What are Stablecoins?
Stablecoins are a new class of cryptocurrencies with a fixed price and the goal of providing price stability. The price is usually pegged to $1 USD per unit. Stablecoins try to bridge the gap between fiat currencies and cryptocurrencies. This type of asset is used for:
- Trading: parking money on the sidelines which doesn't appreciate or depreciate
- Crypto-based lending and derivatives market
- Remittance: an Asset for cross-border transactions which don't change its price per unit in the process of transacting
- Commerce & Payments: businesses that accept day-to-day payments with Cryptocurrency need to avoid volatility
- Long-term Hedging: miners, for example, can lock in their profits in a non-volatile asset
We make a distinction between distributed Stablecoins and centralized Stablecoin. Distributed Stablecoins like DAI aim to combine censorship resistance with the price stability of traditional financial assets, such as the US Dollar or gold. Centralized Stablecoins like Tether and USD-Coin aim to provide a digital equivalent of the US Dollar with a fixed price.
How do Stablecoins work?
There are four types of Stablecoins which are using different approaches to reach the same goal:
- Asset-backed Stablecoins: Every unit is backed by a physical asset like US Dollar. Basically, this represents an IOU.
Examples: Tether, True USD, USD Coin, Gemini Dollar
- Crypto-collateral Stablecoins: Every unit is backed by another Cryptoasset with a liquidation premium. These assets are held in collateral.
Examples: MakerDAI and Havven
- Mechanism Desing Stablecoins: Central Bank Mechanisms are designed to control the units price stability, the peg is maintained by increasing and decreasing the supply.
Examples: Basis, Carbon, Basecoin, and Kowala.
- Hybrid Stablecoins: Combination of two or more of the models.
What are the advantages and disadvantages of every type of stablecoins?
In my opinion, Asset-backed Stablecoins are the best solution. This type uses $1 USD in a bank account for every unit of the digital currency in circulation. So every unit is backed on a one-to-one basis with one physical US-Dollar. The downside is the level of transparency, in some cases, it cannot be verified that this promise holds true.
Any user has to know who is the banking partner and which types of debt instruments, if any, is the issuer allowed to hold?
The new generation of Asset-backed Stablecoins is issued by a central authority, for example, USD Coin (USDC) was created by Coinbase and Circle. These are trusted entities which put their reputation at stake and they USD-reserves are regularly audited.
In stark contrast to Tether (USDT) which is issued by Tether Limited (same people who are behind Bitfinex) and they operate outside the US in dubious island states.
The big downside of regulated Stablecoins like USDC is that the entities behind it can censor, delete or call-back transactions.
These are centralized Stablecoins, they offer high transparency and security but sacrifice censorship-resistance.
This brings us to Crypto-collateral Stablecoins which are distributed Stablecoins. They offer censorship-resistance but lack security.
For example, the MakerDAO protocol which issues the DAI Stablecoin. MakerDAO is a decentralized autonomous organization on top of the Ethereum ecosystem with the goal of issuing for governing the creation of the Stablecoin DAI. DAI is simply a loan against Ethereum. Anyone can create it by providing ETH as collateral. It works like this:
- ETH is turned to wrapped ETH (WETH) which is an ERC20 wrapping around ETH. So, your ETH gets "tokenized".
- WETH is turned into “pooled ETH” (PETH), this means it is added to a large pool of ETH which serves as collateral for all DAI created.
- With PETH you can create a “collateralized debt position” (CDP), which locks up your PETH and allows you to draw Dai against your collateral.
- When you create DAI the ratio of debt in the CDP increases and there is a limit of a maximum amount of DAI you can create against your CDP.
- The newly created DAI can be transferred or spend.
When DAI is worth above $1, mechanisms step in to decrease the price and when one DAI is worth below $1 mechanisms to increase the price step in. Market makers are part of these mechanisms because they earn money anytime Dai is not perfectly worth $1. If someone opens a CDP, he/she can draw a maximum of 60% of the value in Dai, for example, if you draw up 10 000 USD in ETH you can create a maximum of 6000 DAI. It the collateralized ETH now falls in price the collateral could get liquidated.
This is a very complex system, the advantage is censorship-resistance but the downsides are that this thing is wholly dependent on the survival of the Ethereum ecosystem and it is highly experimental and not tested for long.
Even more complex are the Stablecoins that work with Mechanism Design. They are not collateralized by fiat or cryptocurrencies, instead, they use a crude mixture of behavioral economics and Math to keep the peg intact. Basically, they create a “central bank” that algorithmically maintains the supply of currency, increasing it when the price goes up and decreasing it when the price goes down.
They create a substitute for physical dollars and cryptocurrencies. This is dangerous, because if their Stablecoin trades below 1 USD the issuers must spend hard dollars, Bitcoin, or Ether to restore the peg.
This is dangerous because future expectations for seigniorage shares means that it cannot be known how resilient a coin is to downward pressure and the system requires always increasing future demand. An additional risk is added by the use of smart contracts to control the supply schedule. These contracts rely on Oracles who provide the system with external data. They are prone to manipulation and the so-called "Oracle Problem" is not solved. Examples of this are Basecoin and Basis.
Stablecoins are highly experimental at the moment. They must trustworthy solution today are fiat-backed Stablecoins that are issued by a trusted entity. The best are USD Coin (USDC) and Gemini Dollar (GUSD). Although they are not censorship-resistant, they are issued by legally approved companies within the United States.
Tether (USDT) has the highest marketcap of all Stablecoins, it is Asset-backed but operates outside of regulated financial systems. After a ton of research, we are convinced that USDT is legit and has serious banking partners at the moment, but this can change very quickly. So, why take the risk if you have access to fully compliant Stablecoins like USDC?
The only advantage of Tether against USDC and GUSD is that the latter two are ERC20-tokens and Tether (USDT) works on the Ethereum and the Omni ecosystem parallel.
If you value censorship-resistance over security and liquidity, go for DAI. We recommend our clients to stay away from Mechanism Design Stablecoins for now. They are too complex, prone to manipulation and depend on smart contracts and oracles.
Analyst at BlockchainWhispers.com - a top crypto trading team
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