For cryptocurrency enthusiasts, the long game of blockchain ecosystems is to create open platforms controlled by no single authority, inviting open participation from anyone. This, of course, is in an effort to move forward the culture of open source, from static code branches sitting in source trees to living and evolving useful systems ready for live interaction, still egalitarian and open access in nature.
At the heart of this vision lie practically immutable accounting systems that store the widely accepted state of the world to ensure global integrity. Large visions are rarely achieved in one fell swoop and are instead typically realized through the emergence of solutions for related and meaningful short-term problems. The volatility problem is one such important candidate.
Due to the nascency of cryptocurrency markets, volatility has remained a staple for both outside observers and users. Although traders may fare well from the conditions, those wishing to use the assets in particular and unlock the true value of these accounting systems may have a different experience altogether. An asset bought as a medium of exchange (MoE) may lose its value before any value from spending that asset has truly been captured.
The volatility problem is important to solve because its resolution in the short-term unlocks the financial and technical engineering groundwork necessary for cheap, swift, secure, and disintermediated global payment systems based on blockchains. Users of these systems will be able to transact seamlessly with peers at a far cheaper rate and with a dramatic increase of security due to the nature of these cryptographic systems. In the long term, solving this problem will vastly reduce the barrier to entry for use of smart contract-based services on public, consortium, and private blockchains—truly unlocking the automation value these technologies have to offer.
A cryptocurrency-based contender that has appeared in order to solve this crisis is called a stablecoin. A stablecoin is a cryptocurrency that is pegged by various means to a traditional fiat currency to maintain its price or is backed by precious metals and other commodities. To date, there have been stablecoins backed by fiat currencies in reserve, gold, and even cryptocurrency itself. Although some have failed and lost their desired peg, recent iterations have proven quite successful so far in their stability.
Value opportunity: Digital money
The digital money industry is booming, driven in recent years especially by the Asia-Pacific region. In 2017, the revenue opportunities exceeded $1.9 trillion, trending double-digit percentage growth per year. While cryptocurrencies have many desirable properties for digital payments, such as low transaction fees, asset transfer simplicity, and auditability, the price volatility of mainstream cryptocurrencies is currently untenable for production use cases. Wild price swings are not good for buying groceries and paying rent. Simple tasks become unreasonably complex, as accounting loses its stability on a multitude of scales.
For example, cross-border payments are easy to facilitate with cryptocurrencies but their value fluctuation makes the process unreasonably complicated. If a farmer in an emerging economy wishes to send their family cryptocurrency, they must account for price fluctuations that may devalue the asset at a double-digit percentage before it can be liquidated for a local currency. Stablecoins have the opportunity to reap the benefits of cryptocurrencies while mitigating price volatility to acceptable levels.
Value opportunity: Open platforms
Smart contracting platforms have the potential to solve problems “once and for all,” in the same vein as cloud service providers touting infrastructural block storage (Amazon S3, Google Cloud Storage, Azure Blob) and computing power (Amazon EC2, Google Compute Engine, Azure Compute). Due to their open nature, smart contracts may easily extend to the application layer and offer turnkey solutions to digital money, trade financing, supply chain management, and sharing economies.
Smart contracts can run at cost without intermediaries carving out high margins, a paradigm similar to well-run public utilities. However, the dominant way to pay for smart contract-based goods and services has been with volatile cryptocurrencies, adding currency risk to businesses that operate on more stable national currencies such as dollars, yuan, or euros. Alternatively, businesses may choose to purchase exact amounts of volatile cryptocurrencies as necessary, minimizing currency exposure but incurring new transaction fees with each subsequent transaction.
With the rise of stablecoins, businesses incur smaller currency risks and transaction fees. Due to a guarantee on the price of the asset being processed, there is minimal volatility risk and users and businesses alike can benefit from this stability. This can, in turn, drive adoption for smart contract systems due to reduced risk and improved ease of use. Businesses feel safer due to the benefits of automation and lower transaction costs, and users feel safer in knowing their personal assets won’t be devalued.
Stablecoins aren’t a new revelation in the cryptocurrency space, as attempts at their implementations have been in motion since 2014. The first two attempts at creating stablecoins came from both BitUSD of BitShares, and NuBits—both of which were crypto collateralized iterations. Although both failed due to collateralization instability, they paved the way for new iterations that learned from their mistakes as well as strengthened the case for a price-stable asset represented as a cryptocurrency.
The first implementation of a reserved back stablecoin came in late 2014 from Tether, which was initially built on Bitcoin through the Omni layer. Although Tether offered the creation and redemption process typically associated with reserve backed stablecoins, its lack of transparency paved the way for transparent reserve backed stablecoins such as CENTRE’s USDC and Gemini’s GUSD.
There are, in fact, three types of stablecoin implementations: reserve backed, crypto collateralized, and algorithmic, each with its own associated risks and tradeoffs. While reserve backed implementations provide transparency and absolute stability from natural arbitrage opportunities, there is added counterparty risk from the centralized controller. Crypto collateralized implementations forego counterparty risk at the expense of the volatility from their underlying collateral. Algorithmic stablecoins are dependent on incentive mechanisms and speculation, and haven’t had a proven implementation yet. However, all three are interesting in their approaches and allow users to gauge their comfort in using their choice of asset.
Stablecoin implementation types
A reserve backed stablecoin is one that is typically issued by a central provider and is backed 1:1 to a fiat currency by means of both a tokenization and redemption process. To generate new tokens, customers send collateral to the provider, and the provider then mints or creates new tokens. The provider typically has the underlying collateral under custody with regular attestation reports, and “burns” or removes the tokens from circulation once they are redeemed.
Recent examples of reserve backed stablecoins include Gemini’s GUSD, CENTRE’s USDC, and Paxos’ PAX. Legacy reserve backed stablecoin Tether (USDT) has suffered much scrutiny due to the provider’s lack of regular auditing of the underlying collateral. However, the latest class of reserve backed stablecoins have been consistently providing audit reports from reputable firms.
Reserve backed stablecoins typically retain their peg from arbitrage cycles. For example, if Gemini’s GUSD is trading under $1, arbitrageurs are incentivized to buy the asset until it stabilizes and redeem the tokens for the underlying collateral, thereby making a profit. If the asset is trading over $1, arbitrageurs are incentivized to send collateral to Gemini in order to generate new tokens and sell them for the higher rate.
Typically in these systems, there’s an increased counterparty risk due to the ability of the central provider to freeze assets at any time. This issue came up recently with Gemini customers having redemption issues.
A crypto collateralized stablecoin is one that has cryptocurrency as its underlying collateral and uses price feeds associated with the collateral as a means of keeping the stablecoin at one dollar. In the case of crypto collateralized stablecoins, plenty of projects have made the attempt at stabilizing a system, but none have succeeded as much as MakerDAO.
Originally launched in 2017, DAI, the crypto collateralized stablecoin from the MakerDAO project, has remained relatively stable with continued development interest. Currently, DAI is collateralized by Ether (ETH), the native currency of the Ethereum blockchain, and the project plans on utilizing other assets for collateral in the future. Users wishing to obtain DAI must first lock ETH in a “CDP,” or collateralized debt position. Due to the high volatility of ETH, DAI is typically overcollateralized at rates well over 100%.
If an individual’s CDP is ever close to being insolvent, the system triggers the sale of the user’s underlying collateral. If the system ever becomes insolvent due to a market crash in the price of the underlying collateral, Maker or “MKR,” the other token in the MakerDAO system, acts as a buyer of last resort where new MKR tokens are minted, effectively diluting current holders, and sold on the open market as a means of stabilizing the system.
MKR holders are responsible for voting on resolutions and regulating the entire system through MakerDAO’s governance mechanisms. A fee in MKR is also paid to open CDPs to acquire DAI, effectively reducing the supply as more are opened.
Currently, the key centralized aspect with the most risk in MakerDAO’s system is its oracles that generate price feeds for the underlying collateral. Other centralized actors include “keepers,” or automated market makers that keep DAI around its target price. Considering limited arbitrage opportunities on a redemption process such as DAIs, external mechanisms such as these must be consulted to maintain stability.
The last major implementation of stablecoins is based on algorithms that trigger supply inflation and deflation in relation to the stablecoin’s target price. Algorithmic stablecoins aren’t backed by collateral, but rather have speculators involved with associated secondary and tertiary assets to keep the system balanced.
Algorithmic stablecoins are typically reliant on an elastic supply scheme building on Robert Sam’s Seigniorage Shares, where a base stable-asset is produced, but secondary and even tertiary assets generated and redeemed to ensure system stability. Seigniorage generally involves profiting from the creation of currency; the difference in the cost of the production of money and the money itself. In an algorithmic system, speculation on the secondary and tertiary assets to keep an algorithmic system stable is designed to yield a profit. One recent example of an attempt at creating such a system was Basis, a project seeking to build an algorithmic model that recently refunded investors.
The Basis model included three tokens: a stablecoin to retain its peg at one dollar, and “bonds” and “shares” that act as the secondary and tertiary assets. Bonds are created by the system during periods of price decline under the desired peg and are purchased using the stablecoin to deflate its supply and increase its price. The bonds are immediately redeemed once the price reaches above its target of $1. Shares act as a hedge on a healthy system, as shareholders are granted newly minted stablecoins if all bonds have been redeemed and the stablecoin continues to trade above $1. The inflation mechanism of the stablecoin is meant to drive the price down, as shareholders are granted tokens from it.
To date, no algorithmic stablecoin has launched successfully. The next attempt at an algorithmic stablecoin launch will likely come from Carbon, and their CUSD stablecoin. At the moment, Carbon is fully collateralized by U.S. dollars held in bank accounts, but they plan on eventually transitioning to an alternative system.
A plethora of implementations
There is no shortage of projects wishing to issue stablecoins, as it has become quite a hot topic in recent times. To date, there are more than a dozen launched stablecoin projects with more continually being developed to serve different purposes. Most of them have been pegged to the U.S. dollar, but there are a few examples being collateralized by other fiat currencies and commodities. The most notable of which is Digix—which is backed by gold held in a custodial vault. Being able to leverage cost savings internally to an existing ecosystem is one of the primary use cases for institutions and enterprise companies to partner with or create their own stablecoin.
Last year, in particular, saw a dramatic rise in the number of reserved backed stablecoins that launched. Businesses such as Paxos, Gemini, and Circle saw the benefits of launching these assets and have since been building lofty ecosystems around their respective assets. They have also set the standard in regular auditing, providing attestation reports for each asset on a regular basis. This further lowers the risk profile of these assets while providing a safety mechanism to encourage originally skeptic outsiders to finally enter and interface with these technologies.
Volatility mitigation in production
In order to reap the benefits of stablecoins, decentralized finance (DeFi) services are beginning to accept stablecoins as a means of interfacing with services. DeFi services are those that provide traditional financial services while ensuring transactions are protected, peer to peer, and that users retain custody of their assets at all times. Examples of these services include exchanges, automated asset management funds, and debt platforms.
One example of such a service is Dharma —a suite of decentralized lending products. Dharma’s main product involves peer-to-peer lending where users can collateralize their cryptocurrencies in exchange for Ethereum or USDC—a stablecoin. This would allow risk to be averted, as the recipient would be able to avoid market volatility upon receiving a stablecoin. Even BlockFi, a competitor to Dharma, recently announced the integration of GUSD on their platform to help users avoid volatility.
Decentralized exchanges have also taken note of stablecoins and have continually added them as an available asset for trading. For example, Ethfinex, DDex, and Kyber Network have all listed DAI on their exchanges in order to better assist new traders and those who need to exchange assets and avoid risk after liquidation. Even seasoned traders can now use DAI in order to hedge risk in short-term market fluctuations and benefit from its stability.
There are a number of additional projects in the process of launching this year, including MelonPort, an asset management protocol, and Origin, a marketplace generation protocol that will also accept stablecoins as a way to mitigate volatility risk. The increase in stablecoin adoption is a positive signaling mechanism that is demonstrating a natural fit. As more decentralized applications and protocols continue to be developed, stablecoins will naturally serve as a transactional asset to greatly benefit end users.
Mass proliferation, or “One to Rule Them All”
The recent announcement of the JPM Coin, a stablecoin by J.P. Morgan (which clearly demonstrates an institutional interest in the space), is going to usher in a wave of stablecoins in the next few years. These assets will range from other sovereign-backed fiat currencies such as the Yuan, Yen, and Euro, to other traditional commodities such as precious metals and rare earth minerals. However, their implementations will definitely take note of current iterations that provide a regular price peg free from value fluctuation (if a fiat currency), the least amount of risk for users.
The reasoning is that in the short to medium term, stablecoins provide an entrance toward a new financial system. Through this stable onramp into blockchain systems, users need not worry about market volatility when thinking about traditional payments, nor do they need to worry about open platform access being rescinded due to a market downturn. They provide predictability in price and provide a way to sideline funds during market swings without having to pay additional fees moving back into fiat.
It is unlikely in the long term that there will be as many stablecoins as are currently available and being developed. While there won’t be a single controlling stablecoin due to the myriad of assets they could be pegged to, there will be a basket that commands a majority of the trading volume. Even with all of its historical issues, Tether still commands a vast majority of trading volume relative to other stablecoins simply because of its social relativity and continued redemption and minting arbitrage opportunities. Competition will drive pricing down and force the technology to grow quickly, but will also result in low or negative margins for the firms producing these but not operating at efficient enough scale.
The other inherent risk is to consider if and when cryptocurrencies reach a sufficiently high market capitalization and trading interest. Once enough volume reaches traditional medium of exchange (MoE) cryptocurrencies, prices may begin to plateau and stabilize due to a lack of illiquidity. If Bitcoin were to reach over a sufficient amount of trading volume, having a daily price fluctuation of 10%+ would be highly unlikely, lessening the value proposition of stablecoins. However, stablecoins for the foreseeable future will continue to provide a key stability mechanism by way of the policy and monetary controls we are starting to see implemented in some popular stablecoins today.
Allowing stablecoins to have monetary controls in place allows not just users but regulators and institutional entities to have a comfortable experience with a traditionally volatile asset class. Enterprises didn’t jump right into cloud computing, and to this day most still have at least some of their processes run locally—this will most likely be the same case for stablecoins and their adoption. Facebook has recently been noted to be working on a stablecoin with their WhatsApp messenger and have been testing it in India. This allows them to govern the monetary policy inside of their apps and build pathways into and out of their ecosystems. Not only does this allow them to save on transaction fees associated with more traditional systems, but it also allows them to guarantee stability in their walled gardens while using cryptocurrency. Facebook being an already digitally native company allows them to test the cost savings aspects while also complying with various regulatory requirements for their users across geographic lines.
As the stablecoin ecosystem continues to grow between enterprise players and existing blockchain ecosystem players such as Gemini and Coinbase, users will continue to have the freedom and flexibility to transition between fiat and crypto seamlessly, and more importantly, be granted the stability needed to avoid cryptocurrency’s current volatility crisis.