Stablecoin — the ultimate manifestation of cryptocurrencies
By: Moazzam Khan
Tags: Research Reports, Stablecoin, Blockchain, Ethereum, Decentralization

Introduction

The biggest revolution in all things crypto since Bitcoin’s inception is stablecoin!

Seemingly innocuous as a result of their non-volatile nature, they have the power to drive crypto-exchanges to the top, something top exchanges like Binance and Bitfinex are well aware of, as well as the power to make significant inroads into mass crypto adoption through a plethora of use cases, something that various private and public organizations are attempting these days.

That is why the stablecoin space captures significant interest from some of the biggest companies and venture capitalists in the blockchain world: Bitmain, Peter Thiel, Andreessen Horowitz, Polychain Capital, Jump Trading, Blocktower capital, Coinbase Ventures, and many others. By only adding the funds raised by the top 5 funded projects (Basis, Terra, Saga, nUSD, and TrueUSD), we have over USD 246M[1] in funding. In addition, the oldest and biggest stablecoin project, tether, alone has a market capitalization of over USD2.7 Billion[2] with a 24-hour daily traded volume that ranges from 100 Million[3] to over 4 Billion[4] in the past one year alone.

This paper aims to give readers a broad understanding of all things stablecoin; we start with a broad understanding of what stablecoins are, before we move off into their state of current and potential-future adoption. Next, we look at the different categories of stablecoins and examine in detail one relatively new and noteworthy stable coin per major category. Lastly, we look at some of the issues that are hindering their greater adoption.

What are stablecoins

Stablecoins are cryptocurrencies that maintain their value and are pegged to some other relatively stable asset; the peg could be a currency, a basket of currencies or some other source of stability. Stablecoins can enjoy the whole suite of benefits that cryptocurrencies are privy to — decentralized, secure, (almost) immediate settlement, transparent, globally accessible, and tamper-proof. In addition, stablecoins also aspire to achieve the three essential functions of money[5] as a medium of exchange, store of value, and unit of account. They are also without the biggest limitation that hinders greater cryptocurrency adoption: price volatility. The high degree of volatility that mires cryptocurrencies today is good for speculation, investment (depends on which side you are on) and trade but not necessarily as a store of value, since its value can appreciate or depreciate quickly; it is not uncommon to see double digit price fluctuations within any 24-hour period even for the top 10 cryptocurrencies.

Adoption

Before diving deeper into the various different types of stablecoins, let us first examine the use cases stablecoins beget. Thus far, stablecoins have seen the greatest adoption in crypto-exchanges which are examined first. Next, we dive deeper into the other use cases that have great promise which is yet to show.

Use on Crypto exchanges

Fiat currencies are the handiest unit of account and store of value on crypto-asset exchanges. However, obtaining the rights and accounts necessary to operate fiat currencies on exchanges is a difficult and cumbersome process which requires collaborations with banks, regulators, and lawyers[6]. Further, this creates another layer of centralization, which is beyond the exchange’s control. It has only been achieved by some of the oldest and biggest exchanges around: Coinbase, Kraken and Gemini, amongst others. As a result, a lot of the newer exchanges tend to start off with Stablecoins, which are able to hold their value just as well and are able to offer some of the other benefits of cryptocurrencies as well.

Benefits

i. Traders benefit from risk management (hedging) that stablecoins provide. A stablecoin maintains its value and helps the trader buy in and out of crypto-assets at their whim.

ii. It is more cost-effective for traders and easier to set-up and support for exchanges since it does not involve banks and other costly intermediaries.

Some of the more popular stablecoins that are currently on exchanges include tether (USDT), TrueUSD (TUSD), and Dai (DAI). Interestingly, USDT alone has the second highest 24-hour volume of ~USD2.5 Billion amongst all crypto-assets and only USD1.5 Billion lesser than that of bitcoin, as shown in the screenshot below. This is indicative of the success that the first stablecoin has received since its inception.

Source: Coinmarketcap on 12th September

Opportunities

Albeit viable, the following use-cases have been little explored thus far but remain strong cases for further development in the stablecoin ecosystem.

Remittance

Any stablecoin has the potential to be used as a medium to send remittances across physical borders. It would, in most cases only incur transaction costs, which with Tether would be 0, if you are sending from a tether.io wallet or minimal (gas costs) in the case of GUSD, Dai, or any other Ethereum compatible stablecoin. The bulk of the costs for most of the stablecoins would be incurred when users withdraw into their fiat-based bank accounts (USD20 or 10 Basis Points (BPS) in the event of tether). The notable exception to this rule is the newly released GUSD which charges no withdrawal fees (at the time of writing). In addition, if users trust the blockchain to hold their funds and there is sufficient real-world usage, these fiat-bank withdrawals could be skipped altogether.

Payment gateway

Transacting with stablecoins would make transacting cheaper as it would avoid the hefty credit card processing fees that are levied upon merchants, and range anywhere from between 1.55% to 3.5% as per the diagram from ValuePenguin[7] below:

Average credit card processing fees

Developing economies

Some of today’s developing economies suffer from high rates of inflation as a result of their inability to maintain their own floating legal tender. Examples of countries that have faced such situations in recent history or are still facing such issues include Venezuela, Zimbabwe, and Argentina. Traditionally, these countries would choose to adopt or peg their local currency to some foreign currency, normally the US dollar, in an attempt to avoid local currency inflation and restore their economy. Instead of adopting another currency and buying foreign currency, these countries could instead adopt stablecoins, which will be less volatile than their own currency, be easier to procure, and help eliminate the cost and hassle of transportation.

The situation in some of these countries has been so dire that they have decided to adopt volatile cryptocurrencies like Dash in Venezuela, which is forecasted to experience a 1,000,000%[8] rate of inflation on their local currency this year or a proposal for having the Argentinian reserve hold 1% bitcoin[9]. These situations could be better addressed through the use of a stablecoin, especially one that helps to maintain purchasing power. Venezuela’s Petro, an oil reserve backed stablecoin could be a decent example, if successful, that other countries could look up to.

Types of stablecoins

Nearly, if not all stablecoins are premised on the belief that they will retain their value. Although there are numerous different stablecoins, all of them can be divided into the two overarching categories; collateralized and uncollateralized. Since crypto-collateralization has become popular as of late and varies vastly from traditional fiat-collateralized stablecoins, we will be examining a fiat-collateralized, crypto-collateralized, and non-collateralized stablecoin in the following section.

Collateralized

These crypto currencies are backed by either real-world assets or digital assets. In the case of real-world assets, they can be backed by fiat currencies as is the case for Gemini Dollar and tether, both of which are backed by US Dollars or precious metals as is the case for Digix which is backed by Gold. There could also be backed by a single digital currency as is the case for Dai, which is backed by ether or by a group of digital assets as is the case for Reserve, which uses multiple digital assets.

Fiat collateralized: Gemini Dollar (GUSD)

A stablecoin issued by Gemini — one of the biggest and best regulated exchanges in the United States. It is fully collateralized and pegged to the US dollar on a 1:1 ratio. It is built on the Ethereum network and is ERC20 compliant. In addition, it is approved by New York department of financial services (NYDFS) and has the benefit of American regulatory oversight.

It solves some of the biggest problems facing other stablecoin projects. Its near negligible cost of procurement and redemption (only incurs Ethereum’s gas) would make it the cheapest to buy and sell, which would inherently make it more stable than others like tether and TrustUSD which charge withdrawal fees since it facilitates cheaper arbitrage. GUSD would feature regular attestations along with American government’s oversight, the first of which tether lacks and latter of which both tether and TrustUSD lack. Thus, it can be seen that GUSD is leaps ahead of its biggest competitors.

It also features an interesting implementation where GUSD is operationalized using the following three types of smart contracts:

i. Proxy: A façade that token holders interact with. Its methods would be implemented in the Impl smart contract

ii. Impl: An implementation of the methods in proxy. A separate contract is used to allow for this to be upgraded at a later point, and the new impl contract would be referenced from both of the Proxy and Store contracts

iii. Store: This contract stores the actual ledger (user balances). It exposes methods that will be called by Impl

Price stability mechanism

It would be stabilised by market forces of demand and supply. If GUSD’s market price is above $1, users would be inclined to buy more since they are getting a bargain at its USD1 price. This would increase its available supply and reduce its market price. The converse is also true where is priced below $1, users would be inclined to sell their GUSD for a fiat dollar per unit which would remove units from available supply thereby applying an inflationary pressure on its market price.

Pros

- Likely to be most stable

- Government regulated (and thus avoids the trust issue that some of the other asset-backed crypto-assets and stablecoins have)

- Transparent in that its smart contract code as well as its audit reports are available for the public

- Still onboarding users who can then directly purchase/redeem GUSD, there are some other stablecoin projects like tether that have halted new sign ups[10]

Cons

- Still in infancy stage with limited funds in circulation (~101K GUSD in circulation, ~95K of which is still held by Gemini as of 12th September 2018)

- Subject to Ethereum’s latency issues

Crypto-collateralized: Reserve

A stablecoin, called Reserve (yes, it does make explaining it a tiny bit more difficult), that uses a mix of algorithmic and crypto-collateral based approaches to peg itself to the USD on a 1:1 ratio. It has the added benefit of being able to adapt to crypto-volatility by changing its reserve ratio (reducing it) with the improving volatility (increasing stability) of the crypto-world. Reserve also has a share token called “Reserve Share” that would provide incremental value to end users by virtue of the network effects brought about by an increased demand for the Reserve token. Reserve’s pool of underlying assets (a.k.a reserve conventionally) is called a ‘Vault’ and will hold various crypto-assets from different crypto-ecosystems in an attempt to further hedge Reserve’s volatility.

It does attempt to overcome some of the more pertinent issues in other crypto-collateral based stablecoins in that it is diversifying its underlying “reserve” pool to better mitigative crypto volatility and reliance on a single asset.

Price stability mechanism

If the market price of the Reserve token is above $1, the protocol will mint new Reserve tokens and exchanges them for “Reserve shares”. More interestingly, when the price of the Reserve token falls below $1, the protocol would buy back Reserve tokens by using either the assets in its vault or by using Reserve Shares. The choice of which of the two assets to use depends on the overall health of each of those assets in the ecosystem; the vault is used by default, but this mechanism could also be used to add deflationary pressure on the market price of Reserve Shares if it is too high.

Pros

- It has the ability to balance itself algorithmically whilst also enjoying the benefits of having underlying assets backing it

- Impressive group of strategic partners that includes Peter Theil, Coinbase Ventures, and Blocktower capital amongst many others

- Can be completely decentralized (would however depend on its actual implementation)

Cons

- Crypto-assets generally move in the same direction. Hence, risk hedging by using multiple crypto-assets might not be as risk averse

- Difficult to understand with lots of moving parts (just like most others in this category of stablecoins)

Non-collateralized

These include some of the more novel stablecoin concepts that attempt to mirror the way central banks work. Popular projects in this category include Basis, Carbon, Fragments, Kowala, amongst more. None of the aforementioned non-collateralized projects have any stablecoins in circulation as of the time this paper was written (17th September 2018).

Algorithmic — Basis

Basis envisions a completely decentralized cryptocurrency that is controlled algorithmically to maintain its price peg. Basis is still in its infancy and not yet in circulation. It introduces its monetary policy like mechanics where the price via its reliance on oracles (external feeds) for exchange rates, which could be completely decentralized, would allow for expansion or contraction of total Basis supply. It is through the change in total Basis supply that the peg would be maintained.

Additionally, this project shows a lot of promise. It has one of the largest, and strongest investor bases amongst the different stablecoin projects where it raised about USD133 Million[11]. It also boasts a strong team and an equally strong group of advisors.

Price stability mechanism

Basis requires the coordinated effort of its price feed, bonds, shares, and current supply for price stability. In the event where Basis’s market price is below its peg, the Basis network would issue bond tokens which can later be redeemed (within 5 years of issue) for a single unit of Basis. This has the benefit of reducing current circulating supply of Basis thereby increasing price. In addition, the desire to purchase future Basis tokens at less than market value would also incentivize traders to purchase the bonds using their existing Basis thereby also increasing demand.

In the event where the market price of basis is above that of its peg, the algorithm would buy back prior bonds in the order they were issued, and if still required issue new Basis tokens to Basis shareholders. This would cause an increase in Basis supply which would push its market price down.

Pros

- Can be completely decentralized

- Extremely well-funded and supported by big names in the blockchain space

Cons

- Based on belief that the currency will retain value (more so than the rest since there is no asset backing this either). In the event that Basis fails to gain traction, there are no underlying assets that holders or users could redeem to recuperate their losses

All of the categories, and their idiosyncratic projects, feature trade offs that other categories are able to satisfy. There is no one size fit all, but the users are able to choose a project/coin that they are more comfortable with.

Under development

The following section explores other noteworthy projects that are helping to promote the stablecoin ecosystem within the various categories presented below.

Government interest

Governments around the world are prototyping and experimenting with digitization of their currencies as well as increasing their regulatory oversight in the private stablecoin market.

Government’s maneuver into cryptocurrencies (with stablecoins)

1. Central Bank Digital Currencies (CDBC) are cryptocurrencies that are likely to be issued and maintained by a country’s own central bank in order to gain some of the benefits that cryptocurrencies beget. Countries looking at CDBCs include but are not limited to Switzerland[12], Canada[13], China[14], and India[15].

2. Singapore created a prototype[16] to put the SGD on a distributed ledger in which bank users can exchange digital SGD with one another without expensive processing fees and lengthy processing times. Further, as an extension of the same project, Singapore’s MAS tried out 3 different distributed ledger technologies for inter-bank gross settlements. This project is called project Ubin and more details can be found here: http://www.mas.gov.sg/Singapore-Financial-Centre/Smart-Financial-Centre/Project-Ubin.aspx

3. Venezuela is adopting an oil backed stable cryptocurrency called Petro that is backed by untapped oil reserves in Venezuela. The government is promoting the Petro by pegging their pension and salary systems[17] as well as by ordering all banks to report their financials in Petro[18]. Although cynical and full of skepticism, you can find more details from https://www.reuters.com/article/us-cryptocurrency-venezuela-specialrepor/special-report-in-venezuela-new-cryptocurrency-is-nowhere-to-be-found-idUSKCN1LF15U

Government’s regulation of privatized stablecoins

Paxos and Gemini Dollar are two examples of government regulated stablecoins that are currently in circulation. Gemini Dollar is already examined above and Paxos is briefly examined in this paragraph. Paxos is a fully collateralized stablecoin based on the Ethereum network (conforms to ERC20) and it is pegged to the US dollar on a 1:1 ratio. All funds are stored in custody and the trust is regulated and approved by the NYDFS. For more information, please refer to: https://www.coindesk.com/paxos-unveils-dollar-backed-stablecoin-approved-by-new-york-regulator/

Other noteworthy projects

The following list contains other interesting and upcoming stablecoin projects that are gaining significant traction. They are lumped into categories that they are best known for.

Go to market strategies

Terra: Another algorithmic stablecoin that comprises of two tokens: terra the stablecoin, and Luna the reserve. Luna would have equity like characteristics and would function as the reserve. The project is best known for its go to market strategy and their success at having onboarded various e-commerce platforms like Carousell, TMON, Pomelo, amongst others prior to launch. They are also well backed and funded with organizations like Binance Labs, FBG Capital, and Polychain Capital amongst others. For more details, check out https://terra.money/

USDC: USD Circle is a partnership between Circle and Bitmain that aims to create a collateralized US dollar pegged stablecoin. They also have an extensive go to market strategy by using Circle’s existing network of 7 million users on platforms such as Circle pay, Circle Trade, OTC desk, and Poloniex. For more information, please check: https://cointelegraph.com/news/island-of-stability-stable-coins-keep-attracting-big-league-investors

Fully insured

Anchor: IBM and stellar are partnering with a startup called Stronghold to deliver a USD pegged stablecoin called Anchor. The trifecta is proud of their regulatory friendly policies, their existing relationships with the regulators and the fact that their token will be fully FDIC insured where the trust would add bank accounts as soon as the FDIC insurance limit per account is met. For more information, please check out: https://www.coindesk.com/ibm-is-helping-launch-a-price-stable-cryptocurrency-insured-by-the-fdic/

Factors hindering adoption

Despite their many benefits, it is not all rosy in the stablecoin market either. There are natural issues with having an untested system with significant investment that is based on a theory (market forces) or basing your ideas on a (currently) unscalable system. These issues are all briefly examined below.

Belief in market forces

All of them are premised upon the fundamental notion of market forces being used to maintain price. With the ever-increasing number of stablecoin projects, it is unlikely that all projects would see significant enough funds or users to maintain their pegs. This problem is most apparent in algorithmic systems that only work on the belief that the market would maintain the peg. Without sufficient traction, they would have a tougher time to get off the ground.

Ethereum based

Ethereum’s network is in a state where it gets congested easily. When this happens, the gas prices increase significantly and makes transacting on the network very expensive. Until proper scaling solutions are created, the network is far away from being able to support a crypto-exchange based stablecoin market let alone domestic or international commerce. Popular tokens that are based on Ethereum include a variant of Teher, TrustUSD, Dai, Reserve, Gemini Dollar, Paxos, and many others.

Conclusion

Despite the concerns above, there are rapid developments in the stablecoin space where each project is voraciously trying to outdo all others before them. As such, stablecoins are increasingly filling the volatility vacuum that cryptocurrencies created by offering price stability whilst also offering most, if not all, of the benefits that cryptocurrencies promised.

Although different in their implementations, all stablecoins crave and desire greater adoption of cryptocurrencies and require the support of significant market forces to maintain their stability. Their greater adoption will be as game changing for emerging economies and the global marketplace as it has been for crypto-exchanges. It remains to be seen which of the projects would be most promising and successful for that would have the potential to influence and perhaps even change the way we think about and deal with money. Although still early in the game for other crypto-assets, the time for stablecoins has come.