A Brief Overview of Stablecoins
By: Matus Steis
Tags: Blockchain, Cryptocurrency, Stablecoins, Investment, Bitcoin

Cryptocurrencies are so volatile that owning some has become a bit of an adrenaline sport and checking one’s phone every 5 minutes is a central feature to crypto trading. Without a doubt, cryptocurrencies are currently the most volatile of asset classes. Just to illustrate, in early 2017 Bitcoin fell from its all-time high of $19,783 to $6,953 in the course of just 50 days. Overall, cryptocurrencies fell from an all-time high of $813 billion to around $332 billion, which is roughly a 60% loss. Despite numerous advantages that use of cryptocurrencies have to offer, events like these prevent their wide adoption. After all, why would you pay the equivalent of $40 for dinner one day and $100 the next? In order to bring cryptocurrencies into mainstream use, this problem has to be addressed. Rather than wait long years for the influx of institutional money and more regulation to make Bitcoin and Ethereum less volatile, developers are working on creating the so-called stablecoins.

What are stablecoins?

Stablecoins are cryptocurrencies with stable value relative to a fiat currency, which makes them much more suitable as a store of value, medium of exchange and unit of account. Apart from not having to worry about wild price swings when shopping for groceries, there are many other areas where stablecoins can make people’s lives easier. Countries with two digit inflation, such as Egypt, Argentina or Nigeria can use it as a reliable alternative to faltering national currencies. These countries usually solve the problem of hyper-inflation by dollarization, a partial adoption of US dollars. If they used stablecoins instead, no physical money would have to be transported and a lot would be saved in transportation costs. Crypto traders are another group that would also profit from stablecoins. Thanks to stablecoins, they can exit and enter trades via cryptocurrencies, as opposed to fiat currencies. That can have more beneficial tax implications, especially in EU countries, where crypto-to-crypto transfers are not taxed. Stablecoins can also be used as collateral for real-world asset digitization.

How are stablecoins made stable

Putting “stable“ in stablecoins can be achieved in several ways. The simplest way is to collateralize the coin with a fiat currency, such as the dollar or the euro. In short, a centralized entity holds these fiat currencies and the coin is a token representing a claim to these currencies. The main risk of such arrangement is in the centralization of the collateral. The most notable example is Tether, a currency with very high market cap mostly used by crypto traders. However, some people argue it is not actually a cryptocurrency as they are holding their fiat in Taiwanese banks. This means Tether has complete control over the collateral, which does nothing to address the problem of centralization. Collateralizing stablecoins with fiat also means that these coins can never replace fiat. Other examples include TrueUSD and NuBits.

Another way of achieving stability is to collateralize the coin using other cryptocurrencies. The collateral is managed by a smart contract, which reduces the risk of centralization, but does not remove it altogether. The main risk here is the volatility of the collateral, low potential for scalability and easy devaluation of the collateral in black swan events. One of the most notable examples of crypto-collateralized stablecoins include MakerDao. In order to obtain $100 worth of Dai, the MakerDao cryptocurrency, one needs to deposit $150 worth of Eth of collateral. It would probably be easier to change the Eth for dollars and have $50 worth of Eth left. This is probably the major shortcoming of crypto collateralized stablecoins and will probably stand in the way of their widespread adoption. Other examples include Havven and Alchemint.

As described above, these types of stablecoins present significant problems and risks. In order to address these, different models of stablecoins have been created, in which no collateral would be needed to stabilize the coin. Non-collateralized stablecoins use their own algorithms to expand or contract the coin supply and thus regulate the price. This minimizes the problem of scalability and centralization, but also presents numerous other challenges that need to be overcome in order for non-collateralized stablecoins to work. Below are the examples of the most interesting non-collateralized stablecoins that we came across.

Non-collateralized stablecoins

Basis (formerly Basecoin)

Basis is probably the most high-profile stablecoin project. It has managed to raise $133 million from top crypto investors, such as Bain, Google Ventures and LightSpeed. It is in principle similar to monetary politics of a central bank.. If the Basis stablecoin is trading for more that 1 USD, the system creates and distributes new Basis tokens. These are give to holders of bond tokens and Base Shares. If Basis is trading for less than $1, the system creates and sells bond tokens in an open auction to take coins out of circulation. Bond tokens cost less than 1 basis and the have the potential to be redeemed for exactly 1 Basis when new coins are created to expand supply. This way, speculators are incentivized to buy bonds when they are selling for lower price, hoping that the price will revert back to $1. Basis is simply an abstraction of demand for its bonds.

Kowala

Kowala is a non-collateralized stablecoin relying on an elegant energy efficient mining solution based on a proof-of-control mechanism. Traditional blockchain consensus mechanisms make miners compete with each other. On the other hand, Kowala’s Yap Consensus (proof-of-control) makes miners cooperate and thus reduces energy wasting. Apart from the stablecoin itself, Kowala also plans to build its own app acting as a wallet.

Kowala distributes a family of self-regulating, asset tracking cryptocurrencies called kCoins. kCoins can be traded on open exchanges and are pegged to a mainstream currency. Each kCoin is identified by a symbol consisting of the letter “k” followed by a symbol of the underlying asset (e.g. kUSD, etc.). Each kCoin is implemented as an independent blockchain (own tokens, community, smart contracts, etc.). Public exchanges act as oracles for the kUSD blockchain, which then automatically increases or decreases the kUSD money supply based on the market price to keep the value of kUSD close to $1.

The system is based on 3 core mechanisms that are supposed to keep the price stable.

Block rewards — If the price of kUSD rises above $1, miners are paid more, which increases supply and reduces price, if the price falls below $1, miners are paid less. The reward can even go down to 0 for a certain period of time (which does not matter that much, as mining on Kowala is not very energy demanding). Stability fees — If block rewards not sufficient to bring price back, special fees applied to each subsequent transaction in order to reduce supply until the market price begins to rise. The fees are normally very low (0.1%), but could climb up to 2% when needed. Trading activities — Traders expected to engage in trading activity that brings the price closer to 1 USD. These mechanisms should return the price to parity (this provides arbitrage opportunities for traders).

Kowala is an interesting solution to the volatility of stablecoins. However, in order for the system to work, miners need incentivized to mine, sometimes even for free, if the price of the coin gets below $1. Another potential pitfall is that if transaction fees can get up to 2%, that can potentially discourage people from using Kowala as making a transaction will simply become too expensive.

Carbon

Carbon is another stablecoin with stabilizing mechanism similar to Basis. It has raised $2M in seed funding phase from investors like General Catalyst, Digital Currency Group, First Mark Capital, Plug and Play, The Fund and Haystack. Carbon uses an elastic supply policy to adjust the quantity supply of the coin in response to its market demand and thus achieves price stability around $1. This is done by using two types of tokens: Carbon Stablecoin (CUSD), the actual stablecoin and Carbon Credit which is used to absorb demand and price shocks to CUSD. When coins are trading for less than $1, Carbon Credits are auctioned off to participants willing to burn their stablecoins, creating upward price pressure and appreciating stablecoin price back up to 1 USD. When coins are trading for more $1, coins are distributed to Carbon Credit holders pro rata, bringing the price back down to $1. The whole project will be run on Hedera Hashgraph, a new type of decentralized ledger technology, which is allegedly faster and offers lower fees per transaction than blockchain.

In order for Carbon to function properly, it is important that demand for its bonds is high. If users lose confidence that the price will revert back to $1, the whole system will collapse. Therefore it is important to focus on how developers intent to keep the Carbon community active.

Terra

Terra is a stablecoin developed in Korea, with a wide array of renowned investors, including Binance Labs, Huobi Capital, OKEx, Polychain and Hashed. The way it works is that every predetermined medium of time the protocol estimates the current price for Terra and takes votes regarding its price weighted by stake of the deposit holders in its reserve pool. Terra maintains a reserve pool which will be guaranteed to be greater than the value of the Terra coin economy. The market value of the reserve is greater than the value of Terra in circulation — reserve pool will be made of Luna tokens, a different class of tokens used for staking.

It contracts by means of the reserve: If the price of Terra is smaller than the price peg, then the reserve pool buys Terra from market and burns it. It expands through fiscal spending: if the price of Terra is bigger than the price peg, the system mints new Terra and takes votes from Luna stakeholders to engage in decentralized fiscal spending for improvement of the system. Variable transaction fees will regulate the price of the reserve pool. This means that the protocol levies a small a fee from Terra transactions calibrated to guarantee that the market value of the reserve pool exceeds Terra’s circulating supply. Transaction fees flowing to the pool in turn increase the value of Luna tokens in the pool.

Founders of Terra are experienced in e-commerce. They founded Ticket Monster, the largest Korean e-commerce platform and intend to integrate the stablecoin with the platform as their go-to-market strategy, planning to offer a Stripe-like payment option. This is a similar strategy to that of PayPal, so it will be very interesting to see how they do in the future.

Challenges non-collateralized stablecoins face

There are still numerous challenges non-collateralized stablecoins need to overcome in order to be functional. One of the main ones is the oracle problem. The algorithm governing the coin somehow needs to gain trustworthy information regarding the exchange rate between the stablecoin and the asset that it is pegged to. One way of going on about it is the trusted oracle scheme. This includes single feed from an exchange such as Coinbase or Kraken. The problem with this approach is that it is centralized and can be manipulated. Another way of going on about it is a set of delegated data feeds scheme. This is still semi-centralized, as small group of token holders are selected by vote and they all provide exchange rate information when asked. Then a median exchange rate is selected and applied. The advantage of this approach is that if there is a bad actor trying to sabotage the system, they can be voted out of it. The most advanced and least centralized approach is the Schelling point scheme. In here, every participant can vote what the exchange rate should be. Then their vote is weighted according to the number of tokens they own, the weighted median is taken as the true exchange rate. Participants who guessed close to the weighted median are rewarded and those who didn’t can be penalized. Most stablecoins are currently looking into ways of implementing this approach.

Another challenge stems from the fact that in order for stablecoins to function, they require constant trust of the participants — mining activity — this is problem is partly addressed by the stablecoin companies keeping some share of the tokens. However, developers also need to build a community of miners which are incentivized to mine and thus keep the price stable.

Conclusion

Stablecoins are an interesting subset of cryptocurrencies. Although several attempts at creating a functional stablecoin have been made in the past, none of them was deemed a success. There is currently a couple of projects claiming to have found the answer. However, the wider adoption of cryptocurrencies, influx of institutional money and more regulation will mean that mainstream currencies will become more stable and it is hard to imagine that stablecoins will be dominant currencies 30 years from now. Despite that, stablecoins provide for interesting use cases in the meantime. It is still difficult to determine which stablecoin is going to have the edge over the others and if that is going to happen at all. Technologies presented above are open source, which means that superior ones can be copied and applied. Therefore, what will make stablecoins a success is the go-to market strategy and that’s what we should be on the lookout for when evaluating which stablecoins to invest in.