One of the many challenges facing cryptocurrencies is the issue of stability. One proposed solution or approach is to use stablecoins. The theory is that stablecoins can provide the benefits of cryptocurrencies but are immune to the volatility of market-traded cryptocurrencies such as bitcoin.
There are multiple overarching objectives depending on the issuer(s) of the stablecoin. Some implicitly aim at replacing money and/or improve its velocity by correcting the volatility associated with cryptocurrencies and, again in theory, to improve liquidity. As part of this objective, proponents expect stablecoins to more effectively manage specific context such as cross-border payments.
Much of this thinking is misguided. To begin, stablecoins are immature at multiple technical, economic and usage-specific levels. While they may improve access to additional market liquidity, in of themselves they don’t necessarily add to liquidity overall. Contextual management of cross-border payments also implies a given pre-existing understanding and behavioral willingness to use them in spite and/or instead of as or more effective alternate solutions. Exploring the ways they attempt to alleviate volatility also reveals some fundamental challenges. And this also helps to define them in more detail.
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The Shape and Form of Stablecoins
Collateralized off-chain –
- One approach is to peg their value to fiat such as the USD (the dominant peg for stablecoins), a mix of fiat currencies or a commodity (asset backed). Also called collateralized off-chain, this works by adjusting the supply of the currency or by holding matching reserve assets in the selected fiat currency. In other words, issuing IOUs redeemable for the underlying asset.
- Collateralized off-chain is the dominant stablecoin category. They tend to be more centralized by nature as their target monetary variable is centralized (eg. USD). As a result, they may provide some mechanism (but no guarantee) to deal with volatility.
- The role of blockchain technology is limited in that context since decentralization is not part of the intent. Especially from a governance perspective. And this leads to opacity and therefore risk. Some of the issuers of such stablecoins do not provide auditable records of their fiat or asset reserves. And this level of opacity could damage the adoption and use, and most importantly perception of blockchain technology in general.
Collateralized on-chain –
- Another approach is to peg the value of a stablecoin to a cryptocurrency or basket of cryptocurrencies. Hence they are collateralized on-chain. A smart contract dictates that the underlying cryptocurrencies can only be accessed “when clearing the stablecoin debt”.
- This can lead to a circular process when such stablecoins are used to back up cryptocurrencies such as ETH or BTC. Due to the volatility of the underlying cryptocurrencies, over-collateralization tends to be a common practice for this category. However since the collateral is on-chain, it is more transparent than the off-chain variety.
- They tend to be more decentralized as they rely on other cryptocurrencies, but their contribution in terms of reducing volatility is more limited. Their level of liquidity is bound by the liquidity of the individual cryptocurrencies of the reserve basket, which impacts their valuation.
- Another more complex, but more decentralized approach, is to rely on a clever combination of algorithms and smart contract capability. This approach is non-collaterized and depends on models such the seigniorage shares model. This latter uses “ flexible money supplies governed by algorithms that programmatically buy and sell a stablecoin’s tokens in order to maintain the token price near the intended peg”.
- This is a complex construct and we recommend to read “The Cryptoeconomics of seigniorage shares stablecoins: Basis and Carbon” as well as the original paper which introduces the underlying model is “A Note of Cryptocurrency Stabilisation: Seigniorage Shares“.
- The algorithm aims are replicating the actions of a central bank,its open market operations, but without the resources of a national treasury. In order to achieve the target peg, it discounts shares on a secondary market to attract investors who are relying on the stablecoins to purchase such shares.
- The challenge with this approach is the level of complexity required to write the smart contract, the quality and the nature of its ownership. Attempting to replicate a central bank’ behavior is a daunting challenge. But from an exploration of the capability of smart contracts, this is a fascinating test of their level of maturity. In other words, the real test for stablecoins is whether the algorithmic version can mature and gain adoption.
- However the implications for monetary policy are such that central bankers are unlikely to devolve decision making to an algorithm created by a third party as illustrated by the ongoing discussion on Libra. Cf. “Facebook Libra — Liberator or Trojan Horse?”
Not That Stable
Another issue that deserves more attention is the claim that stablecoins are smart money since the smart contract is responsible for managing the collateral, trading behavior, market operations – including the terms and conditions of doing business with different entities. But this demands more scrutiny of the smart contract construct: Who wrote it? Who controls its execution? How is it secured? What are its dependencies? Can they handle the need for circuit breakers?
Furthermore most stablecoins have not been successful in maintaining price parity with the underlying fiat currency they were pegged to. And this includes the dominant and most simplistic type of stablecoin, the Tether collaterized off-chain stablecoin. As mentioned above, there is also some issue with opacity. Regulators such as the US Justice Department and Commodity Futures Trading Commission have explored the role of the Tether stablecoin as a tool to manipulate the Cryptocurrency markets, with the New York Attorney General investigating the Tether issuer cf. https://www.natlawreview.com/article/bridging-week-gary-dewaal-april-22-26-and-april-29-2019-stablecoin-not-stable-no.
Bottom line is that we need to recognize the lack of maturity of stablecoins while recognizing there is no single category. You should therefore challenge any analysis that treats stablecoin as one category and that they are a natural candidate to the evolution of the Future of Money. We would also recommend to consider stablecoins as part of the overall universe of tokens as discussed in the following report “Expand Your Token Universe to Create New Business Models“.
Christophe Uzureau is a Vice President at Gartner. He is a co-author of a new book: The Real Business of Blockchain: How Leaders Can Create Value In A New Digital Age.
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