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A Condensed Guide on Stablecoins

Elias Mendel
Sep 14, 2021 11:24:54 AM

While the cryptocurrency industry has undergone an incredible bull run in the first months of 2021, with the market cap temporarily peaking at over $2.5 trillion just to plummet by nearly 50% in the subsequent months, it is exactly this circumstance that once again revealed a major issue standing in the way of crypto mainstream adoption - the tremendous volatility. On the one hand, said volatility is precisely what makes the likes of bitcoin, ether and other tokens prone to speculation and literally forges overnight millionaires, however, when it comes to actually replacing traditional financial services, this is a non-neglectable obstacle.  -  Author: Elias Mendel 

What’s the problem?

An essential prerequisite in order to widely compete with the conventional finance and banking sector is price stability. Although price stability stands in the way of you becoming rich in a short period of time, it is a necessity for seamless trade, commerce, planability, payments and the running of the entire economy in general.

How can businesses and individuals rely on cryptocurrencies to be their new way of transacting if their holdings could lose 20, 30 or 40% of their value in a matter of days?

Figure 1: 30-Day Volatility BTC/USD (blue) vs 30-Day Volatility USD/EUR (yellow) by Buy Bitcoin Worldwide1

This is where an increasingly used and popular class of cryptocurrencies that revolves around solving this particular problem comes into play - stablecoins. Stablecoins attempt to provide stable prices (hence the name) and seek to combine the best traits of both traditional finance and digital money, merging decentralization, cheap and ultimately secure transactions, high accessibility and transparency with the overwhelmingly volatility-free stable valuations of fiat currencies. However, as we will see later in the article, stablecoins do not always achieve these ambitious objectives.

There are multiple ways of achieving this desired stability, either by collateralizing the coins with underlying reserve-assets or by applying sophisticated algorithms. The majority of stablecoins is pegged at a 1:1 ratio to respective fiat currencies and can be traded on DEXes and central crypto exchanges like Binance or Coinbase just like any other token.

Figure 2: A view on the market cap of the largest stablecoins by Coingecko2

Types of stablecoins

1. Fiat-backed stablecoins

Fiat-collateralized stablecoins are based upon a fiat currency reserve, such as Euro, Chinese Yuan or US-Dollar, serving as collateral which in return allows for the issuance of a certain quantity of tokens. Usually, for each unit of collateralized fiat currency, one unit of stablecoin is issued, e.g. 1 token is backed by and equivalent to $1.

An example for this is TrueUSD (TUSD), an ERC20 token collateralized by legally protected US-Dollar reserves3. The issuer has to comply with a number of rules and regulations and is audited for adherence to the respective standards on a regular basis.

2. Commodity-backed stablecoins

These stablecoins, similar to the US gold standard that existed until 1971, rely on commodities instead of fiat currencies as reserves. They could either be collateralized by a single commodity, like gold or oil, or a basket of different commodities, e.g. a selection of multiple precious metals. Especially for critics who deem the intangibility of cryptocurrencies as a fatal flaw (the same might actually apply for the overwhelmingly non-collateralized fiat currencies too) this kind of coin might be the ideal solution, as it yields real, physical value. Depending on the value of a single unit of the respective stablecoin, this might even be some sort of fragmentization of otherwise fairly pricey assets and therefore increase their affordability.

A good example for commodity-backed stablecoins is Stellar fork Kinesis Money, which includes fully allocated silver (KAG) or gold (KAU) digitally represented, with each token being equivalent to 1 gram of the underlying precious metal. The gold and silver are vaulted across various locations globally and audited regularly to guarantee transparency.

3. Cryptocurrency-backed stablecoins

Collateralizing stablecoins using other cryptocurrencies is a viable option as well. As the crypto-reserve itself might fluctuate starkly in price, a necessity is “over-collateralizing” these stablecoins, meaning the collateral’s value exceeds the value of issued stablecoins.

A well-known example is MakerDAO’s DAI stablecoin: to issue Dai, you lock up collateral worth more than 150% of the desired amount of Dai in a smart contract called a Vault and if your collateral falls below a set threshold it is being auto-liquidated to pay for your DAI4.

4. Algorithmically adjusted stablecoins (AAS)

Instead of relying on any assets to back them, these kinds of stablecoins, also called non-collateralized stablecoins or seigniorage shares, make use of algorithms to maintain price stability. This in some sense resembles the interference of central banks when their currency is suffering from extreme price swings, exaggerated devaluations and speculative attacks. AAS reply to significant market events by applying respective measures that are hardcoded into smart contracts and aim at creating stability.

Unlike the previously mentioned alternatives which in one way or another ultimately rely on at least one entity, ASS, once launched, are fully decentralized and give rise to institution-independent monetary policy, something that has never really been accomplished in history before. Some projects working on this include Basis Cash, Frax and Terra Money
5.

A good example to illustrate the mechanism behind AAS is Ampleforth, which simply responds to changes in supply and demand by increasing or decreasing the total amount of AMPL tokens. There are 3 different states that AMPL needs to adjust to:

a) Expansion

If for some reason the demand for AMPL spiked, and 1 AMPL would temporarily be priced at $1.5, the algorithm would automatically enlarge the total supply of AMPL by a factor of 1.5X, so that each AMPL would be valued at $1 again.

b) Contraction

This describes the exact opposite. Once the demand for AMPL token significantly drops and a temporary devaluation occurs, the circulating amount of AMPL is automatically decreased in order to artificially create additional scarcity.

C) Equilibrium

Lastly, there is the state of equilibrium, where no intervention is required. This state exists as long as the price of 1 AMPL does not deviate more than 5% from the underlying US-Dollar6.

Figure 3 down below shows the core principle behind AMPL. Once the 5%-threshold is violated either the expansion or contraction mechanism sets in and adjusts the AMPL supply.

Figure 3: Different states of the AMPL protocol by Finematics7

Further considerations

One aspect to bear in mind is that stablecoins are only as stable as their underlying asset - be it gold, silver, fiat currencies, real estate or cryptocurrencies. And all of these can - obviously to varying extents - fluctuate in value.

Besides, let us not forget about the general issuer risk - if the issuer gets into trouble (or worse, declares bankruptcy), e.g. when it is questionable whether all circulating stablecoins are properly collateralized as it has repeatedly been the case with Tether, the coins are prone to depreciate in value as well.

Furthermore, one can oftentimes observe a deviation of stablecoins from their underlying assets, majorly as result of the impact of changing trading volume. A 2018 study done by Santiment gathered extensive data about the volatility of 9 stablecoins (in %).

Figure 4: Daily standard deviation of stablecoins 2018 by Santiment8

Usually, whenever the price of these coins deviates from the targeted $1, you will find arbitrageurs stepping in and eliminating the price discrepancy. However, as with fiat currencies that are pegged to one another, there is no guarantee that this will always be the case. As soon as people commence losing trust in a currency or coin, its value will drop significantly, and there will most likely be no one capable of deterring this. The following graph shows you the maximum all-time deviations of the above stablecoins, and how threatened their stability seemed to have been during uncertain times.

Figure 5: Maximum fluctuations of multiple stablecoins since their release by Coingecko

While there is no distinctive pattern identifiable as to when these extreme fluctuations occur, we can generally note that during turbulent market times, e.g. the Corona crash of 2020 or this year's crash in May, stablecoins tend not to be unaffected and at times can significantly lose stability. Also, in some instances, major price swings come along with the novelty of the projects - it might just take some time to gain constant stability, identify potential concerns and eliminate other threats.

Final thoughts

Stablecoins appear to be a key ingredient in rendering blockchain, cryptocurrencies and decentralized finance mainstream-suitable, as they pose somewhat of a secure “investment haven” in an otherwise turbulent space, in particular for more conservative, less crypto enthusiastic investors. And let’s not forget the potential they entail when it comes to enabling the unbanked - a staggering number of 1.7 billion people - to transact. Stablecoins can be fairly beneficial in that context, as they allow for the seamless execution of everyday transactions (groceries, pharmaceuticals etc.) and, as opposed to the “normal”, volatile cryptocurrencies better manage to bridge the traditional and digital, decentralized financial system in that regard (because they can be pegged at a 1:1 ratio to any fiat currency).

Furthermore, they achieve to bring some planabilty and continuity to an extremely dynamic environment - perhaps a precondition for continuous innovation. We have provided you with a summary of the main ways of maintaining price stability, and the years to come will show which ones are most apt.

Remarks

About Sharpe Explorer: At Sharpe Explorer, we help our customers leverage the crypto and DeFi revolution to access predictable returns, optimize their portfolio and gain a competitive advantage. Our mission is to provide the best and most trusted user experience for investors in the market. We are going to be the one-stop-shop for the focused and comprehensive assessment of any DeFi asset. Sharpe Explorer is going to open the door to the world of DeFi and will give you direct access to wallets and DeFi protocols.

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Author

Elias Mendel studies International Business and Economics at University of Applied Sciences Schmalkalden. Currently, he works on several projects dealing with DLT, digital assets, and blockchain. You can contact him via email.

Sources

  1. https://www.buybitcoinworldwide.com/volatility-index/
  2. https://www.coingecko.com/en/stablecoins
  3. https://www.coininsider.com/what-is-a-fiat-backed-stablecoin/
  4. https://defipulse.com/blog/how-to-generate-dai-with-a-maker-vault/
  5. https://medium.com/coinmonks/what-are-algorithmic-stablecoins-1dfc9278a43b
  6. https://medium.com/dinsight/into-the-world-of-algorithm-stablecoin-2119dda821a2
  7. https://finematics.com/wp-content/uploads/2020/07/ample-threshold-768x433.png
  8. https://partners.santiment.net/wp-content/uploads/2018/11/Pic-1.png

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