Updated: Mar 26, 2019
by Clemens Scherf
All of 2017 and 2018 we have been hearing about how Bitcoin and other Altcoins will establish themselves as new means of payment, as electronic peer-to-peer currencies and as the electronic version of gold, the ultimate store of value. After an insane bull run, with the total market cap of cryptocurrencies ballooning up to a value of USD 800 billion, and the consequent crash and bear market, which have brought the markets back to a value of around USD 140 billion, Bitcoin still has not proven to be what it proclaimed to be: a digital currency. While yes, technically it is and it still has a long way to go, no one is using it as a means of payment. A currency whose charts resemble the Nasdaq more than they do the Euro, Peso or Dollar and boasts a year on year performance of minus 50 percent, is useless as a currency and is now mainly being held as an object of speculation. In the midst and aftermath of the crypto boom and bust, stablecoins have emerged as an effective take on creating a digital currency.
The US banking giant J.P. Morgan recently made big headlines in the blockchain sphere by announcing it would be launching its very own cryptocurrency the JPM Coin. This comes as a surprise in light of public statements by JPMs CEO Jamie Dimon about Bitcoin and cryptocurrencies. The largest bank in the US is not the only major institutional player that has made such a move; the notorious investment bank Goldman Sachs is backing the Fintech Startup Circle, who has released their very own cryptocurrency, the USD Coin. Although both coins are built on the blockchain, there is a crucial difference which separates them from all other cryptocurrencies: Their prices are stable and reliable. In other words, no other major cryptocurrency, such as Bitcoin or Ethereum, can currently appeal to the mass market as a currency. Stablecoins work around the problem of extreme volatility by pegging itself to a euro, a dollar, a yen or a piece of gold. We can differentiate between three different types of Stablecoins:
A fiat-collateralized stablecoin is a centralized approach to stablecoins, where a central entity bundles a set of assets and in turn issues tokens, each representing a fraction of those assets. The most famous fiat-collateralized stablecoin is USDT or Tether, where each USDT token is backed by one dollar held in reserve. There has been a lot of controversy over whether those funds actually existed in reserve as there has been no trustworthy audit yet verifying Tethers claims. JPM Coin and USD Coin fall under this category as well.
Easy to conceptualize
Value will match USD with certainty if properly implemented
Must trust third party to hold fiat for collateral
Need additional third-party for audit to make sure appropriate collateral is being held and units of stablecoin match deposits
Expensive and slow to audit
Instead of backing units of a stablecoin 1:1 with fiat, crypto-collateralized stablecoins hold a ratio greater than 1:1 of a cryptocurrency or basket of cryptocurrencies and issue units of a stablecoin supported by the cryptocurrency held. Since cryptocurrencies are extremely volatile, this approach requires over-collateralizing which means that there is a huge rate of capital involved. Crypto-collateralization is conducted using a cryptocurrency, like Ethereum, as collateral and avoids the issue of trusting a third party by creating this solution on the blockchain. An issue with crypto-collateralization however, is the volatility of the underlying collateral. The giant priceswings of most crytpcurrencies require a higher ratio of collateral, as much as 2:1 or even greater. MakerDAO is the most famous example of a crypto-collateralized stablecoin.
Does not rely on third-party custody like fiat-collateralized stablecoins
Conducted on-chain which enables a faster increase/decrease of stable coin units and liquidity than fiat-collateralized
Transparent without the need of auditors
Not capital efficient
Complex selection process if a basket of cryptocurrencies
questionable price stability/security if just one cryptocurrency
Non-collateralized Stablecoins do not, as its name implies, rely on fiat or cryptocurrency holdings. A stablecoin´s value is kept stable through a system of complex algorithms, incentives and tokens. In this model an artificial central bank is created which algorithmically maintains the supply of currency, using a system which expands and contracts the supply of the coin depending on the deviation from its goal value (i.e. 1 USD). The Quantity Theory of Money states that ’the general price level of goods and services is directly proportional to the amount of money in circulation, or money in supply’. Within the context of non-collateralized stablecoins such as Basecoin and Carbon, it means that the supply of the coin will be dictated by the price of the stable coin. If the price is above $1.00 the supply increases, and when the price is less than $1.00 the supply decreases. This sort of mechanism exists in hopes of creating upward and downward pressure on the price, as required. Non-collateralized stablecoins are based on the idea of seignorage shares, a theory first conceptualized by Robert Sams in “A Note on cryptocurrency stabilisation: seignorage shares”.
Dual Token Model
The concept of seignorage shares is also known as the dual token model. According to it we hold some assets to spend and others in the hope for future returns. In this model, one token is stable, therefore being the stablecoin, and the other volatile token is used to maintain that peg. The system works through a dynamical increase and decrease of the stable tokens supply. Supply is increased by distributing coins to the volatile token holders and decreased by selling volatile tokens. Bitcoin has powerfully demonstrated the problems of a one token model digital currency: if too many hold the tokens in hopes for future returns, it stops being used to transact. Basis, Carbon, DAI, Havven, Reserve, NuBits, Reserve, and BitShares use variations on this scheme.
Does not require collateral
Theoretically risk-independent of other currencies
Not as intuitive or easily explained as other structures
Input of future expectations for seignorage shares means that it cannot be known how resilient a coin is to downward pressure
Require always increasing future demand
No relevant regulatory framework in place yet
Stablecoins are paving the way to achieve, for the first time ever, truly free and instantaneous mobility of capital. Cross-border transactions that used to take days, now settle within seconds; remittance services such as Western Union, which charge high percentage fees, are coming under intense pressure from crypto-payment networks and stablecoins being used as a means of sending cash abroad; citizens in countries where the central bank is not trustworhty, interest rates and inflation are skyrocketing in hyperinflation, have a currency on whose value they can rely on. Through the obvious use-cases for stablecoins, they could lead the way to mass adoption of crypto.