Stablecoins

stablecoins

15 min

stablecoins

15 min

Greetings and salutations, dear readers! It may come as no surprise to WBS readers that we are covering stablecoins right after mentioning them in the previous WBS, we tend to do that.

Let’s remember that this is the Weekly BS and not the weekly glossary--this is going to be a thought provoking discussion about stablecoins (If you’re expecting quick definitions, you’re in the wrong place, it’s a few paragraphs down!).   The hardest part of this WBS is using the word “adventure” to discuss a topic beginning with the word “stable” - and now that I’ve done just that (yes it counts) we can focus on the answer to this riddle:  What is (sometimes) mortally bound to the very thing it’s (figurative) kingdom seeks to destroy, and whose value is (sometimes) determined and backed by a thing whose value is not backed by anything?  A Stablecoin

Ok, maybe there are better ways to communicate the point. Still, it helps in understanding that stablecoins are pegged to the value of other (presumably more stable and trusted) assets, including fiat like USD - the very things a blockchain based economy is meant to replace.  Stablecoins are a type of token native to alternative digital economies like a blockchain network, but their value is often tied to very conventional things, like real-world currencies and commodities.  Don’t let that steer you into thinking that stablecoins aren’t useful or “authentic.” In fact, they are an elegant solution to the problem of token instability and they can act as a “bridge” between DeFi and TraFi (that’s short for traditional finance - trying to be innovative here).  And a big BTW, this isn’t all that new of a solution, since money itself (in non-fiat form) was often backed by gold, silver, and other commodities for the sake of stability.

Token instability is a problem we have discussed on numerous occasions, directly and indirectly. The price of a network token can be extremely volatile due to an imbalance between its utility value, speculative value, and liquidity - typical of newer or less popular network tokens.  This can result in a lack of trust in a network’s tokens and/or coins (cryptocurrency).  A lack of trust usually means participants will try to mitigate their exposure to price fluctuations (that’s risk) by either not accepting a token as a means of payment, or converting tokens into fiat or a more stable cryptocurrency as quickly as possible (hopefully on a registered/regulated market, maybe even one named after a Greek hero, and not the movie! Though it was a Ridley Scott masterpiece).  Too much token conversion means too little HODLing and leads to the bad kind of high token velocity.  In case this isn’t clear yet, stablecoins aim to remove (to varying degrees) the need to convert tokens, and increase trust in token transactions and valuations by always being worth what a more stable and trusted asset is worth.

Stablecoins can also aid in bridging different networks, or interoperability - in both a blockchain and a classic sense.  As long as the majority of people’s financial activity and holdings still take place via fiat using (centralized) banks and cold hard cash, there needs to be a seamless connection between the traditional and the blockchain world of finance to attract more participants.  Having tokens worth exactly what popular currencies or commodities are worth just makes it easier for non-blockchain/crypto savvy people (who don’t read the WBS) to invest and interact with the emerging world of blockchain based finance (including Defi).  Additionally, stablecoins support blockchain interoperability by allowing participants from different blockchains to interact with each other by providing a stable, efficient, and recognized form of value transfer.  Basically, it means that digital payments and money transfers become routine and less risky.

We promised definitions, and it’s actually essential for investors to understand what types of stablecoins are out there.  The main distinction is whether they are collateralized, meaning backed by a reserve of the asset they are pegged to (usually redeemable for that asset), or non-collateralized, with an algorithm adjusting money supply (supply vs demand) to control the stability of the price, known as Seigniorage shares based stablecoins (really cool read here about two proposed Seigniorage based coins and the original Seigniorage shares white paper here).  Don’t judge the non-backed stablecoins too quickly; theoretically, they’re the only ones that would survive the apocalypse since they aren’t correlated to any currencies, commodities, or crypto!

Within collateralized stablecoins, there are a few variations (we need your undivided attention here):

Fiat Collateralized - These are tokens typically issued by either a central authority like a country, bank, or corporation (centralized), or by a decentralized organization.  They are often backed by the US Dollar, or Yen, or some other national currency with different levels of reserve ratios.  Examples include Tether/USDC, USD Coin, Paxos.

Commodity Collateralized - These are usually pegged to commodities like gold, silver, precious metals, oil, even real estate (SwissRealCoin/SRC, they have a clever model).  As long as there is decent price discovery and stability, it can be a candidate for a pegging (what a difference “a” single letter can make).  These types of stable coins are usually issued by companies and often fall under the centralized category because of the singular and more vulnerable physical location of the asset reserves.  Examples include the infamous (and not actually collateralized) Petro, and the less notorious yet still popular Paxos Gold (PAXG), and Tether Gold (XAUT).

Crypto Collateralized - Well, you could have seen this one coming. These stablecoins are pegged to really popular (though not all that stable) cryptocurrencies, like BTC and ETH.

What’s interesting about crypto collateralized stablecoins is that they are sometimes over-collateralized, requiring a deposit or lock-up of more of the underlying asset than the value of the stablecoins received in exchange (as high as 2:1).  This measure is unique and necessary because crypto isn’t as stable as fiat currencies or commodities.  But, cryptocurrencies can be decentralized, therefore potentially removing the risk of a centrally located physical reserve such as in the case of commodities.  Dai, a token issued by MakerDAO, is probably the most well-known crypto collateralized stablecoin, but it’s pegged to the Dollar (the plot thickens).  Let me explain:  To get Dai, you would need to deposit ETH or BTC - and at that point in time, a spot USD value would be locked in and you would receive the equivalent amount of Dai (1 Dai = $1), minus a haircut (basically a reserve percentage of your deposit meant to protect Maker in case the collateral crypto tanks - that’s over-collateralization).

In thinking deeper and evaluating stablecoins and their real viability as a financial instrument, you have to look beyond the motivation of stability.  After assessing the underlying asset and collateralization (if any), how stablecoins are issued and by whom are the key questions to consider as an investor.  The “how” mostly relates to whether they are on-chain or off-chain and their degree of decentralization.  The “who” is an adventure in itself (you thinking what I’m thinking?).

There are major companies like Facebook and their Libra token, which is a stablecoin pegged (sort off) to a basket of assets and currencies in their reserve.  Interestingly, Libra seems to imply a decentralized on-chain model longer term.  Or the JP Morgan issued token backed by USD 1:1 - but only usable within the bank's network in their larger effort towards economically viable blockchain technology adoption.  Maybe this example will really resonate; Dai, the crypto-backed token we discussed, is meant to be on-chain, decentralized, and eventually interoperable across networks/chains in exchange for products and services - it is literally a more stable Bitcoin, at least conceptually.  Food for thought:  consider that stablecoins are not all that fundamentally different from existing financial instruments...even the most cutting-edge non-collateralized stablecoins are based on the same principle as fiat, and before the Dollar went fiat, it was backed by gold.

And now a few reading suggestions:

Here’s a list of major stablecoins (Tether/USDT, PAX, DAI) that are pegged to a variety of assets (like USD, Gold, Euro, Yen, Bitcoin, etc.) and prices (ca$h money). Also, this guide is a nice intro.

This is a WONDERFUL (shoutout to JP) post describing the need for stablecoins written many years ago by Vitalik (skip a turn and go back 5 WBS’s if you don’t know who we mean) and check out this more recent and much shorter post (we’ll cut to the chase, he suggests that smart contract and token protocols must have some sort of compatibility built-in so that stablecoins can be used cross-chain to facilitate true interoperability, which would be awesome).

In the words of Freddy Mercury “Well, aaaalriiiiight!” - meaning we’ve had a semi-deep discussion, provided some definitions, and even gave you some additional reading!  So (sadly) it’s time to wrap this WBS up. Have a great week everyone!

PS:  While it’s a small, relatively unknown school that you probably never heard of - Harvard Law School released an excellent paper on stablecoins that is an easy and informative read.