Stablecoins Part 2
Stablecoins are essentially a currency peg which can be maintained within a certain scope of market behaviour. The scope would include:
- The degree of volatility (or downward selling pressure) the peg can handle
2. The cost to maintain the peg
3. How transparent true market conditions can be observed by participants
“An ideal stablecoin should be able to withstand a great deal of market volatility, should not be extremely costly to maintain, should have easy to analyze stability parameters, and should be transparent to traders and arbitrageurs.” — Haseeb Qureshi
The three key type of stablecoins are as follows:
Fiat-collaterized stablecoins
This is the most simple form of stable coin and offers 100% price stability. It is also more secure because no collateral is held on the blockchain.
A certain amount of fiat currency is deposited as a collateral and coins are issued 1:1 against this fiat money. Although this method is simple and robust, it requires a central party (custodian) which guarantees the issuance and redeemability of the stablecoin. Regular audits are needed to ensure that the stablecoin is indeed fully collateralized. This is essentially the category USD Tether belongs to, though many people suspect Tether is actually a fractional reserve and don’t hold all of the fiat as they claim they do.
A fiat-backed scheme is also highly regulated and constrained by legacy payment rails. If you want to exit the stablecoin and get your fiat back out, you’ll need to wire money or mail checks — a slow and expensive process.
Examples include: USTD, TrueUSD (same as USTD but proposes more transparency), Digix Gold (gold backed)
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins work quite similar to their fiat-counterparts, with the exception that the collateral is not an asset in the “real-world” but rather another cryptocurrency.
Collateral is therefore held on the blockchain which makes it susceptible to hacks and other security risk but means it can be liquidated quickly and cheaply. Moving away from fiat also means moving away from centralisation and reliant on a central third party.
These stablecoins are often over-collateralized (and hence capital intensive) to account for the price-volatility of the underlying cryptocurrency used as collateral. For example:
- A $100 worth of ETC is required as collateral deposit in return for say the issuance of 50 stablecoins each with $1 worth. The collateralization ratio of 200% is very transparent on the blockchain and easy for everyone to inspect.
- This means that if the price of the underlying cryptocurrency depreciates by 20%, the stablecoin can skill keep its price stable as there are still $80 worth in ETH collateral to back the $1 value of the stablecoin.
- The position can be liquidated here: giving $50 worth of ETH to the owner of the stables, and the remaining $30 in ETH back to the orginal depositor.
Why would anyone over-collateralized or lock up $100 worth of ETC for $50 worth of a stablecoin? There may be two incentives:
- The issuer can be paid interest on the collateral
- The issuer can choose to create the extra stablecoins as a form of leverage. For example:
- If a depositor locks up $100 of ETC, they can create $50 worth of stablecoins
- They can then use the $50 worth of stablecoins to buy another $50 worth of ETH, you now have a leveraged position of $150 ETH, backed by $100 in collateral. If ETH goes up 2x, you now have $300 as opposed to $200 which you would have otherwise made.
However, the downside is that in a black swan event, where the underlying asset falls to zero, the stablecoin would collapse too. The loss exposure is worsen for the stablecoin owner because of the over-collateralisation.
Examples include BitUSD (collateralised with BitShares), MakerDao’s Dai (collateralised by ETC although you can follow updates for multi-collateral Dai here).
Non-collateralized stablecoins
Non-collateralized stablecoins are not actually “backed” by anything other than the expectation that they will retain a certain value.
One often-mentioned solution to non-collateralized stablecoins is the seigniorage shares approach. This concept builds on smart contracts that algorithmically expand and contract the supply of the price-stable currency much like a central bank does with fiat currencies, but in a decentralized manner.
Example include Basecoin (which builds upon Seignorage Shares by adding a first-in-first-out “bond” queue)
In the final part of our stablecoin series, we will look in more depth into some of the key stablecoins in the market, including Tether, MakerDao and BitUSD. For more details on the three types of stablecoins, you can check out a great explanation by Haseeb Qureshi at Metastable Capital:
