What are Stable Coins?

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Transcript:
When I first heard of Bitcoin, I thought it was supposed to be a somewhat stable coin that you could rely on to make transactions, buy things, basically treat as digital money. I did not expect it to end up as the equivalent of digital gold.

I was raised in Zimbabwe, Africa before heading off to University in South Africa. Up until 2009 Zimbabwe had its own currency, the Zimbabwean dollar and when I was a kid the Zim dollar was on par with a USD. However, in the early 2000’s the currency headed into a major crisis resulting in crazy inflation, like thousands of percentage points. People would call a restaurant in the morning to check prices and by the time they showed up at night the prices had increased. My friends were paying for gas with trash bags full of useless cash. Eventually they started printing trilling dollar bills. At one point, the government allowed citizens to keep a USD bank account but one day, overnight, the government just changed everyone’s USD into local fiat at the government rate of exchange, way lower than the black market rate. That is scary!

Eventually all commerce was being conducted or priced in USD so when the government decided to make the USD the official currency in 2009 it was an easy switch. But you should see the notes in circulation. Bear in mind there’s no switching out old notes for new. Those notes have been circulating up and down Africa for years and some are one shake away from completely disintegrating!

When I first heard of bitcoin a few years later I thought wow, that would have been handy in Zimbabwe a few years back. Here was a currency that wasn’t controlled by any government, could easily be sent or transported internationally without interference, was easier to safeguard than physical dollars, and couldn’t be seized. The only problem was that Bitcoin wasn’t a safe hedge against fiat inflation because Bitcoin itself was too volatile.

The solution is a stablecoin. Stablecoins, in their most ideal form, are simply cryptocurrencies with stable value against some peg. They share all the features listed above that make Bitcoin so appealing, but don’t suffer from the same volatility, making them much more usable as a store of value, medium of exchange, and unit of account.

Stablecoins aim to become global, fiat-free, digital cash, so the total addressable market is simply that of all the money in the world: ~$90T. A fiat-free currency that’s price stable will challenge the legitimacy of weak governments around the world.

At a high level, a trustless, fiat-free stablecoin sounds impossible. How can a free-floating currency remain price stable given the natural ebbs and flows of supply and demand? And what’s it stable against? The USD, the Euro? Gold? The concept, on the surface, appears to violate basic economic principles. Despite the perceived challenges, many teams are attempting to create stablecoins.

There are four features that a cryptocurrency needs in order to become global, fiat-free, digital cash:
– Price stability
– Scalability
– Privacy
– Decentralization

There are three fundamental approaches to designing a stable coin:

Centralized IOU Issuance
The first is to issue IOUs. This is the model used by Tether. Here, a centralized company holds assets in a bank account or vault and issues tokens that represent a claim on the underlying assets. The digital token has value because it represents a claim on another asset with some defined value. The problem with this approach is that it is centralized. Tether is a classic example given the serious concerns that the public has about their solvency and legitimacy.

Collateral Backed
The second approach is to back the coins with other trustless assets on-chain. Here the collateral backing the stablecoin is itself a decentralized crypto asset. In the case of Maker, for example, Maker’s Dai stablecoin is backed by Ether held as collateral in an Ethereum smart contract. This approach has the benefit of being decentralized. The collateral is held trustlessly in a smart contract, so users aren’t relying on any third party to redeem it.

To make the coins stable, the idea is to lock up collateral in excess of the amount of stablecoins to allow for the volatility of the Ether itself. The collateral is held in a smart contract, where it can be accessed by paying back the stablecoin debt, or can be automatically sold by the contract software if the collateral falls below a certain threshold. This allows for collateral-backed stablecoins that don’t require trust in a central party.

Algorithmically Expand / Contract the Coin Supply
The final approach is to algorithmically expand and contract the supply of the price-stable currency much like a central bank does with fiat currencies. These stablecoins are not actually “backed” by anything other than the expectation that they will retain a certain value.

In this model, some initial allocation of stablecoin tokens is created. They are pegged to some asset such as USD. As total demand for the stablecoin increases or decreases, the supply automatically changes in response. While different projects use different methods to expand and contract the stablecoin supply, the most commonly used is the “bonds and shares” method introduced by Basecoin.

As the network grows, so too does demand for the stablecoins. Given fixed supply, an increase in demand will cause the price to increase. In this model, however, increased demand causes the system to issue new stablecoins, thus increasing supply, and ultimately lowering price to the target level. This works conversely, using “bonds” to remove coins from circulation.

Challenges
Global digital cash must be fast, cheap, and private. That can only occur if the platform it is built upon can scale. It must also be private, for both philosophical and practical reasons. A decentralized stablecoin could never serve as global, digital cash without some guarantee of privacy. While many people don’t immediately think that they care about privacy, businesses, governments, and financial institutions that transact in the stablecoin would certainly need privacy guarantees to protect their business interests, relationships, and more. A completely transparent ledger like that of Bitcoin is not usable for these purposes.

Even though Bitcoin addresses are pseudonymous, simple chain analysis can link addresses with known entities with a fair degree of certainty. This traceability also destroys fungibility, an essential feature of digital cash.

One of the other challenges facing stablecoins is that they all are designed to be “pegged” to some underlying asset, usually USD. The problem is that the peg isn’t always perfect so they aren’t going to get perfectly fungibility.

Once economies develop around the stablecoin itself, the peg will begin to matter less and less. If merchants are willing to hold and accept USD-pegged stablecoins, and they in turn pay their suppliers in the same stablecoin, and that stablecoin is widely used as a medium of exchange, then maintaining a perfect peg becomes increasingly less important. Getting to that future state, however, would be no small feat.

Conclusion
In conclusion, there are still lots of unanswered questions. Are we over thinking this? Is it overly optimistic to expect a new stable coin from getting such ubiquitous traction that it really does take on a life of its own as digital money. Will a digital USD or a crypto backed by gold end up winning the day. Don’t know. But it would be nice to think that in the same way progressive governments separate Church and State, we could separate Governments and Money so they can stop messing it up.

Andrew Playford

Andrew Playford is a cofounder of Coin Profiles. Andrew is a keen crypto investor, ICO advisor and general blockchain enthusiast.

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Andrew Playford

Andrew Playford

Andrew Playford is a cofounder of Coin Profiles. Andrew is a keen crypto investor, ICO advisor and general blockchain enthusiast.

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