Achieving token stability

Tokens are digital representations of any asset/commodity in the blockchain world which have some value. They are not the same as cryptocurrencies but are tradeable and exchangeable. Ex- Tokens which follow ERC-20 standardization.

Use cases

1. They are usually used to raise funds for projects in Initial Coin Offerings (ICOs). Example — TheDAO tokens.
2. They are used in the governance of a project or protocol. Example — Uni Swaps UNI tokens.
3. They are used in lending and borrowing mechanisms. Example — DAI tokens.

Imagine a scenario where you buy 10 XYZ tokens for 1$ each, and now a week later you want to use these tokens to buy some stuff, you would expect that you will get items worth 10$. Now let’s say this XYZ is a token with an unstable value and suppose the price of each token dropped. So you wouldn’t get things worth 10$. And the second problem is the vendor wouldn’t accept the XYZ tokens because of their volatility.

So the tokens you own representing an asset having a value must be stable (at least short-term stability ) to be widely adopted.

There are different conventional ways by which developers of the token try to give a stable value to tokens.

Methods used to achieve stability

1. Asset-Collateralized Stable Tokens

A simple way to achieve a stable token is to back them with off-chain assets that have stable or relatively stable prices, such as fiat currency or a commodity like gold or diamonds. Now before we go ahead, let me explain the term Backed by — Many times you would have heard/read somewhere that a national currency is backed by gold and it refers to the concept of a gold standard in the nation’s monetary system where the value of a country’s currency is directly linked to a fixed quantity of gold. The idea behind the gold standard is that the value of the currency is ultimately determined by the value of gold. Since gold has a limited supply and is widely recognized as a store of value, it provides stability to the currency.

Example — Tether(USDT) is one of the first stable tokens and it follows a 1:1 ratio against the US dollar. This means that for every 1 USDT in circulation, 1 USD is collateralized in a centrally managed saving account.

Problem — The problem with this type of stabilization is that the collateralization is taken care of by centralized entities.

2. Crypto-Collateralized Stable Tokens

To mitigate the centralization problem is to back the stable tokens with a native blockchain token such as BTC or ETH, which is why these stable tokens are also referred to as “decentralized stable tokens.” In this system, the stable token is collateralized with BTC or ETH. The collateral token (BTC or ETH) is managed entirely on-chain by a smart contract, instead of a third party.

Example — DAI is a stable token operated by MakerDAO. The price is pegged 1:1 to the USD. DAI is backed by ETH which can be collateralized in a smart contract. ETH token holders can deposit their tokens in a smart contract to generate DAI tokens. The smart contract locks the deposited ETH as collateral and it is automatically released by the smart contract when all debts (DAI tokens) are paid back.

3. Central Bank Digital Currencies(CDBCs)

Central banks have started to tokenize their own currency which already has a stability mechanism. Such a central bank token (CBDC), acts as a tokenized representation of a country’s fiat currency. Stability is designed by the central bank in collaboration with the fiscal and monetary policy of a national government. The tokens would be part of the base money supply, together with other forms of money such as cash and other cash equivalents. Currently, the cost of managing the cash supply of a country is high, as are cross-border transactions and some economists believe that CBDCs compete with commercial bank deposits and reduce the cost of managing the local and international payment system

Many governments are thinking of tokenizing their currency or have already started to do so to various degrees (around 80 percent), such as the Bank of England, Central Bank of Sweden, Central Bank of Uruguay, Marshall Islands, China, Iran, Switzerland, and the European Central Bank. “Synthetic CBDCs” (sCBDC) is an alternative concept whereby private institutions issue tokens fully backed with central bank reserves.

4. Algorithmic Stable Tokens

Stable tokens that are pegged to assets using legacy financial services might seem simple and obvious, but could also be perceived as somewhat contrary to the spirit of the underlying decentralized technology so algorithmic solutions are on the rise that might do more justice to the nature of smart contracts.

“Seigniorage Shares” is a concept for an algorithmic stable token that was first proposed by Robert Sams in 2014, in his whitepaper he outlines how a smart contract can be designed to work as a central bank that formalizes monetary policies so the token trades at a stable price. Similar to how central banks control the supply of fiat currencies the algorithm automatically adjusts the token supply to keep a stable price. If the price is too high, the mechanism will increase the supply. If the price is too low, tokens need to be “frozen,” in one way or another.