The quest for a stable coin
By Oleg Bakatanov on ALTCOIN MAGAZINE
While cryptocurrencies spread over the world and start participating to some extent in regular business transactions, they remain highly volatile in value. Not stable value limits use of cryptocurrencies and actually prevents them to take main functions of money: being the store of value, mean of exchange and unit of account.
Stablecoins is a group of cryptocurrencies which try to fulfill these three functions of money more effectively using different price stabilization mechanisms.
In our analysis we will cover only those coins which aim to execute all three functions with more or less efficiency. As far as the most widespread unit of account in current economic conditions is US dollar, for current research we assume that only a stablecoin pegged to US dollar (or other major fiat currency) can be effectively used as unit of account.
Here we need to mention that there is a number of coins which try to be stable vs. other pegs such as gold, basket of currencies or other. While these coins can be really interesting beginnings as store of value or investment instrument, they are hardly capable to execute two other functions in current economy. It is difficult to imagine that, for example, gold-based coin can be widely used for pricing and trading purposes, just because nobody is accustomed to use gold for pricing and trading. For that reason we intentionally omit such stablecoins in our analysis.
If we consider a stablecoin as a substitute to traditional fiat money in the digital space, the best way to see advantages and disadvantages of existing solutions is to analyze how each of them fulfills three main functions of money.
1. Stablecoins from store of value perspective
Ability of a stablecoin to store value means that it’s purchasing power, in the long term, remains stable compared to goods or assets it can buy. As far as prices for most goods and assets in the modern global economy are nominated in USD, ability to store value in our case means ability to hold peg to USD in the long run.
Stablecoins use different mechanisms to store value, some of them are quite reliable, other are rather questionable. We would outline several main mechanisms which are used to protect value of a stablecoin
1.1 Collateralization:
a. By fiat currency
b. By cryptocurrencies and tokenized assets
c. By real assets or mixed
1.2 Support from internal system revenues
1.3 Money supply regulation
1.1. Collateralization
Collateralization is the most obvious and straightforward approach to stabilize currency value. Some form of collateral exists in almost every stablecoin project, but its mechanics and quality widely varies.
a. Stablecoins collateralized by fiat currencies
Using fiat currency as a collateral to create stablecoin is a method which currently has the largest practical implementation. We believe the reason for it is that this approach is technically simple and quite straightforward to explain to users. It also enables to ensure quite tight peg to US dollar which makes these stablecoins quite good as a substitute of a dollar for trading in the digital space.
However, this method also has serious drawbacks : such stablecoin is not decentralized and always controlled by some people or entities. Value of this currency can be questioned by many trust issues such as solvency and honesty of a token issuer, reliability of intermediaries holding assets, transparency of the collateral, risk of seizure of these assets by third parties (including governments).
In the long term we also suppose that all stablecoins collateralized by USD or other major currency will be regulated as strict as fiat currencies, thus, they won’t be very different from USD on your bank account. This also means such stablecoin won’t be attractive to users who want to be protected from political risks.
Nevertheless, these drawbacks doesn’t prevent such currencies to be effectively used for settlement operations or trading.
In our analysis we use TrueUSD as a first really collateralized by fiat stablecoin. Now we can see many other coins on the market having the same mechanism, such as GUSD, USDC, PAXOS, other. We assume they all have the same main characteristics as TrueUSD.
b. Stablecoins collateralized by cryptocurrencies and tokenized assets
A quite promising way to issue stable and, at the same time, truly decentralized cryptocurrency is to create a coin which is backed by some other valuable digital assets or services. In our opinion, stable coins collateralized by digital assets can solve many issues which stable coins backed by fiat currencies can’t:
- it remains fully digital in nature and trustless as cryptocurrency concept itself to a large extent;
- its collateral is stored in a digital wallet(s) and easily observable by anyone;
- its issuance and redemption can be made in the most transparent way in exchange of provided collateral, this process can be managed by a smart contract in a trustless way;
- it always has some fair value and can be exchanged on it;
- the digital wallet(s) with collateral is controlled by no one except smart contract itself and can be effectively protected from theft, confiscation or seizure of any type.
The most important problem of such stablecoins is that value of a digital collateral is likely to be not stable and highly volatile. For that reason some mechanism required, which guarantees that collateral exists in necessary amounts.
Currently we see two major ways to create a mechanism which enables to provide enough collateral in volatile digital assets to a stablecoin.
The first is direct collateralization which is very similar to collateralized bank loans. This scheme is implemented in such projects as Maker DAO(Dai), Alchemint and Sweetbridge. Direct mechanism assumes that there is a group of players who takes loans in a stable coin (thus issuing them to the market) and provides some valuable collateral which level they pledge to support. If collateral value goes below some minimal requirements then, exactly like for a bank loan, borrower must add more collateral or his collateral will be liquidated on the market.
We believe this approach to be quite promising if stable coin designer finds enough incentives for borrowers to come to the system, pledge their assets and take system risks. In other words, the whole community of people ready to take stable coin risks needs to be created to make this approach scalable. Supporting necessary level of collateral also requires creating quite sophisticated risk management system which looks like difficult but doable task.
Another approach is indirect mechanism to support necessary value of collateral. Indirect means that to make a coin stable we don’t rely on people who come to our system to provide us some collateral on purpose. Alternatively, we use already existing market with effective risk management systems — cryptocurrency derivative market. This market gives us an opportunity to peg value of our digital assets to a stable fiat currency via contracts with other market players. Advantage of this approach is that every player on cryptocurrency derivative market has its own incentive to trade, it can be investment, hedging or short time speculation. To stabilize collateral value we don’t need to attract or incentivize a counterparty to take our risks, this counterparties already exist and are always willing to trade with us. In addition, we don’t need to create a risk management system controlling sufficiency of the collateral. This system already exists inside derivative exchange and is very effective because all risks are divided on relatively small stakes and spread over multiple players.
1.2. Support from internal system revenues
Each stablecoin is based on a quite complex economic system which can generate income for its issuer or for the overall stablecoin system. If this income can be used to sustain a stablecoin value, this drastically increases its chance to survive in the long run even when other stability mechanisms (like collateralization) fail.
We distinguish three main sources of such income:
- Transaction fees, paid by stablecoin holders for transactions;
- Operating income — income derived from different services, provided using stablecoin benefits;
- Investment income — e.g. collateral can generate some investment income or interest rate.
There is a number of projects which use, explicitly or implicitly, internal system revenues to support stablecoin value.
In our view, quite good example is Tether. Despite one may believe that Tether is a collateralized stablecoin and its value is backed by USD dollar reserve, we would argue that Tether is not a collateralized stablecoin and its stability is derived from revenues Tether generates for its creators.
Tether is not collateralized in the commonly used sense because:
- there is no legal or smart contract obligation of Tether issuer to exchange USDT back to USD;
- collateral existence, sufficiency and safety is not clear
Hence, the only reason for Tether to be stable is willingness of its masters to support it. At the same time Tether creators and supporters are closely related to several major cryptocurrency exchanges and Tether is likely to generate decent profits for them. This means that Tether stability is directly related to ability of its masters to derive profits from it.
Another good example where transaction fees are explicitly used for stablecoin support is Havven. Havven’s nUSD (stablecoin) stability model is based on utility token, which gives a right to receive part of transaction fees paid by nUSD holders. Therefore, utility token value (and market price) directly depends on anticipated cash flow from fees. Then, utility token can be used as collateral to issue more nUSD. So, we have a growing spiral here: nUSD generates fees which increases Havven utility token value and allows to produce more nUSD.
Proposed model recalls shareholder / bondholder structure where shareholders (utility token owners) put their assets under risk to receive profits, while bondholders (nUSD holders) receive stable value. Using such model itself sounds very reasonable and, in our view, it is one of the most promising models to issue stablecoins.
In the case of Havven, we see the problem in using utility token as a collateral, because it has no any value other than receiving fees and directly depends on nUSD issued and paid transaction volumes. This creates kind of a circular reference system where downward spiral is as likely as upward. Decline in fees means decline in collateral value which means decline in nUSD attractiveness which further leads to decline in fees. If we take into account that some stablecoin projects may offer very cheap or free transactions and at the same time provide liquid high quality collateral which value doesn’t depend on perpetual growth assumptions or stablecoin mass adoption, Havven can hardly compete with it if it doesn’t offer to nUSD holders something more than just stable cryptocurrency.
As we mentioned before, we believe that an idea to use system revenues as a source of stability is very prospective one, but at the same time, we think that an idea to use commissions charged from stablecoin users as a source of stabilization is quite questionable as it strongly reduces stablecoin attractiveness.
1.3. Money supply regulation
Money supply regulation mechanism is based on Quantity Theory of Money which basically states value of a currency depends on quantity of this currency in circulation (supply) and demand on it from those who want to hold or use this currency. Hence, to achieve needed price peg for a stablecoin we need to increase or decrease its quantity in circulation corresponding to increase or decrease in demand for it. This theory is quite popular in government monetary policy and central banks widely use this concept to regulate price of national currencies relative to other.
Some stablecoin projects (the most known is Basis) plan to regulate and stabilize stablecoin value by controlling number of coins circulating on the market similar to central bank money supply policy. In such case, no collateral or other backup is required to make a coin stable. The main reason, why this approach must work is a fact that all major fiat currencies (including US dollar) currently are not collateralized by anything from the legal point of view but, at the same time, some of them remain very stable only because of smart money supply regulation.
This approach seems very attractive, because, if it worked, production of a stable coin wouldn’t require any serious efforts and, at the same time, would be infinitely scalable.
At the same time, the claim that, if fiat currencies are not collateralized and remain stable, one can do the same with non-governmental cryptocurrency, ignores one very important fact. In reality, such stable fiat currencies as US dollar are collateralized by the power of economies which issue them and grant exclusive rights to be the only legal currency on that territory. In other words, if somebody holds a US dollar, he is guaranteed that in foreseeable future he can buy with it a can of Coca-Cola or other goods produced by US economy. At the same time US government guarantees that the only legal tender of payment in US economy is US dollar, which generates needed demand for dollars. This is the main source of US dollar stable value, and Fed’s smart money supply policy only helps to fine-tune it.
Any private currency doesn’t have exclusive rights and competes with many other, hence, the is no reason why demand for it cannot drop substantially at some moment and never recover after. This means that holders of this currency will suffer losses in value which will never be compensated.
In other words, a stable coin which relies only on supply regulation mechanism can be stable only in the case of stable or growing demand for it in the long run, which can’t be always true.
2. Stablecoins as a unit of account
Unit of account is an important function of money which allows them to be universal benchmark of nominating value of goods and services. National currencies are the unit of account inside national economies while US dollar is commonly used as unit of account for international trade. Choosing unit of account is a matter of habit or tradition, as well as network effect. An international trader would likely price his goods or services in US dollars just because everybody else is doing the same and US dollar is accepted almost everywhere.
We believe that at current conditions only a coin which is linked to US dollar or other national currency which is already widely used can play unit of account function effectively.
If we consider for now only USD-pegged stablecoins, what make one coin better than other as a unit of account? Obviously, if a stablecoin aims to substitute US dollar for pricing purposes, its price should be tightly pegged to US dollar even in the short run. Hence, good unit of account is a coin which price regulation mechanism allows to provide very small stablecoin volatility (<1%) around US dollar price.
Here we want to analyze which methods or regulating short term value are available for different coins.
2.1. Market — making / Interventions
To provide short term stability, almost every stablecoin project would employ market-making mechanism where a dedicated market-maker having some capital will hold price of the coin in certain limits. For projects implementing coin supply regulation (like Basis), market-making will be coincided with interventions (issuing more coins to circulation to increase demand or selling kind of bonds/stocks for coins to reduce demand). Obviously, market-making can be a good stabilization tool for small price moves but has very limited power. Price interventions which try to curb coin price growth issuing more coins will work perfectly, but only in the case when coin price is going up.
This mechanism leaves a big question mark for the case when coin demand and price goes down. In this case, intervention mechanism must sell something (bonds, stocks, whatever) in exchange of coins to reduce coin supply and, hence, stabilize the price. Demand for such bonds is likely to be volatile, moreover, supply reduction itself doesn’t guarantee immediate price recovery.
In our view, such price stabilization mechanism is not perfect and may lead to quite large moves of stablecoin price around its peg.
2.2. Stimulating issuance and redemption
This mechanism is likely to work for loan-type collateralized stablecoins which mechanism doesn’t assume immediate access to collateral for anybody who holds the coin (e.g. Dai, Sweetbridge). In such systems, when price of a stablecoin goes below price peg, borrowers have an incentive to repay loans, and, vice-versa, when price is too high, borrowers may like to borrow more.
The problem of this approach is that relatively small price variations (say, 2–3%) can be not enough to incentivise borrowers to act. This means such mechanism, effective in the long run, may fail to ensure tight peg in the short run. Which is still quite bad for a coin which is used as US dollar substitute for pricing and trading purposes.
2.3. Collateral redemption / Risk-free arbitrage
Risk-free arbitrage is the mechanism which guarantees the most tight peg of a stablecoin. This mechanism is possible when collateral is liquid, easily and fastly redeemable, that means that everybody may exchange a coin for underlying collateral or backwards even when only small price distortion exists. In our view, even small variations around price peg (1% or even less) may force arbitrageurs to act, making price peg very tight.
Stablecoins implementing such stabilization mechanism are ideal candidates as units of account.
3. Stablecoins as a mean of payment
To analyze stablecoins from mean of payment perspective, we would consider two main factors: transfer speed / costs and control/privacy issues.
3.1. Transfer speed and costs
High transfer speed is important for real-time payment applications and may strongly limit coin’s proliferation. Most popular stablecoin — Tether mostly uses Bitcoin (Omni) blockchain and, probably, is the slowest and the most expensive to transfer stablecoin. At the same time, it is still much more attractive than traditional banking transfers. Other stablecoin projects use either Ethereum blockchain (Dai, True USD) or develop their own blockchains, which claim to be even faster and cheaper.
Need to mention that new generation blockchains (such as EOS) can potentially enable almost instant transfers with zero fees for the users. At the moment of writing this article, stablecoins based on EOS blockchain didn’t exist but they could be quite attractive proposition for stablecoin users.
3.2 Control/Privacy issues
Cryptocurrencies have been invented with a spirit of freedom, meaning that only private key holders may decide how and where to use their money. Meanwhile, many stablecoin projects set some constraints on users (strict KYC procedures) and operations or have a potential to do so in the future.
This especially relates to all projects which use fiat as collateral. Given that governments have full access to such collateral and regulations, in general, become more strict, we may assume that most stablecoins which are fiat-based will be regulated as tough as regular banking accounts in the future.
This means that holders of such coins may face problems similar to what they experience now in banks: tough and long KYC, potential limits on transfers, requirements to explain some operations and all other things which inspired creation of cryptocurrencies.
We also know that all regulatory burden is always transferred to the client which means that fiat-based coins can be more difficult and expensive to use in general.
Stablecoins that don’t have fiat-collateral (especially in USD) have smaller risk of been regulated or restricted which should be attractive to their holders.
As a summary of our stablecoin research we suggest this generic stablecoin map based on how well they play their money functions.
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