Stablecoins: Strengths & Weaknesses

But not all stablecoins are created equal…

Part 3: A brief explainer on stablecoin strengths & weaknesses

  1. Use a trusted data source, a centralized solution
  2. Use the median from a set of data feeds, also a centralized solution
  3. Use a Schelling point scheme, a decentralized solution

Stablecoin strengths & weaknesses by collateralization type:

  1. Fiat-collateralized (Centralized)
  2. Crypto-collateralized (Decentralized)
  3. Non-collateralized (Algorithmic)

1. Fiat-collateralized (Centralized)

  1. The 1-to-1 IOU stability mechanism reduces the chance of high volatility
  2. Relatively simple and easy to understand
  3. Less vulnerable to hacks, since no collateral is held on the blockchain
  4. Bridges gap between cryptocurrencies and fiat
  5. Scalability : IOU systems can grow to support a vast ecosystem
  6. In the event of a black swan event or a financial crisis, government and central assurance can provide a fallback (but is this a pro, or a con?)
  1. Centralized operation and issuance
  2. Geopolitics: Highly regulated, beholden to a central bank or government, and vulnerable to government intervention
  3. Lack of transparency: Essential regular audits to ensure transparency and reserves
  4. Counterparty risk:
  5. Need a trusted custodian to store the fiat, trust in custodial solvency and legitimacy
  6. The need to trust the “independent” auditor
  7. What if the issuer chooses not to maintain the buy wall at some point?
  8. Expensive liquidation into fiat
  9. No innovation over what banks currently offer

2. Crypto-collateralized (Decentralized)

  1. Decentralized and thus censorship resistant
  2. Transparency creates certainty and auditability
  3. The only form of stablecoin without systemic risk
  4. No counterparty risk
  5. No geopolitical risk, locality risk
  6. Usually can be liquidated quickly and cheaply into the underlying crypto collateral
  7. Can be used to create leverage, opening up the entire supply of money
  1. Volatility in the collateral backing the stablecoin may be able to destabilize the peg (often mitigated by over-collateralization)
  2. Can be auto-liquidated during a price crash into underlying collateral
  3. Scalability : These systems can operate at scale only if the underlying collateral can scale and scale of all system actors remains consistent
  4. Inefficient use of capital
  5. Less price stable than fiat

3. Non-collateralized (Algorithmic)

  1. No collateral required
  2. Independent money issuance
  3. Transparency and auditability
  4. This stablecoin is, ultimately, a Schelling point. If enough people believe that the system will survive, it will.
  1. Complex math makes analysis difficult: How much downward pressure can the system take? How long can it withstand that pressure?
  2. Experimental fallback procedures
  3. Requires continuous growth, or else will not be able to maintain its peg
  4. Peg vulnerability during bear markets and flash crashes: if selling pressure is maintained for an extended period of time, price will drop below what the system can absorb, triggering a death spiral
  5. Resembles a pyramid scheme: low coin prices are strengthened by the promise of future growth, but that growth must be subsidized by new entrants buying into the scheme
  6. Issuing money is easy, but consistently being able to contract money supply while maintaining value is difficult

Conclusion:

Resources:

Thanks for reading!

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Stability for the blockchain @ MakerDAO.com

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