Why current approaches toward stability are moving in the wrong direction
Introduction — Stablecoins
The majority of articles and whitepapers about stablecoins suffer from two major issues. Most of them fail to explain what mechanism makes the price stable, and those who do, can not describe that mechanism clearly. They lack the large-scale view and their weak monetary knowledge sinks them into complicated technical terms before they get a clear overview of the topic.
This article aims to demonstrate how a stablecoin can be designed. It argues that current approaches towards explaining and classifying stablecoins are heading toward wrong directions and cannot attract the majority of activists in the blockchain community. This is evident in their limited market size. That is one of the essential reasons why stablecoins — with all their exceptional potential and s
pecial significance — have turned in to mere tools for speculation.
Providing a simple, straightforward explanation of stablecoins and what they entail, and, creating an ideal stablecoin accordingly, not only make a greater number of people understand and implement stablecoins in their routine life, but will encourage major central banks to hold them as a big part of their reserves. Stablecoin will ultimately replace dollars in the reserve. This view is fully elaborated on in previous articles)
Collateral, buy-wall/sell-wall, and all approaches that rely on the future growth and investment are not designed to maintain stability. We will discuss the key factor of stability after reviewing these approaches and what they are designed to do.
The Key Factor Of Stability; Flexible Creation Based On Demand
First-generation cryptocurrencies implement a rule under which tokens are created through time without considering the rate of their demand. Thus, changes in their demand result in the volatility of their price. This is partly due to the fact that their new tokens are awarded and are impossible to be eliminated.
Stablecoins, however, should have an algorithm that makes a flexible creation based on demand possible in a completely decentralized manner. Whenever there is more demand for them, stablecoins should be able to create new tokens in order to prevent an induction of price. On the other hand, if the demand is low, in order to avoid a decrease in price, they ought to have the ability to eliminate some of their existing tokens. This procedure sets the supply amount relative to demand. Therefore, a smart mechanism is needed that can appropriately decrease or increase the supply according to its sense of price and set the pace of creation and elimination.
Henceforth, the mechanism for creating stablecoins can not award new tokens, because, in that case, eliminating tokens will be impossible. Therefore, contrary to previous methods where new tokens were awarded after their creation, a different method shall be implemented through which the ability to eliminate tokens is possible so we can have a flexible supply.
Creation based on debt is the method that makes setting a flexible supply possible. In this approach, new tokens are created by paying new loans and existing tokens are eliminated by settling existing loans. Similar to current banking systems where one has to provide an asset as collateral in order to receive a loan; in stablecoins, creating new tokens, or in other words paying new loans, requires collateral.
Long story short, If the stablecoin is pegged to a trustworthy index, as soon as the system is alerted that the price is more than 1 unit of the index, new loans are paid and the supply gets bigger so that the price returns to its stable status. Similarly, in order to bring a decreased price back up to its stable rate, the system either makes the process of creation and paying loans slower or starts settling existing loans which in turn eliminates some of the existing tokens and shrinks the supply.
Therefore, the key factor in maintaining the price is the ability to set the rate of paying and settling loans by using an appropriate algorithm. The stablecoin systems that do not consider this key factor in the creation of their loans can not keep their peg and maintain their value in the long run.
Does collateral really affect stability?
As mentioned before, the only function of collateral in stablecoins is to guarantee that the loans paid can surely be settled. For instance, some stablecoins require the customers to provide two or three times the value of the loans they want as collateral to ensure that even if the price of the collateral is decreased to half or one third, the loans can be easily settled.
Systems like Maker claim that they can maintain stability through collateral, but they do not consider the fact that their preferred kind of collateral and its amount have nothing to do with the world and market outside and can not help the system handle changes in demand. They get too complicated in explaining collateral, its various types and its implementations, before realizing the basic fact that collateral has nothing to do with stability.
To sum up, non-collateral stablecoins or other methods that do not implement debt for creation can not guarantee the algorithmic elimination of coins. They will eventually not be able to maintain stability and might fail due to the lack of hope in the market.
Why ‘buy-wall/sell-wall’ mechanism is not effective for maintaining stability — Buy-Wall/Sell-Wall
What is called a ‘buy-wall/sell-wall’ mechanism is simply where an investor, in order to gain some interest, puts a ‘buy order’ for a large volume of goods or stocks when the prices are low in a way that his order is the best choice for all the sellers. Then, when the prices are higher, he puts a ‘sell order’ for what he has bought. His ‘buy order’ which is also known as ‘buy-wall’ eventually deflates the supply, and, his ‘sell order’ also known as ‘sell-wall’ inflates the supply.
This well-known mechanism in the stock market has been a model for the founders of many stablecoins in cryptocurrency markets. They try to negotiate with and convince investors so that whenever the price of their stablecoin gets lower than the index it is pegged to, investors put a ‘buy-wall’ on the market so that firstly, the price does not get any lower and secondly, the supply is reduced and the price starts to get higher and closer to its ideal price.
The same process happens vice versa when the price gets higher than the index. In this way, investors put ‘sell-walls’ on the market so that every buyer would find their price the best. This process brings about a bigger volume of supply and decreases the price down back to its ideal price. Investors, subsequently, have bought tokens in a lower price, sold them in a higher price, helped the stablecoin maintain its peg, and gained handsome amounts of interest for themselve.
The main problem with this mechanism is that on one hand, it makes the system centralized by making the fate of the whole system dependent on the motivations and decisions made by the investors; on the other hand, this mechanism will only function so long as the market size has not reached a huge amount and the investors’ capitals can cover the changes in demand and support the ideal price.
To sum up, the ‘buy-wall/sell-wall’ or any other mechanism that is in need of future growth and new investors and capitals in order to keep their peg is not functional in maintaining stability.