Stablecoins: Cryptocurrency Without Chaos (So Far)

Balancing on a tight rope

As far as investible assets go, cryptocurrencies are quite volatile. This price volatility has significantly hindered the ability of cryptocurrencies to function as a medium of exchange and unit of account (i.e., two of the three functions of money). Indeed, why would you want to be paid in bitcoin, for example, when it could depreciate by a significant amount at any given moment?

This is where stablecoins come to the fore. As their name implies, stablecoins are cryptocurrencies designed to maintain a stable value. For the vast majority of stablecoins, their value is pegged to that of a collateralising asset—or basket of assets. This makes them far less volatile than bitcoin and many other cryptocurrencies.

How Stablecoins Are Used

  • Bear Repellent—demand for stablecoins often escalates during times in which the cryptocurrency market is enduring a strong sell-off. Investors and traders will flock to stablecoins in order to limit exposure to non-stablecoin cryptocurrencies. This is typically far more cost- and time-effective than converting cryptocurrencies to fiat.
  • Redefining Remittance—because stablecoins maintain parity, they are far more capable of functioning as a medium of exchange than other cryptocurrencies. And because they are built atop blockchain technology, stablecoins can enable transfer of value that is significantly faster and cheaper than a bank wire.
  • Enabling dApps—pairing smart contract technology with stablecoins has allowed dApp developers to build more viable solutions. The decentralised finance space, for example, would most definitely not be where it is today had it not been for the recent proliferation of stablecoins.
  • Financial Inclusivity—censorship-resistance stablecoins can offer a much-needed alternative for those living in countries with dubious monetary systems and tight capital controls.

Are stable-value assets necessary? Given the high level of interest in “blockchain technology” coupled with disinterest in “Bitcoin the currency” that we see among so many in the mainstream world, perhaps the time is ripe for stable-currency or multi-currency systems to take over. — Vitalik Buterin (The Search for a Stable Cryptocurrency; November 11, 2014)

Types of Stablecoins

Despite each of them offering the same utility, the form and function of stablecoins differ tremendously. Broadly speaking, stablecoins fall into one of the five categories described below.

Fiat-collateralised

By far the most popular stablecoin type, fiat-collateralised stablecoins essentially function as an IOU. That is, a centralised third party will mint and issue stablecoins in exchange for a specific fiat currency (e.g., the U.S. dollar) at a fixed one-to-one exchange rate. Then, when a stablecoin is redeemed, that same centralised party will return the equivalent fiat currency and destroy the redeemed stablecoin.

Because fiat-collateralised stablecoins require interaction with and trust of a centralised entity, it introduces an uncomfortable amount of counterparty risk (i.e., the likelihood that one or more parties to a transaction fails to meet their obligations). Indeed, many fiat-collateralised stablecoin issuers are—to varying degrees—vulnerable to losing banking relationships, injunctive actions, and regulatory enforcement.

Some well-known U.S. dollar-collateralised stablecoins are tether (USD₮), TrueUSD (TUSD), USD Coin (USDC), Paxos Standard (PAX), Binance USD (BUSD), and Gemini Dollar (GUSD). Stablecoins pegged to the value of the Australian dollar include Synthetix-based sAUD, TrueAUD (TAUD), Sparkdex-supported Sparkdex.AUD, and AUD Ramp (AUDR). Of course, it would be remiss not to highlight the currently-under-development Libra coin, which the Libra Association plans to back with a basket of fiat currencies and government securities.

Commodity-collateralised

There are a number of stablecoins that are fully backed by commodities. Just like their fiat-collateralised equivalent, commodity-collateralised stablecoins involve a trusted third party. To build and maintain trust, any credible commodity-collateralised stablecoin issuer will routinely have their corresponding real-world precious metal holdings verified by an independent auditor.

Precious metals—typically gold or silver—are the most common form of commodity-collateralised stablecoin. Australia-based Ainslie Wealth’s Gold Standard (AUS) and Silver Standard (AGS) tokens are two examples of commodity-collateralised stablecoins. Note, calling these stablecoins is perhaps a slight misnomer, as commodities are typically more volatile than major fiat currencies.

Cryptocurrency-collateralised

A stablecoin that is collateralised by another cryptocurrency—or a basket of cryptocurrencies—offers a solution that is far more censorship-resistant than a fiat-pegged stablecoin. That’s because the collateral type (i.e., cryptocurrency) is held by a smart contract—which runs atop a decentralised blockchain (e.g., Ethereum)—as opposed to a bank or some other off-chain entity.

Because these stablecoins are collateralised with volatile cryptocurrencies, they require over-collateralisation so as to absorb the inevitable fluctuations in the collateral’s value. This is extremely capital inefficient and can be a difficult concept for prospective users to grasp.

The most well-known example of a cryptocurrency-collateralised stablecoin is Dai (DAI), which is pegged one-to-one to the U.S. dollar through a system of smart contracts, over-collateralisation, dynamic feedback mechanisms, and incentive structures that incorporate Maker (MKR)—the governance token native to the eponymous decentralised autonomous organisation. Ether (ETH) is currently the only asset that can collateralise DAI. This will all change, however, when multi-collateral DAI goes live.

Seignorage-style

Arguably the most decentralised of any stablecoin type, seigniorage-style stablecoins function by algorithmically—hence why they are sometimes called ‘algorithmic stablecoins’—expanding or contracting circulating supply in order to meet demand. The smart contract-based models enabling these stablecoins mimic a central bank seigniorage system—which explains the name!

Importantly—and unlike the aforementioned stablecoin types—seigniorage-style stablecoins are not collateralised. They do, however, require continual network growth and capital inflows, with investors earning a proportional amount of seigniorage. Such a mechanism exposes seigniorage-style stablecoins to a considerable amount of regulatory risk.

It’s also worth pointing out that seigniorage-style stablecoins are incredibly difficult to build and maintain. Many, such as NuBits (USNBT), have tried and failed to maintain parity. Whilst others like Basis (formerly Basecoin) never even went live, period.

Stablecoin-collateralised

Time to go meta. Indeed, stablecoin-collateralised stablecoins are a thing. Developers of such solutions argue that the recent propagation of fiat-pegged stablecoins has made things incredibly confusing for prospective users and has fragmented the stablecoin market; an effect they argue is handicapping the rate of adoption.

dForce’s USDx is one such stablecoin-collateralised stablecoin. USDx is an Ethereum-based ERC-20-compliant token that is pegged to a basket of constituent stablecoins including USDC, TUSD, PAX, and DAI. The composition of USDx’s basket is adjustable through an on-chain governance mechanism.

Another price-stable solution utilising multiple stablecoins is the Cowri Shell Protocol. With Cowri, so-called ‘stablecoin shells’ act as wrappers over an arbitrary number of underlying stablecoins. Cowri users don’t even have to agree on which stablecoins to hold. That’s because the protocol makes use of a stablecoin liquidity pool similar in functionality to Uniswap, the main difference being that whereas Uniswap uses ETH as an intermediate cryptocurrency, Cowri trades are direct (i.e., stablecoin-to-stablecoin).

Are Stable-ish Stablecoins Sustainable?

Sure, it’s all well and good describing how different stablecoins’ mechanisms function. Just as important, though, is the need to scrutinise the extent to which stablecoins are maintaining parity with their collateralising asset—or basket of assets.

People are often surprised to learn that basically every single collateralised stablecoin—yes, that includes the most popular ones—is currently failing to sustain parity. Indeed, these stablecoins spend an eyebrow-raising amount of time trading on exchanges for a value that is one or two percentage points either side of parity.

For the average Joe and plain Jane, such a discrepancy is likely tolerable. But when you entertain a future in which stablecoins are serving as the backbone of dApps for use cases such as finance, insurance, remittance, and prediction markets—each of which seeing substantial flows of capital—then such one- and two-percentage-point deviations from a stablecoin’s pegged value would likely impede further adoption, particularly from the commercial realm.

Summing Up Stablecoins

There’s no denying that the roles stablecoins are playing—both as a viable medium of exchange and unit of account for permissionless, blockchain-based applications as well as a bridge between fiat currencies and cryptocurrencies—is an incredible boon to the still-nascent cryptocurrency ecosystem.

For the foreseeable future, it’s likely that fully collateralised, fiat-pegged stablecoins will continue to dominate the stablecoin market. All the while, you can guarantee skilled developers will be continuing in their efforts to construct a decentralised stablecoin that’s permissionless, censorship-resistant, and trustless. Should the creation of such a stablecoin actualise, expect trustless dApps to become a whole lot more powerful.

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