The late 2017 Bitcoin price rally and the sudden drop in pricing highlighted an important property of cryptocurrency that's both a risk and an opportunity: volatility. Cryptocurrencies are highly volatile assets. Even on an ordinary trading day, it's not uncommon to see a 10% price swing in the value of a crypto-asset. While that can be a speculator’s dream come true, it can also be a nightmare as seen with the Bitcoin price swing in 2017.
High volatility drives speculation but inhibits real world adoption of cryptocurrency
Volatility drives demand as speculators move in to cash in on potential upswings in crypto-asset prices. It was very instrumental in the growth of cryptocurrencies into the mainstream market in the past few years. But it's also a double-edged sword and carries with it the seeds of its own destruction. While price volatility has driven strong demand for cryptocurrencies, it may also ultimately be a factor that drives investors away from digital currencies in the long run.
At the end of the day, a useful currency shouldn’t just be a unit of account and medium of exchange but also a "store of value." Cryptocurrencies are a nightmare when it comes to this store of value part. One can't preserve value effectively on an asset that fluctuates 20% in a day. If this volatility isn't managed, we're likely to eventually see a large exodus of investors from this asset class dealing a blow to any hope of cryptocurrencies ever seeing mass adoption.
To solve this volatility issue, cryptocurrency innovators are coming up with new price-stable cryptocurrencies that will be immune to wild price fluctuations. They're aiming to make cryptocurrencies more like fiat money and thereby create the “Holy Grail of Cryptocurrencies” that gives users the most ideal currency. This is called a "stablecoin."
What is a Stablecoin?
A stablecoin is a new class of cryptocoins that is price-stable and whose market price is pegged on the price of another stable asset or a smart contract. The aim of the stablecoins is to offer investors greater price stability and steady the valuations so as to make the cryptocurrencies more usable in mainstream transactions.
The stablecoin aims to create a model cryptocoin that is capable of retaining its purchasing power and which will have a minimum inflation in order to encourage users to begin spending the coins instead of simply storing them and waiting for a future upswing in pricing. The stablecoins are aiming to achieve the ideal behavior of a typical fiat currency. Through stablecoin implementations, cryptocurrencies are able to live to their potential and offer users the best of both worlds by combining the anonymity, security, decentralization of a cryptocurrency with the low volatility that is associated with a fiat currency.
How is a Stablecoin Made?
Stablecoins are mostly created out of pegging. The stablecoin can be pegged against the US dollar, a consumer price index or other world currencies. It’s somewhat similar to the currency pegs that have been done by some of the world’s central banks in order to arrest runaway inflation. The challenge with a currency peg is that it is generally difficult to maintain, especially in the face of adverse market conditions.
To be objectively strong, the peg must be maintained within a certain band of market conditions. In the formulation of a currency peg, what the creator or regulator must determine is the reasonable limits of the market band within which the currency peg can be maintained. You have to decide the band of market behavior that peg can reasonably support. For example, how much of volatility will it withstand? What will be the cost of maintaining the peg? Will there be transparency that allows traders to observe the true market conditions and finally, will it be easy to analyze the range or band of market behavior within which the peg can recover from adverse market conditions?
All these factors are taken into account when designing a stablecoin. The ideal stablecoin will be one that is capable of withstanding significant market volatility, is easy to maintain, transparent to both the traders and arbitrageurs and whose stability parameters will be easy to analyze.
There are only three possible implementations of a stablecoin.
All the strategies or schemes used in designing stablecoins will be based around these dimensions and there is very little scope for the diversity in the models. In fact, all the stablecoin schemes in place are subtle variations of one another because they have to satisfy these four parameters for an ideal currency peg. There are three possible strategies for creating stablecoins. These include the following:-
- Fiat-collateralized coins
- Crypto-collateralized coins
- Non-collateralized coins
This is the simplest, most stable and most robust collateralization scheme for cryptocurtencies. In fiat-collateralized cryptocurrencies, the stablecoin is pegged against a certain amount of a major fiat currency such as the U.S. dollar. The cryptocurrency is simply converted into an IOU that is redeemable for a USD $1. In other words, it uses the US dollar as a collateral to issue cryptocurrencies.
The number of cryptocurrencies issued is pegged 1:1 against a fiat currency, enabling a fairly reliable stablecoin ecosystem. A user can simply deposit fiat currency such as the U.S. dollar in a bank account and then issue an equivalent in stablecoins against the fiat currency. If a user wants to liquidate their stablecoins and re-convert them into fiat currency, the stablecoins are simply destroyed and then they are wired the money. Apart from a fiat currency, it can also be collateralized against commodity collateral such as gold, silver and oil.
The fiat-collateralized stablecoins is so simple and reliable that it can be used by central banks in order to issue their own cryptocurrencies. It is capable of withstanding any kind of cryptocurrency volatility thanks to the centralization that assures its price-robustness. All the collateral remains intact even in the event that the cryptocurrency collapses.
The fiat-collateralized stablecoins is centralized and will require a custodian that will hold the fiat money or the commodity collateral and then guarantee the issuance and redemption of stablecoin tokens. This scheme also needs various operational processes such as regular audits and valuations in order to ensure its guarantee.
The main drawback with a fiat-collateralized stablecoin is that it is constrained by legacy payment systems. To liquidate the stablecoin and get back fiat currency or commodity collateral, you have to send money via check or wire transfer.
Stablecoin projects with a fiat-collateralized structure include:-
A crypto-collateralized stable coin is very similar to a fiat-collateralized stablecoin but in this case, the underlying collateral used is another cryptocoin rather than a real world fiat currency or commodity collateral.
This kind of scheme of course exposes the crypto-collateralized stablecoin to the volatility of the underlying collateral cryptocurrency. To eliminate this risk, the crypto-collateralized coins are often over-collateralized. What this means is that a cryptocurrency with a much higher value will be used in issuing one of a lesser value. For example, instead of a 1:1 peg like in fiat-backed stablecoins, $800 of bitcoins may be used to issue $400 worth of stablecoins so in the event that the bitcoins lose even $25% of their value due to highly volatility the stablecoin is still well covered.
Crypto-collateralized stablecoins are also subject to regular audits as well as top-ups so as to make up for any shortfalls in the collateral value. This scheme is however not 100% safe. There is the risk that the cryptocurrency used as the underlying collateral may go totally burst or collapse completely or that the extra top up for the collateral may not be done in time. There could also be procedural issues with the audit process. If the stablecoin is bottlenecked by any of these conditions, its valuation will plummet and your usage of stablecoin to avoid cryptocurrency volatility will all have been in vain.
Stablecoin projects with crypto-collateralized structure:-
The non-collateralized stablecoin turns the whole concept of backing up a currency with an underlying stable asset upside down. It is the most ambitious stablecoin implementation scheme. What if you don’t really need collateralization? What will you use to design a price-stable crypto coin in the absence of a stable asset? It is not the first time that the concept of the collateral in a currency system is being put to test. The U.S. and all countries in the world calmly walked out of the gold standard and embraced fiat money and the world did not come to an end.
All the world’s currencies are fiat money, deriving their value by government order and not through any underlying collateral asset. What if a cryptocurrency stablecoin could also adopt the same model? That is the concept on which the non-collateralized stablecoin is based. But how does this work in a totally decentralized crypto ecosystem where you can’t issue a fiat to create value in a cryptocurrency?
The answer is in what is called smart contracts. In cryptology, a smart contract refers to computerized transaction protocol that will execute the terms designed in a contract in order to ensure certain common contractual obligations are met. It is a set of rules and regulations coded into software that govern the terms of a contract. A smart contract will verify the contract and then execute based on the agreed upon terms of the contract. It is coded with “if-this-then-that” instructions that make the system autonomous thereby eliminating the need for escrow services and intermediaries.
So how does this apply in a stablecoin ecosystem?
A non-collateralized stablecoin based on smart contracts can be modeled to operate very much like a typical central bank that prints and buys up bank notes to maintain the stability of the currency. The cryptocurrency can be designed with rules that ensure that the quantity of coins in circulation is adjusted in proportion to the changes in the value of the cryptocoin thereby helping keep the value of the coin stable. This is realizable by implementing a smart contract in a decentralized platform that can run autonomously. It is the ultimate Holy Grail of a cryptocurrency system.
Let’s assume that you model a smart contract whose sole monetary policy is to ensure that the issue currency trades at $1. Since you are issuing the currency (stablecoin), you can get to control the trading price by regulating the monetary (cryptocoin) supply.
If the trading price rises to $2 which is too high, the smart contract can counteract this by minting new cryptocoins and auctioning them in the open market. This will increase the supply of coins and depress the trading price back to $1. The smart contract also makes extra profits from this regulatory action. In the traditional central bank, this profit is called seignorage.
What if the coin is trading at a very low price below your set $1? Since you cannot “un-issued” currency that is already in circulation, the smart contracts will buy up the coins in the market and decrease the circulating supply. That means that your smart contract system must have enough seignorage saved to buy up the extra coins and regulate the price back to normal.
What happens if the seignorage saved is not sufficient to buy up the extra issue currency? In this case, you can simply issue shares that will entitle traders to future seignorage so that the next time you mint coins and earn new seignorage, those shareholders will be entitled to a share of that seignorage. Some have been skeptical about the non-collateralized stablecoin because it operates somewhat like a pyramid scheme. The peg or stability of the cryptocurrency is anchored on future growth and on new entrants purchasing into the scheme. In such a scenario, the system will fail to maintain its peg if it stops growing. The system is also capable of maintaining a downward pressure though it might enter a death spiral if the selling pressure continues for too long.
Stablecoin projects built around smart contracts:-