An analysis of the 3 types of stablecoins

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Price swings that would be deemed as catastrophic in traditional equities markets happen on a daily basis in the cryptocurrency space. Cryptocurrencies like Ethereum or Bitcoin often see daily price fluctuations in the double digits of their total percentage value, these fluctuations are often a lot more violent with coins with a smaller market capitalization and less trading volume.

As a result of these wild fluctuations, the cryptocurrency community has forged several terms and memes to stay positive during downturns in price, or to ferociously celebrate in a price upswing. Probably the most widely used term is the word “HODL”, this term was coined by a drunk cryptocurrency investor back in 2013 on the Bitcointalk forum when he misspelled the word “Hold” while the bitcoin price was crashing. These memes are especially welcome by the newcomers to the space, who are usually shocked by seeing their portfolio fluctuate by 20% in a matter of hours.

While cryptocurrencies slowly move away from just being “magic internet money” and are starting to form part an ever increasing important role in the world’s economy, memes won’t do the job anymore. In order for cryptocurrency to be massively adopted in global commerce, volatility needs to decrease drastically. Bitcoin volatility is clearly on a downtrend since its inception, however, it is still light years away from achieving fiat-currency like volatility or a “store of value” status, which is what merchants seek.

In this article, we will explore the 3 different types of crypto stablecoins that exist and analyze their pros and cons.

Introduction to blockchain-based stablecoins

Gold and the US dollar are often perceived as stable assets, however, when carefully analyzed it is evident that both assets are far from being “perfect” stable assets. The first has the downside that its total supply is unknown and has to be approximated, thus making it hard to accurately estimate it’s value, additionally, gold is very costly to transport and store. The latter is inflationary and has a central point of failure, the Federal Reserve.

A stablecoin is a cryptocurrency which price remains stable and constant, thus making it appropriate for short and mid-term use as a unit of account. Or simply put, a coin pegged to a fixed value, like for example 1 USD or a basket of goods.

It is fair to assume that the ideal stable asset has a known supply, is easy to store and transport and does not have a central point of failure. Interestingly, a blockchain-based stablecoin could address all these points at once.

However, it’s important to mention that while blockchain-based stablecoins protect investors against certain risks, like removing a central point of failure, they obviously don’t protect investors from *all* risks associated with traditional stable assets. In order to transact with crypto stablecoins, an investor will always need internet access, which makes an apocalyptic event or disaster that shuts down the electric grid an unlikely but dangerous risk to keep in mind.

Fiat-collateralized stablecoins

The simplest scheme for a stablecoin is a fiat backed coin. In this scenario, you deposit dollars into a bank account and issue stablecoins 1:1 against those dollars. When a user wants to liquidate their stablecoins back into USD, you destroy their stablecoins and send them the USD.

This method for ensuring price stability requires a certain degree of trust in the custodian of the fiat since technically there isn’t much that would stop this person from running away with the funds or not fully collateralized the issued coins. This is a concern that the famous stablecoin Tether has made part of its brand image since the firm refused to perform public audits of the assets it held. These rumors sparked a degree of uncertainty in the cryptocurrency markets since some players suspected that Tether was printing un-backed Tether coins which could have led to the recent cryptocurrency bull-run.

Furthermore, a fiat-backed scheme is also highly regulated and constrained by the traditional banking system. If you want to exit the stablecoin and get your fiat back out, you’ll need to wire money, which is a tedious and expensive process.

A well known fiat-collateralized stablecoin is the controversial currency Tether. The asset has a $2B+ market capitalization, which means that the company should, in theory, have an equal amount of fiat on one or more bank accounts. The company has been heavily criticized due to its inability to provide a report that proves the fiat holdings of the company.


Crypto-collateralized stablecoins

By moving away from fiat, we can also get rid of the centralization from the stablecoin. The process of thought is simple instead of backing a stablecoin with fiat, cryptocurrencies are used. No fiat required.

However, there is one big and obvious drawback over this scheme: cryptocurrencies are FAR from being stable, which means the collateral may violently fluctuate, contradicting the definition of what a stablecoin is. The solution? Over-collateralization.

By over-collateralizing a cryptocurrency some of its collateral can be used to absorb the volatility, just like an airbag. Say we deposit $2000 worth of ETH and then issue 1000 $1 stablecoins against it. The price of ETH can, therefore, drop by 25%, and the stablecoins will still be collateralized by $1500 worth of Ether, and can still be valued at $1 each. However, if the price drops by over 50%, the backer needs to immediately add more collateral or the position will be liquidated. This makes black swan events an incredibly dangerous situation for cryptocurrency backed stablecoins.

But what is the economic incentive for someone to lock up ETH to receive significantly less stablecoins? In most cases, it is the fact that this is a very efficient way of leveraging one’s position. A depositor could lock up a certain amount of ETH and use the stablecoins he generated to purchase even more ETH. This would allow an investor to speculate on the price of a certain cryptocurrency with more capital than he actually has.

Fundamentally, all crypto-collateralized stablecoins use some variant of this scheme. You over-collateralize the coin using another cryptocurrency, and if the price drops enough, the stablecoins get liquidated. All of this can be managed by the blockchain in a decentralized way.

One notorious example is MakerDAO’s stablecoin DAI, which price stability is ensured through collateralized debt positions on ETH. Future plans include the support for using other tokenized assets for collateral like for example DigixDAOs gold tokens.

Non-collateralized stablecoins

After having analyzed two types of stablecoins that are collateralized by an asset or by a basket of assets, let’s explore a radically different option: no collateral at all. As crazy as it may sound at first, why shouldn’t it work? After all, stablecoins are just a coordination game where arbitrageurs believe that the coin will eventually trade at a certain value, for example, $1. The United States was able to successfully move off the gold standard and is now no longer backed by an underlying asset. Perhaps this means collateral is only an option, and a stablecoin could adopt the same model.

Enter Seignorage Shares, a scheme invented by Robert Sams. Seignorage Shares is based on a simple idea: modeling a smart contract as a central bank which monetary policy only has one mandate, issue a currency that will trade at $1. Now by controlling the monetary supply, this smart contract can make sure that the coin always trades close to $1.

For example, if the price is too high the smart contract can generate new coins and auction them on the open market, increasing supply until the price returns to $1.

This would leave the smart contract with some extra profits, called the seignorage. On the other hand, if the coin is trading too low a different approach needs to be taken since it’s not possible to un-issue circulating money. In this case, the only option is to buy up coins on the market to reduce the circulating supply, by using saved up seignorage.

Now, what happens if the saved up seignorage is insufficient to lift the coin to its target price? This is where Seignorage Shares come into play.

Instead of giving out seignorage, shares are issued that entitle its owners to future seignorage.

In other words, the next time coins are issued and seignorage is earned, shareholders will be entitled to a share of those profits.

Many have publicly criticized this system for resembling a classic pyramid scheme. Low coin prices are buttressed by issuing promises of future growth. That growth must be subsidized by new entrants buying into the scheme. If the system ever stops growing, it will collapse.

While this may sound like an inevitable destiny at first, maybe it really isn’t. After all, the monetary base for most world currencies has experienced growth for the last several decades. Why shouldn’t it be possible for a stable cryptocurrency to experience similar growth?

Although this system can be very dangerous because it is hard to estimate how much downward pressure it can take before collapsing, it also is an extremely ambitious design. A non-collateralized coin is independent of all other currencies. Even if the US Dollar and Ether collapse, a non-collateralized coin could survive them as a stable store of value.

A successful non-collateralized stablecoin could radically change the world and the way we think about value and money. However, an unsuccessful one would be catastrophic. After raising tens of millions in funding, Basis is attempting to become one of the first non-collateralized stablecoins. Only time will tell how this economic model develops.

The post An analysis of the 3 types of stablecoins appeared first on CoinDiligent.

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