Stablecoins: in search of a perfect solution

Instant transactions, low fees, full transparency — Bitcoin has many benefits when compared to traditional means of payment. But it has a serious drawback that prevents its adoption: volatility. Bitcoin’s rate jumps up and down like crazy which makes it inappropriate for daily usage as it undermines traditional business models and makes merchant’s profits unpredictable.

How can one combine Bitcoin’s advantages with the stability of fiat currencies? That’s right: invent the mechanism that would allow issuing cryptocurrencies with a stable rate. This is exactly how stable coins have come out into existence.

While in its early years the market was dominated by a single player Tether, now the range of options is much wider (Cryptoslate lists 36 of them at the time of writing). How do they manage to maintain a stable rate in such an unstable market? Our experts at Numbrs have decided to investigate this topic in detail and review different types of stable currencies in the blockchain niche.

Fiat-collateralized stablecoins

Such coins are typically issued by a single entity while their rate is pegged to the rate of fiat currencies such as USD or EUR. For each dollar that users send to the issuing company, they get a digital alternative while the fiat money itself is stored on the company’s banking account. By request, the company buys back its tokens and gives fiat in return.

The mechanism is pretty simple, but aside from this, such a model has more drawbacks than benefits. The concerns are as follows:

• What if the number of coins issued exceeds the amount of fiat accepted?
• What if the political situation in the country where the issuer resides changes for the worst and affects the regulation processes?
• What if the issuer spends the fiat elsewhere? The issuer may act in good faith here, btw, aiming to diversify its portfolio and reduce risks. For example, Tether has recently revealed that aside from cash, it backs up its reserves with gold, short-term deposits, and even Bitcoin. What will happen if the gold price drops or borrowers prove to be insolvent?

Tether: Cash and its equivalents make up 76% of its backup reserves

All in all, the questions are aplenty as such stable coins are not decentralized. Although issuing companies are subject to regular audits, what’s the use of these audits for end-users who have no way of ensuring their trustworthiness themselves?

The most popular fiat-collateralized stable coins include:

• Tether USDT
• Binance BUSD
• Coinbase USDC
• Gemini GUSD

Note that all of them are issued by commercial companies that may go bankrupt at any time leaving their users with nothing but remorse. Stable coins issued by governments could resolve this issue and there have been many talks in the media about different countries planning to provide their citizens with digital alternatives of their local currencies. However, none has moved any further so far. At the time of writing, the only solid roadmap is specified for Chinese digital yuan and United Emirate Coin.

Crypto-collateralized stable coins

Having to rely on fiat and thus depend on centralized financial institutions is not the best idea when operating with cryptocurrencies. Let’s consider an alternative of backing up stable coins with crypto.

In order to avoid the high volatility of cryptocurrencies that serve as collateral, issuers of such coins keep them in an over-collateralized position which allows absorbing the rate swings and keeps the price stable. For example, if you want to issue 100 stable coins each one equal to 1 USD, you will have to provide a set of cryptos worth 200 USD in total as collateral.

Such currencies are controlled by smart contracts. If the price of the collateral reaches the critical minimum, it gets liquidated automatically.

The pros of such an approach are as follows:

• Decentralization makes the coins censorship-resistant
• Transparency
• A possibility to quickly buy and sell other cryptocurrencies
• No risks of counterparty
• Can be used to create financial leverage and give higher returns

The technology has its cons as well:

• Lower stability and higher complexity compared to fiat-collateralized coins
• Automatic liquidation of coins when the market drops
• Inefficient usage of collateral

BitUSD created by Daniel Larrimer in 2014 was the first coin based on such a scheme. The coin doesn’t seem to be alive now, so the experiment can be considered unsuccessful. More relevant cases worth mentioning include MakerDAO DAI and Synthetix sUSD. The technology is on the rise now thanks to the growth of the DeFi market.

Algorithmic stable coins

The problem of inefficient collateral usage brought forward one more type of stable coin governed by algorithms.

Algorithmic stable coins, also known as seignorage coins, rely on algorithms that increase or reduce the circulating supply of tokens when the demand in the network grows or declines correspondingly. This helps to maintain the price at a stable level.

What they do is similar to central banks’ governance. The difference is that the whole process is fully transparent and managed by the code instead of opaque centralized structures.

Such an approach comes with the following advantages:

• No collateral is needed
• Transparency and no dependence on a centralized party

The main problem with algorithmic stable coins is that they can’t operate normally if they don’t have a sufficient number of users and a solid level of capitalization. If the number of users is too small, no algorithm would be able to keep the price stable during the panic sell. Let’s review some samples.

Example 1. Ampleforth

Ampleforth (AMPL) is a good example of an algorithmic stable coin. Its idea is quite simple. If AMPL’s price grows, its holders gain additional tokens on their wallets. For example, if you store 10 AMPL and its price grows by 10%, the system issues additional tokens to stabilize the price. Thus, your 10 tokens turn into 11. The bad news is that if the price drops by 10% the number of tokens on your wallet will get reduced by 1 as well.

Such an approach is much fairer than the one utilized by central banks that use the newly issued currency at their sole discretion. With Ampleforth, new coins are distributed across all the system participants. However, in practice, it can’t be called productive as AMPL’s price is far from stable.

CoinMarketCap: AMPL price usually swings between $0.6 and $1.7 per coin

Example 2. Empty Set Dollar

Empty Set Dollar (ESD) is another example of an algorithmic stable coin with an ecosystem that relies on 2 coins instead of 1.

The system implements coupons that are in fact bonds backing up the debts in the protocol. When ESD drops below $1, the protocol stops minting new coins and issued coupons instead. To get these coupons, users have to burn ESD. And vice versa: when the market price of ESD gets above $1, new ESD coins are minted to lower the price and to buy back the coupons.

The idea is surely great, but the results don’t impress either as there is no stability.

CoinMarketCap: although the price of ESD was hovering around 1 USD after the launch, it has dropped in just a couple of months after that and now hovers around $0.15 per coin

Is there no perfect solution then?

It seems that all ways to maintain stability on the blockchain fail in vain as none of them is able to eliminate the faults of the other without gaining some new ones instead.

However, there’s no need to despair. 20 years ago, who would have dreamed that there would be an alternative means of payment at all? Now in addition to Bitcoin, we have a huge variety of altcoins that are not only independent from central authorities but also maintain a stable rate (more or less so).

Yes, they are imperfect, but the technology doesn’t stand still. Earlier or later, an ideal stable coin must be invented that would come without all the shortcomings of existing solutions and provide users with a truly decentralized and stable means of payment.

Originally published at https://www.numbrs.com/ on June 6, 2021.