Block by Block is a series where we dive into different industries and examine the entry-points for decentralization.
Stablecoins are, as some would like to say, the “Holy Grail” of cryptocurrencies. They promise to offer the stability of fiat currencies while maintaining the censorship-resistant features of cryptocurrencies. With the recent string of announcements¹ from stablecoin companies, we’ve decided to take a look at the growing asset class.
Before we examine how stablecoins can survive in the crypto-ecosystem, we must first understand the three core classes of stablecoins:
- Fiat-backed: Fiat-backed stablecoins are collateralized by fiat currency — maintaining a one-to-one ratio with their respective fiat currency. Traditionally, these stablecoins try to maintain a peg to the U.S. dollar.
- Crypto-backed: Crypto-backed stablecoins are collateralized by cryptocurrencies. Instead of maintaining a one-to-one ratio, crypto-backed stablecoins attempt to peg their prices to a fiat currency by maintaining a greater collateral-to-stablecoin ratio. Collateral could be a single cryptocurrency or a basket of different cryptocurrencies.
- Algorithm-backed: Algorithm-backed stablecoins are not collateralized. These stablecoins attempt to maintain their fiat peg through a monetary policy similar to central banks.
The volatility of cryptocurrencies make them difficult to use as money. Cryptocurrencies, because they are in their infancy stage, are notoriously difficult to accurately value.This difficulty leads to a lot of speculative investing, which ultimately leads to extreme price volatility. Extreme price volatility is an unappealing feature for merchants accepting cryptocurrencies and consumers paying with them.
How do stablecoins solve the issue of volatility?
- Fiat-backed stablecoins maintain a one-to-one ratio: Fiat-backed stablecoins solve the problem of volatility by directly linking the value of their stablecoin to a fiat currency. Under this system, a third-party entity holds fiat currencies in a bank account and issues stablecoins representing claims on these fiat currencies. As such, a holder of one fiat-backed stablecoin should be able to redeem it for one unit of fiat currency.
- Crypto-backed stablecoins overcollateralize: Because the collateral supporting crypto-backed stablecoins is naturally volatile, crypto-backed stablecoins often “over-collateralize” in an attempt to absorb this volatility. That helps maintain the stability of the coin. As an example, the current ratio deemed “safe” by MakerDao for the Dai stablecoin is 150ETH:100DAI.
- Algorithm-backed stablecoins enact monetary policy: To maintain price parity, algorithm-backed stablecoins attempt to control their money supply through monetary policy. They do this by expanding and contracting the available supply of coins on the market. For example, if the price of a stablecoin is too high, the stablecoin protocol’s algorithm will mint new units and introduce them into the market — increasing the supply until price parity. If the price is too low, the algorithm will buy up the stablecoin on the market by selling bonds at a discount. These bonds entitle their holders the right to one unit of a stablecoin at a future date — incentivizing stablecoin holders to sell their stablecoins for bonds and decreasing the total supply until price parity.
What are the barriers to adoption?
- Centralization: All fiat-backed stablecoins require centralized entities to maintain their one-to-one ratio. This means that a holder of a fiat-backed stablecoin will have to trust that the centralized entity is properly maintaining collateral fiat deposits and that their stablecoins are redeemable. If the centralized entity fails to maintain their deposits properly, holders run the risk of not being able to redeem their stablecoins.
- Censorship: Because fiat-backed stablecoins are effectively managed by custodians and are centralized they run the risk of financial censorship. Regulators can, in theory, force the entity behind a fiat-backed stablecoin to ban transactions to specific individuals. The risk of financial censorship for fiat-backed stablecoins would make them no different than the digitized dollars managed by banks. Some stablecoins, like the GUSD, have hard-coded the ability to censor transactions.
- Black swan: Because extremely volatile assets back them, crypto-backed stablecoins will always run the risk of a black swan event. If the underlying asset depreciates drastically, the stablecoin can instantly become un-collateralized.
- Capital efficiency: Over-collateralization makes crypto-backed stablecoins capital inefficient. Users are effectively forced lock up capital that could be utilized elsewhere. As an example, to create a $100 stablecoin, perhaps $150 in value needs to be locked up. This additional $50 is taken out of the economy and will no longer become a value-generating asset, i.e., used for investment or to consume goods and services.
- Complexity: Managing what is essentially a digital central bank is a complex task. The core developers behind an algorithm-backed stablecoin must determine the optimal money supply to keep their stablecoins at price parity with the USD. While expanding the money supply to keep up with high demand is easy — “print” more stablecoins — contracting money supply is much more difficult. The primary way algorithm-backed stablecoins try to contract the money supply is to sell discounted bonds. The issue with selling bonds is the lack of guarantee that the bonds will be redeemable in the future as most of these are new projects with short track records. For holders to be incentivized to sell their stablecoins for bonds, they must believe that the stablecoin platform will still be there when the time comes for bond redemption. If the survival of the platform is less certain, stablecoin holders will not sell, resulting in an oversupply of coins on the market which will force the price to drop — unpegging the stablecoin.
Stablecoins are a fascinating concept in the world of crypto. Many in the community believe it is impossible for a stablecoin to be both decentralized and stable. Yet, like the Holy Grail, the mystique of a perfect stablecoin will galvanize entrepreneurs and developers alike to continue their search.