What are Stablecoins?

Stablecoins are cryptocurrencies with underlying mechanisms meant to reduce the cryptocurrency’s price volatility, thereby making the cryptocurrency more valuable as an actual currency. There is significant debate around which of these mechanisms is most effective, and also around which organizations are creating the best implementations of those mechanisms.

A History of Currency

In order to understand the issues facing stablecoins and cryptocurrency today, one must understand the history of currency, what traits that modern currency is expected to have, and how those traits impact how people use and interact with money. There is general consensus that before money existed, bartering was the primary way people would trade. People would be able to trade in any given instant for one good or service for another: for example, someone might trade an apple for a piece of meat.

Over time, however, societies across the world began to realize that this was not an ideal system: it was hard to figure out fair trades. For example, it would be hard to convince someone to take food in payment for an iPhone today- in order for the trade to be worth it, you would need more food than you could eat before it would go bad.

As a result, the concept of money was created: money is a conceptual amount of value that you can use for indirect trades that do not need to involve specific goods on both sides of a given trade. However, money needed a physical representation, thus currency was born in numerous forms — ranging from early goods such as animal skins, shells, and stones, to the modern paper money. Some major issues arose as a result: people began to realize that currency needed a few key traits:

6 Traits of a Currency

1. Durability: the characteristic of resisting decay
2. Portability: the ability to easily transport everyday amounts of spending value
3. Divisibility: the ability to break down into smaller amounts to pay for lesser value goods and services
4. Uniformity: the state of being homogenous and exhibit sameness
5. Limited Supply: restricting the creation of currency would protect the intrinsic value otherwise would lead to hyperinflation if no limit is enforced
6. Acceptability: the recognition of that currency as a legitimate method of paying for goods and services

Why Stablecoins?

Cryptocurrency has always had its issues in becoming a medium of exchange: when Bitcoin was first released, the only way to obtain Bitcoin was to run programs from the command line; once you could buy Bitcoin, you could only make transactions from your home computer, and the only place to spend it was on a black-market website on the dark web. At many points, various major cryptocurrency networks such as Bitcoin have slowed down to the point where they could only handle tens of transactions per hour, demonstrating the need for deliberate analysis of cryptocurrencies’ usage as actual currencies.

As a result of this volatility, cryptocurrencies simply were not fulfilling the functions of a currency: they were too risky to be used as stores of value; they were far too volatile to be used as a unit of account; and they were far too erratic to be used as a medium of exchange unless you already happened to have some (which was only the case for investors, because they were a bad store of value).

In order to create a cryptocurrency which might actually function as a currency, both to enable organizations to benefit from new advances in distributed systems technology (blockchain), blockchain developers and researchers began to postulate a cryptocurrency with built in protocols to prevent price volatility. In fact, some researchers postulate central banks implementing digital currencies on top of popular blockchain networks — or, in other words, making their own cryptocurrencies. In these situations, the need for a stablecoin mechanism is strongly evident. The first stablecoin to be proposed was BitShares, a system proposed in 2013 and created in 2014 to allow people to “create market pegged assets (stablecoins)” for one cryptocurrency through the purchase and subsequent trade-in of BitShares’ unpegged cryptocurrency; it does this through a forced collateral ratio.

Stablecoins Today & Innovations

Stablecoins today have attempted to implement various price stabilization mechanisms. Each implementation has had varying success, but in general, public sentiment of them demonstrates huge excitement, resulting in huge investment. In 2018, the money invested in stablecoins grew over 700%, with certain stablecoins each raising over $100m USD from ICOs or private investment. This investment has allowed many mechanisms to be tested out on public blockchain networks.

Mechanism 1: Supply Controls

Mechanism 2: Collateralized Debt Positions

Stablecoins which use collateralized debt positions require users to deposit collateral into a smart contract in exchange for the stablecoin. This mechanism typically charges users an interest fee for holding onto the stablecoin. In essence, a collateralized debt position stablecoin ensures stability through reserves deposited by users.

There is one huge issue in that the reserves themselves can still highly volatile assets. If the market were to fall substantially, then the reserves would be eradicated, and a bank-run (a situation in which too much money is loaned out and the holder of the debt cannot fulfill all of its own debt obligations) would occur. This mechanism could work given that the underlying assets are not too volatile: an approach such as exchanging the collateral cryptocurrency for national currencies or precious metals, or simply assuming that the underlying cryptocurrency is not too volatile, would enable these stablecoins to achieve low volatility and usage as a currency.

Mechanism 3: Self-Collateralization

Self-collateralized coins are similar to collateralized debt positions, but tend to be more restrictive in nature as to what uses the stablecoins have, and to have much lower reserve ratio requirements. This mechanism puts itself at immense risk of bank run scenarios as mentioned for collateralized debt position coins; in general, these are not advisable and expose users to substantial risk. Beyond the aforementioned risk of bank runs from a substantial fall in the price of cryptocurrencies, even just standard daily cryptocurrency price volatility or a global recession could trigger a bank run scenario, depleting the value out of these systems.

Mechanism 4: Bond Redemption

Bond redemption coins work by automating the supply of the cryptocurrency: they allow users to trade in the cryptocurrency when the price is lower than the currency peg in exchange for bonds that can be redeemed for full value once the price recovers (Zambarakji, 2019). This approach is similar to elastic supply coins, but instead of having an automated system for buying and selling the currency to expand and retract the supply, it does so by incentivizing users. Furthermore, some implementation of bond redemption coins have attempted to mimic the capabilities of a central bank, in a distributed way. Basis, a bond redemption coin, also implemented governance shares in fixed supply to allow users to vote on how to change the monetary policy of the system (Zambarakji, 2019). Basis, and similar systems which might mimic central banks, are currently the most promising mechanisms for achieving a sustainable, low-volatility currency. However, some of these systems (Basis included) risk overlooking where the inherent value comes from: without adoption for transactions or outside investment as a store of value, the price of the coin may simply fall below the pegged currency’s price and never recover (Zambarakji, 2019).

Mechanism 5: Collateral Redemption

Collateral redemption coins are also similar to collateralized debt position coins: they create and grant stablecoins in exchange for depositing collateral using a monetary policy system (Zambarakji, 2019). They differ from collateralized debt position coins because users can only withdraw their deposits at any point in time, without charging fees. This allows an easy and direct peg to other cryptocurrencies. However, this mechanism also has various weaknesses, such as being hard to peg to units outside of the cryptocurrency world.

Mechanism 6: Centralized Mechanism

In addition to the decentralized mechanisms above, there are also centralized mechanisms for stablecoins. Tether has been one of the most popular stablecoins, and their method to a centralized stablecoin mechanism is to have reserves equal to the stablecoins that they release to the market: in theory, this provides a stable, 1-to-1 exchange rate with the USD. However, there have long been concerns that Tether does not actually have the reserves to support this concept (Lee, 2018). For this, and similar concerns around any centralized cryptocurrency that they could be easily manipulated to steal value from the system, centralized cryptocurrencies are not discussed in depth in this paper. On similar grounds of faulty mechanisms, growth-backed stablecoins do not have any proper technical mechanism to sustainably ensure low price volatility, so they are discussed in the next section (Wen, 2018).

Each of the mechanisms for stablecoins mentioned affect cryptocurrencies’ use as currency in different ways. For example, a decentralized stablecoin implementing elastic supply and bond redemption automated with algorithms could theoretically function identically to a typical central bank, without the risk of hyperinflation through irresponsible fiscal policy, and without the overhead and regulation associated with a central bank. If such a solution were capable of mimicking the stability of the most stable currencies, then it could create a real currency using cryptocurrency technologies without many of the costs associated with real currencies in the world today. Given such a solution, fees for various financial transactions worldwide would plummet 50%-80% and become virtually nonexistent in comparison to current systems, and the efficiency and speed of transactions would greatly increase (Raskin & Yermack, 2016). This highlights the huge potential that stablecoins could have to create a functioning currency out of cryptocurrencies. Automated monetary policy without vulnerabilities could enable the stablecoin to: have low long-term risk and function as a store of value; have low price volatility and function as a unit of exchange; and fuel the adoption required to function as a medium of exchange.

Potential Shortcomings of Stablecoins

There are numerous issues with stablecoins: from their use in circumventing financial regulations to bad implementations and exit scams. Some of the mechanisms by which stablecoins regulate their prices are simply flawed. The impact that such issues can have ranges from counteracting and detracting from any progress towards turning cryptocurrencies into currencies, to simply losing people money and causing the stablecoins’ parent companies to go insolvent.

Shortcoming 1: Incorrect Implementation

NuBits is an example of a poorly designed and poorly implemented stablecoin which utilizes a mechanism of self-governing non-automated elastic supply paired with bond redemption. In March of 2018, NuBits fell over 50% from $1 to $0.45. This failure to maintain price stability demonstrates that the mechanisms used by stablecoins to reduce volatility are inherently flawed, and NuBits provides an example of an inadequately designed stability mechanism.The creators of NuBits have since abandoned the project. Incorrect implementations such as these have repeatedly decimated the savings of people who thought that they had a stable store of value by using a stablecoin, thereby slowing the adoption of cryptocurrencies for everyday usage.

Shortcoming 2 & 3: Security and Bank Run Vulnerabilities

1. Vulnerabilities in Bancor’s underlying algorithms used to automate the market maker process which create a massive price lag and arbitrage opportunity.
2. Existence of “double linked reserve ratios” which open up the possibility of bank run scenarios which could result in massive hyperinflation.
3. Incorrect implementations highlighted in the paper were later exploited as vulnerabilities and used to steal nearly $25m from the Bancor network.

One major use case for stablecoins, as previously mentioned, are financial institutions. Ivanitskiy emphasizes that even for interbank transfers, blockchain makes little sense: payments will never be publicly visible, and even with a private blockchain that only the banks can access, the institutions are likely to appeal the blockchain’s record in the court system from time to time. Ivanitskiy also highlights how regulation could simply restrict or prohibit the use of blockchain systems by financial institutions, thereby annulling the entire use case.

Shortcoming 4: Potential Illegality

Even assuming a well-implemented and well-designed stablecoin, in any situation where financial institutions fail to use stable coins, then the adoption of stablecoins, originally imagined to be powered by financial institutions, would be greatly slowed, possibly to the point where even stablecoins wouldn’t be used as a medium of exchange for day-to-day transactions.

The excitement around the “JPM Coin” mentioned at the start of the page highlights the belief that financial institutions would spearhead the adoption of cryptocurrencies by using stablecoins for inter-bank transactions. Instead, stablecoins may simply end up being used to circumvent domestic and international monetary regulations. Stablecoins, originally imagined as a way to turn cryptocurrencies into true currencies, could serve solely as a store-of-value for criminal transactions. Furthermore, if stablecoins were to be used in this way, then there would be significant concern and increased regulation around them, potentially making such systems illegal to use or implement.