A Case for Stablecoins

Putting a damper on volatility in a turbulent market(?)

Cody Solomon
Oct 31, 2018 · 5 min read

Money is what money does. Contrary to popular belief, money is not a “thing.” Money is a feature, an idea. We define money by its function; something is money if it can be effectively used as a medium of exchange, a unit of account and a store of value.

Cryptocurrencies — the latest addition to a long list of attempts to build the perfect medium for the facilitation of commerce — excel at the first function but arguably fail at the latter two. Satoshi’s ingenious solution to the double spending problem led to the creation of the first digital, decentralized, and truly trustless medium of exchange. That’s great for a start, but if cryptocurrencies ever ought to become money — they first need to solve the problem of volatility.

Volatility hinders all three functions of money and slows down the mainstream adoption and global proliferation of cryptocurrencies. If we wish to reap the benefits of Distributed Ledger Technology (decentralization, security, immutability, transparency…) while maintaining the trust and stability of fiat currencies — we need a stable cryptocurrency.

Enter stablecoins

There are three fundamental approaches to designing stablecoins: (i) Fiat-collateralized approach which pegs crypto tokens to stable underlying assets such as fiat currencies — a slight variation on this model would be commodity-backed; (ii) Crypto-collateralized approach which pegs crypto tokens to other on-chain crypto assets; and (iii) Non-collateralized approach which uses seigniorage shares to control the monetary supply of the appropriate stablecoin.

To give you a better understanding of the benefits and drawbacks of stablecoins and how they achieve stability, we’ll briefly examine all three approaches.

Fiat-collateralized stablecoins

Fiat-backed stablecoins are the most simple, stable and robust of the three systems. They achieve all of this, however, chiefly because they’re heavily centralized, which in turn creates issues with transparency, solvency, and legitimacy and imposes a serious counterparty risk to the owners of the tokens.

Crypto-collateralized stablecoins

Because everything is kept on the blockchain, crypto-backed stablecoins are fully transparent and offer very fast liquidation. However, being decentralized and pegged to volatile cryptocurrencies, they’re inherently less stable than fiat-backed stablecoins which arguably makes them riskier and more prone to auto-liquidation during price crashes of the underlying asset.

Non-collateralized stablecoins

Grossly oversimplifying it, the volatility control mechanism works like this: when the price of the stablecoin is higher than the expectation — the smart contract prints more coins; when the price is lower than the expectation — it issues bonds to remove coins from circulation.

Non-collateralized stablecoins based on the seigniorage shares model are the most “crypto-native” out of the three because they’re fully independent and largely decentralized (at least, in theory.) Currently, non-collateralized stablecoins are in the experimental stage and are yet to demonstrate the theory in practice.

The search for the ideal continues…

Money — as imperfect as we know it to be today — is a product of a long evolutionary process that is far from over. That being said, the controversies surrounding the current stablecoin projects should not disappoint and discourage us — after all, we’re in the midst of making one of the most disruptive financial technologies of the future. The promise of a true stablecoin far outweighs any and all obstacles that we may encounter on the way and, once we get it right — the world may never be the same.

Bonus content: This is one of my favorite episodes of my favorite podcast. It has several fantastic stories about money, from governments making up fake money and calling it “real”, to money at the bottom of the sea that still is used for transacting— The Invention of Money from This American Life.

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