A Case for Stablecoins

Putting a damper on volatility in a turbulent market(?)

Money is what money does. Contrary to popular belief, money is not a “thing.” Money is a feature, an idea. We define money by its function; something is money if it can be effectively used as a medium of exchange, a unit of account and a store of value.

Cryptocurrencies — the latest addition to a long list of attempts to build the perfect medium for the facilitation of commerce — excel at the first function but arguably fail at the latter two. Satoshi’s ingenious solution to the double spending problem led to the creation of the first digital, decentralized, and truly trustless medium of exchange. That’s great for a start, but if cryptocurrencies ever ought to become money — they first need to solve the problem of volatility.

Volatility hinders all three functions of money and slows down the mainstream adoption and global proliferation of cryptocurrencies. If we wish to reap the benefits of Distributed Ledger Technology (decentralization, security, immutability, transparency…) while maintaining the trust and stability of fiat currencies — we need a stable cryptocurrency.

Enter stablecoins

Stablecoins are “conventional” cryptocurrencies — minus the volatility. They share (at least, in theory) all of the aforementioned features of cryptocurrencies but don’t suffer from the considerable fluctuations in price.

There are three fundamental approaches to designing stablecoins: (i) Fiat-collateralized approach which pegs crypto tokens to stable underlying assets such as fiat currencies — a slight variation on this model would be commodity-backed; (ii) Crypto-collateralized approach which pegs crypto tokens to other on-chain crypto assets; and (iii) Non-collateralized approach which uses seigniorage shares to control the monetary supply of the appropriate stablecoin.

To give you a better understanding of the benefits and drawbacks of stablecoins and how they achieve stability, we’ll briefly examine all three approaches.

Fiat-collateralized stablecoins

The mechanism behind fiat-collateralized stablecoins is fairly simple: issue one crypto token that is essentially an IOU redeemable for one USD. Stablecoin projects, such as Tether, that utilize this model basically create one token for every USD they receive and lock away in the bank as collateral; when someone wants to liquidate their stablecoins, the company destroys the users’ stablecoins and wires them the USD. An example of the commodity-backed variation of this approach would be to peg to a fungible asset — gold in the case of Digix.

Fiat-backed stablecoins are the most simple, stable and robust of the three systems. They achieve all of this, however, chiefly because they’re heavily centralized, which in turn creates issues with transparency, solvency, and legitimacy and imposes a serious counterparty risk to the owners of the tokens.

Crypto-collateralized stablecoins

The second generation of stablecoins was pioneered by BitShares and later employed by projects such as Maker, Havven, and others. The underlying idea of this model is to back the issued tokens with another cryptocurrency and keep everything on the blockchain. However, if cryptocurrencies are inherently volatile, how can a token pegged to a volatile asset maintain a stable price? If the price of the underlying asset (usually BTC or ETH) drops suddenly, the stablecoin becomes undercollateralized. So how do we solve this paradox? One way is to overcollateralize. For example, when a stablecoin issuer generates $100 worth of stablecoins, it locks up $150 worth of crypto in a smart contract as collateral. Maker’s Dai takes a vastly different approach however, and I encourage you to read more about those mechanics as they’re quite interesting.

Because everything is kept on the blockchain, crypto-backed stablecoins are fully transparent and offer very fast liquidation. However, being decentralized and pegged to volatile cryptocurrencies, they’re inherently less stable than fiat-backed stablecoins which arguably makes them riskier and more prone to auto-liquidation during price crashes of the underlying asset.

Non-collateralized stablecoins

The third generation of stablecoins currently being developed by Basis.io (and others) is based on a system of so-called “shares and bonds” which uses smart algorithms to expand and contract the supply of the issued tokens. Sounds familiar? That’s because it’s the same logic and the same mechanism that central banks use in esse to control the price of fiat currencies. This model is often called “seigniorage shares model” after the term seigniorage which comes from the Old French seigneuriage or “right of the lord (seigneur) to mint money.”

Grossly oversimplifying it, the volatility control mechanism works like this: when the price of the stablecoin is higher than the expectation — the smart contract prints more coins; when the price is lower than the expectation — it issues bonds to remove coins from circulation.

Non-collateralized stablecoins based on the seigniorage shares model are the most “crypto-native” out of the three because they’re fully independent and largely decentralized (at least, in theory.) Currently, non-collateralized stablecoins are in the experimental stage and are yet to demonstrate the theory in practice.

The search for the ideal continues…

Even though many critics believe that decentralized stablecoins are impossible and centralized ones are useless, the quest for this ideal medium for the facilitation of commerce must continue.

Money — as imperfect as we know it to be today — is a product of a long evolutionary process that is far from over. That being said, the controversies surrounding the current stablecoin projects should not disappoint and discourage us — after all, we’re in the midst of making one of the most disruptive financial technologies of the future. The promise of a true stablecoin far outweighs any and all obstacles that we may encounter on the way and, once we get it right — the world may never be the same.