Stablecoin — “bad” idea, “good” investment
By: Fan Wen
Tags: Cryptocurrency, Stable Coins, Blockchain, Cryptocurrency Investment, Bitcoin

Stablecoin has undoubtedly become the hype of 2018 with its 700%+ annual growth. A lot of discussions arise around this hot topic, and most people believe stablecoin is suspicious with problems such as lack of transparency and high centralization/single-point failure.

As of today, three stablecoin mechanism designs have been invented. To most people, none of the three stablecoin mechanism designs is good. However, regardless of many flaws, Basis Protocol (previously Basecoin), one stablecoin, has attracted $133 million from a list of big-name VCs: Lightspeed Venture, Google Ventures, Bain Capital Ventures, and Andreessen Horowitz.

In this article, I am not going to repeat much about the stablecoin 101. Instead, I will primarily focus on analyzing the non-collateralized/growth-backed type stablecoins using Basis Protocol as an example.

Summary

The best result for the fiat-collateralized stablecoin is that governments/banks/highly regulated entities will issue the coins with their reserve. These coins are just digital versions of the existing currencies with the same limits. The crypto-collateralized stablecoin mechanism will not work since it may still have a high volatility. The non-collateralized/growth-backed stablecoins (‘Seigniorage Shares’) may work in the short term before the demand stops growing. However, it may not work in the long run since there is not a permanently growing demand. Though the growth-backed stablecoins, such as Basis Protocol, are not a good idea, they can be good investment opportunities. The TAM for Basis can be as huge as $108.901 billion. The growth-backed stablecoins are printing free money that will eventually depreciate when the growth ends. This mechanism can become a Ponzi scheme if the growth cannot be sustained.

Background

If you have the basic knowledge of stablecoins, you can skip this section.

Due to the high volatility, cryptocurrencies have never been widely used as an exchange medium since their existence. No merchant will want to accept a coin that values $100 at this moment while only $50 in the next hour. To address this volatility issue, people invented the Stablecoins, which are price-stable cryptocurrencies.

To achieve the stability, three types of stablecoins have been introduced:

1. Fiat-collateralized stablecoins are the coins backed by fiat (e.g. USD) reserves. The most prominent example is Tether, which dominates the major stablecoin market now. For the Fiat-collateralized stablecoins, the major challenges are:

(1) Highly centralized — the currency is backed by one company

(2) Lack of transparency — it is difficult to verify the reserve

(3) Lack of scalability — it is difficult to scale up with a 1:1 reserve

(4) Difficulties in bank relationships — it is highly possible that government will intervene and banks are highly regulated

Long Story Short:

(1) Tether has not been audited yet, and a lot of research (source 1, source 2) indicate that they may just be a Ponzi scheme;

(2) New audited USD-pegged cryptocurrencies such as Paxos are being issued, while they will be regulated by local government.

Conclusion: the best scenario for this stablecoin design is that governments and/or banks will issue these stablecoins with their reserves. It will just be a digital version of the existing currencies, which will not be freely used worldwide.

2. Crypto-collateralized stablecoins are stablecoins that are backed by other cryptocurrencies such as Bitcoin and Ethereum. To provide sufficient stability, these stablecoins will prepare excessive reserve. For example, to issue 100 stablecoins, each of which values $1, an issuer will reserve some Bitcoins or Ethereums that value $200. However, what would happen if the price of the coins used as reserve drops dramatically and the issuer cannot provide more reserve?

Conclusion: this is simply a bad idea since the value of other coins are highly volatile (and correlated) and a high reserve rate will never provide sufficient stability.

3. Non-collateralized stablecoins (‘Seigniorage Shares’-type/Growth-backed stablecoins) are stablecoins that are not backed by any real/digital asset. Instead, the issuer use an algorithm to control the supply/demand of the stablecoins to stabilize the price (e.g. at $1 per coin). I will elaborate on this type of stablecoins in the next section.

Basis Protocol: a growth-backed stablecoin

1. Mechanism

The Basis protocol has three different tokens — ‘Basis’ (the stablecoin), ‘bond tokens’, and ‘share tokens’. The mechanism of this protocol is much like that of the central banks: when the price of Basis goes over $1, the Company (Intangible Labs) issues more Basis; when the price of Basis goes below $1, the company sells bond tokens with 1-Basis face value for less than 1 Basis to reduce the Basis supply in circulation.