The Rise Of Stablecoins

The Rise Of Stablecoins

By Oliver Carding - min read
Updated 22 May 2020

Stablecoins are increasingly growing in popularity and have been gaining traction since last year. However, it seems like most of the crypto audience is having a hard time understanding the concept of ‘stablecoins’. Nobody’s to blame for this mainly due to the fact that they are a pretty hard concept to grasp, especially considering that most of the projects aren’t ready for large-scale use, or are just white papers, which invariably are hard to understand. This post aims to introduce you to the concept of stablecoins and look at some of them in more detail. 

What Is a Stablecoin?

In simple terms, a stablecoin is a “cryptocurrency that has price stable characteristics” as defined by 1confirmation founder Nick Tomaino.

They can also be defined as ‘price stable cryptocurrencies’ as stated by Haseeb Qureshi. Typically, most stablecoins are pegged against the USD, but some implementations intend to move over to a basket of currencies or an index such as the CPI(consumer price index) in time. This is in hopes of having a currency independent of fiat in the near future.

Cryptocurrencies like bitcoin and Ethereum are, by all means, disruptive and game-changing, they serve as an exemplary medium of exchange, but given their volatility, this can pose a problem for users. One of the primary factors driving merchants away from accepting cryptocurrencies is the volatile price coupled with rising transaction fees. This has caused several mainstream companies to drop bitcoin as a form of payment. In comparison, stablecoins can potentially serve as the backbone of financial applications on the blockchain, especially considering that some of them are compatible with smart contracts.

According to several industry influencers and venture capitalists, the promise of stablecoins is larger than that of bitcoin itself. While this might sound far-fetched, upon learning the benefits you’ll likely agree that they have promise.

The idea of a price stable cryptocurrency goes back a few years (The Search for a Stable Cryptocurrency – Ethereum Blog) but it has only been over the past year that stablecoins have really begun to gain momentum, with the launch of VC backed entities such as Basecoin, Carbon, and the launch of projects such as MakerDAO, which has been worked on for several years.

According to the Stablecoin Index, created by Multicoin Capital Research Associate Myles Snider, at the time of publishing there are already over 25+ stablecoin projects.

This points back towards the fact that there are several teams racing to create a stablecoin used by a majority of people in the ecosystem, given the outsized economic incentive.

There are however, several things to take into consideration, such as economic stability, token mechanics, the design of the stablecoin and the initial traction required to maintain the peg and future stability. Even with the promise and increased interest, they are still vastly underutilized with the most prominent use case right now being traders using them to preserve capital during bear markets and periods of volatility.

Why do we need a stable coin?

One of the most common arguments for stablecoins is that they are a hedge against volatility. You can insulate yourself from market volatility by holding stablecoins instead of cryptocurrencies like bitcoin or ethereum. For example, if bitcoin is priced at $8,000 and you traded 1 BTC for a stable coin which was pegged to USD, you’d have 8000 units of the stable coin. Assuming the price of bitcoin goes down to $7,000 over the course of the week, you still have $8,000 worth of stablecoins which can be converted back to BTC anytime. This way, you don’t lose the $1000 worth of value as a result of volatility.

Other use cases are prediction markets, derivatives, options, etc where a stable coin would be the ideal currency. If you place a bet that has a long timeframe, denominating it in terms of a stable coin makes a lot of sense when compared to a volatile cryptocurrency.

Types of stablecoins

Stablecoins can be broadly categorized as three different types: Fiat collateralized, crypto collateralized and non-collateralized. There is also the possibility of having stablecoin proposals which do not fall into the above three categories as time passes by, given the nascent stablecoin ecosystem, but we will be sticking to these three categories for now, and go over miscellaneous implementations towards the end of this post.

Fiat collateralized

This is a more centralized approach to stablecoins wherein a central entity holds money as collateral and issue a token that represents the money held by the entity. This is probably the most straightforward method of creating a stable coin – creating a token that represents reserves held by a central entity.

Tether is the most popular example that implements this sort of architecture. With a market cap of roughly $2.3 billion and a daily volume exceeding $1billion ($1.4 billion at the time of writing), it definitely seems like a successful project on paper, however, the project has been plagued with controversy including issues with their auditors, Friedman LLP and Bitfinex being served a subpoena (Bitfinex and tether share the same chief executive officer). More recently, Tether have been able to answer their critics having hired Washington based law firm, Freeh Sporkin & Sullivan LLP to audit their accounts, revealing that Tether’s fiat reserves match the amount of Tether tokens currently in circulation. 

Despite being probably the most well known, Tether only scratches the surface when considering the potential of Stablecoins. One of the biggest issues with being fiat collateralized is that users have to trust the central entity that holds the fiat reserves, and so far, especially with tether, that isn’t working out well, with several allegations about insolvency, links to tether being used to drive up bitcoins price and the issues with their previous auditors. Although many of these issues have been resolved, it highlights the issues that arise when having to trust a third party.

The main benefit of this sort of architecture for a stable coin is the price stability. Although it is centralized, this sort of a stable coin can withstand some of the most adverse market conditions, such as the recent crash after the massive bull run in December. Another important things Haseeb Qureshi, points out is that a stable coin implementing this architecture is that they are “constrained by legacy payment rails”.

Another noteworthy fiat collateralized stablecoin is TrustToken’s flagship offering – TrueUSD, which is a stablecoin pegged to the US dollar. Owing to issues with tether, TrustToken has come up with an interesting transparency mechanism.

The company has most recently raised a $20 million investment round from a16z crypto, ZhenFund, BlockTower Capital, Distributed Global and others. They also have a public sale on CoinList currently, which is limited to accredited investors. Their most recent attestation of funds as of July 16th 2018 can be found here

In the long term, fiat collateralized stablecoins may not be scalable owning to the fact that there is significant wastage of capital, in terms of fiat currency sitting idle in bank accounts, but they are definitely evolving and becoming increasingly popular.

Crypto collateralized stablecoins

Fiat collateralized stablecoins are the simplest, but most centralized example of stablecoins and the very fact that you have to trust the central entity contradicts the point of decentralization. Moreover, if a stablecoin is to succeed at scale, you’d assume that it has a massive market cap. With collateralized stablecoins, its far from possible for the issuing authority to safely and properly store that sort of money, apart from the obvious fact that there is a huge wastage of capital in the process of doing so. If we were to look into a much more decentralized approach, we arrive at crypto collateralized stablecoins wherein the stable coin is backed by cryptocurrency reserves. This is usually from a decentralized perspective.

However, given the fact that cryptocurrencies are extremely volatile, this approach requires over-collateralizing which means that there is a huge rate of capital, and this sort of an approach can’t get through to the entire crypto audience and cannot satisfy the idea of a new form of money.

Nick Tomaino, whose fund 1confirmation has backed MakerDAO, a crypto collateralized stablecoin states that “User control and minimized volatility is a holy grail in not just digital currencies but currencies broadly”

MakerDAO, which has been in development since 2015, is fairly complex and a difficult to understand stablecoin implementation.

A typical crypto collateralized stablecoin would behave like this: A user is required to deposit crypto assets into a smart contract upon which he receives a certain number of stablecoins. It is important to note that the cumulative value of stablecoins received is lesser than that of the crypto assets deposited.

A major issue with crypto collateralized stablecoins is that if the cryptoassets in collateral do go through significant value depreciation, the loans taken out by users are automatically liquidated.

Non-collateralized stablecoins

Non collateralized stablecoins are price stable cryptocurrencies that aren’t backed by any collateral. Most implementations right now make use of an algorithm or a system which expands and contracts the supply of the coin depending on the price of the coin. This is based on the Quantity Theory of Money which states that ’the general price level of goods and services is directly proportional to the amount of money in circulation, or money in supply’. Within the context of non-collateralized stablecoins such as Basecoin and Carbon, it means that the supply of the coin will be dictated by the price of the stable coin.

If the price is above $1.00 the supply increases, and when the price is less than $1.00 the supply decreases. This sort of mechanism exists in hopes of creating upward and downward pressure on the price, as required. One example is Basecoin which was announced in October, and is backed by some of the biggest names in the industry, including Andreessen Horowitz and Metastable Capital. Basis (Recently rebranded from Basecoin) makes use of a three token system: basecoin, base bonds, and base shares in order to implement an architecture analogous to an algorithmic central bank. When the supply is contracted, the system offers bonds valued $1 to token holders at a subsidized rate, which pay the principal of $1 coupled with interest in the future. The coins used to buy these bonds are destroyed, hence contracting supply. When the demand for the coins increases in the future, this triggers the system to increase supply. As it creates new coins, it first pays the bond holders. This is partially part of the incentive structure of Basis.

Apart from this, Basis also employs another token called ‘base shares’, which is a fixed supply coin created at the genesis block. Holders of base shares receive dividends in the form of newly generated basecoins, once the base bonds are paid off, and the demand for new coins still exists.

Additionally, Carbon, another promising implementation of a non-collateralized stable coin led by people who were previously at Stanford, Columbia & Consensys is compatible with smart contracts which gives it the unique value proposition of out of the box feasibility to be used in financial applications. The carbon stablecoin is being built on the Hashgraph platform. Considering the explosive dApp landscape(growth of ethereum based games), a spur in financial dApps will most likely be catalyzed by a smart contract compatible stable coin. 

Another notable project worth mentioning is Saga, which doesn’t necessarily fall into any of the above categories, but has a solid advisory council, boasting the likes of Jacob A. Frenkel(chairman of JP Morgan Chase), Emin Gün Sirer(professor at Cornell & director of IC3), Zeev Suraski(early PHP developer). Having raised a $30 million seed funding round from prominent VC firms Lightspeed, Singulariteam and Mangrove, Saga is an extremely ambitious project with a rock solid set of advisors. Essentially, Saga is a non-anonymous stable cryptocurrency that is completely different from what we’ve heard of so far. It is backed by reserves and makes use of something called a ‘variable fractional reserve’ which is essentially a reserve of conventional currencies. The money supply varies depending on the size of the Saga economy. The proposed SGA token will be available for purchase in Q4 2018, although only for accredited investors.

One final development to mention in the space is Reserve, a project founded by Nevin Freeman. They recently closed a $5 million investment round from Coinbase, Peter Thiel and a long list of other investors. It is yet to be seen as to how they rollout but they are definitely a project to look out for.

Overall, stablecoins are an extremely interesting invention likely to evolve over the coming years. Substantial venture capital interest coupled with the gradual rise in interest by highly qualified entities is resulting in a very healthy competitive spirit. It looks like time will decide the one true stable coin that has a huge share of the pie. Right now, coins such as tether pose great risks to the entire ecosystem, potentially posing as a bubble, and crypto-collateralized coins such as MakerDAO, although extremely ambitious and technologically very sound, don’t seem to be able to make the cut for large-scale adoption.

To put things into perspective, the stable coin landscape is slowly growing, and has experienced a lot of development in 2017. We should see several advancements released in 2018, with the launch of non collateralized stablecoins, which can potentially direct the ecosystem in a new direction, depending on their effectiveness.

Editors note: This post was updated in July 2018 to add new projects and additional information regarding Tether.