Stablecoins 101 – The Who, What, Why and How

With the recent news of the IBM-backed cryptocurrency payments company Stronghold, the spotlight is back on stablecoins. These tokens present a variety of valid use cases yet have proven difficult to bring into practice.

With the initial creation of Bitcoin, the dream of a decentralized, anonymous, easily transactional and frictionless currency was partially realized. The pronounced snag, one which plagues nearly all cryptocurrencies, is price volatility.

Speculation in cryptocurrencies has become quite popular; unfortunately, volatility renders cryptocurrency unsuitable for some functions. Stablecoins propose to be currencies capable of performing the functions required of digital currency with the added benefit of remaining stable.

For starters, stablecoins allow high-value transactions to proceed with greater financial certainty. Imagine buying a car with Bitcoin, only to have the value of your new ride decrease by 20 percent (or more) within a month. I know the stories of Lamborghinis and other lavish purchases with Bitcoin but those are the exception, not the rule.

Additionally, stablecoins can provide banking, credit and financial services to those currently un- or under-banked, a practice that is currently impractical with high-volatility cryptocurrency. For individuals who cannot afford even the smallest of bank fees, or who lack the necessary government-issued ID to open a bank account (refugees and migrant workers, for example), digital currencies can be a path to security. But that digital security is a mirage if the value of the currency is not stable.

Finally, stablecoins will remain a reliable store of value on a censorship-resistant ledger, completely separated from local banking systems, currency controls or a collapsing economy.

However, there are a few requirements for a successful stablecoin. It must be able to scale, maintain user privacy and have a method to remain decentralized.

A stablecoin that meets the second two requirements but can’t scale to meet demand is dead in the water. One that cannot operate without maintaining some form of privacy for its users will have decidedly limited applications. And one that solves the first two problems but is still centralized will be subject to censorship and attack.

There are a variety of companies operating in the space under different models. Let’s look at each to see how they work and whether they fulfill all three requirements:

1. Centralized IOU Issuance

A centralized company holds assets in a bank account or vault and issues tokens that represent a claim on the underlying assets. The digital token has value because it represents a claim on another asset with some defined value, i.e. gold, USD, EU, etc. This model was used by the U.S. until 1971, “The Gold Standard.” Examples: Stronghold USD, Tether, TrueUSD

Scalability? Check.

Privacy? Check.

Decentralized? “Centralized” is in the name, so that’s a no. Because there’s still one entity holding the underlying assets, it’s still vulnerable to censorship and attack.

2. Collateral Backed On-Chain

Users lock another cryptocurrency as collateral via a smart contract. The key is that users receive slightly fewer tokens than the value they used as collateral. By doing this, the token accounts for price fluctuations of the underlying currency, hence the requirement of over-collateralization. Let’s say you want to create a stablecoin equal to 1 USD. You can lock 1.5 USD worth of Ethereum as collateral, and if the value of the Ether drops, the stablecoin will still remain backed. However, this model does not account for “black swan events” in which the market drops so rapidly that even over-collateralization will not keep the currency backed.

Examples: BitShares, Maker.

Scalability? Potentially. The scalability of the stablecoin is limited by the throughput of the blockchain the collateral is stored on.

Privacy? Potentially. If the underlying blockchain has privacy measures then the stablecoin will, too.

Decentralized? Yes, if the underlying blockchain is truly decentralized.

3. Seigniorage

The seigniorage model is less intuitive. An initial allocation of stablecoin tokens is created and is pegged to another asset, for example, USD. As total demand for the stablecoin increases or decreases, the supply automatically changes in response–for instance, issuing more coins to increase the supply, or decreasing it by buying back the stablecoins and issuing bonds for future payments. They are not collateralized by any other asset.

Examples: Basecoin, Carbon.

Scalability? Potentially. The major challenge of the seigniorage model is figuring out how to increase and decrease the monetary supply in a way that is both decentralized, resilient, and un-gameable.

Privacy? Potentially. This is entirely dependent on the centralized issuer developing privacy standards.

Decentralized? Nope. The current seigniorage model relies heavily on a centralized issuer and is subject to price manipulation by anyone who can control enough of the total supply.

Conclusion

Following on the heels of several notable false starts from high-profile stablecoins, liquidity and audit-friendliness have also joined the ranks of critical markers for a successful stablecoin. Users may be willing to sacrifice some degree of privacy in favor of liquidity. Large-scale enterprise users will require a huge degree of liquidity but may undercut the public market by opting to only use the stablecoins among a select network–somewhat in the way the U.S. Treasury used to use $10,000 bank notes for transfers.

Stablecoins will help ease consumers into digital currencies–they will be familiar enough to lend security, yet novel enough to attract interest. As new companies attempt to differentiate themselves in the marketplace, each creates a variation on the three basic models. Eventually, one will emerge that is a perfect fit for global use. As with any blockchain business, those with the best product will emerge and win.

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