Stablecoins pegged to the price of commodities such as gold are one of the less well-capitalized segments of this asset class. Nevertheless, as tokens based on a blockchain, commodity-backed stablecoins offer the intriguing potential to overcome some of the challenges of holding traditional commodities and could yet break through as mainstream investable assets.
Have you read our previous stablecoin articles? Our first one provides a general overview of the asset class and introduces the “stablecoin trilemma”, while examines fiat-backed stablecoins. This latest insights article covers tokens backed by gold and other commodities, examining their investment rationale and associated risks.
As a newer asset class, the only defining characteristic of commodity-backed stablecoins is that they must be backed by the commodity to which they are connected. Generally, such coins are backed one-to-one by a standard unit of the commodity. For instance, a typical gold-backed token is the equivalent of one Troy ounce of gold.
As such, similar to fiat-backed stablecoins, commodity-backed token issuers should maintain audited physical reserves so that users can redeem their tokens should they wish. Redemption can be a physical redemption of the underlying asset or the fiat equivalent.
The “Stablecoin Trilemma”, introduced in our first article on this topic, outlines how stablecoin issuers face a trade-off between peg stability, capital efficiency, and decentralization. Asset-backed tokens generally fail on the decentralization test, as almost all examples have been issued by centralized entities. However, they can be more reliable performers on peg stability and capital efficiency, as there is generally no requirement to overcollateralize.
By and large, the investment rationale for holding a commodity-backed token as part of a diversified portfolio would be the same as for the underlying commodity itself. However, there are some specific advantages associated with tokenized commodities. Tokenized commodities don’t require physical storage, and the holder should not be liable for any theft of- or damage to the underlying reserves. Therefore, it can be a more cost-efficient and safer way to gain exposure to assets such as gold.
Furthermore, particularly for metals like gold, tokenized versions can be a more reliable price proxy than many gold-linked derivatives available on traditional markets. For instance, many gold tracking indices include assets with more indirect exposure, such as mining company stocks, that may be subject to market forces other than the price of gold.
Tokenized commodities also make it easier to own fractions of assets, which can be useful when considering large-value assets or the commoditization of assets such as diamonds.
Finally, commodity-backed tokens can be more liquid than their physical counterparts. For instance, gold-backed tokens issued according to the ERC-20 standards can be swapped for a vast array of other EVM-compatible assets with near-instant settlements.
Gold-backed tokens are by far the largest and most established segment in this category. The most dominant token by market capitalization and trading volume is PAX Gold, issued by stablecoin issuer Paxos. One PAX Gold token is equal to one fine troy ounce of a London Good Delivery gold bar, which is redeemable for physical gold or fiat via Paxos. Fractional ownership is possible, with the minimum purchase of PAX Gold set at 0.01 PAXG (i.e.: 0.01 Troy ounce of gold / around $15).
Paxos offers customers the option to purchase allocated gold or unallocated gold. Allocated gold is identified with a unique serial number, which the PAX Gold holder can view on the Ethereum blockchain, showing that their tokens correspond to physical gold. Unallocated gold holders are entitled to redeem a quantity of gold but do not actually own a specific gold bar. Paxos is regulated by the New York Department for Financial Services.
Tether Gold (XAUt), issued by stablecoin issuer Tether, is the closest competitor to PAX Gold. It shares many similar characteristics with PAX Gold, with a few exceptions. Tether only issues XAUt against allocated gold, so any user can always view the serial number of their reserve allocation by typing in the blockchain address of their tokens. Tether is an unregulated issuer, and it has a minimum investment amount of 50 troy ounces. XAUt can only be redeemed for gold.
Other comparable projects, but of substantially lower market capitalization, include Digix and Goldcoin. Kinesis is a somewhat experimental project which aims to make precious metals more liquid and tradeable via gold and silver-backed tokens, thereby enabling commodities to become a medium of exchange. This initiative is less about creating an investable product than an attempt to establish a medium of exchange that is independent of fiat.
Oil-backed tokens have a somewhat checkered history and limited success. The idea gained some publicity during the crypto boom in 2017 and 2018, when then-president of Venezuela, Nicolas Maduro, announced his plan to launch the Petro. The Petro was supposed to be backed by Venezuela’s rich oil and gas reserves and provide a means for the country to meet its crippling international debts. However, it was predominantly perceived as a means of evading sanctions among the international community, so it did not gain acceptance. Maduro briefly attempted to revive the idea in 2020.
Around the same time as the Petro was making its debut, other oil-backed tokens attempted to launch. However, neither Petrodollars nor OilCoin managed to prevail. In 2019, reports emerged that the Russian government was planning a legislative act on cryptocurrencies, including an oil-backed digital currency. However, the plan does not appear to have progressed. More recently, it has been reported that Russia and Iran are working together on a gold-backed stablecoin that would support their joint “de-dollarization” efforts.
A handful of projects offer tokens backed by other types of commodities. In March 2022, Santander announced it was collaborating with Agrotoken, a tokenization platform for agro-commodities, with a view to creating loans secured by tokens, which in turn are backed by products such as soya beans, corn, or wheat. This allows producers the opportunity to access lines of credit backed by the sale of their grains. Santander claims this is the first time that agricultural products have been used to collateralize crypto-assets.
Renewable energy and carbon credits have also been of interest to token issuers. The Australian firm PowerLedger has developed a platform for trading renewable energy between providers, enterprises, and individuals. As part of its offering, it allows the trading of energy-backed tokens that can be redeemed for energy or fiat currencies.
KlimaDAO is a decentralized autonomous organization that aims to protect the environment via its KLIMA token, which is backed by carbon credits. KLIMA holders can stake the token in return for incentives. The aim is to gamify the carbon economy by incentivizing people to reduce their carbon consumption via KLIMA.
Diamonds are not traditionally considered a commodity due to a lack of uniformity among gems and a consequent lack of standardization in valuation systems and methodologies. However, Diamond Standard is a blockchain initiative that aims to standardize and commoditize the diamond industry through diamond-backed tokens. It uses physical coins embedded with a quantity of diamonds corresponding to a fixed value, which are recorded and tokenized on the Ethereum blockchain.
From an investment perspective, holding commodity-backed tokens is likely to come with very similar risks as holding the commodity itself. However, asset-backed tokens also share many of the same risks as fiat-backed stablecoins – a fact that is especially pertinent considering that the two biggest gold-backed tokens are issued by two of the largest stablecoin issuers, Paxos and Tether.
Any commodity-backed stablecoin comes with a degree of reserve risk. Investor due diligence should be carried out to determine how the reserves are stored and managed, and to ensure there are independent attestations as to the integrity of reserves. Commodity-backed tokens should always be backed one-to-one by the reserve asset.
Paxos issues regular reports from WithumSmith+Brown, an independent third-party accounting firm, which attests to the quantity of gold held in the Paxos Gold reserves. Tether’s XAUt reserves are audited by BDO.
While proof of reserves offers some guarantee that the issuing company is solvent, there may still be a degree of risk that the issuer could go out of business. Investors should also seek legal reassurance that they would have a valid claim on the underlying reserves in the event of any financial dispute affecting the issuer. Counterparty risk should also be considered to be a part of due diligence.
Commodity-backed tokens are likely to fall under the provisions of the EU’s upcoming “Markets in Crypto Assets” regulation (MiCA), which has a provision for asset-referenced tokens. Therefore, it is possible that commodity-backed stablecoins could be outlawed or heavily regulated in the future.
However, given their relative market size compared to fiat-backed stablecoins, they are unlikely to be a primary target for regulators. Furthermore, commodity-backed assets that seek to coordinate market participants to achieve collective goals, such as reducing carbon emissions, could act as a balancing force against excessive regulation.
Given the relatively new and often experimental nature of these products, comprehensive due diligence to adequately assess AML, reserve, and counterparty risk will be paramount.
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