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Digix stablecoin based on gold

Stablecoins Guide: A Brief Introduction and List of Stablecoins

One of the hottest categories in crypto startups right now is the stablecoin. Designed as an alternative to traditional crypto’s volatility, these stablecoins keep their prices pegged to a target value. But why would anyone want to buy something they can’t sell at a profit?

This Stablecoins 101 will help you wrap your mind around a cryptocurrency whose price doesn’t change.

Stablecoins: A Brief Introduction

Over the past two years, it became evident that Bitcoin and other cryptocurrencies are just too volatile to serve as a reliable form of day-to-day currency. Enter the stablecoin, a token that holds steady against a target price.

Stablecoin benefits

A common question that arises when talking about stablecoins is “Why buy a stablecoin that’s pegged to a dollar when you could just buy a dollar?” From the fiat-world perspective, the question is perfectly valid. Stablecoins’ biggest benefits, however, only appear in the crypto world.

Consider an exchange that lists normal cryptocurrencies like litecoin and ether on markets in US dollars and bitcoin. Since you can’t exchange litecoin for ether directly, you have to take an intermediate step. You could keep everything crypto by trading on the LTC/BTC and then the ETH/BTC markets, but bitcoin’s volatility will expose you to some level of risk. The other option is to reduce your risk exposure by trading litecoins for dollars and then dollars for ether.

The question is, did you really have any dollars? Odds are, the exchange used a dollar-pegged stablecoin like tether. As eToro market analyst Mati Greenspan explained to Business Insider:

“What exchanges like Bitfinex do is, rather than having a client’s balance held in dollars, they hold them in [tether]. So if somebody’s got their money on an exchange such as Bitfinex and they don’t have any current open positions, they’re actually probably in Tether.”

Handling internal transactions in stablecoins is much easier and less expensive than handling them with fiat currency. The often-troubled relationships between crypto exchanges and banks makes minimizing fiat transactions a good strategy.

Criticisms

As with most cryptocurrencies, the relative anonymity and unregulated nature of stablecoins make them attractive vehicles for money laundering and other nefarious activities. UC Berkeley computer security researcher Nicholas Weaver wrote that the stablecoin tether is “the primary vehicle for hiding money flows by allowing customers to switch between different cryptocurrencies. In short, they represent a significant problem.”

Another criticism focuses on the spotty history of pegged asset classes from the gold standard to the Soviet Union’s rouble. Market manipulation, debasement by central authorities or the general rigidity of these systems eventually lead to their collapse.

Preston Byrne, a cryptocurrency pioneer and founder of Monax, once wrote that fiat-world examples of pegged assets form “an object lesson in why you don’t try to peg currencies: because you are unable to hold the peg any longer than you can afford to subsidize your differences of opinion with the market.”

In another article, Byrne (a frequent critic of stablecoins) wrote that stablecoins are “the techno-magical idea that a cryptocurrency can tell the market what its price should be, rather than the market determining what a cryptocurrency’s price should be.”

Stablecoins Backed by Real-world Assets

How they work

One way to peg a stablecoin’s price is to buy an asset, such as gold or a dollar, for every stablecoin issued. You pay a dollar to buy a dollar-tracking stablecoin, for example, and that dollar gets held in a reserve. When you sell the stablecoin, its price will be a dollar. By holding one-to-one reserves, proponents argue, the price will remain stable.

Criticisms

Crypto advocates criticize asset-backed stablecoins because of their inherently centralized nature. One company owns all of the dollars or all of the gold and can control the stablecoin’s policies.

Crypto critics focus on the lack of transparency. US dollar-denominated tether is a particularly controversial example. The project’s management has been notoriously cagey about tether’s numbers, creating doubts about whether the stablecoin truly has a one-to-one dollar reserve. A recent study of tether’s blockchain found that only 0.2% of the addresses hold more than 90% of the tokens — more than $2 billion worth if the dollar-to-tether value is real. Another study from University of Texas researchers found evidence indicating that tether speculation was used to drive the price of bitcoin in the 2017-18 bubble.

Examples

Vault's stablecoin based on gold
Source: Vault

Digix: Digix uses gold reserves to hold the value of a dgx to one gram of gold. This means that the currency value of dgx will go up and down as the price of gold fluctuates. The French certification company Bureau Veritas audits the gold held in Digix’s Singaporean bank. The July 2018 audit confirmed that digix had 50,200 grams of gold in its vaults. Availability: Now.

Stasis: The eurs stablecoin will use one-to-one reserve holdings of the euro to stabilize its value. Using Ethereum’s EIP-20 protocol, the eurs smart contract does not require the token-holder to supply gas for transaction processing. One of the Big 4 accounting firms will audit stasis’ reserves every quarter. Availability: Q4-2018.

Stronghold USD: New Zealand-based Stronghold, part of the Stellar ecosystem, launched a dollar-backed stablecoin earlier this year. Tech giant IBM is one of the company’s backers and will test the use of stronghold USD to settle payments on its own blockchain network. The company has not provided details on auditing policies. Availability: In private beta.

USD Coin: Crypto financial company Circle, the parent company of the Poloniex exchange, announced its own dollar-based stablecoin in May 2018. The Wall Street-backed company will hold full dollar reserves and provide transparent audits of its holdings. Through its subsidiary Centre, Circle will create stablecoins based on other fiat currencies. Availability: mid/late 2018.

USDVault: The Swiss-Canadian company will back up the value of its dollar-tracking token by depositing gold in the vaults of Swiss banks. Third-party fiduciaries use hedging strategies to manage any volatility in the dollar price of gold. The gold reserves will be audited and the results posted on the Vault website. Availability: 2018.

Stablecoins Backed by Cryptocurrencies

How they work

A purely crypto-based approach to stablecoins uses one or more cryptocurrencies as the basis for maintaining the target price. You hand over a certain amount of crypto as “collateral” for a “loan” of the stablecoin.

One catch with these systems is how much of your crypto holdings you have to hand over. Given the volatility of crypto markets, the reserves for these stablecoins can’t be one-to-one. Instead, you will see reserves over-collateralized by 1.5X, 2X or even more.

Let’s say that a particular ether-backed stablecoin tracks to the value of the dollar. You may need to pay 200 ETH in order to get 100 units of the stablecoin. Smart contracts manage the supply of the stablecoin to keep its value pegged at the dollar. When you sell the 100 stablecoins, you get the 200 ETH back.

Criticisms

Volatility, the very problem that stablecoins address, is the biggest weakness of crypto-backed stablecoins. Over-collateralization is the way these projects protect themselves against volatility, but holding a 2X reserve may not be enough in a market crash. A sudden shift in the price of a stablecoin’s reserve crypto could be enough to break the price peg. Once that happens, confidence in a stablecoin never really returns.

Venture capitalist Haseeb Qureshi pointed out another weakness of crypto-backed stablecoins. They are designed to automatically revert back to the underlying cryptocurrency if the crypto price drops far enough. “This could be a dealbreaker for exchanges,” Qureshi suggests, “ in the case of a market crash, they would have to deal with stablecoin balances and trading pairs suddenly mutating into the underlying crypto assets.”

Examples

Rocky pricing for nubits
Source: CoinMarketCap

NuBits: Founded in 2014, nubits was the first stablecoin to last a year without breaking its peg to the US dollar. Unfortunately, the peg broke in mid-2016 and again in March 2018. The price collapsed and now hovers below $0.16. Available: Now, but why bother?

Nomins: Australian crypto firm Havven created a combined decentralized payment system and dollar-pegged stablecoin. The Proof-of-Stake blockchain uses its own token, the havven, as collateral to stabilize the price of nomins, the stablecoin. Available: Now

MakerDao: MakerDao launched the dai as an ether-backed, US dollar-tracking stablecoin. Testing of a multi-collateral version begins in September. The assets you use to get dai are locked up in a smart contract, effectively holding them in escrow until you sell the dai back. MakerDao lets third-parties, called “Keepers”, manage the supply of dai through automated arbitrage algorithms. Available: Now.

Terra: Korean e-commerce platform TicketMonster brought together other e-commerce companies across Asia to form the Terra Alliance. Combined, the companies generate $30 billion in sales every year which will be facilitated by the new terra stablecoin. The collateral used to stabilize the terra will be a new Proof-of-Stake coin called the luna. Available: 2018

Stablecoins Backed by Algorithms

How they work

In our first example, we saw stablecoins backed by real-world assets. Our second example took that model virtual by using cryptocurrencies as assets. Now, in our third example, we’ll look at stablecoins that get rid of asset holdings altogether.

Modeled after the way central banks manage their countries’ monetary supplies, these projects use algorithms to automatically increase and decrease the stablecoin supply to keep the pegged price stable.

Let’s say a stablecoin has a $1 peg, but the price drops to $0.80. In that case, the supply of stablecoins is higher than the demand. The algorithm issues “bonds” which can only be bought with stablecoins, thus reducing the supply and raising the price. These bonds are promises to put the bondholders at the front of the line when new stablecoins are issued. People are essentially investing in the growth of the stablecoin supply. This happens when demand exceeds supply and the price rises above the peg.

Criticisms

Some economists question the decision to manage coin supply through bond issuance. The Swiss Finance Institute’s Richard Senner and Didier Sornette point out in a recent paper that the recent use of Quantitative Easing (QE) tried to restore the US economy by flooding the market with new bonds. However, they point out “QE was not overly effective because it did not channel new liquidity to ordinary people, who would have a high propensity to consume. The design of Carbon and [Basis] is similarly flawed, where only a certain group of bondholders get new coins, without any incentives to actually spend them.”

Another criticism lodged against this approach is that investing in the stablecoin’s “bonds” is a bet that the stablecoin will grow. But the only way the supply can grow is if the price goes up. As Byrne closes his critique of Basis, “An investment scheme backed by introducing new investors… and not backed by income-generating assets can be called a number of things. I leave it to you, dear reader, to decide what name you will choose to give to this one.”

One final issue is the fact that regulators classify real-world bonds as securities. Should these algorithmic stablecoin bonds get classified the same way, then these startups will face a whole host of regulatory hurdles.

Examples

Basis stablecoin based on nothing
Source: Basis

Basis: Formerly known as Basecoin, the Basis project calls itself an “algorithmic central bank”. Although its first product will use a US dollar peg, future products could peg against the euro, commodity prices or a consumer price index. Available: TBD

Fragments: With a mission “to produce a fair and stable money for the world”, Fragments is developing a dollar-pegged stablecoin with backing from Pantera Capital and other prominent crypto VC firms. Available: TBD.

Final Thoughts

At a time when cryptocurrencies’ volatility discourages their widespread use in commerce, stablecoins provide an attractive alternative. They can reduce the operating risks of crypto exchanges, improve the efficiency of blockchain based payment systems and offer investors a crypto-centric alternative to cashing out to fiat.

The hype machine surrounding stablecoins, however, may be setting them up to fail. These projects are promising perpetual stability. But things change, and sooner or later each of these pegged coins will break. How many Nubit-like experiences will it take for confidence in all stablecoins to wane?

Christopher Casper

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