Stablecoins represent a class of crypto-assets that aim to maintain a stable value against a target price. They are heralded as gatekeepers to the mainstream adoption of crypto and making them useful for day-to-day activity. Heeling volatility, keeping money in the crypto realm and its utility as on-ramps for assets are among the reasons cited for their usefulness. However, despite the interest in stablecoins, there are plenty of criticisms and misconceptions surrounding the numerous models of stablecoins that have surfaced.
“Money” as we know it
Money exists for three reasons:
- To act as a store of value and a hedge against depreciation
- To provide a form of accounting and record keeping
- To facilitate a medium of exchange between parties and function as a predetermined measure of value
These factors are critical in day-to-day application as it allows us to use money in a range of situations. We may elect to receive the fruits of our labour in money, with the reassurance that it won’t be devalue overnight or use money for the transaction of goods and services amongst one another, knowing that the value being exchanged is being accurately represented on either side.
Cryptoassets, as we know them, struggle to meet all three criteria outlined above. Wrought by volatility, we find that we are unable to pay for our coffees in Bitcoin, nor is it preferable to hold our saving in Bitcoin. Such has been the biggest critique of Bitcoin, the fees and volatility associated with transaction make it impractical to use as a form of ‘digital cash’ from Satoshi’s vision. So while cryptocurrencies represent an exciting innovation and technological advancement, they are still far from mainstream adoption.
Enter Stablecoins.
The Impossible Trinity
The maximalists have consistently argued that money is controlled by a centralised unit. Consequently, many love (and frequently cite) the work of Hayek that represents the anti-establishment ethos from his book, ‘The Denationalisation of Money.’
“I don’t believe we shall ever have a good money again before we take the thing out of the hands of government. That is, we can’t take them violently out of the hands of government. All we can do is by some sly roundabout way introduce something that they can’t stop.”
Hayek mentions that in order to have “good money”, it must be separated from government. However, that is not enough to have “perfect money”. Perfect money needs to be separate from the government, able to maintain a stable value and have an inherent value. This is why gold has often been cited as being the perfect form of money by former Federal Reserve Chief, Alan Greenspan. He elaborates as follows:
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”
Stablecoins are an evolution of cryptocurrencies aimed at addressing the “stability” factor of perfect money. However, they still fail to meet the trinity below:
At the moment, stable coins currently fall into one of the below categories.
Centrally Issued
A centrally issued currency has the features of being backed (usually by the issuer) and with it, brings stability. The lack of decentralisation however, is problematic as it can lead to transparency issues. For example, consider the recent issues surrounding Noble Bank and Tether.
Tether (USDT) is an interesting case study as it represents a coin claiming that for every USDT issued, it is backed by a corresponding amount of USD in a vault, apparently somewhere in Puerto Rico. However, according to a Bloomberg piece this month, Noble Bank International, the bank responsible for opening accounts for USD-backed token Tether, was looking to sell anywhere between $5 to $10 million, raising questions around Tether’s solvency. A public audit would set minds at ease but Tether has refused to submit to such requests, claiming that it will never be audited. The nature of how Tether is structured, a British Virgin Islands entity incorporated in Hong Kong, has made it difficult to pierce the veil to obtain any form of transparency.
This approach requires a central entity to guarantee redemption but with Tether, that is clearly not the case. It may also be one of the reasons behind Tether’s recent implosion. This category of stablecoin can be thought of as a digital IOU.
Currencies such as Digix Gold (where one DGX is equivalent to one gram of gold) are aiming to address the issue of centralised issuance, however the issue of physical storage of gold at a centralised location still stands. A commodities backed stablecoin sits in unique position as it does not maintain parity against a currency, but rather a more volatile precious metal. Arguably the usage of a commodities backed stablecoin may be less relevant for payments but more so for supply chain management as investors have traditionally used gold as a volatility hedge and portfolio asset.
Algorithmic
Algorithmic currencies aim to maintain a peg by algorithmically adjusting the supply of the coin in response to price fluctuations. They have the features of being stable and self-sovereign. Although their prices remain stable and have no central entity controlling it, their value is arbitrarily determined as it is not collateralised by any asset.
Terra is an algorithmic currency project that has recently raised $32 million from some of the largest investors in the space. In an algorithmic currency model, there are usually two tokens at work — the stablecoin (i.e Terra) and one with a fixed supply variable price token (i.e Luna). Luna acts as the stability piece which holders of the token stake in a fund known as the “stability reserve”. The stakeholders are entitled rights in the decision making process in scenarios where Luna may be required to buy back the Terra token in high season (and burn tokens in low season) to keep the price stable (known as the “reserve ratio”). Manipulating the supply of the token is how algorithmic coins seek to maintain their price.
What’s curious about Terra is that they’re not attempting to build just the stablecoin piece, but rather a decentralized payment network. Terra has already differentiated itself from the crowd by signing up a list of partners to work with, including the likes of Woowa Brothers, Qoo10, Carousell, Pomelo, and Tiki. This means that with each transaction, a small payout will be generated that goes to the value of the Luna token. Ultimately, Terra aims to be collateralised by the very shares of the network (Luna), which receive transaction fees as dividends.
However, the value of Luna is arbitrarily determined, at least at the beginning. So as part of the adoption process, Terra intends to implement a decreasing fiat reserve. At genesis, the Terra token will be backed with a 100% fiat reserve with the intention of gradually decommissioning the reserve until it becomes zero as the number of transactions increase.
Collateralised
This leaves the class of collateralised currencies have features of being backed and self-sovereign. These are currencies they are collateralised by another underlying cryptoasset(s). The trade-off is that they are often unstable as the collateral, usually other cryptoassets, are volatile in their own right.
MakerDao is a collateralised currency project that recently raised $15 million from a16z. There are also two tokens at work when it comes to the collateralised model. One token will be stable (i.e DAI ) and the collateral token, MKR. MKR is created and sold onto the open market in order to raise the additional collateral. This provides a strong incentive for MKR holders to responsibly regulate the parameters at which CDPs (collateralised debt positions) can create Dai, as it will ultimately be their money on the line should the system fail, not holders of Dai. The MKR holders are incentivised to govern the network and receive fees for their work. The mechanics and role of MKR is a far more detailed discussion and a summary can be found here.
Potential problems with collateralised currencies include the strong likelihood for the collateral to fall below its peg (even if collateral-to-debt ratio is at least 150%), and also the opportunity cost of collateralising 150% of said stable coin. Say you wanted to create a CDP and posted 150 DAI-worth-of-ETH to mint 100 DAI. Wouldn’t you arguably be better off liquidating your ETH on an exchange for its dollar’s worth and keeping the remaining $50?
This problem is by no means exclusive to MakerDAO — this issue is ubiquitous across all collateral-based stablecoins. What’s interesting about DAI is that the team is gearing up to launch multicollateral DAI, which will supersede the sole ETH collateral. Creating a diversified basket is incredibly clever as it provides a portfolio hedged position — so using other tokens beyond ETH, stablecoins and even delta one derivative products (see DYDX’s margin token). The injection from a16z will provide much needed liquidity for the system to stabilise the price of DAI.
What’s next?
Stablecoins will undoubtedly represent the future of the economy. Projects like Tether represented version 1.0 of the stablecoin wave, a pioneer of the concept but innately flawed in its execution. Subsequently, this brought a wave of stablecoins that followed Tether, which can be represented as version 1.X — projects that attempted to solve for the problem Tether had but struggled in addressing fundamental concerns outlined in the impossible trinity.
This brings us to version 2.0 — the category of coins that begins with one side of the trinity, but are attempting to solve for the missing piece which is seen in Terra (collateral through transaction fees) and MakerDAO (stability through multicollateral) in pursuit of a currency which can be stable, backed and self-sovereign.
