What is a Stable Coin?
Stablecoin is a cryptocurrency that is designed to offer price stability and steady valuations.
why were stable coins created?
Cryptocurrencies such as Bitcoin and Ethereum (amongst others) are known for their price volatility. Although price volatility may be an attractive feature for traders and speculators, it makes it increasingly difficult for pricing goods and services and encouraging trade.
For example, let’s say you sell a widget for US$10. The product costs you US$8 to import that product from China, which is about RMB56 as an exchange rate of US$1 to RMB7. We know that the exchange rate of USD to RMB is not volatile, so you can estimate your profits to be around US$2 for the following year. However, what if the exchange rate was very volatile? What if the USD depreciated to US$1 to RMB5? Your product would now cost you US$11.20, and you would be making a $1.20 loss on each widget you sold. You would either have let this loss impact the profits of your company, or adjust your price to suit which might frustrate your customers. Thus, stable foreign exchange rates are an attractive feature for financial markets in the pricing of goods and services.
Some of the detractors of cryptocurrencies state that as prices are too volatile, as merchants are reluctant to price goods and services and individuals prefer to trade or hold on to cryptocurrencies as a speculative investment, thus discouraging mass spending and adoption. An ideal currency retains its purchasing power and has some inflation that is sufficient to encourage spending coins instead of storing them. Stable coins aim to achieve this ideal behaviour.
HOW DO STABLE COINS WORK?
There are three types of stable coin, and they differ in terms of the working mechanism used to maintain price stability.
These three types are as follows:
i) Fiat money/commodity collateralized stablecoins
ii) Crypto-asset collateralized stablecoins.
iii) Non- collateralized (algorithmic) stablecoins.
1. Fiat/commodity collateralized stablecoins
This is a centralized approach where the organization issuing stablecoins holds the fiat or commodity assets in a bank account or vault (i.e., collateralization occurs off-chain). Owners of stable coin can redeem the backed stablecoin on demand with one unit of the fiat/commodity asset(s) that backs it (e.g., USD$1, 1 pound of gold). It is considered capital efficient as the underlying fiat/commodity collateral is not too volatile, thus these stablecoins do not need to be over-collateralized. The amount of fiat/commodity used for collateralizing the stable coin has to reflect the circulating supply of the stable coin.
- Simple and easy to understand
- Redeemable system is scalable and reduces price volatility.
- Less vulnerable to electronic attacks as collateral is held off-chain
- Centralized operation and issuance.
- Lack of transparency and auditability.
- Expensive liquidation to underlying fiat/commodity asset.
- Geopolitical & counterparty risk.
- Little innovation beyond the existing financial system.
2. Crypto-collateralized Stablecoins
This is a decentralized approach where the stablecoin is collateralized by other crypto assets on the blockchain that are held in smart contracts. It is considered to be less capital efficient as the price of the crypto-asset collateral can be volatile, thus these stablecoins tend to be over-collateralized. Price stability is achieved via supplementary instruments and incentives, not just collateral. The peg of the stable coin is regulated on-chain using smart contracts.
- Decentralized and censorship resistant.
- Transparency and auditability.
- No counterparty or geo-political risk.
- Can be liquidated quickly & cheaply into the underlying crypto collateral.
- Can be used to create leverage, opening up the entire supply of money.
- Need to over-collateralize positions due to volatility in crypto asset collateral.
- Underlying collateral can be auto-liquidated during a price crash.
- Scalability only possible if underlying collateral and system actors can scale.
- Inefficient use of capital
- Lower price stability than fiat.
3. Algorithmic Stablecoins
This is a seigniorage approach where stable coins are not collateralized. The stable coins retain their value based on the expansion and contraction of the supply of the stablecoin that is algorithmically determined on the blockchain. This is a similar approach taken by the central banks with fiat currencies, except now performed in the blockchain in a decentralized, algorithmic manner. Algorithmic stablecoins are not “backed” by anything other than the expectation that there is a pricing mechanism that will ensure that the stablecoin retains a certain value. As there is no collateral, these stable coins are the most capital efficient. They are also decentralized as the decision making processes are spread across holders of utility tokens, algorithms are stored in smart contracts on the blockchain, and are not associated to any crypto-asset, fiat currency or commodity.
- No collateral required.
- Independent money issuance.
- Transparency and auditability.
- Algorithmic stablecoins are a Schelling point.
- Contract money supply while maintaining value is difficult.
- Uncertainty regarding whether algorithmic mechanisms can sustain downward price pressure.
- Requires continuous growth.
- Low coin prices are strengthened by the promise of future growth, but that growth must be subsidized by new entrants buying into the scheme (i.e., pyramid scheme).
WHY INVEST IN STABLECOINS?
Stablecoins are a fusion of the best features of cryptocurrency (i.e., global on-demand accessibility, immutable transactions, security, anonymity) and fiat currency (i.e., understandable, stable value). They are seen as the bridge for everyday consumers concerned with the price volatility of cryptocurrencies to transition from fiat-currency to cryptocurrencies.
- Day-to-day currency
- Streamlining recurring and P2P payments.
- Fast and affordable remittances for migrant workers.
- Protection from local currency crashes.
- Generate the highest interest of all cryptocurrencies on lending platforms
- Lower intermediation costs compared to fiat currency. For example, on crypto-exchanges there are processing lags for fiat currency withdrawals and some exchanges do not have a fiat on-ramp.
Tether tokens (USDT) are pegged to the US dollar. As of Jun 2020, It is the most popular stable coin and has the 3rd highest market cap of USD10B and a 24 hour trading volume of USD10B. It set an all-time high for stablecoin funded projects with USD1B raised via an IEO. In June 2018, an academic paper by John Griffin and Amin Shams from the University of Texas showed that transaction patterns indicated that Tether was used to provide price support and manipulate cryptocurrency prices.
Tether was launched in 2014, and is collateralized by a mix of cash, cash equivalents, crypto-assets and loans. In April 2019, Tether announced that 74% of its tokens are backed by cash, not 100% as previously claimed.
Tether is issued on the Bitcoin (Omni Layer), Ethereum (ERC-20 token), Tron, and EOS blockchains.
DAI stable coin is pegged to the USD and was released in late 2017. It is purported to be the first decentralized stablecoin on the Ethereum blockchain. DAI was created by MakerDAO, an autonomous and decentralized institution that introduced a new approach to making stable coins by using a two-coin system, MKR governance tokens and DAI stablecoin.
MKR token holders can vote for business and risk management decisions in the Maker system. DAI holders can use DAI for payment, savings or collateral. DAI holders are able to earn DAI Savings Rate accruals that were created by the MKR governance to increase demand for the stablecoin. Many DeFi applications use DAI as a core stablecoin, which has led to a rapid surge of 344% in transaction volume in the first quarter of 2020.
For DAI to maintain its value, a dynamic system of collateralized debt positions (CDPs), autonomous feedback mechanisms and external actors having relevant interest are used.
The price of DAI is supported by over-collateralizing DAI with ETH, and stabilized using a monetary-policy tool decided by holders of the MKR token. MKR token holders vote on a “stability fee” which is the fee charged for borrowing DAI. This is analogous to a central bank setting an interest rate on borrowed money.
To create DAI, the user opens a collateralized debt position (CDP) by depositing ETH into a smart contract in a ratio of 3:1 (i.e., 3 ETH for 1 DAI). The DAI then can be used to purchase goods and services just like any other cryptocurrency. For the user to redeem his ETH, the CDP must be closed out. For the CDP to be closed out, the DAI must be paid back plus a “stability fee” in MKR tokens.
If the collateral that is deposited for DAI issuance drops below the 3:1 ratio, the collateral is immediately liquidated by the smart contract. A Target Rate Feedback Mechanism (TRFM) is used to stabilize the value of DAI and ensure that it is close to its USD1 peg. TRFM is used to incentivize users to either hold DAI or borrow more DAI. For example, when DAI is trading less than USD1, the following happens
- The Target Rate increases.
- DAI generation via CDPs become more expensive
- DAI borrowers are incentivized to redeem their DAI (i.e., increase in demand)
- DAI borrowers buy up more DAI from the market thus increasing demand.
- DAI supply is reduced since less is generated via CDPs
- This combination of changes in supply and demand causes DAI’s price to rise back to USD1.
The last resort to guarantee the DAI peg is “Global Settlement”. When global settlement is triggered, the Maker system is shut down thus all holders of DAI and CDP users receive the net value of assets they are entitled to. The process is fully decentralized and is an emergency mechanism accessed by Maker token holders.
MKR tokens and DAI stablecoin are both ERC-20 tokens on the Ethereum blockchain
An Honorary Senior Fellow at the University of Queensland with professional experience as a quantitative researcher for BlackRock and Bank of America Merrill Lynch in New York, USA. He led research teams in the development of capital models, securitized products and factor models in both equities and fixed income asset classes. Rand has several academic publications in cryptocurrency, portfolio management, systemic risk & quantitative trading