Finding the Perfect Stablecoin
Alongside usability, volatility* is one of the largest inhibitors to mainstream cryptocurrency adoption. Stablecoins have the potential to make payments anywhere as easy, fast, and cheap as sending an email while ensuring that your purchasing power remains intact.
The potential of stable value digital assets has caused an explosion of experimentation over the last four years. There are three broad types of stablecoins: fiat collateralized, crypto collateralized, and Seigniorage-style*.
Fiat-backed stablecoins are backed by off-chain assets like the US Dollar. The collateral is typically stored with a bank or custodian. Stablecoin creation happens when fiat is sent to a centralized party and the stablecoin is “destroyed” when the party returns fiat to the stablecoin holder.
Crypto-collateralized stablecoins are backed by on-chain assets like Ethereum. Users can borrow stablecoins by locking up their on-chain assets in a smart contract, usually with a minimum overcollateralization ratio (e.g. $2 worth of Ethereum for every $1 loaned out).
Seigniorage-style stablecoins algorithmically expand or contract the supply of the stable token in order to match demand by shifting volatility to a non-stable (seigniorage) asset. The value of the seigniorage asset effectively determines its stability.
While all of these Stablecoin types have advantages, there are significant trade-offs with each type. Fiat-backed stablecoins suffer from opaqueness and regulatory risk. Indeed, Tether’s Lawyer admitted that the stablecoin is only 74% backed by fiat-cash, a significant discrepancy from the promised 100% (see here for details).
Crypto-collateralized stablecoins, while transparent through on-chain auditability, suffer from extreme volatility of the assets they are backed by. MakerDao, creator of DAI, ended up adding a fiat-backed stablecoin, USDC, after the Maker Protocol went from a $USD 500,000 surplus to a $4 million deficit (“bad debt”) within 5 hours (see here for details). Normally, there is an orderly auction process in which participants bid on assets (e.g. ETH) being liquidated. However, due to network congestion in periods of high volatility, the participants effectively received liquidated Ethereum without bidding any DAI. Volatility risk can be mitigated with a high collateralization ratio, but this reduces asset efficiency if you have to pay, for example, $300 to get exposure to $100 of an asset. Synthetix, for example, is a decentralized synthetic asset issuance protocol whereby assets are collateralized by the SNX token which when locked in the contract enables issuance of synthetic asset, Synths; however, Synths have been backed by a 800% collateralization ratio (see here for details).
Seigniorage-style stablecoins suffer from an overreliance on a non-stable (seigniorage) asset to absorb volatility in the stablecoin. With Steem Dollars (SBD), for example, when you decide to cash out of your Steem Dollars, you will get as many Steem tokens which are worth the SBDs in your wallet. What happens though if the Steem tokens decline significantly and can’t cover the issued Steem Dollars?
Perhaps the perfect stablecoin is some combination of the above types. At cLabs, we are contributing to the Celo Ecosystem. The Celo price stability protocol that supports the Celo Dollar (cUSD) can be thought of as a hybrid of the crypto-collateralization and seigniorage-style stablecoin types. The protocol uses a seigniorage-like model whereby stablecoin liquidity is tied to demand for the stablecoin rather than demand for borrowing against crypto assets which is the case with Maker Dai (crypto collateralized type). At the same time, the Celo Reserve holds hard assets including Bitcoin and Ethereum, to support the Celo Dollar, unlike pure seigniorage stablecoins like Steem Dollar which depends on the value of a seigniorage asset. Finally, by using digital assets as collateral, the collateral is always transparent, auditable, and free from issues with the traditional banking system (please see here for more details).
Of course, this hybrid approach is not without unique challenges, including: 1) maintaining sufficient collateral in the reserve at all times to ensure stablecoins are redeemable anytime, which is especially challenging in the digital assets space due to high correlations amongst digital assets and few assets with meaningful liquidity; and 2) ensuring accurate and timely exchange rates are captured via oracles* so that arbitrage opportunities are exploitable (please see here for more details).
We are still very early in the stablecoin saga. The total average daily turnover of stablecoins is less than $80 billion with over half of that volume coming from trading-driven USDT compared to over $6 trillion turnover in the foreign exchange markets. However, early experimentation amongst the three stablecoin archetypes points to the perfect stablecoin being some combination of the three to mitigate the disadvantages amongst pure-play archetypes.
Key Terms:
* Volatility here is defined relative to the US Dollar or a local benchmark currency determining purchasing power;
* Seigniorage traditionally has meant the profit that governments make by issuing currency above the production costs. In this context, seigniorage is in reference to algorithmically driven stablecoins that aren’t backed by outside collateral.
* An oracle is a way for a blockchain or smart contract to interact with external data such as price feeds.
Disclaimer: the author is an employee at cLabs and works on Celo, any views expressed here are his own.
