Stablecoins: Paving the way to Stability
This article will elaborate on Stablecoins that can possibly trigger cryptocurrencies to experience an unprecedented cycle of mass-adoption and aid its transition into a mainstream medium of exchange. This is the dream that has evaded every other existing cryptocurrencies thus far.
An introduction to Stablecoins
The truth is, Bitcoin had many design flaws and was completely useless as money. It contained a consensus algorithm which made P2P transactions possible but there was essentially no economic sense to this virtual currency. With a perpetually fixed supply of coins vis-a-vis a heavily fluctuating demand, this created regular swings in market prices. Bitcoin was not considered cash… it was nothing but a repeat of the hyper inflated german currency during the 1923 French invasion!
To become a useful currency like the fiat U.S dollar, a currency must fulfill the criteria of becoming a medium of exchange, a unit of account and a store of value. Traditional cryptocurrencies like Bitcoin only fulfill the the condition of becoming a medium of exchange. They are currently too volatile to qualify as an effective store of value. Now, this is where the concept of Stablecoins come about.
Stablecoins are price-stable cryptocurrencies with a market price that is pegged to a stable asset, such as the U.S dollar or gold. It serves the purpose of being a global digital currency that possesses the characteristic of having low volatility despite market conditions, allowing for practical utility such as payment for everyday items.
Tether is a prime example of a Stablecoin that ranks top 9 in market capitalization today. If you refer to the diagram above which is a snapshot from Coinmarketcap, the overall crypto market displays a bearish outlook as of 14 July 2018. Most coins are declining in value but Tether displays a high degree of stability by remaining less volatile than the traditional coins in the market.
Why the need for Stablecoins?
Most people today would have the misconception that Stablecoins only serve as a mode of payment. However, to the blockchain community and the governments worldwide, Stablecoins have far greater implications on multiple stakeholders as elaborated in the next few sections:
[1] Credit & Debit Markets
Price stability is a quintessential factor that drives traditional financial products onto the blockchain (insurance, loans, saving plans and even mutual funds). Take for example the case of a mortgage, the greatest risk is probably the risk of default in the perspective of a lender. If your loan is denominated by a very volatile currency such as Bitcoin, you end up charging a very high premium to the borrower to hedge any form of price risk. This creates unnecessary pains to the simplest of financial contracts.
[2] Developing Markets
Furthermore, a stable coin can be used by developing nations to replace their hyper-inflated currencies. As of publication in Q3 2017, Egypt suffered 32% annual inflation, Argentina 23%, and Nigeria 16%. And this is just a sampling of countries whose governments are relatively more stable — let’s not forget Venezuela, whose annual inflation rate is currently at 741%. What would you do if your savings were disappearing at a rate of 741% a year? Such devaluation of currencies can be resolved simply by introducing a stablecoin.
[3] Cryptocurrency Traders
The existing crypto-currency exchange eco system is highly unfavourable towards a crypto-trader today. For example, top exchanges mostly are crypto-to-crypto (only allow deposits in the form of cryptocurrencies and not fiat) and this prevent traders from seeking a price-stable currency they can utilize to wait out in the situation of a bearish crypto market. There remains a high need for a stablecoin that traders can rely on.
[4] The Overall Blockchain Economy
The blockchain community at large are expecting an ecosystem of “Blockchain Applications” soon. This is essentially a phenomenon where existing industries and their respective services are reimplemented in a decentralised fashion. Take for example “Blockchain Grab”, “Blockchain Expedia” or even “Blockchain Airbnb”.
All of these “Blockchain Applications” require an interchangeable system to convert between its “Universal Token” and all of its other application tokens, therefore requiring the “Universal Token” to be price-stable for the entire application to run smoothly.
If there is stablecoin in these applications, imagine your daily grab ride to be fluctuating heavily from a day-to-day basis — you pay $5 dollars for a cab today and $500 for one tomorrow.
3 Models of Stablecoins
Currently, there are 4 distinct features for a cryptocurrency to establish itself as a global digital currency that is fiat-free in nature — [a] Price Stability, [b] Scalability, [c] Privacy and [d] Decentralisation (Collaterals backing the digital currency cannot be held by 1 or a small group of entities/individuals)
With the current state of development, most stablecoins are still working towards achieving all 4 criterias. Scalability and Privacy are still qualities possessed by none of them. However, the community have successfully created decentralised crypto assets.
Type 1: IOU Issuance (Real Asset-Collaterized)
The first type of Stablecoin is the easiest to comprehend — a cryptocurrency that has a redeemable IOU function for a real asset such as fiat USD or gold.
To explain this model in a simple manner — the system receives a dollar into their custodian trust account and issue stablecoins at a 1:1 ratio against it. If a stablecoin owner wants to liquidate and exchange back for the dollar, this system destroy the coins and wire them back in USD.
Since this scheme is entirely centralised, it has the highest degree of price robustness. All collaterals are held in real physical asset reserves (fiat-reserves, or gold reserves) and they will remain intact in the event of any crypto market collapse. This also means they can withstand an extreme level of volatility.
However, a centralised scheme requires the custodian to be highly trustworthy and costly audits are required to ensure that there are enough real assets backing the digital currency. If the custodians have been siphoning all the assets in secrecy, this could cause the entire currency to collapse. (e.g. Tether have not been audited regularly and the community believes that Tether is actually a fractional reserve that do not hold the amount of fiat reserve required to withstand systemic shocks)
This scheme is also the subject of regulatory pressures and constraints by traditional payment processes. A Tether holder will have to undergo an awfully expensive and bureacratic process of wiring or mailing checks if they want to convert their stablecoin back to USD.
Type 2: Crypto-Collaterized
The second type of stablecoin deviates from the idea of having real assets backing it — essentially shifting the entire idea onto the blockchain and establishing decentralisation. Instead of having gold or fiat reserves, the stablecoin is now backed by a sea of cryptocurrencies.
All crypto-collaterized stablecoins are over-collaterized using another cryptocurrency such that it gets liquidated if the market price dips low enough. What is over-collaterising? For example, we deposit USD$500 worth of bitcoins into the reserves and issue USD$100 worth of stablecoins. The coins are 500% collaterized. This tells us that if the price drops by 50%, there is still USD$250 worth of bitcoins to back these stablecoins (USD$100), allowing each coin to remain at a USD$1 valuation each.
The reason for over-collaterising can be explained in two benefits to the issuer — they can either earn interest from coinholders or establish leverage by issuing extra coins.
Ultimately, a crypto-collaterized coin is capital intensive because of how it has to be over-collaterized to the maximum extent. They are highly vulnerable to large price swings as compared to real asset-collaterized coins. They can also be destroyed without warning if the cryptocurrency backing the coin crashes too much.
Type 3: Seigniorage Shares (Non-Collaterized)
The last type of stablecoin is highly decentralised, absent of the need for any collateral backing. To understand Seigniorage Shares model, one must have a basic understanding of demand and supply.
Seigniorage Shares was a scheme invented by Robert Sams. The idea was to ensure a smart contract can emulate the function of a central bank which is to control money supply of the fiat currency. In this case, the model has one purpose and it is to control the supply of stablecoins, ensuring that it is always traded at say, USD$1.
In the past, the government minted money to finance their operations, the profits were termed “seigniorage”. Similarly in the seigniorage shares model, a smart contract can create new stablecoins and auction them on the markets to increase supply and reduce the prices back to USD$1 if the coin was trading at a higher price.
If the coin was trading at a price lower than USD$1, all the system has to do is to buy up coins and increase the demand within the system such that it creates an upward pressure to reach equilibrium of USD$1 once again. If the system does not have enough seigniorage to buy up all the coins needed, they can instead issue seigniorage shares which allows one to claim future seigniorage. This means that shareholders are entitled to the future profits earned from issuance of more stablecoins in future.
I’ll share with you one commonly used method of expanding and contracting stablecoin supply through a “bonds and shares” process — this was introduced by basis (formerly known as basecoin).
The main issue faced by seigniorage shares is how to manipulate money supply in a decentralised and secure manner. Increasing supply is easy (you just have to print money i.e. issue stablecoins) but reducing it isn’t.
For basis, the system issue bonds (“bond tokens”) with par value of USD$1 that are discounted and thus motivate basis holders to remove stablecoins from circulation by purchasing them (might disburse pay out at future date). This ultimately reduces the supply of stablecoins in the event that the coin has a market price lower than its intended range.
If the demand increases within the network, there must be an increase in supply to regulate the prices. Basis software will pay out bondholders (“bond token” holders) in accordance to the order the bonds previously purchased before paying those who own shares within the system. This means that bond holders have a higher priority of claim than shareholders, a conventional pecking order we’ve accustomed ourselves to within the traditional finance world.
The “fluctuating supply” concept introduced by basis may be confusing and entirely new to many but it is well established in the world of economics — Quantity Theory of Money. Many central banks are also using this method to ensure stability of their fiat currency (e.g. Federal Reserve).
Always remember that the seigniorage shares model is currently the most “crypto-native” method in creating a truly decentralized and secure stablecoin. They remain one of the most exciting, unprecedented and experimental ways of creating a solution for mass-adoption in the cryptocurrency world. In put matters into context, Basis has received USD$133 million funding from renowned backers such as Andreessen Horowitz, Bain Capital Ventures, Lightspeed Ventures, Google Ventures and others.
Conclusion
To summarise, Stablecoins are an imperative step towards the mass-adoption of cryptocurrencies. Successful creation of an ideal Stablecoin could create fundamental long term improvements to the world we live in today.
However, the path towards an ideal Stablecoin will continue to be arduous. Existing Stablecoin variants each possess their own strengths and weaknessses. Till date, none is better than the other. For example, an IOU-issuance stablecoin is highly centralized and more secure to crashes compared to crypto-native stablecoins.
The crypto community have been known to be extremely innovative and new variants might soon emerge in the coming months. These variants will almost certainly build their systems based off the fundamental designs of the existing ones we’ve discussed in this article.
While each variants have different methodology in establishing the characteristics of becoming a fiat-free, decentralised digital currency — the markets will eventually decide which one will emerge as the sole winner.
Note: This article first appeared on bytepapers.com
