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Stablecoins are cryptocurrencies with stable value; unlike most other crypto assets, they have low volatility against the world’s most important sovereign-backed currencies (fiat). They are essentially a cryptocurrency with a fixed price.

The idea behind them is that cryptos cannot achieve mainstream adoption if they suffer from daily double digit inflation, and since stablecoins don’t suffer the same volatility as other coins, they can be used as a medium of exchange in the real world.

Bitcoin has been criticized because its fees and volatility make it impractical to buy a cup of coffee, and a stable coin aims to be the solution. In the Bitcoin whitepaper, Satoshi’s vision was to create “digital cash”, but Bitcoin has evolved into a ‘store of value’, a kind of digital gold, because the currency is rarely used as a daily medium of exchange.

Creating a stable, digital cryptocurrency is considered to be the highest convexity program in crypto because the total addressable market is all the money in the world, since it aims to be global, fiat free, digital cash. This makes the stablecoin addressable market much larger than Bitcoin itself.

Today, the most transactions are via TrueUSD (TUSD) and Tether (USDT): but new stablecoins are arriving all the time.

Why do stablecoins matter?

A reliable stablecoin will enable greater use cases on the blockchain because it will allow people to transact in the short term with cryptocurrencies in a practical manner, while also providing the long term stability required for financial functions such as loans and credit.

Distributed stablecoins could have the same advantages of Bitcoin, like being an electronic, censorship resistant payment method, without the same volatile exchange rates.

Many forms of fiat money, including USD, have not even achieved true stability – credit cycles can put the USD bank deposits at risk, so a price stable cryptocurrency that builds on top of USD is never going to be more reliable than traditional banking.

After Bitcoin’s historic run of 1,300%+ returns in late 2017 the crypto market is widely considered a speculative one. Even with this volatility, in countries like Venezuela, where the native currency hit inflation of almost 50,000% in the last 12 months, storing your value in Bitcoin for as little as a few weeks will make you nominally wealthy compared to those with 100% exposure to its socialist, hyperinflated currency called Bolivars. Their currency has almost become useless in their own country, and it’s easier to charge for a coffee by the weight of the paper bills than it is to charge millions of Bolivars. Merchants are now using scales to weigh the stacks of paper at the checkout.

Stablecoins are very valuable in trading as well. They reduce friction by allowing investors to manage their risk without fully converting to fiat. This avoids the need to create even more taxable events, pay high withdrawal fees through exchanges and banks, and make more know-your customer (KYC) bank integrations, which can be tedious for traders even though the need for KYC is well-documented.

Another benefit is that stablecoins will keep more money in the crypto realm. Think about crypto and blockchain businesses, such as mining companies, crypto hedge funds, and blockchain projects who have done ICOs. All of those companies are likely bullish on the cryptocurrency industry, but they also have “real-world” bills to pay that are denominated in their local fiat currencies. They are still a part of the regular economy and need to keep the lights on in their offices – last time I checked most landlords don’t accept Bitcoin (yet).

These companies need to liquidate their crypto profits on the market (driving sell-side demand) to pay their bills. With a stablecoin they could keep a higher proportion of their revenue in crypto.

Stablecoins and “money”

A low volatility asset could be a better global solution than Bitcoin because it offers a better solution to the definition of “money”. There is less risk of depreciation, and the theory is that it will be a better medium of exchange due to lower volatility.

The definition of money is based on three simple criteria:

Store of Value : a way to hold wealth without it depreciating Unit of Account : an accounting system Medium of Exchange : can facilitate a sale with an agreed upon expected value by all parties

When thinking about payment tokens (any token where their only use case is to pay for the service that their specific platform offers) doesn’t it make sense to substitute that token with a stable version, where the end user would never have to subject themselves to altcoin volatility? Think about how disruptive this could be to utility token ICO’s.

The economic theory behind blockchain-based stability

Bitcoin maximalists love to cite economist Friedrich August von Hayek (1974 Nobel Prize Winner) because of his anti-establishment ethos when it comes to money. Hayek believed that the world would never have true money until it’s taken out of the hands of the government. He was a proponent of introducing a sly roundabout currency that the government can’t stop. Hayek is often quoted when people are asked why Bitcoin will become a widely adopted currency, but I believe his original vision looks more like a stablecoin.

One of Hayek’s most famous books, “The Denationalization of Money”, argues that government shouldn’t have a monopoly on the supply of money and that it should be like all other consumer goods – subject to competitive markets to serve the best interests of its users. He envisioned that private institutions should issue their own money to compete directly with governments and he described his own hypothetical version in his book, calling it the “Ducat”.

This is how Hayek designed the Ducat:

Issuing party would make the Ducat available by selling it to the public against government money, while promising to keep the price stable. The currency would have one legal obligation: a Ducat holder was permitted to redeem his Ducat for fiat at any time at a fixed rate from the issuer. The legal obligation would act as a price floor. The issuer would also use a monetary policy. If the market price of the Ducat fell below the promised purchasing power then the issuer could use its fiat reserve (raised in a public sale) to buy Ducat in the market. If the market price rose above the desired purchasing power then the issuer could print more and sell it on the market.

Hayek never mentioned the economic incentive for the issuer to start this business, but there are two plausible reasons:

The issuer can profit as a market maker. The issuer can invest its fiat reserves in appreciating assets.

How do you make a coin stable?

Monetary and cryptocurrency specialists have come to agree that there are four features required to create global, fiat-free digital cash:

Price Stability

Scalability

Decentralization

Privacy (this is heavily debated if it is necessary, but there are great arguments for it. Do you really want public visibility on the blockchain for how much you spent at the pub last night?)

According to Multicoin Capital, a US-based crypto hedge fund, there are three fundamental approaches to designing stablecoins. These approaches all attempt to create assets that double as global, fiat-free digital cash.

Centralized IOU Issuance :

A centralized company holds assets in an account or vault and issues tokens that represent a claim on the underlying assets. For example, holding USD in an account and issuing digital tokens on par with the American dollar, where you can claim USD for your digital token at any time. The digital token therefore acts as an “I owe you”.

This design is easy to conceptualize and the value should match USD with certainty if the system is properly designed, but the problem is that it is expensive and slow to audit the reserves, there needs to be trust in the 3rd party that is holding the reserves; and another 3rd party needs to be trusted to conduct an audit – it’s a centralized solution in an ecosystem that’s trying to evade centralized power. Two examples of projects like this are Tether (USDT) and TrueUSD (TUSD).

Collateral Backed :

An entity can lock decentralized assets up in a smart contract on the blockchain and issue tokens that represent a claim on those assets. For example, a basket of ETH, BTC, XMR and XRP where your token represents a proportional ownership of $1 worth of those assets. In this design collateral needs to be locked up in excess of the amount of stablecoins created to account for the volatility of the underlying asset, because crypto assets can drop in price quickly; making the stable coin undercollateralized (i.e. locking up $150 worth of ether to print $100 in stablecoin).

This is a preferred design because no third party custody is required and it is transparent without the need for an audit, but the problem is that the basket selection of collateral assets is difficult, which questions the price stability of the coin in the long run. It is also capital inefficient because of the need to account for crypto volatility. Projects that use this method are Bitshares (BTS), Maker (DAI), and Havven (HAV).

Seigniorage Shares :

An entity can use a monetary policy, similar to the Federal Reserve System, that algorithmically expands and contracts the supply of the currency to keep the price stable. These coins aren’t backed by anything other than the expectation that they will retain a stable value. An initial allocation of the stablecoin is created, you peg the coin to an asset such as USD, and then the supply of the coin algorithmically changes with demand fluctuations.

This is the preferred method for academics because there is no collateral required and it’s risk independent from other currencies, but the major challenge is designing an algorithm that expands and contracts supply in a way that is decentralized, not gameable and resilient (especially to short positions).

The highest profile project that uses this method is Basis, and since this method is not as intuitive as others I will explain how Basis works below:

Basis raised more than $130M USD in traditional venture raises from high profile funds such as A16z, Bain Capital Ventures and Polychain Capital. They’re viewed by many as the leader of the algorithmic stablecoins and the company was started by a strong team of computer science graduates from Princeton who have backgrounds in quantitative finance and at Google.

There are three components to their protocol:

Basis Tokens : This is the stablecoin that is going to initially be pegged to USD. Its supply will and expand and contract to maintain the peg. Bond Tokens : Bonds represent 1 Basis token and are issued and repaid based on the price of Basis in relation to the peg. Share Tokens : Have a fixed supply and derive value from market forces; accruing value as new Basis tokens are issued (like dividends).

There are two main algorithmic functions to understand:

Contraction : This happens when Basis tokens are trading below the peg (let’s say 95 cents) and they need to become more valuable. Bonds are issued and sold at a discount, which is an attractive offer. These bonds promise a Basis token in the future (likely at $1). As a Basis token holder you can exchange your token (that is worth < $1) for a bond that guarantees a Basis token in the future (that likely = $1). This allows the algorithm to contract the supply of tokens outstanding, which will increase the price and maintain the $1 peg. Bonds have a maximum term of 5 years, but the protocol can prepay at any point in FIFO (first in first out) order. The caveat is that bonds expire without payment after the 5 year maturity period… Ouch. Expansion : This happens when Basis tokens are trading above the peg (let’s say $1.05) and they need to decrease in value. The algorithm needs to expand the tokens in circulation. First, it will repay any outstanding bonds to issue more Basis tokens. Second, shareholders (remember Share tokens?) will receive Basis tokens pro-rata; giving value to their shares proportional to the growth of the Basis network.

There are several risks with this method:

Faith : Bond holders are subject to odd terms (fluid repayment and expiry without repayment), which makes it easier for the market to lose faith in their value. If new lenders believe there’s a chance they won’t be paid then these bonds could become useless. Trust : People don’t question what underpins the value of the US dollar, but people will constantly question “why does Basis have value?”. Since it is not as intuitive as other systems it may be difficult to achieve the peg to begin with, which makes scaled adoption much harder. Shorting : There’s an asymmetric incentive to short all seigniorage share stablecoins because the risk of a short squeeze (the risk of being in a short position) is zero and your downside is capped at the interest rate you agree to on the short position. The risk is zero because the algorithm will print more coins if the the value ever goes above the peg, thus making it impossible to get squeezed.

* A short squeeze is a jump in the price of an asset that forces short sellers to close their position.

What I find interesting about stablecoins isn’t the possibility to make the world’s first ever “stable coin” that isn’t subject to any inflation – it’s the fact that we may see them replacing crypto assets (such as payment tokens) so that the ecosystem is more user friendly.

This will make blockchain applications, like Augur (implementing the Dai token in their app) easier to use because users don’t need to be subject to cryptocurrency volatility to get involved.

It also allows for more wealth to be held in digital currencies, and I’m sure global governments will see this trend and help pave the road through favourable legislation.