The Power Of Code: Stablecoins (Part 4)
The search for the “Holy Grail” of crypto — a fully decentralized cryptocurrency with a stable price that comes at no cost of collateralization has introduced the algorithmic type of stablecoins. Algorithmic stablecoins are designed to maintain a stable, targeted price, without locking up any additional assets (crypto- or fiat currencies or commodities) and without having a central party that drives the price to the desired level. Some of the algorithmic stablecoin solutions include supplementary bond-like or share-like instruments or behaviours that are used for supply and price adjustment, with algorithms that mimic the actions of a central bank — that’s why this type of stablecoins is referred to as “seigniorage share” by some authors.
The idea of algorithmic stablecoins isn’t exactly new, in terms of the decade since the inception of Bitcoin, as the first algorithmic stablecoin was issued in 2014. The number of published white papers proposing the introduction of additional algorithmic stablecoins increased significantly during the past year, due to the increased demand for cryptocurrencies that will maintain a stable price during market contraction and the shaken trust in the alpha fiat-backed stablecoin — the USD Tether.
One of the most anticipated algorithmic stablecoins of the past year, the launch of which was expected in the third quarter of 2018, was the Basis*. The Basis proposal included the issuance of an algorithmic stablecoin, accompanied by a bond-like instrument and a share-like instrument. The intended role of the “bond” was to decrease the supply of the stablecoin at times when it would have been traded at prices below the target, by giving the holders of it redemption right at full target price at a later time, with expiry of 5 years. Holders of the stablecoin could have obtained the “bonds” by “burning” their Basis. At times when the Basis would exceed the target price, the “share” (additional supply of the Basis stablecoin, distributed to holders in form of a dividend) would have been used to increase the supply with the expectation of lowering the price back to target level.
The Carbon stablecoin is proposing a similar concept to Basis, with two significant differences. The first of them is the fact that they plan to offer a fully fiat backed stablecoin at launch (expected in the second quarter of 2019), and then migrate to algorithmic “governance” at a later stage, through a stage of hybrid (fiat-backed and algorithmic) price targeting. The other difference is in the profitability of the ”bonds” — the instrument used to decrease the supply and push the price upwards to the target level: while the Basis proposal allowed for maximum of 15% yield to “bond” holders, with the rest of the premium distributed as dividends to Basis holders, this type of yield limit is not proposed for Carbon Credit (the “bond” instrument of the Carbon stablecoin), making participation in the Carbon project theoretically more profitable.
The Ampleforth algorithmic stablecoin project (currently also in pre-launch phase), initially introduced under the name Fragments, offers a similar concept, realized without additional instruments. The supply adjustment is proposed to be done by increasing and decreasing balances of holders of the stablecoins, through a process dubbed “rebasing”. Just as with Basis and Carbon, the decrease in the supply is expected to drive the price up, the increase back down to the target.
In essence, one can say that algorithmic stablecoins attempt to adjust the behaviour of holders of the coin through a number of incentives, with the aim of maintaining a stable price. It is really the extent of success to reach the target in this symbiotic behaviour of coin holders and the coin (or the algorithm driving it) that will determine if the coin will really be a stablecoin, once it’s launched onto the volatile cryptocurrency market. The volatility of the cryptocurrency market also plays a significant role in achieving the desired performance of this type of coins: in case changes in the market are slow enough for stablecoin holders to respond in a timely manner, by burning (obtaining bonds) or selling the excess of their coins, there’s a greater chance of keeping the price close to the target and maintaining the peg. In case of quick and sharp movements on the market, in whichever direction, the inertia of the stablecoin holders, and their late reactions to market changes, may contribute to breaking of the peg, regardless of the performance of the algorithm, and entering a downward spiral from which the target price can’t be recovered.
The case of the former stablecoin NuBits
This was, at least, the case of NuBits, the first algorithmic stablecoin launched in 2014. NuBits survived its’ first loss of peg in 2016 and recovered to the target price of 1 USD after over a month of lingering below the desired value, but after the peg was broken for the second time, it didn’t recover, and is currently traded at 0.037 USD.
The first time the peg was broken, the pressure to sell was caused by spiking of Bitcoin and the desire of holders to rather “ride the wave” than hold on to stable-priced NuBits.
If one zooms into the period when the NuBits peg to the targeted price of 1 USD was broken the first time, and observes the movement of the price of Bitcoin in the same period, it is clear why the NuBits price went down sharply. With the stabilization of the price of Bitcoin, the NuBits regained its’ target value, even after a month of staying well below 1 USD. But then in hindsight, everything is clear.
*Since the research for this series of articles has started, in October of 2018, the organizers of the stablecoin project Basis canceled the project mid-December and returned the ICO funds to investors. The project was US-based, and the SEC interpreted the proposed stablecoin design as a security, subject to full regulation. Nevertheless, Basis was chosen for analysis in this article because of its’ proposed features and available documentation.
Algorithmic stablecoins which are yet to be launched will face the same challenges — regulatory and market risk. With the development of cryptocurrencies, the technology, and the market, one can expect that some lessons have been learnt, but it will again be left to the holders of algorithmic stablecoins and proprietary supplementary instruments to respond to incentives adequately and in a timely manner in order to see the success of the project.
The views expressed in this article are not investment advice nor recommendations. The facts contained herein are not necessarily complete and readers of this article should do their own due diligence, including seeking independent financial advice, before investing. This article is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.