The Quest for Price Stability

An introduction to the three types of stablecoins

Bitcoin was conceived as a peer-to-peer alternative for inflation-plagued fiat currencies, with its fixed supply and predictable, ungameable minting schedule qualifying the decentralized digital currency as ‘sound money.’

Being ‘sound money’ means that the purchasing price of Bitcoin is determined by markets, independent of governments and political parties. While these are desirable properties for a non-sovereign store of value to have, the crypto markets are prone to excessive fear and greed, making bitcoin too volatile for use as a medium of exchange. The quest to provide a price-stable cryptocurrency which can be used in everyday trade has led to the proliferation of coins pegged to the US dollar and other major currencies, known collectively as stablecoins.

Stablecoins recently took a large leap into the mainstream with the announcement of PAX and Gemini Dollar, two USD-backed stablecoins launched with the approval of the New York Department of Financial Services (NYDFS). They join an already congested field including market leader Tether, Basis protocol and MakerDai amongst others. The entire stablecoin industry comprises three primary sectors:

1) Fiat-backed stablecoins

2) Crypto-backed stablecoins

3) Algorithmically-backed stablecoins

Fiat-backed Stablecoins

In the most popular iteration of stablecoins, a central entity holds a dollar in reserve for every dollar-valued coin it issues. Theoretically, investors can redeem their coins for the equivalent value in fiat currency, giving the coin a price floor of a dollar. Incumbents using this model include Tether and TrueUSD, each maintaining its own reserves of US dollar.

One drawback of fiat-backed stablecoins is the counterparty risk that is introduced by the use of a centrally-managed reserve. If investors begin to suspect that the dollar amount held in reserve does not accurately reflect the circulating supply of coins, the loss of confidence could prompt a massive sell-off which would affect not only the stablecoin, but the market as a whole.

Indeed, industry players issued growing calls for more robust auditing and transparency processes in the stablecoin industry at the beginning of 2018 in response to concerns surrounding the integrity of Tether’s reserves. This led to the Winkelvoss twin’s and Paxos introducing PAX and Gemini Dollar, respectively, hoping that investors will prefer their NYDFS-approved solution over the unregulated incumbents.

Crypto-backed Stablecoins

While fiat-backed stablecoins require an off-chain auditing process to guarantee that they are backed 1:1 by fiat currencies, crypto-backed stablecoins allow the necessary verification to occur on-chain. Users collateralize smart contracts with crypto assets and are issued coins relative to the value of the collateral in return. These smart-contracts are over-collateralized to compensate for the volatility of the crypto assets used as collateral. Any user can audit these networks to ensure they are meeting their solvency requirements.

The most popular of these projects is MakerDAO, which recently received a $15 million funding round from a16z. MakerDAO consists of two tokens, MKR and DAI. While DAI is the network’s stablecoin, MKR is a utility token used to stabilize and govern the network. Other crypto-backed stablecoins include Sweetbridge’s BRC and Haven’s Haven Dollar, which was the first to launch on the EOS blockchain.

Algorithmically-backed Stablecoins

The Quantity Theory of Money, which states that in the long-run prices in an economy are proportional to the total supply of money in circulation, provides the foundation to the mechanisms by which algorithmically-backed stablecoin networks achieve price-stability. While central banks are responsible for controlling money supply in traditional economies, networks such as Basis protocol, algorithmically adjust the money supply in response to price fluctuation.

If the price of Basis exceeds one dollar, the network will begin to increase money supply until such time as a correction occurs. Conversely, a drop in the price of Basis prompts the network to release ‘bonds’ which are sold at less than a dollar and can be exchanged for Basis coin when the money supply increases in the future. Expecting to redeem their bonds at a premium in the future, investors purchase these bonds with Basis tokens, which are then removed from circulation to shrink supply. Built on Hedera Hashgraph DAG technology, Carbon is an another example of an algorithmically-backed stablecoin.