Part 3: The Strengths & Weaknesses of Stablecoins
As the crypto universe expands, the need for stable assets increases. Simple transactions can become incredibly challenging if the underlying currencies are inherently volatile. Enter the “stablecoin.”
The major classifications of stablecoins have their strengths and weaknesses, and carry varying amounts of risk. Some are significantly more risky than others; several others break from the critical motivators behind blockchain. At this point, there isn’t a clear universal “winner,” meaning as a consumer or dapp, it’s important to understand the benefits, risks and tradeoffs of your stablecoin.
Here we examine a few different models and analyze essential factors of successful stablecoins. In this post, we will explore three important classifications of stablecoin. The basis of each type has fundamentally different underlying principles, and they contain very different levels of risk. Particularly when exposed to extreme market fluctuations, negative investor sentiment, geopolitical instability, or the failure of centralized custodians.
Key Factors for Evaluating a Stablecoin
When choosing a stablecoin, we consider the following principles:
- Transparency — How transparent is the system? Does the system rely on the trust of a central actor? If so, are the procedures to view the inner-workings of that central system reliable?
- Auditability — Can everyday users audit the systems financial fundamentals. Can the collateral be confirmed?
- Stability Mechanisms — Assuming regular market operations, what factors keep the coin stable? Are they algorithmic based? Collateral based? Fiat based? What are the strengths and weaknesses of each system?
- Fallback procedures — In the event of a failure in the particular system, how stable are the underlying assets. Do protections exist to return users funds?
- Scalability — Can the system grow to support a broad ecosystem?
Additionally, for each principle, it’s necessary to consider a few factors on how to measure each aspect. Firstly, it’s essential that the system should not have a high maintenance cost. If excessive fees or high overhead costs exist, the system loses efficiency and thus risks instability.
Secondly, It’s also crucial that all market participants can audit the system quickly and reactions can occur at a reasonably fast pace. Efficient market operations depend upon the speed of comprehension and reaction, especially in the event of a “black swan” or unanticipated market event.
Lastly, since many stability mechanisms rely on actors to make decisions based on market information, improving the transparency of the system is an important mechanism. Without a high level of openness, the ability to make accurate decisions based on facts suffers.
Currencies pegged to a stable asset are not a new concept. In fact, many modern currencies were tied to gold for decades. In addition to gold, we’ve seen currencies pegged to other, stronger currencies. For instance, between 1991 and 2002, the Argentine Currency Board pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation and stimulate economic growth.
Despite the peg to the USD, high volatility remained in Argentina which ultimately lead to an economic collapse that resulted in disastrous, long-lasting effects on the Argentinian economy. There were not fair, open market operations, as foreign reserves did not transparently back assets. The system itself was not auditable, and there were no fallback procedures. Ultimately, the goal of the system had failed.
Today, the crypto economy is facing the need for a stable currency on the blockchain. The above shows an example of why we need to evaluate the underlying merits of each system carefully. This post combines historical context in an objective method to compare the strengths and weaknesses of the current stablecoins, including Dai, the stablecoin built by the MakerDAO team.
Current Models of Stablecoins
There has been a recent surge of new stablecoins entering the market, the vast majority of which fall into three primary categories:
IOU models- These models rely on centralized trust and centralized issuance. In this approach, a central actor holds an asset and issues an “IOU” that is redeemable for the underlying asset.
Seigniorage Shares — This system creates algorithmically backed stablecoins. This approach algorithmically expands and reduces the supply of the price-stable currency. In essence, similar to how central banks often maintain stability with fiat currencies.
Collateralization — This approach is on-chain, trustless issuance. In this approach, the system issues the stablecoin when assets are pledged as collateral on-chain. This type of coin maintains stability by overcollaterization, market efficiencies, complimentary incentives, profit motives and fallback procedures such as global settlement.
Type #1: IOU Models
A basic stablecoin is a simple IOU. In this model, a central entity holds an asset and issues a coin redeemable at a 1:1 ratio for the underlying asset. Reliable convertibility of the token for the asset keeps the token pegged. Much like a gift card, or gold held in Fort Knox, the ability to transfer the stablecoin into the base asset keeps the peg maintained.
If, however, the token cannot be claimed for the underlying asset, or there is low confidence that the central entity has enough assets to either cover the amount of IOU’s issued or operate a fractional reserve based system, this model becomes risky. This model is prone to destabilization from external factors such as geopolitics, local regulations, and other forces.
This approach requires trust in a centralized entity, like a bank or a financial institution. It’s important that funds remained escrowed, separate from the operations of the bank. Assets should to be auditable with sufficient proof to show that the centralized entity has enough assets to cover outstanding IOUs.
Counterparty risk is the risk that the other party (the counterparty) of a financial contract will not live up to its contractual obligations.
Counterparty risk for coins operating under the IOU model is high. One of the popular coins in this category has faced many questions about the solvency and legitimacy of the operation. It becomes a problem when independent users of a platform cannot confirm how much is in reserve for each of the coins issued.
For this reason, the importance of audibility of the system becomes essential. Fortunes have been lost due to the weaknesses of a central counterparty, as was the case in the fall of Mt. Gox.
In analyzing the core principles:
- Transparency — Since IOU’s typically rely on a central party, they frequently do not have complete transparency as institutions may not disclose verifiable audits. Critics of this model often cite that the centralized approach means there is little evolution over what banks currently offer.
- Auditability — Since the underlying stable assets are not on a blockchain, an audit by a “real world” accounting firm will be required. Even with an auditable system, it still transfers the required trust to the auditors instead of the blockchain.
- Stability Mechanisms — Assuming regular market operations, this model is very stable. Specifically, when trust and transferability between the stablecoin and the underlying assets functions properly, stability holds. Since the mechanism is a literal 1-to-1 IOU, the underlying stability mechanism reduces the chance of high volatility.
- Fallback procedures — In the event of a black swan event or a financial crisis, government and central assurance can provide a fallback. For example, insurance agencies may be contracted to pay out losses due to theft, or a government may offer support. In practice, however, fallback procedures have not always held up. An example of this occurred when Lehman Brothers fell during the 2008 economic collapse, and funds lost assets held under management.
- Scalability — IOU systems can grow to support a vast ecosystem. Central banks can operate at a nation-scale level, but the scale of their mistakes grows as well. Also, since these operations rely on human input, their scalability often hinges on the ability of staffers to run a large scale operation.
Type #2: Seigniorage Shares
Seigniorage share stablecoins are based on the basic model that when demand for the stablecoin increases, the system issues new coins ,so the price stays stable. Of course, this is just the framework, as they can get a lot more complicated.
While it’s easy to understand how the price can stay flat when the demand goes up, what happens when demand drops?
These stablecoins are not actually “backed” by collateral. They can’t be traded in or redeemed for any other asset. They maintain their stability due to the expectation that they will retain a certain value.
Typically, when demand for an asset increases, so does its price. When demand decreases, its price drops, given that demand is moving quickly relative to supply.
If, however, the rate of demand increase matches the rate of supply increase (and vice versa), the price stays flat.
Since the system creates new stablecoins when demand increases, the system must contract supply when demand decreases. Many projects use a bond issuance system to incentivize users to “turn in” their coins for a bond that might provide a return of stablecoins issued in the future.
Critics of this model argue that’s it’s difficult to create an algorithm that decides issuance and contracting rules that is resilient to manipulation. Consistently being able to contract the money supply while maintaining value is difficult and requires participants believe that demand will increase in the future.
In analyzing the core principles:
- Transparency — Assuming they are purely algorithmic-based operations, these systems can be completed on-chain and therefore offer a level of transparency. If they are not algorithmic backed (like a central bank or Federal Reserve) then their transparency hinges on the decision-makers’ desire to publish their actions to the market.
- Auditability — If the underlying stable assets are on a blockchain, then they can be audited.
- Stability Mechanisms — Assuming that the demand for the stablecoins is consistent or increasing, this model is stable. In periods of high volatility or decreasing demand, the long-term stability is unclear.
- Fallback Procedures — In the event of a black swan event, fallback procedures are currently experimental. There is not yet a tested, proven choice for a mechanism to maintain stability in a market collapse. By definition, these coins rely on predictable, rational, open market operations.
- Scalability — These systems can operate at scale only if the activity and actions of all system actors remain consistent and reasonably predictable. For example, if demand drops for a given side of the ecosystem, the system’s ability to scale drops.
Type #3: On-Chain Collateralization
In this approach, users collateralize an on-chain system, which issues coins relative to the value of the underlying collateral. This process is similar to an escrow, or a “lock up.”
Since the collateral backs the stablecoin, coin stability links to the total value of the underlying assets. If those assets, collectively as a portfolio, are stable, the ability for the portfolio to quickly change in value reduces, further increasing stability.
The system becomes more stable when it becomes overcollateralized with low volatility portfolio of assets and offers proper fallback procedures.
In these implementations, the collateral backing the stablecoin is itself a decentralized, auditable asset. This offers advantages of transparency and auditability. However, if the system’s collateral loses too much value, then it’s possible for the system to become under-collateralized, in which case, the stability depends on the fallback procedures in place.
As the underlying portfolio of collateral increases its stability, so the stability of the system increases as well.
While each of the examples below maintains different approaches for handling market collapse, the general idea with collateral-backed currency tokens is that the underlying collateral keeps them stable in everyday operations, and various redemption or dilution methods keep the system stable in periods of extreme volatility.
MakerDAO and Dai currently offer advanced technology under this aspect. CDPs that provide the collateral for Dai are entirely on-chain, and no counterparty needs to be trusted.
In analyzing the core principles:
- Transparency — Since the development of these systems are entirely on-chain, they offer a high level of transparency
- Auditability — Since the collateral is held in a smart contract, users aren’t relying on a counterparty to audit the system, they can do so directly with on-chain audits.
- Stability Mechanisms — This implementation is stable if the underlying asset is stable. They can increase stability with over-collateralization or robust fallback procedures.
- Fallback procedures — In the event of a black swan event, fallback procedures generally rely on allowing flexibility in the price of the underlying asset, or exchanging the stablecoin for collateral. In both instances, the damage is minimized by the speed that the system can act.
- Scalability — These systems can operate at scale only if the underlying collateral can scale and scale of all system actors remains consistent.
As demand for stablecoins increase, it’s essential to understand the stability mechanisms that underpin each stablecoin. For a true stablecoin system to succeed and scale, it must be free from the risk of centralized parties, maintain the ability to be audited, and have sufficient fallback measures for extreme events. The real promise of the blockchain will be unlocked upon a successful stablecoin implementation, unleashing a new wave of financial innovation.
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