The Complete Guide to Stable Coins

Stable Coins are cryptocurrencies designed to solve the price volatility problem. Read the complete guide to stable coins here.

Crypto Prices Are Too Unstable, Hinders Adoption

If cryptocurrencies promise to change the way we pay for goods and services, why aren’t they being widely used? One reason is that their prices are too volatile. The largest cryptocurrency by market cap, Bitcoin, can have a daily price fluctuation of 5–10 percent. These price movements can be even larger with shifting investor sentiment and speculative behavior which drive buying and selling activities.

Consequently, consumers and businesses face risks if they adopt Bitcoin as a medium of exchange. If workers receive their salary in Bitcoin, the huge value change in disposable income affects their ability to pay for goods and services. For merchants, accepting payments in Bitcoin is risky if prices change from minute to minute (i.e. currency risk). It’s even tougher to offer lending products or price other financial products. The cost of doing business goes up since more resources are used to hedge price changes.

The Bitcoin historical volatility index shows the standard deviation of daily returns. This measures how much risks people take on when they’re holding the asset. Price swings have trended downwards, but the story is still not so good for adoption when we can use traditional currencies like the USD or Euro. Markets typically prefer the USD and Euro to price salary, financial loans, options contracts, and other market instruments.

Stable Coins Aim To Minimize Price Swings

How then can crypto truly become a medium of exchange? One class of solution are stablecoins, or cryptocurrencies that peg its price to another stable asset. The idea of pegging one currency’s value to another currency is not new in our modern global economy.

There are a handful of smaller countries like Jordan and Saudi Arabia that peg their national currencies to the U.S. dollar for security and stability. Countries that are trade-reliant or seeking trading advantage gravitate towards a dollar-pegged regime. Similarly, in the tokenized economy, a cryptocurrency can achieve price stability by pegging to the USD.

According to a Blockchain report, as of Q1 2019, there are more than 50 stable coins on the market (and growing), 39% of which are live.

Three Approaches to Doing a Peg

The goal of stable coins is to take the stability of the US dollar and combine it with a decentralized distributed ledger. There are multiple ways to do a cryptocurrency peg, but each regime type has trade-offs between economic efficiency and decentralization. Let’s dive in the taxonomy:

Fiat Collateralized Stable Coin

Fiat currency is a traditional currency issued by the central government. Stable coins that use fiat collateral has an account sitting somewhere with actual money like US dollars (USD) to back up the tokens you’re issuing. Why the USD? Global markets perceive the USD to be a very stable currency. How does it work?

This stable coin setup is like a centralized system with a banking system. You go to a company that’s safeguarding the assets, then you can deposit 1 USD and get 1 digital token, or redeem 1 token for 1 USD. This scheme is the safest but you would have to trust the counterparty that owns the bank accounts.

Tether (USDT) is the most popular example that brings out the good and bad of dollar-pegged coins. Tether Limited is the company that states for every Tether token they issue, it’s backed by 1 USD stored in reserves at a bank account somewhere.

This scheme is safe and simple, but you would have to trust the counterparty that owns the bank accounts. Tether brings out the good and bad of dollar-pegged coins. Tether Limited is the company that states for every Tether token they issue, it’s backed by 1 USD stored in reserves at a bank account somewhere. But it all boils down to trust, and Tether has a trust problem. There are several key risks:

• Weak supervision and examination: Tether company fell short of substantiating their claim that Tether tokens in circulation are sufficiently backed by USD currency reserves.
• Legal risk: The New York State Attorney General is taking legal action against Tether based on fraud allegations.
• Other risks: the questionable relationship between Tether and Bitfinex, one of the largest exchanges, that holds a large supply of Tether tokens;

But it all boils down to the market’s trust in the middleman and its ability to safely and securely manage the reserves necessary to maintain the peg. In a time of panic, will the coin truly redeemable 1 for 1 in a market panic? Historically, data shows Tether to be a fairly stable peg to the USD, though with several episodes of market gyrations.

Source: Coinmarketcap

Another example is Gemini, the U.S. based exchange, which has the Gemini Dollar as a competitor to Tether. Dubbed as the ‘first regulated stable value coin’, Gemini argues that they have an edge due to its robust compliance program, subject to audits and approval by the NY Department of Financial Services. Their strategy involves outside consultants periodically reviewing the bank to ensure sufficient reserves. Another difference to Tether is Gemini is an ERC-20 token built on the Ethereum blockchain so there’s a public trail on an open ledger.

The latest stable coin of this type is Facebook’s Libra, whose value is pegged to a basket of fiat currencies. The price stability is backed by a reserve of cash-equivalent assets (i.e. short term duration assets). Libra is transacted on a private, permissioned blockchain. There is a central authority you have to trust since it impacts the value of the asset you’re pegged against. Whether the Libra cryptocurrency achieves price stability will depend on the consortium being able to execute on monetary policy, effectively rebalancing the basket of currencies and reserve assets.

In sum, the benefits of collateralized stable coins are simple to understand and achieve higher price stability and collateral held by trusted institution people are used to dealing with. The downsides: we must trust the different players involved in economic management:

• A centralized player such as custodian of collateral-that is real-world money;
• Transparency problem: need an external party to audit or an extra set of eyes to make sure sufficient reserves;
• Reliant on regulators as a last resort if there’s no trust in the first two parties;
• The process to redeem or liquidate to real-world currency can be cumbersome;
• Hard to scale and inefficient way to deploy capital. You need all these banking relationships. Capital is sitting idle in reserves.

So how can we get away from this trusted-middleman model? Have all these trust mechanisms put on the blockchain, or otherwise a truly decentralized stable coin?

Crypto Collateralized Stable Coin

The second approach is using cryptocurrency collateral. This is similar to fiat collateralized, but rather having fiat reserves, you have a basket of cryptocurrencies as the reserve.

You don’t have to the trust banks or a centralized relationship. You can do this through decentralized smart contracts, publicly auditable on the blockchain. You can also liquidate quickly into the crypto collateral since they’re done with smart contracts without going through a middle man like a custodian. It’s highly transparent since any market actor can see the collateralization ratio since the values and history of transactions are stored on the blockchain.

But we’ve hit this problem again: cryptocurrencies are volatile. So you would expect a basket of cryptocurrencies to be overcollateralized to get the token value you want. That means for every token issued, there have to be more than one cryptocurrency units sitting in reserves. That cushion helps to defend price stability when crypto prices that serve as the underlying collateral drop in value.

A good example of this stable coin type is the DAI token, an ERC-20 token built on the Ethereum blockchain. Here you may have to put in $200 worth to get $100 of the value of the stable coin. Overcollateralization can make it capital intensive or capital inefficient. It means for every token you put in, you may only be able to get back less than 1 in collateral. It works well when crypto market prices are up. What if Ether’s value crashes overnight? Will the scheme be able to defend the peg during sizeable Ether downturns? That’s an open empirical question. By contrast, with the fiat collateralized model, the market is confident that one digital token can be backed 1-for-1 with USD. Since the US dollar value is very stable, it can hold that 1-to-1 ratio.

Another example is the Saga Global Digital Currency, which is an Ethereum liquidity pool blended with a mix of fiat currencies sitting in an account. The price hedging instrument holds both cryptocurrency and fiat collateral.

Non-collateralized Stable Coin

The last way to peg falls into the non-collateralized stable coin. This can be done by an algorithmic central bank without a middleman. Smart contracts manage the monetary policy by handling transactions to stabilize the price. The coins can be pegged to traditional currencies or cryptoassets with no reserves. Rather, it manipulates the money supply to dynamically adjust its market price. For instance, when token prices go up vis-a-vis the USD, an algorithmic central bank will respond by increasing the money supply, which puts downward pressure on token price relative to the dollar.

An example of this peg is Basecoin. If the price of Basecoin slips below $1, the algorithm would automatically sell a bond token at a price below $1 with the promise that they will redeem it for $1 Basecoin in the future. If the price of Basecoin jumps above $1, the algorithm would respond by increasing the money supply, adding more basis coins or buying back bond tokens that were purchased.

The benefits of non-collateralized stable coins:

• No need for collateral;
• Decentralized finance, managed by smart contracts;
• Independent central bank that doesn’t depend on an external peg to fiat or cryptocurrencies.

The downsides:

• The market mechanism is hard to grasp;
• Still green, not much stress testing in production (yet)
• Predicated on a market belief that the price of the token would revert to $1. The value of Basecoin can collapse considerably if its central bank algorithm can’t sell bond tokens amidst a confidence breakdown.
• Basecoin raised significant investments in a private pre-sale. It’s an open question whether an algorithmic stable coin can achieve price stability given the nascent tech. Unfortunately, Basecoin has since halted its formal launch citing regulatory hurdles from the US SEC and returned most of the capital raised to investors earlier this year.

Originally published at https://overblock.io on July 15, 2019.