The fallacy of uncollateralised stablecoins

Please note the disclaimer at the bottom of this page.

Stablecoins are cryptocurrencies that are pegged to some underlying, such as the US dollar. In other words, one unit of a stablecoin pegged to the dollar should always be worth one dollar.

Our main conclusions are that uncollateralised stablecoins are problematic

(i) economically, as they will struggle to maintain their purported value; and, depending on the design,

(ii) in that some parties to such a system may have profited substantially at the expense of others should it collapse.

But before we go into details, let us begin by giving a brief introduction to stablecoins.

There would be obvious benefits to having a stablecoin. It would come with all the advantages of decentralised, censorship-resistant and permissionless blockchain, but without the volatility cryptocurrencies have historically been subject to. As such, it could be more suitable as a store of value or a means of payment than other cryptocurrencies such as bitcoin. Use cases range from replacing national currencies in economically unstable countries to more niche applications such as a way for cryptocurrency traders and arbitrageurs to avoid long transaction times for fiat currencies.

A number of projects have attempted to create stablecoins. These can be divided into three different types:

A. Collateralised by the underlying

B. Collateralised by assets other than the underlying

C. Uncollateralised

Type A stablecoins — collateralised by underlying

For type A stablecoins, the underlying is deposited into an escrow account, and stablecoin tokens¹ are issued in return. These stablecoins can then be freely traded like any other cryptocurrency, and redeemed when desired.

Type A stablecoins system. New entrants introduce the underlying in exchange for stablecoin tokens (black). Users can exit the system by redeeming their stablecoins for the underlying (red).

The key disadvantage with this setup is that a trusted third party is required to act as the escrow agent.² Although contrary to the spirit of decentralisation, such stablecoins could solve many of the problems they are trying to address, but much will depend on the jurisdiction and regulatory environment in which the escrow agent operates. A long-running stablecoin of this type is Tether (USDT), which, however, has been mired in controversy.³ Another example is the recent announcement by Circle to launch a USD-backed ERC-20 token.⁴

Type B stablecoins — collateralised by other blockchain assets

With type B stablecoins, it is not the underlying that is being used as collateral, but other on-chain assets. On-chain collateral avoids the centralisation issue, as the issuance and redemption of tokens for collateral can be governed by smart contracts. MakerDAO is an example of a stablecoin taking this approach.⁵ Let us note that MakerDAO makes no claim that it can guarantee to maintain its peg in all market conditions, and even has provisions for a complete liquidation of the system in case the on-chain collateral loses too much value vs the underlying.

Type B stablecoin system. Users can obtain stablecoins by collateralising them with an on-chain asset, possibly even from another blockchain via an atomic swap. On exit, stablecoins can be returned in exchange for the underlying deposited.

Again, although not a perfect solution, there could be many use cases for on-chain collateralised stablecoins. It’s a trade-off between price stability, decentralisation, and cost of capital considerations, as typically type B stablecoins are overcollateralised to provide a certain buffer against adverse price movements.

Type C stablecoins — uncollateralised

Type C stablecoins attempt to maintain a peg to the underlying without any collateral. Basis — formerly Basecoin — is an example of such a scheme.⁶ Although users of this stablecoin will have to pay for the token with US dollars, no fiat currency is retained as collateral but instead accrues to Shareholders,⁷ effectively removing it from the system.

Preventing the price of the stablecoin from exceeding that of the underlying can easily be achieved by issuing more tokens. However, preventing the price from declining is going to be difficult without any collateral. Basis tries to solve this problem by auctioning off Bonds⁸ at a discount that entitle the Bondholder to receive a unit of the stablecoin if demand exceeds supply again within five years and by an amount large enough to pay off all debt from previously issued Bonds. If demand does not recover, the Bonds expire worthless.

Type C stablecoin system Basis. Underlying (USD) is paid in for tokens but not retained in the system (black), leaving stablecoin users collectively stuck in the token-world. Stablecoin users can become Bondholders by auctioning off stablecoins for Bonds (yellow), which either expire worthless or turn back into stablecoins if sufficient new outside capital flows in (red).

A micro-economic argument

In order to understand whether the Basis system can work in the long-run, we could look at it from a micro-perspective and note that the system relies on finding willing buyers for its Bonds to prop up the price whenever demand for the stablecoin is less than its supply. Bonds are paid for in Basis tokens, which reduces the circulating supply. However, Bondholders will only buy bonds at a discount as they are taking the risk of losing their investment. Moreover, the greater the perceived risk, the lower the price of the Bond, and the smaller the reduction in supply — contrary to what one would desire. This could quickly lead to a downwards spiral in Bond prices, as the longest outstanding Bonds are redeemed first. Once Bonds are worthless, the price of the Basis token can no longer be supported, which would then lead to a collapse of the entire system.⁹

Note however, that such a collapse would mostly affect Basis users and current Bondholders, but not Shareholders, who get to keep the USD paid to them.¹⁰ It is questionable why Basis users are required to pay for their tokens in the first place, and why Shareholders should be entitled to the proceeds given that the fiat currency received fulfils no function in the system.¹¹

A macro-economic argument

But could a different design avoid the potential problems with Basis? To see why this is unlikely, we can employ an arbitrage argument. If the price of a stablecoin exceeded that of its collateral, arbitrageurs can deposit more of the underlying and sell the tokens received for a profit, bringing the price down. Hence the value of an uncollateralised stablecoin token converges to zero. However, the Basis system only allows this arbitrage to occur if the token trades above one dollar due to its one dollar issuance fee. So let us assume the token has some value X, where 0 < X ≤ 1 USD. Wouldn’t we have found a way to print money, as one dollar turns into 1+X dollars — one still in fiat, and X in the form of a token?¹² We can’t actually dismiss this right away. After all, we established in the beginning that tokens, by virtue of their digital nature, may have desirable features that the underlying doesn’t have. And indeed, cryptocurrencies have attained significant value over the past few years, despite in general not being collateralised.

So where did our argument go wrong? Well, it didn’t of course. The problem with uncollateralised stablecoins is that they are trying to prescribe a value for X, which is the value the token has as a digital asset.¹³ This value is determined by the token’s present or expected future utility, and we have been able to observe the violent volatility and speculation that have accompanied this value discovery process in cryptocurrency markets. Type C stablecoin projects are failing to see that any value tokens have will depend on the suitability of their respective blockchain technologies for any particular purpose, as well as factors such as adoption by users, regulation, quality of custody solutions, etc. Any promise that this value can be maintained at a fixed amount per token, without taking away wealth from users by destroying tokens when necessary, is arbitrary and fundamentally misguided.¹⁴

Lastly, we encourage the reader to conduct the following thought experiment. Assume an uncollateralised stablecoin mechanism did exist, and peg its token not to the US dollar, but to gold or to bitcoin. It will make the absurdity of uncollateralised stablecoins become even more apparent.

Footnotes

  1. Unless stated otherwise, we use the terms ‘stablecoin’, ‘token’, and ‘stablecoin token’ synonymously. The term ‘token’ may also occasionally refer to other digital assets that may or may not be part of a stablecoin system.
  2. Centralisation brings with it a certain degree of counterparty and censorship risk. Counterparty risk might be quite small if the escrow agent is a regulated entity and holds all collateral in segregated accounts. However, not everyone may have direct access to the escrow agent, for example for practical, regulatory (KYC/AML), or political reasons — think somebody in a war-torn country.
  3. An audit trying to establish whether Thether had indeed fully collateralised its US dollar pegged USDT token was never completed: https://www.coindesk.com/tether-confirms-relationship-auditor-dissolved/
  4. https://blog.circle.com/2018/05/15/circle-announces-usd-coin-bitmain-partnership-and-new-strategic-financing/
  5. https://makerdao.com/whitepaper/DaiDec17WP.pdf
  6. http://www.basis.io/basis_whitepaper_en.pdf. A similar project is Carbon: https://www.carbon.money/whitepaper.pdf
  7. Shareholders are owners of another token, called Shares. These are not shares in the conventional sense, but they do entitle Shareholders to Basis tokens that the blockchain issues in response to an increase in demand. It is not entirely clear from the whitepaper whether these tokens are issued for free and whether Shareholders do indeed have no obligations in respect of the USD they sell these tokens for, although we assume this to be the case. Otherwise, it would be conceivable that some of these proceeds are to be kept in reserve to support the token price when necessary, essentially turning the system into a low transparency version of a centralised type A stablecoin.
  8. Although Bonds do resemble callable zero-coupon bonds in terms of their mechanics, we should note that conventional bonds are used by issuers to raise capital to finance capital expenditures, increase their working capital, or otherwise boost their businesses’ activities. In return, bondholders are rewarded with interest payments to offset the opportunity cost of making their capital available to the issuer. However, Bonds have the opposite function economically. The blockchain issues Bonds to reduce the stablecoin supply by destroying tokens. As a result, Bondholders earn interest not for supporting economically purposeful activity, but only when new capital in the form of US dollars enters the Basis system.
  9. In theory, as we will argue further below, there could be some residual value to the stablecoin, as it still is the native token of a decentralised blockchain. In practice however, it seems more likely that there will be a total loss of confidence in the whole system once the peg can no longer be maintained. It is also somewhat curious that the whitepaper doesn’t go into any detail about the envisaged blockchain technology or other features, such as exchange integrations, that would give the token utility.
  10. If Shareholders had to pay for their Shares, then there is a risk that Shareholders will be left out of pocket too if the system collapses too quickly.
  11. Of course, building and operating a blockchain or even piggybacking on a existing one by developing a suitable smart contract system does incur a certain cost, which would be fair to recover. Our point here is that all USD paid in accrue to Shareholders, seemingly without any link to the costs incurred in relation to the underlying blockchain technology.
  12. Or in the case where there is no issuance fee, generated value out of thin air by issuing tokens that have a positive value?
  13. Note that we speak of value rather than price, as price is a somewhat irrelevant concept for a blockchain-based token that can be issued and redeemed at will. We could easily enforce price stability of such a token by hosting it in a smart contract and automatically destroying or issuing it to users, converting price volatility into volume volatility. The Fragments.org project for example pursues this approach, which is a bit pointless of course, as what really matters to users is value (=price * volume) stability of the token they hold, not price or volume stability.
  14. Coming back to Basis one last time, it seems that the only reason why the token is supposed to be worth one dollar is that the issuance fee is one dollar. There is nothing in the mechanism itself requiring these two values to match, and Basis could have claimed that each token issued is worth 1/2 or 10 USD — in their logic, Bondholders should be equally happy to prop up the price. Of course, if the token is worth less than the issuance fee, people would not to buy in, and if it were worth more, arbitrageurs would immediately bring down the price of the token. So the claim that each token is worth 1 USD is simply born out of necessity, as it is the only value where at which users would consider buying and it is not immediately obvious that the claim cannot be true.

Disclaimer

This article is for information purposes only and is not, nor should it be construed as, investment advice. This article is not an offer, nor the solicitation of an offer, or a recommendation to buy or sell any assets or financial instruments. Readers should not rely on any information or opinions presented in this article and should always do their own due diligence and seek advice from their own financial advisor. The opinions expressed in this article are those of the author.