Who’s the Oxymoron? Stablecoins or Bust
Lesson 10: The Primer You’ve Always Wanted
Recent and persistent criticisms by govenments about the actual stability of cryptocurrency stablecoins provides a good dose of caution; but it can also be misleading. Some stablecoins are designed better than others.
Key questions revolve around how stability is backed and how a stablecoin can absord actual and hypothetical crashes.
Why hypothetical?
A good thought experiment for both designers and users of a stablecoin is to ask,
What would happen if everyone holding a stablecoin were to withdraw it at once?
Ideally, the design of the stablecoin should be able to withstand that event and provide each holder with their assets.
But before exploring how stablecoins might be able to do this, let’s get down to basics.
What Are Stablecoins?
Two of the essential requirements of any system of exchange are having a currency that can act as a medium of exchange AND a store of value, otherwise defined by economists as M1 and M2 (respectively).
It’s important to note, at least from my philosophical perspective, that a currency cannot act as a medium of exchange if it has no relation to a store of value. This relation involves two key features:
- The currency is either valuable itself (like a commodity currency, such as gold or silver); or the currency is backed by and represents real value . . . or, what amounts to the same thing, the currency is back by another currency that in turn is backed by or represents real value (or what occurs when nations “back” their own native currency with US dollars).
- The currency is stable, and can withstand little to no fluctuation during volatile times. This amounts to acting as a reliable store of value.
Stablecoins are often pegged to the US dollar. Not all are designed in this way, and we’ll get to those details later. Notwithstanding these differences, the idea of a stablecoin is that it will provide a more or less reliable medium of exchange and store of value in the volatile market of cryptocurrency trading.
As such, stablecoins are the oil greasing the wheels of exchange on the various blockchains and protocols. While it is true that you can conduct exchange with any form of fungible coin, stablecoins pegged to the US dollar makes it a bit easier to move amounts across platforms.
Another thing to note about stablecoins as a store of value:
During a bear market or crypto winter, values of coins will fluctuate. Keeping the majority of one’s value in stablecoins helps to minimize losses, assuming the peg to the US dollar holds and the US dollar itself does well. So in effect, stablecoins offer a cash option.
On that note, the most heavily traded cryptocurrency by volume happens to be a stablecoin — USDT, or Tether. At the time of writing (Sept 26, 2022), here’s how volume numbers stand:
High volume = the oil greasing the wheels of exchange.
How Are Stablecoins Backed?
Stablecoins have their stability due to the value that backs them. There is no use in being pegged to the US dollar if a coin actually has no value enabling it to maintain that peg.
The issue of backing a currency is a huge, vexed, and murky topic. It touches on enormous philosophical questions about how value arises and works in an economy. It’s what Marx famously called the “transformation problem”, or how material is used by labor and in the process of laboring transformed into value (or use-value for Marx). I’ll come back to this in another Medium article.
For our purposes, we simply need to note how stablecoins have their value by virtue of being collateralized in different ways.
There are five primary stablecoin types, identifiable by their underlying collateral structure: fiat-backed, crypto-backed, commodity-backed, algorithmic, and fractionalized reserve.
Traditional Collateral (Off-Chain)
The most popular stablecoins are backed 1:1 by fiat currency. Because the underlying collateral isn’t another cryptocurrency, this type of stablecoin is considered an off-chain asset. Fiat collateral remains in reserve with a central issuer or financial institution, and must remain proportionate to the number of stablecoin tokens in circulation.
One typically expects a 100% collateralization in order to provide investors with confidence that the stablecoin will not lose value. If the collateralization is not 100%, it can incite a run on the stablecoin where investors dump their stablecoin for a more stable asset. Because the collateral amounts are not 100% it can cause a crash unless the stablecoin provider can inject cash into the collateral pool.
Stablecoins, such as Tether, are backed by a mixture of cash and other assets (they are often called “hybrid” stablecoins). Tether has come under scrutiny since it is not transparent about what types of assets (i.e. commercial papers) are doing the backing. Commercial papers are a debt instrument used by companies to raise money in the short-term. Because they mature in 270 days or less, they are not registered with the SEC. So, if the company using a commercial paper is a default risk, then the stablecoin’s backing is also at risk.
Crypto Collateral (On-Chain)
As the name implies, crypto-collateralized stablecoins are backed by another cryptocurrency as collateral. This process occurs on-chain and employs smart contracts instead of relying on a central issuer. When purchasing this kind of stablecoin, you lock your cryptocurrency into a smart contract to obtain tokens of equal representative value. You can then put your stablecoin back into the same smart contract to withdraw your original collateral amount.
DAI is the most prominent stablecoin in this category that makes use of this mechanism. This is realized by utilizing a collateralized debt position (CDP) via MakerDAO to secure assets as collateral on the blockchain. DAI is pegged to the US dollar but backed by the collateral on its own platform MakerDAO. In addition, like algorithmic stablecoins, DAI uses a strategy to manipulate market activities in order to incentivize increasing or decreasing the value of DAI. The difference is that DAI is not explicitly algorithmic in its manipulation and uses aspects of game theory instead.
Algorithmic Stablecoins
Algorithmic stablecoins do not use fiat or cryptocurrency as collateral. Instead, their price stability results from the use of specialized algorithms and smart contracts that manage the supply of tokens in circulation. An algorithmic stablecoin system will reduce the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks. Alternatively, if the price of the token exceeds the price of the fiat currency it tracks, new tokens enter into circulation to adjust the stablecoin value downward.
For example, when the price of the stablecoin exceeds 1 US dollar, more stablecoins are minted to inflate the number of stablecoins and thus decrease its value so that it drops to 1 US dollar. When the price is lower than 1 US dollar, stablecoins are burned in order to reduce the supply and thus increase its value.
You may be wondering if this can really work when it seems any coin must not only track supply and demand but also be backed in some way by value. The short answer is “yes”.
Not all algorithmic stablecoins track fiat currency. RAI is a notable one which is a non-pegged stablecoin. RAI’s case is unique enough that it requires a separate article by itself. (If my hunch is correct, RAI provides an interesting case for Marx’s transformation problem.)
Commodity-Backed Stablecoins
Commodity-backed stablecoins are collateralized using physical assets like precious metals, oil, and real estate. The most popular commodity to be collateralized is gold; Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. However, it is important to remember that these commodities can, and are more likely to, fluctuate in price and therefore have the potential to lose value.
Fractional Reserve Stablecoins
Fractional reserve stablecoins are those which use a mixture of collateral backing and algorithms to maintain their peg to the US dollar. Instead of minting and burning coins, FRAX uses algorithms to increase or decrease the supply of collateral. FRAX is the only fractional reserve coin to date.
We’re almost to the issue of actual and hypothetical crashes. There’s just one more thing to note about stablecoins — i.e. seignorage.
Seignorage: The Nuts & Bolts of Algorithmic Stability
First, we need to disambiguate two senses of the term “seignorage”. We’ll then unpack a third sense specific to algorithmic stablecoins.
(1)
Conventionally, in TradFi and CeFi, seignorage is the difference between the face value of a coin and the cost to produce it. Apparently, pennies and nickels cost more than they are worth, while dimes and quarters do not:
A dime costs 3.9 cents to make, and a quarter 9 cents. All together, the Mint made $289.1 million on seigniorage — the difference between the value of the coin and the cost to make it — despite a $90.5 million drag from the penny and nickel.
It would seem that given the material disadvantage of fiat currencies, digital currencies would be more cost-effective. They simply use minting power to be formed — that is, energy. And so, their seignorage would be minimal.
However, when referring to seignorage and cryptocurrencies in general, the term does not refer to the material costs involved.
(2)
In DeFi, “seignorage” typically refers to how one type of coin can be minted in relation to a source of value. Just because there is little to no cost in creating a digital currency, it does not simply mean that one can mint or print as much as one wants (unless it is a Ponzi scheme or rug pull). All currencies must in some way be backed by value or represent value in some way.
Seignorage therefore refers to the method and process by which the minting of one coin draws its value from another. This usually occurs by the process of burning. For example, let us say a protocol’s native token is called GUILDER, which is the currency used to buy and sell things. The protocol also has a governance token called SPUD which members of the protocol use to vote on how the protocol is run. The only way to get SPUD is to buy it with GUILDER. So generally, that process can be considered seignorage. Burn 10 GUILDERS to get 10 SPUD, which allows for more voting power. Or to put this more in terms of cost: the cost of 1 SPUD is 1 GUILDER.
(You might be asking yourself: Why not just use one coin for both exchange and governance — i.e. GUILDER? Burning GUILDER to acquire SPUD helps keep theinfation of GUILDER down; users burn it to acquire voting rights.)
(3)
With algorithmic stablecoins, there is an added factor — i.e. stability. To recall, the idea of a stablecoin is that it provides a store of value for the market and thus can be relied upon for exchange and as a cash alternative to more volatile cryptocurrencies.
The aim of seigniorage for stablecoins is to provide a stable price, which is usually pegged to the US dollar. To do this, the burning and minting process is systematic and dynamic. In contrast, the example above in (2) was a spot exchange.
So what’s meant by systematic and dynamic.
Systematic refers to how the stability of the price is determined by what’s going on in the market. Essentially, the system dictates the supply of the stablecoin based on demand. To do this effectively, protocols dynamically react to the market, or system.
Dynamic refers to how the smart contract mechanism uses algorithms to determine how much of the coins involved ought to be burned or minted. The idea here is that dynamic systems don’t require a lot of human involvement because they are supposed to be “smart”. So how might the protocol work dynamically. We covered this above. But let’s reiterate the example:
If demand is low, it usually means the price of the stablecoin has fallen. To balance this, the supply of the stablecoin would be reduced (or burned). Conversely, if demand is low, it usually means the price of the stablecoin has risen. While this is a good thing for most currencies, remember that a stablecoin needs to maintain its peg to the US dollar. So, in this case, more stablecoins are minted.
Sounds foolproof, right?
Take the Money and Run!
The hypothetical thought experiement of asking, “What would happen if everyone tried to withdraw their stablecoins?”, is not merely academic.
If a stablecoin is in fact what it purports to be, the value it represents should exist in real terms. Unfortunately, at least in the case of stablecoins, finding a proof of concept sometimes comes down to some version of the hypothetical question manifesting as a pressure test.
Enter the “bank run”.
In conventional terms, a “bank run” is when the majority of holders of an asset try to withdraw their holdings because they fear that they will not be able to withdraw them. This behavior is often triggered by fear and doubt about the market, or by panic when the market is actually crashing.
A run causes a problem when a bank does not have adequate cash reserves to release to its customers who are attempting to withdraw their savings. Banks need to make money, so they use customer deposits to make interest on fractionalized lending. The Federal Reserve sets the bank reserve requirement. At the start of the 2000s, it was 10%. Since March 2020 (the start of the pandemic), it was lowered to 0%.
With stablecoins, and crypto more generally, a run involves withdrawing coins in order to exchange them for US dollars or another cryptocurrency. This process can be problematic in a number of ways:
- You might have your coins staked, or locked, at a decentralized exchange or yield farming site. If the lock is timed-based, you will not be able to withdraw or unstake your coins until that period is over.
- If it is not locked, and the run is significant, the yield or exchange protocol may decide to halt transactions on the affected coin.
- Or, there could be so much transaction activity (other users trying to withdraw the same coin) on an exchange or yield farming site that requests are placed in a long queue, or the protocol simply cannot handle the volume.
It’s important to note that with cryptocurrency a run can be self-prophetic, based on the feedback loop involving rapidly dropping prices. It’s easy to go to a central or decentralized exchange and watch the value of a coin drop. Most people react to that by getting out before it’s too late–i.e. trading the affected coins.
Examples of this type of run include:
- The near collapse of Iron Finance, which was the first run in cryptocurrency history. On June 16, 2021, a significant amount of IRON, the network’s stablecoin, was redeemed and a significant amount of TITAN, the network’s governance token, was sold. IRON depegged and TITAN plummeted in value. This caused more holders to make a run on the coins. There was no smart contract mechanism to stabilize value between the coins. Stabilization relied on arbitrage trading, and in this case, real-time data feeds were delayed, which made trading unprofitable.
- The Terra-Luna ecosystem fell between May 11–12, 2022. There was a mass sell-off of its stablecoin, UST, on the Curve stablecoin yielding site. UST lost its peg, which caused a run on both UST and LUNA. Interestingly, unlike the TITAN fiasco, Terra-Luna did have a stabilizing mechanism relying on arbitrage trading. But the drop in the value of UST was not taken advantage of by arbitrage traders (i.e. buying it low to sell high). This then caused LUNA to drop.
For more on the risks involved in stablecoins, you can see my two-part article on counterparty risk and conceptual design risk.
What’s the Answer and How Does This Apply to Me?
Any stablecoin using algorithms to help maintain its value or peg, requires 100% collateral backing from another store of value. This is why, when one hears crypto-skeptics making allegations that the cryptocurrency market is a joke because it relies on the value of the US dollar, they are not altogether wrong.
Their criticism points to an interesting crossroads for cryptocurrency as an ideology. Its original rallying cry was decentralization and freedom from authority. I think there are good ways and bad ways to frame this ethos. (Disclaimer: I am definitely not a libertarian.)
For the time being, however, as the crypto market and DeFi space grow AND come to accept forms of regulation, their growth is going to have to rely on conventional and hence stable forms of value. And that lies in the TradFi market we all know.
This means for the average consumer interested in trading cryptocurrencies, stability lies in a) 100% bonafide backing by b) bonafide assets, like fiat currency (and less in debt securities, etc.).
Here’s the catch, though. With decentralized projects, the backing should be transparent because assets can be tracked on the blockchain (as immutable and public). With centralized organizations, it can remain unclear about asset-backing, as is the case with Tether (noted above).
So there is a mix and confusion. Yes, on conventional forms of value to back a coin. No, in terms of conventional forms of organization which can hide how a coin is backed.
But perhaps that will be sorted out in the not-so-distant future. RAI may have a special place in that sense.
One last practical note: bonafide backing by bonafide assets means that stablecoins are mostly or entirely backed by fiat currencies or tradition commodities. When backed by other cryptocurrencies, those types of stablescoins may be risky. (Again, RAI may be an exception.) This is because the asset doing the backing is itself volatile. Most (but not all) cryptocurriences tend to follow the leader (i.e. Bitcoin) when the crypto market declines.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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