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Stablecoin

Stablecoins are cryptocurrencies designed to minimize the effects of price volatility, thus they seek to function as a store of value and a unit of account.

To minimize volatility the value of a stablecoin can be pegged to a currency, or to exchange traded commodities (such as precious metals or industrial metals). Stablecoins backed by currencies or commodities directly are said to be centralized, whereas those leveraging other cryptocurrencies are referred to as decentralized.[1]

Centralized Stablecoins

Asset backed cryptocurrencies are by definition centralised since a controlling centralised body must manage the tangible physical asset.[citation needed]

Advantages of asset backed cryptocurrencies are that coins are stabilized by assets that fluctuate outside of the cryptocurrency space, that is, the underlying asset is not correlated, reducing financial risk. Bitcoin and altcoins are highly correlated, so that cryptocurrency holders cannot escape widespread price falls without exiting the market or taking refuge in asset backed stablecoins. Furthermore, such coins, assuming they are managed in good faith, and have a mechanism for redeeming the asset/s backing them, are unlikely to drop below the value of the underlying physical asset, due to arbitrage.

The main disadvantage and criticism levelled at centralised stablecoins is that they counter the decentralized, trustless ethos that has been crucial to the popularity and adoption of cryptocurrencies.

Centralized stablecoins are subject to the same volatility and risk associated with the backing asset. They are also exposed to loss of confidence in the centralized governance (issuer, custodian and auditors).[2]

Centralised stablecoins can be divided into fiat-backed and commodities-backed stablecoins:

Currency backed stablecoins

Cryptocurrencies backed by currency are the most common and were the first type of stablecoins on the market. Their characteristics are:

  • Their value is pegged to one or more currencies (most commonly the US dollar, also the Euro and the Swiss franc) in a fixed ratio,
  • The tether is realized off-chain, through banks or other types of regulated financial institutions which serve as depositaries of the currency used to back the stablecoin,
  • The amount of the currency used for backing of the stablecoin has to reflect the circulating supply of the stablecoin.

The value of stablecoins of this type is based on the value of the backing currency, which is held by a third-party regulated financial entity. In this setting, the trust in the custodian of the backing asset is crucial for the stability of price of the stablecoin. Fiat-backed stablecoins can be traded on exchanges and are redeemable from the issuer. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator.

Examples: TrueUSD (TUSD)[1], USD Tether (USDT),[3] Paxos Standard (PAX),[4] Centre,[5] Gemini Dollar (GUSD)[6] and others.

Exchange-traded commodities backed stablecoins

Stablecoins backed by commodities such as precious metals (gold, silver etc) are quite similar to fiat backed stablecoins. Their main characteristics are:

  • Their value is pegged to one or more exchange-traded commodities, in a fixed ratio,
  • The peg is realized off-chain, through regulated financial institutions which serve as custodians of the commodity backing the stablecoin,
  • The amount of exchange-traded commodity used to back the stablecoin has to reflect the circulating supply of the stablecoin.

Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve of the exchange-traded commodity and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator.

Examples: Digix Gold Tokens (DGX)[7] and others.

Decentralized Stablecoins

Cryptocurrency backed stablecoins

Cryptocurrency backed stablecoins are issued with cryptocurrencies as collateral, which is conceptually similar to fiat-backed stablecoins. However, the significant difference between the two designs is that while fiat collateralization typically happens off the blockchain, the cryptocurrency or crypto asset used to back this type of stablecoins is done on the blockchain, using smart contracts in a more decentralized fashion. In many cases, these work by allowing users to take out a loan against a smart-contract via locking up collateral, making it more worthwhile to pay off their debt should the stablecoin ever decrease in value. To prevent sudden crashes, a user who takes out a loan may be liquidated by the smart contract should their collateral decrease too close to the value of their withdrawal.

Significant features of crypto-backed stablecoins are:

  • The value of the stablecoin is collateralized by an another cryptocurrency or a cryptocurrency portfolio,
  • The peg is executed on-chain via smart contracts,
  • The supply of the stablecoins is regulated on-chain, using smart contracts,
  • The price stability is achieved through introduction of supplementary instruments and incentives, not just the collateral.

The technical implementation of this type of stablecoins is more complex and varied than that of fiat-collateralized stablecoins, which introduces a greater risks of exploits due to bugs in the smart contract code. With the tethering done on-chain, it is not subject to third party regulation creating a decentralized solution. The potentially problematic aspect of this type of stablecoins is the change in value of the collateral and the reliance on supplementary instruments. The complexity and non-direct backing of the stablecoin may deter usage, as it may be difficult to comprehend how the price is actually ensured. Due to the nature of the highly volatile and convergent cryptocurrency market, a very large collateral must also be maintained to ensure the stability.

Live stablecoins projects of this type are Havven (the pair: nUSD - stablecoin and HAV - the collateral- backed nUSD),[8]  DAI (pair: CDP - Collateralized Debt Position and MKR - governance token used to control the supply)[9] and others.

Seigniorage (algorithmic) stablecoins

Stablecoins can be linked to a decentralized autonomous organization which controls issuance and pricing, which are referred to as seigniorage-style (or algorithmic) stablecoins.[1][10] These stablecoins are fully digitalized and non-reliant on any types of collateral, with their supply and target price are to be controlled only by the program code. This feature makes the fully decentralized with no third party regulation possibility and highly scalable as they don’t require additional collateralization when the supply increases.

Algorithmic stablecoins are characterized by:

  • Full decentralization,
  • High scalability,
  • Peg is realized on-chain,
  • Low cost of price stability, as they require no collaterals.

The supply of algorithmic stablecoins is typically controlled by issuing and destroying coins depending on the market demand, until the target price is reached. In the general case, market participants are incentivized to act in a way that the price is kept at target level by issuing either bonds, in times of decreasing price or seigniorage shares when the price is above target.

Currently, no algorithmic stablecoins are live.[11] Ampleforth,[12] and Kowala[13].

Tethered cryptocurrency assets

Tethered cryptocurrency assets have certain features of algorithmic stablecoins - and can be considered their sub-type, except they don’t offer incentives in form of separate instruments (bonds or shares) to holders of the “underlying” cryptocurrency and there is no governing algorithm that forces the price towards the target, except at the moment of creation of the asset.

Features of tethered cryptocurrency assets:

  • Full decentralization,
  • Collateralization is realized on-chain when creating tethered assets with a fixed value denominated in the chosen peg (which is spent by the issuer and is the creation cost) without locking additional assets,
  • Peg is realized on-chain, based on consensus,
  • Unlimited valuation scalability,  growth scalability is limited by the market capitalization of the underlying cryptocurrency,
  • Specific handling due to non-mandatory on-chain usage.

Tethered cryptocurrency assets are issued on-chain, by holders of the native cryptocurrency, with different pegs chosen by the issuer. The peg value is imported into the blockchain by consensus and can be a number of fiat currencies and exchange-traded commodities (e.g. USD, EUR, gold, silver, etc). The issuer selects the peg and issues the tethered asset by paying the proprietary amount in the native cryptocurrency. As the cryptocurrency supply is fixed, in order to maintain the market capitalization at the time of issuing the tethered asset, the amount of cryptocurrency used to issue the asset is redistributed to holders on pro-rata basis. A specific mechanism controls the supply of tethered assets at the moment of issuance: in case there are tethered assets offered for sale, the issuer will buy them at face value, while the process of creating new assets will be triggered only in cases when there are no tethered assets offered for sale. An additional feature is to be built in the wallet, that will allow holders of tethered assets to trade them for a discounted price, a well as to trade assets with different pegs (e.g. USD tethered assets for gold tethered assets).

The main risk of this type of stable-asset is the loss of value of the peg (as with any other pegged stablecoin) and the excess liquidity of tethered assets which may drive the price of e.g. USD tethered asset below its’ face value.  

Tethered cryptocurrency assets with published implementation proposals are in pre-launch phase.[14][15][16]

Criticisms

Tether, the largest stablecoin by market capitalization, has faced accusations of being unable to provide audits for their reserves while continually printing millions; many have attributed their unverifiable creation of new coins to Bitcoin's rise in price in 2017.[17] Stablecoins can be prone to failure as well due to volatility and upkeep required in many cases; NuBits is one example of a stablecoin which has failed in keeping its peg.[18]

References

  1. ^ a b c Memon, Bilal. "Guide to Stablecoin: Types of Stablecoins & Its Importance". Retrieved 22 Oct 2018.
  2. ^ "Gold-Pegged Vs. USD-Pegged Cryptocurrencies". Investopedia. Retrieved 27 October 2018.
  3. ^ Tether. "Tether: Fiat currencies on the Bitcoin blockchain" (PDF). Tether: Fiat currencies on the Bitcoin blockchain: 7. Retrieved 2018-10-23.
  4. ^ Cascarilla, Charles (2018-09-09). "Paxos Standard White Paper" (PDF). Paxos Standard White Paper: 5.
  5. ^ Centre (May 2018). "Centre Whitepaper" (PDF). Centre Whitepaper: 10.
  6. ^ Gemini Trust Company, LLC. "The Gemini Dollar: A Regulated Stable Value Coin" (PDF). The Gemini Dollar: A Regulated Stable Value Coin: 2. Retrieved 2018-10-23.
  7. ^ Eufemio, Anthony C.; Chng, Kai C.; Djie, Shaun (Jul 2018). "Digix's Whitepaper: The Gold Standard in Crypto-Assets" (PDF). Digix’s Whitepaper: The Gold Standard in Crypto-Assets: 2.
  8. ^ Brooks, Samuel; Jurisevic, Anton; Spain, Michael; Warwick, Kain (2018-06-11). "A decentralised payment network and stablecoin" (PDF). A decentralised payment network and stablecoin v0.8: 6–9.
  9. ^ "The Dai Stablecoin System". Retrieved 2018-10-23.
  10. ^ "Stablecoin". Investopedia. Retrieved 27 October 2018.
  11. ^ Al-Naji, Nader; Chen, Josh; Diao, Lawrence (2017-06-20). "Basis: A Price-Stable Cryptocurrency with an Algorithmic Central Bank" (PDF). Basis: A Price-Stable Cryptocurrency with an Algorithmic Central Bank: 8–16.
  12. ^ Kuo, Evan; Iles, Brandon. "Ampleforth - An Ideal Money". Ampleforth - An Ideal Money: 10–11.
  13. ^ Glover, Eiland; Reitano, John W. "The Kowala Protocol: A Family of Distributed, Self-Regulating, Asset-Tracking Cryptocurrencies" (PDF). The Kowala Protocol: A Family of Distributed, Self-Regulating, Asset-Tracking Cryptocurrencies: 5–11.
  14. ^ PoCC/rico666 (2018-07-16). "To-All Transactions".
  15. ^ PoCC/rico666; PoCC/ac0v (2018-07-16). "Anchor Real-World Data in Blockchain".
  16. ^ PoCC/rico666 (2018-07-16). "Tethered Assets".
  17. ^ "'Without this bitcoin price would collapse'". NewsComAu. Retrieved 2018-06-11.
  18. ^ "Stablecoin NuBits Loses $1 Peg, No Recovery in Sight - Chainstate". Chainstate. 2018-05-12. Retrieved 2018-06-11.