Taylor Wei
May 1 · 11 min read

In a decentralized blockchain ecosystem, the token acts as the glue that holds all the pieces together. Still, there are many critics that insist there is no reason for a token, and that traditional fiat payments would suffice in almost every scenario. What these pundits miss is the unique features that only cryptocurrencies can provide. Among the most important of these aspects is programmability. Without a token, the use of smart-contracts and automatic incentive mechanisms becomes impossible barring middlemen oversight. In effect, a token allows a platform to run autonomously.

There are many other reasons besides programmability that make cryptocurrencies better suited for use within blockchain ecosystems when compared to fiat money. However, decentralized digital currencies also bring unique challenges that government controlled fiat monies are often unaffected by. One of the most critical of these is volatility. In response to the issue of volatility, a few solutions have been proposed. The most popular proposals fall into three categories: stable coins, two-token systems, and low-friction free market mechanisms.

— — — — — — — — -Stable Coins — — — — — — — — —

Stable coins are cryptocurrencies that aim to maintain a 1:1 peg to a fiat currency. There are two broad categories of stable coins that are in use today: fiat-collateralized and crypto-collateralized.

Fiat-collateralized stable coins are backed by physical fiat reserves, which are usually held by a bank. The most widely used fiat-collateralized stable coin is Tether (USDT). The workings of this category of digital currency are simple. When fiat currency is deposited into a bank, an equivalent amount of stable coin is issued. These coins are like digital IOUs that allow holders to redeem them 1:1 for an equivalent amount of fiat currency at any time.

While this is an efficient and simple way to create a stable coin, there are a few major trade-offs. Holders of the stable coin are somewhat blindly trusting that the custodian will not misappropriate the reserves, and that the centralized infrastructure — typically a bank — is sufficiently secure.

When people purchase a fiat backed stable coin, they do so trusting that each coin is actually backed up by the correct amount of fiat currency. If the custodian in control of the reserves becomes malicious — and for instance slowly siphons reserves off unbeknownst to the holder — the effects could be catastrophic. Since a stable coin’s value comes almost exclusively from its redeemability for fiat money, revealing that the reserves are insufficient to back the full amount of circulating stable coin would trigger a mass panic, causing the stable coin to lose its peg as people frantically attempt to sell their holdings. In a worst case scenario, the issuer could run off with all the reserves, causing the now very unstable coin to completely collapse.

Unlike autonomous running cryptocurrencies such as Bitcoin, fiat backed stable coins are usually run in a centralized manner, and so there needs to be a way to generate revenue for sustainability. In general, the business model for this class of stable coin revolves around earning interest from the fiat reserves through some sort of savings account. However, this brings up another issue. Unless the issuer of the stable coin is constantly being audited, it’s almost impossible to know for sure how the reserves are truly allocated.

It is entirely possible that the custodian of the stable coin reserves are participating in fractional reserve banking. History has shown that entrusting a single centralized entity to responsibly handle large sums of money often ends badly. The temptation to invest in high-return risky assets is too great, especially when there is little government oversight. As the world found out from the financial collapse of 2008, even the most “trusted” institutions with strict government oversight cannot resist the urge to gamble with money that is not their own. Besides, requiring trust in a single entity is exactly the type of thing cryptocurrencies are supposed to liberate us from, and so fiat-collateralized stable coins seem like a step in the wrong direction.

Pros:

  • Simple: Fiat-collateralized stable coins work though simple principles, and so it is easy to predict the conditions for failure
  • Hard-Peg: Fiat-collateralized stable coins stay pegged under most circumstances.

Cons:

  • Centralized: Requires trusting a central entity, and the use of centralized infrastructure. Inherits the flaws of the legacy financial system.
  • Audits: Holders depend on the issuer presenting third party audits to be sure the coin is sufficiently backed.

Crypto-collateralized stable coins are backed by an underlying cryptocurrency, or even a basket of crypto assets. The goal is to issue tokens that stay pegged to a fiat currency, but in a decentralized manner. The obvious issue here is that crypto assets are volatile themselves. Simply backing up a cryptocurrency with another volatile crypto asset does not create stability, and in fact it seems rather paradoxical. Clearly there must be some ingenuity involved when creating a crypto-collateralized stable coin.

Since these types of stable coins are very complex and depend upon the implementation, it’s better to consider a specific example for illustrative purposes. The most successful attempt at a crypto-collateralized stable coin has come from the Maker DAO (Decentralized Autonomous Organization) project, which successfully issued an ETH collateralized cryptocurrency called Dai which is soft-pegged to USD.

While Dai has done a relatively good job so far at maintaining its peg during times of volatility, it is still very experimental. We won’t dive too deep into the inner workings of the Maker DAO as that would require a separate article, but from a high level, the mechanism for stability consists of a complex system of smart-contracts that allow anyone to lock up ETH in exchange for Dai. When the price of ETH fluctuates, a combination of smart-contracts and carefully designed incentive mechanisms act to keep one Dai pegged to one USD.

These special smart-contracts are called Collateralized Debt Positions (CDPs). The Maker DAO is run by the holders of Maker token, and provides oversight to the ecosystem by voting on certain parameters, such as the ratio of Dai received to the amount of locked ETH in a CDP. The Maker holders are also responsible for enacting fail-safe protocols in the case of a black swan event, such as the price of ETH crashing very quickly.

Pros:

  • Decentralization: Using smart-contracts with oversight from a DAO removes the need for custodians and centralized banking infrastructure. Apart from centralized oracles that feed the smart-contracts market data from exchanges, the Maker DAO system is decentralized.
  • Transparency: Holders of the Maker token transparently govern the ecosystem through voting, and since everything is logged transparently on the Ethereum blockchain, it is easy to check if anything nefarious is going on.

Cons:

  • Complexity: The more complex a system is, the more difficult it is to predict certain outcomes, especially when there are many situations that have yet to be encountered. Add to this the experimental nature of DAOs and there is significant risk at this early stage.
  • Reliance: A crypto-collateralized stable coin critically depends upon the cryptocurrency(s) being used as collateral. While Dai is made to handle price swings, extreme volatility or the slow death of the underlying asset being used as collateral could cause troubles.
  • Capital Inefficiency: For every $1 worth of Dai issued, at least $1.50 worth of ETH must be locked in a CDP. Furthermore, if the market value of ETH decreases, the owner of the CDP must put more ETH in or risk being auto-liquidated and slapped with a penalty. This puts risk on CDP owners, and could make it difficult to galvanize enough people to open up CDPs, which could lead to a lack of liquidity. Compare this to fiat-collateralized stable coins where the issuance is 1-to-1, and there is no risk of liquidation.

— — — — — — — Two-Token Systems — — — — — — — -

Another proposed method to combat the negative effects of volatility is the two-token system. Without going into too much depth, the basic premise is that one token is used as an investment vehicle, while the other is used as a utility token. The purpose is to separate the speculative trading component of cryptocurrencies from the utility they can provide. The main token usually allows holders to participate in things like governance and staking. In many models, holding the main token also pays out dividends in the form of the second token.

The secondary token is used as a medium of exchange to pay for infrastructure level utilities, such as gas for smart-contracts. While this system has its benefits, it does not fix the underlying issue of volatility on its own. The secondary utility token which is used by clients and service providers to pay for things in the ecosystem is still subject to volatility. In fact, the volatility could be amplified, since there will be less liquidity if investors and speculators only purchase the main token. As a general rule, the higher the market cap of a token, the harder it is to quickly move the price.

— — — TOP Token: The Free Market Solution — — — -

Stable coins and two token systems can help address some of the issues surrounding volatility, but there are trade-offs involved with both of these solutions. To understand why TOP prefers a free market solution, let’s first understand the issue that volatility creates in regards to the actual functioning of the platform.

There are two main parties that participate in a token economy: clients, and service providers. Until the glorious day that cryptocurrencies become universally accepted, both consumers and service providers will generally value tokens based on the amount of fiat money they are worth. So when the fiat value of a token changes wildly from day to day, it makes it difficult to price services. For instance, assume a provider charges 2 TOP tokens for a certain part of their service. If the price of the token suddenly falls by half in terms of its fiat trading value, the provider would essentially be receiving half as much fiat money for the same service.

This seems like a huge issue. Imagine if this was a regular occurrence in our economies. A t-shirt priced at $10 one day would only cost $5 the next day. Luckily, token economies have some features that the traditional payment systems don’t. Token payments can have extremely low transaction fees, and allow for programmability through use of smart-contracts. The key to addressing the pricing issue caused by volatility is a highly efficient, low-friction decentralized marketplace that allows service providers and clients to seamlessly adjust offers and bids very quickly.

To see how this works, let’s analyze the two possible negative outcomes that can result from volatility. As an example, assume a VPN billing unit has discovered a fair price of 2 TOP tokens through free market mechanisms.

  1. The token price increases dramatically: If the service were to remain priced at 2 TOP tokens after a sudden 25% increase in token price, the clients would be paying too much in terms of fiat equivalent. To compensate, clients could adjust their bids down to a lower number of TOP tokens in order to remain paying the same amount in fiat for the service. In a free market, there should be enough competition to ensure that enough service providers will accommodate the new bids, and not remain priced above fair value.
  1. The token price decreases dramatically: If the service were to remain priced at 2 TOP tokens after a sudden 25% decrease in token price, the clients would be paying less than fair value for the service. To compensate, service providers would renegotiate their offers by proportionally increasing the amount of TOP tokens so that the service remains priced at the same fiat value. Most service providers would quickly follow, as there are operational expenses that must be covered, and there is little incentive to undercut and run at a loss.

By pricing in terms of fiat instead of TOP tokens, service costs can remain effectively stable as long as smart-contracts can be renegotiated easily and cheaply. Using TOP Marketplace, offers from service providers and bids from clients can be quickly renegotiated when the price of the token changes. The work of deploying and enforcing the smart-contract negotiations is handled by the Market Protocol, and so it is relatively simple to renegotiate new offers and bids. Furthermore, low or even zero fee transactions means that there is essentially no loss incurred from the renegotiation of a service agreement.

Many of the negative effects of volatility can be greatly reduced by pricing in terms of fiat instead of TOP tokens. In fact, it is likely that most ecosystem participants will rarely even look at the number of TOP tokens, and instead price everything in terms of fiat. The equivalent number of TOP tokens can be calculated in the background based on the current market value. This is especially true for end users, who should not have to think about token volatility, or be forced to do calculations just to figure out the amount of money they are actually spending on services.

While in theory an efficient free market can solve the issues surrounding volatility, there are a few assumptions being made here. The first is that a sufficient number of providers are offering each service. Free markets only work when there is enough competition between service providers. If there are only a few providers for a given service, prices will take longer to re-balance to a fair value after a bout of volatility. The other assumption is that smart-contract agreements are relatively short in length. Long-term smart-contracts are still prone to the negative effects of volatility, as the terms cannot be renegotiated quickly after large swings in price.

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — —

In the broader picture, volatility in the crypto markets should reduce going forward. As a project’s market cap gets higher — and the liquidity in the ecosystem increases — volatility becomes less extreme. Additionally, as a token’s use transitions from a speculative asset to something with real utility and demand, volatility will become less and less apparent. For TOP Network in particular, once 60 million users are ported to the platform providing a large amount of liquidity and real demand for TOP, volatility as a result of speculative trading will become far less significant. This mass influx of users will also provide the incentive to attract enough service providers to create the bustling and efficient free marketplace necessary to bring stability to TOP.

TOP Network

TOP Network is a decentralized open communication network that provides cloud communication services on the blockchain. TOP offers secure, low-cost services such as messaging, calling, video, VPN, CDN, IoT data sharing and more.

Taylor Wei

Written by

Co-founder & CTO of TOP Network, the world’s first decentralized open communication network powered by blockchain 4.0. Cryptography Expert.

TOP Network

TOP Network is a decentralized open communication network that provides cloud communication services on the blockchain. TOP offers secure, low-cost services such as messaging, calling, video, VPN, CDN, IoT data sharing and more.

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