of the Financial Industry to the Blockchain

The fractional reserve banking system began in the 19th century, advocating for the collateralization of bank deposits and opening up the ability to finance loans while managing cash flows and the risk of default. This system deployed money that otherwise would have been hoarded back into the economy, allowing it to grow quicker and leading to more complex forms of derivatives and financial products over time, now paralleled by the rapid evolution of decentralized finance.

As a result, traditional finance is witnessing a period of accelerating disruption following the emergence of digital assets and blockchain technology. For the first time in history, retail users and institutions may transact freely and efficiently at a fraction of the costs incurred by traditional finance. However, unsatisfactory asset backing models, lack of interoperability, and complicated user interfaces are stopping DeFi from reaching its full potential.

Speaking of asset backing models, historical context is needed.

Before the advent of modern banking, collateral and money were the same. By separating money from collateral, banks realized that paper money did not necessarily derive its value from the collateral it represented, but the value of goods and services it could purchase in the economy. It is only due to human perception of value that assets like gold were considered collateral in the first place, and the recognition of wealth in such assets is effectively an illusion created by a shared collective belief.

Even though collateral was initially believed to be necessary for paper money to have value, the opposite was discovered after they were separated. Rather than being tied to the value of the collateral used to back it, the value of money proved to be more of a function of the flows within the currency markets. Consequently, fiat currencies with favorable exchange rates have created some of the most successful economies in history.

The collateral currently backing stablecoins consists of credit risk assets in the case of Tether and highly volatile digital assets in the case of decentralized alternatives like DAI. Yet, just as in the fiat world, their value is endorsed by market participants through supply and demand, with more secure pegs being needed to facilitate blockchain-based Forex trading.

Managing hard stablecoin pegs will be essential to ensuring the stability of financial markets throughout the CeFi to DeFi migration, but that’s not to say models from the old cannot be adapted and transferred to the new, ushering in additional benefits.

Preparing for a Future Where All Transactions Take Place On-Chain

Onomy’s infrastructure is designed for a future where all Forex transactions occur on-chain. It proposes a reserve-based migration of the financial industry to the blockchain. By acting as a base layer to mint tokenized representations of national currencies and a non-custodial bridge between CeFi and DeFi, enabling users to mint, trade, lend, and pay with stablecoins of their preferred denomination, Onomy will become the de-facto decentralized reserve bank. The cross-chain liquidity aggregation of the Onomy Network also allows assets to be transferred more efficiently between blockchains, delivering real-time trade at scale, a key component that’s been lacking thus far.

In the Onomy Protocol, $NOM provides the much-needed underlying fractional collateral for stablecoins, referred to as Denoms, deriving its value from the ability to mint stablecoins as endowed by the Onomy Reserve (ORES). As Denoms become a trusted substitute for their represented fiat currencies and exchange flows grow as Denoms become the go-to means of payment, $NOM is endowed as the perfect fractional collateral.

Denoms are not only collateralized by NOM but also by the market. Therefore, if a Denom is stabilized against its counterpart fiat currency, it becomes collateralized by the market given sufficient liquidity.

Powering Decentralized Exchanges to Support Forex and Traditional Assets

By merging blockchain technology with traditional finance and providing a scalable multi-chain DEX infrastructure to include forex and other legacy markets in the new digital economy, Onomy Protocol will break barriers, granting participants access to a 24/7 market where assets are held non-custodially and transacted with seamless efficiency.

The Onomy Network (ONET) blockchain is built on Cosmos. It powers the hybrid Automated Market Maker and Order Book-based Onomy Exchange (ONEX) to provide 100x times the efficiency of Ethereum, leaving traditional AMMs like Uniswap in the dust. With interoperable bridges, Onomy connects to external blockchains, delivering cross-chain functionalities that current DEXes lack.

Building on the success of AMMs by expanding into traditional markets, opening up liquidity, introducing a DEX approach to forex trading, and leveraging stablecoins that are fractionally collateralized by $NOM tokens, Onomy empowers $NOM holders to issue and trade virtualized fiat currencies in a decentralized cross-border, cross-chain environment with instant settlement.

$NOM also serves to secure the network through validator staking, while operating as Onomy’s governance token.

$NOM staking is incentivized through an inflationary supply schedule designed to encourage stakers to secure the network in return for a share of the transaction fees generated by the bridged liquidity pools and ONEX, countering the impact from the increasing $NOM supply.

Denom supply is determined by ORES minting, burning, and staking with validators. Minters are incentivized to deposit $NOM to the ORES by negative interest rates and stakers are incentivized to delegate to validators and earn rewards that fluctuate to prioritize staking, minting, or burning of Denoms at any time to balance the monetary system.

Summary

Onomy’s comprehensive approach to networking, collateral, inflation and monetary structure draws from fractional reserve banking and market collateralization lessons. It is ideally suited to migrate foreign exchange markets to the new world of blockchain-powered decentralized finance, saving retail users and institutions billions over the long term. While current USD-pegged stablecoins have proven efficient, they lack the underlying infrastructure to onboard the world’s most liquid market onto the blockchain realm.

The stability of financial markets, therefore, depends on how resilient a bridge can be built from the past to the future, with a transitory approach being more favorable.