Stablecoins [Tech Talk] - An analysis of designing a cryptocurrency with price stability

in #blockchain6 years ago

Written by Jonathan Itzler

This report is a product of Blockchain at Columbia, whose weekly Tech Talks have inspired this content.

Before we dive into Stablecoins, here are some basic definitions:

Blockchain = A distributed ledger in which transactions are recorded, verified, and maintained chronologically and publicly.

Cryptocurrency = a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.

Stablecoin = A digital asset that offers price stability characteristics, designed to be used as a unit of account and a store of value.

The Need for a Stable Cryptocurrency
Back in 2014, Vitalik Buterin (founder and creator of Ethereum) addressed the main problem with using Bitcoin as a store of value,

“One of the main problems with Bitcoin for ordinary users is that, while the network may be a great way of sending payments, with lower transaction costs, much more expansive global reach, and a very high level of censorship resistance, Bitcoin the currency is a very volatile means of storing value” (Ethereum Blog).
Because of strong speculation, Bitcoin and other cryptocurrencies are subject to massive price volatility in both directions. This volatile nature of digital assets makes them unsuited for many mainstream uses, particularly payment. Could a company realistically pay a salary in a digital currency that can fluctuate 20% or more within a single day? It is difficult for cryptocurrency to become widely used and accepted when it fails as a store of value and as a unit of account. Vitalik acknowledges these disadvantages, and asks,

“Can we have the full decentralization that a cryptographic payment network offers, but at the same time have a higher level of price stability, without such extreme upward and downward swings?” (Ethereum Blog).
Vitalik is speaking of a Stablecoin.

The idea of a Stablecoin, a cryptocurrency that maintains its decentralization while offering a stable price, seems straightforward at first. Simply create a cryptocurrency and peg its price to a relatively stable asset, such as the US dollar. But how can you ensure the currency stays pegged to the chosen asset? You cannot just decide what the price of the currency should be, price is determined by market demand and supply. A Stablecoin attempts to be an asset that determines its own price, a task that while not impossible, has proven very difficult to accomplish. This leads to the question: how does one go about designing a pegged or price-stable currency.

Types of Stablecoins
There are three main design types for stablecoins that have been introduced in the blockchain space: Fiat-collateralized, Crypto-collateralized, and Uncollateralized.

Fiat-Collateralized

Let’s start with Fiat-collateralized stablecoins, which use a relatively simple design. You take a stable asset, such as the US dollar, and deposit a certain amount of US dollars into a bank account. For every dollar deposited, you issue one stablecoin. Everytime a user liquidates their stablecoins into US dollars, you destroy the stablecoins that were liquidated. This is the simplest solution to creating a stablecoin, and fiat-collateralization is demonstrated in the most popular stablecoin on the market: Tether.

Lifecycle of a Tether — Tether Whitepaper
There are evident issues present in this solution to the stablecoin, the first one being centralization. In order to maintain a fiat-collateralized stablecoin, a central entity must be responsible for facilitating distribution, liquidation and holding the collateral fiat currency in a bank account. By nature, this process is not decentralized because it requires trust of a middleman. This central entity responsible for the stablecoin must also be audited repeatedly to insure that the stablecoin is being faultlessly distributed and destroyed with the transfer of fiat. This concern of audit has come up repeatedly with the Tether stablecoin, and many do not trust the company because it has not yet been audited.

There are also doubts about whether or not Tether truly possesses all fiat collateral, because there is no structured liquidation process of Tether back into US dollars. That being said, fiat-collateralized stablecoins do have a strong advantage in that they are not affected by the volatility of other cryptocurrencies. Because their value is entirely held in fiat collateral, they can withstand the fluctuations in the cryptocurrency market. Tether has had fair success in its peg to the value of $1.00, but has struggled with increased volume.

Tether Price History (Coinmarketcap)
Pros

Most price-stable
Most simple creation process
No collateral is held on the blockchain means less hack vulnerability
Cons

Centralized , needs one trusted central entity to store the fiat
Difficult to provide liquidation into fiat
Need consistent audits for transparency
Crypto-Collateralized

Another way to collateralize a stablecoin is crypto-collateralized. This type of stablecoin holds cryptocurrency as its reserve collateral instead of fiat currency. The main problem that crypto-collateralized stablecoins face is the volatility in the price of the cryptocurrency that serves as collateral. A stablecoin by definition should not fluctuate in value, and the way crypto-collateralized stablecoins maintain their price stability is through overcollateralization. Imagine for every $1 of stablecoin created, a larger amount of collateral is locked up, say $2 worth of Ethereum. This way if the price of Ethereum were to fall by anything less than 50%, the stablecoin would still be safely collateralized and could be liquidated back into Ether.

Crypto-collateralized stablecoins also come with many risks and disadvantages. In order for this process to work, there needs to be a party that is willing to deposit cryptocurrency as collateral. This is a difficult convince as the depositor needs to lock up more collateral in cryptocurrency than actual stablecoin created. To encourage this, there would need to be some sort of economic incentive in place for depositors, such as interest rates paid on the collateral or leverage opportunities.

The biggest risk of crypto-collateralized stable coins is the scenario where the price of the collateral falls enough to where it is below the price of the stablecoin itself. If this were to happen, the stablecoin is forced to be liquidated into into its underlying crypto asset, which would defeat the entire purpose of its stability. In the example given above, if the price of Ether were to fall by more than 50%, then the $2 worth of Ether that was originally collateralized would be worth less than $1, and the stablecoin created would be liquidated into Ether.

All crypto-collateralized stablecoins use essentially some variation of this process. MakerDAO’s stablecoin, Dai, is the most widely used stablecoin using crypto-collateralization. MakerDAO issues Collateralized Debt Position Smart Contracts, which are a form of locked up and leveraged Ethereum used to collateralize the stablecoin.

Pros

Decentralized
Simple liquidation process into underlying collateral
Transparent , collateralization ratio can be viewed
Cons

Inefficient use of capital for collateralization
Can be auto-liquidated during a price crash
Subject to volatility of underlying cryptocurrency
Uncollateralized

The third and perhaps most unique solution to stablecoin design is the uncollateralized stablecoin. The idea behind an uncollateralized stablecoins is that there is no underlying collateral at all, similar to the US dollar that is no longer being backed by the gold standard. With no underlying collateral, how do you maintain stability?

Seigniorage Shares is a complex system invented by Robert Sams. The idea is to model a smart contract with the sole purpose of issuing a currency with a fixed price, similar to a central bank. If the price gets too high, the smart contract mints new coins and auctions them on the market, increasing the coin supply until the price returns to the fixed price. This process would result in the smart contract making profit on the newly issued currency, because the cost of creating the digital currency is less than the value of the currency itself. This phenomenon is not a new one. When issuing currency, governments make profit off of the face value of coins vs. their production costs, and this profit is referred to as seigniorage.

When the price of the stablecoin is too low, decreasing the coin supply is not an option. However, using its seigniorage profits, the smart contract can buy back coins in circulation until the price of the stablecoin is returned to the fixed price. But what if the smart contract does not possess enough seigniorage to fund the buy back of the coins in circulation?

The smart contract would have to auction off some sort of Seigniorage Shares in order to fund the buy back, and these shares would entitle shareholders to a portion of future seigniorage profited by the smart contract. Buying seigniorage shares is investing into the idea that the system will continue to function in the future, and allows for the smart contract to decrease the money supply based on the value of the seigniorage that it will earn in the future.

Obviously systems like this always have more flaws in actuality than in theory, and some have criticized the idea for resembling a ponzi scheme that requires continues growth to operate. However, some aspects of the idea resemble the way that many monetary systems operate, simply point at the continuous growth throughout history of the US money supply.

The main risk in the seigniorage share idea is the threat of eventual collapse from downward sell pressure. If users and investors were to completely lose confidence in the system, once the sell pressure were to start, there is little that can be done to stop the stablecoin from continuing to lose value. This would lead to an eventual collapse and death of the entire system.

An uncollateralized stablecoin is the hardest to design, but could also have the most potential as a solution without weakness or reliance on other systems. A system is really just defined by the amount of confidence that people have in it. Fiat-collateralized and Crypto-collateralized stablecoins would would both fail with the collapse of the underlying collateralized asset, such as the US dollar or Ethereum. An uncollateralized stablecoin could survive both of those events, as it does not rely on anything except confidence in the system itself. Maybe it is not far fetched that a day will come when people have more confidence in an uncollateralized stable asset than any other currency on the planet.

Pros

No collateral required
Most decentralized and independent with least reliance on other systems
Cons

Needs continual growth and confidence
Uses shares or bonds to change money supply
Cannot be liquidated in a crash, can lead to death spiral

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Coins mentioned in post:

CoinPrice (USD)📈 24h📈 7d
BTCBitcoin6322.320$-0.84%4.44%
DAIDai0.995$0.73%0.24%
ETHEthereum450.451$0.27%0.35%
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