In the second half of 2018, stablecoins gained massive popularity within the blockchain and digital asset industry. During times of extreme volatility, stablecoins allow users to easily transact in fiat value, pseudo-anonymously, without any rent-seeking middlemen or intermediaries. In essence, a stablecoin provides the same benefits as Bitcoin while holding a stable price to enable a much more effective medium of exchange for everyday goods and services. Moreover, stablecoins allow crypto investors to hedge their investments while avoiding having to exchange their crypto for fiat currencies and suffer from deposit/withdraw delays and when choosing to move their holdings back and forth from their bank accounts.
As of January 2019, there are two primary approaches to stablecoin design that have become common knowledge to date. These approaches are fiat-collateralized and crypto-collateralized. While some groups are experimenting with obscure collateralization methods, these rarely gain traction. This article attempts to outline the differences between these approaches for new readers along with taking the topic a bit deeper by further examining innovate use-cases for stablecoins in the coming year.
Note: If you’d already consider yourself to be pretty knowledgeable on stablecoins, we encourage you to skip to the “Stablecoin Use-Case” section of this article.
Stablecoins that retain a 1:1 peg by utilizing reputable financial institutions to hold an equivalent amount of legal tender in reserves (most commonly US Dollars).
- Tether ($USDT)* — a fiat-pegged stablecoin built on top of the Bitcoin blockchain via the Omni Layer Protocol. Each tether issued into circulation is backed with a one-to-one ratio with the equivalent amount of fiat currency held in a custodial account by Hong Kong based Tether Limited.
- USD Coin ($USDC) — Fully collateralized US dollar ERC-20 token founded by Centre (backed by Circle) and Coinbase. USDC is an open source project which operates within US money transmission laws, uses established banks and auditors while leveraging Ethereum-based smart contracts.
- TrueUSD ($TUSD) — USD-backed ERC20 stablecoin that is fully collateralized, legally protected, and transparently verified by third-party attestations. TrueUSD uses multiple escrow accounts to reduce counterparty risk and to provide token-holders with legal protections against misappropriation. TrueUSD is the first asset token built on the TrustToken platform.
- Paxos Standard ($PAX) — Backed one-to-one by USD deposits and available through Paxos. PAX is available one-to-one in exchange for USD and redeemable one-to-one for USD. Upon redemption, PAX tokens are immediately removed from the supply; PAX are only in existence when the corresponding dollars are in custody.
- Gemini Dollar ($GUSD) — Created at the time of withdrawal from the Gemini platform. Gemini customers may exchange U.S. dollars for Gemini dollars at a 1:1 exchange rate by initiating a withdrawal of Gemini dollars from their Gemini account to any Ethereum address they specify.
*It’s important to note that while Tether claims to be backed by an equivalent amount of USD reserves, they are the only currency on this list that has not provided a proven audit report and cannot immediately be redeemed at a consumer’s request.
- Liquidity — The large majority of fiat-backed stablecoins allow for issuance and redeemability in line with US Money transmission laws. Virtually all respectable secondary exchanges have included a minimum of one fiat-backed stablecoin pair.
- Peace of Mind — Many of projects listed above have dollar deposits that are held in FDIC-insured U.S. banks or collateralized by U.S. government treasuries. These audits are often publicly available on the projects’ website to provide transparency and validate that their claims are true.
- Custody Control — Fiat-backed customer dollars are accounted for as customer property. Once successfully purchased or issued, these currencies are free to be used however the customer desires, without the need of a third party to approve any transfers or usages.
- Centralization — Most fiat-backed stablecoins heavily relies on a custodian and solvency of the parent company for long-term success. While this issue is not seen as a threat in the eyes of many traditional businesses, centralization is one of the big issues that blockchain technology hopes to disrupt.
- Lack of Anonymity — Most of the stablecoins listed above require registration and KYC/AML requirements prior to the issuance, purchase and/or redemption of any fiat-backed stablecoin or underlying asset directly from the parent exchange. With the extent to how important anonymity is to varying individuals, all of the projects listed above will require you to pass KYC/AML in order to redeem your stablecoin for the underlying asset.
- With that being said, not only is there the risk of the custodian (i.e., Tether Limited or Paxos) going bankrupt or absconding investor funds but also the bank which holds the funds could become insolvent or freeze and confiscate the funds held in the account.
As described above, fiat-backed stablecoins hold a 1:1 peg to the US dollar by maintaining an equal amount of legal tender held as collateral by a financial institution. This is why most of the fiat-collateralized stablecoins described above require the transfer of USD before issuing any new stablecoins. For those wondering where they’ve heard this before, the biggest scrutiny of Tether’s illegitimacy is due to the fact that new Tether stablecoins are often created without a fully transparent transfer of USD to the parent company, Tether Holdings Limited.
Beyond collateralized reserves, fiat-backed stability is maintained through arbitrage opportunities to take advantage of any price volatility. In the instance that one of these stablecoin falls below it’s 1:1 peg, third parties are presented with the ability to purchase the undervalued stablecoin at less than a dollar (say $0.95) and redeem it from the issuing entity for the full $1 value. Conversely, if a fiat-backed stablecoin is trading above $1, parties currently holding the token are encouraged to liquidate excess tokens until the price stabilizes at 1 USD.
By taking advantage of the price increase, third parties are able to enjoy an increased position by selling the stablecoin at say, $1.06 and buying back at $1. As a result of these varying arbitrage opportunities, new markets surrounding stablecoin exchange rates has slowly been gaining traction on larger secondary exchanges such as Binance.
A general synopsis of when to use the token
Fiat-collateralized stablecoins are generally attractive to use when the party owning or transferring the token holds little importance on centralization risks and is looking for higher liquidity relative to crypto-collateralized stablecoins. As we mentioned above, the stablecoins listed above rely on the trust of a centralized custodian to maintain their collateralized reserves.
If a new user is comfortable with recognizing that centralized parties are responsible for the long-term maintenance of a specific fiat-collateralized token, these stablecoins currently have the largest liquidity pool and fungibility across various exchanges. For example, Tether (not a project that we’d recommend using due to the reasons mentioned above) currently has over 400 listed trading pairs, providing consumers with the ability to liquidate their holdings on virtually any recognized exchange in the industry.
From our perspective, fiat-collateralized stablecoins serve as a great solution for users using stablecoins in limited use-cases. If a project really only needs to use a stablecoin for a one-time hedge or transfer, fiat-collateralized stablecoins offer the least amount of risk and highest amount of confidence that they will satisfy the short term needs of the purchasing party.
Stablecoins that require digital assets such as Ethereum to be held in escrow as collateral for the issuance of new tokens.
- Maker Dai ($DAI) — The DAI is a crypto-collateralized ERC20 token backed by an excess amount of collateral of another cryptocurrency (most commonly Ether) through Collateralized Debt Positions (CDPs). The DAI has several price stability mechanisms directly implemented in smart contracts combined with a governance token, MKR, in which owners commit to the purchase of all outstanding DAI during times of severe volatility to maintain stability.
- Synthetix ($sUSD) — Previously Havven, this is a crypto-collateralized network enabling the creation of on-chain synthetic assets on the Ethereum blockchain. Synthetix assets are overcollateralized in order to provide sufficient liquidity for users to redeem their collateral at face value. Synthetix plans to outpace the competition by offering stablecoins for other legal tenders such as the euro, yen, and the Korean won.
- Staticoin — Fully fungible Ether backed ERC-20 token which requires no individual counterparties. The ecosystem is comprised of two tokens, StatiCoin and RiskCoin, designed to be the equivalent value of a given currency and a more sensitive version of the exchange rate between the currency and Ether, respectively.
- Decentralized — With a majority of existing stablecoin built on the Ethereum network, crypto-collateralized stablecoins are able to piggy-back on the security of a widely adopted public network such as Ethereum and mitigate centralization risks.
- Transparent — The nature of blockchain technology enables full transparency and accountability by recording each and every transaction on an open and public ledger. This completed eliminates the lack of full transparency commonly found in fiat-collateralized stablecoins.
- Over-Collateralized- All existing crypto-collateralized stablecoins require over-collateralization, meaning that when placing the asset as collateral on a loan, the value of the asset exceeds the value of the loan itself. Therefore, if you lock $200 of Ether, you will receive less than $200 worth of the respective stablecoin.
- High Volatility in Underlying Asset — Given that the underlying asset is a crypto asset, such as Ether, there is high volatility from an asset which may be subject to significant changes in price. This can be an issue when a user who wishes to exchange their DAI for their collateralized crypto asset and the underlying asset has been in a downtrend since the creation of the CDP. Assuming they are able to cover the redemption unlock, the user would receive the same amount of the collateralized asset as when they first deposited it, however, the value of that asset would have changed significantly since the initial collateralization.
Crypto-collateralized price stability derives from the value of the reserved digital assets. In the case of Maker Dai, an individual sends Ether to the Maker CDP smart contract in order to take out a DAI loan. If the USD value of the ether in a CDP (monitored using price tracking oracles) goes below a certain threshold, the owner is forced to either pay back the smart contract DAI balance (plus a stability fee) or it will automatically auction off your ether to the highest bidder. In the case that the price of the underlying asset depreciates (take ETH for example), the CDP smart contracts have parameters in place to liquidate the outstanding ETH balance to maintain the current Target Price of 1 DAI = $1USD. In short, these methods allow all DAI to theoretically always be backed by an over-collateralized amount of assets that could be redeemed at any time at the promised 1:1 rate.
Additionally, in times of crisis, Maker has established a variety of parameters to combat a significant decrease in price. First and foremost, holding MKR tokens provides individuals with governance rights of CDP smart contracts including the ability to enable a Target Rate Feedback Mechanism in which the creation cost and capital gains from holding DAI can be adjusted to achieve equilibrium. In a rare situation that enabling the Target Rate Feedback Mechanism does not achieve the goal of price stability, MKR is created and sold onto the open market in order to raise the additional collateral to cover the amount of Dai in existence.
While other crypto-collateralized stablecoins have different mechanisms in place for maintaining stability in times of crisis, the underlying principle of reserving a higher amount of USD-valued digital assets than the outstanding USD-stablecoin balance is almost always used.
A general synopsis of when to use the token
Crypto-collateralized stablecoins are great solutions for entities looking for higher degrees of anonymity and decentralization in order to eliminate any outstanding centralized risks. In particular, DAI has become the de-facto stablecoin for many Ethereum-based open source financial primitives in the Decentralized Financial (#DeFi) blockchain community. If your company is long on cryptocurrencies as a whole, putting your money where your mouth by using a crypto-collateralized stablecoin is a great way to justify your confidence in the long-term viability of these markets.
Other instances of stablecoins can utilize obscure collateralization methods such as price monitoring APIs to stabilize price relative to the underlying supply and demand of a given ecosystem or backing a stablecoin to a set reserve of physical assets such as gold.
- Basis — Designed to expand and contract supply similarly to the way central banks buy and sell fiscal debt to stabilize purchasing power. Basis was created to act as an algorithmic central bank. Unfortunately, having to apply US securities regulation to the system had a serious negative impact on the team’s ability to launch Basis, ultimately leading to the project’s shutdown in December of 2018.
- Terra — A protocol of money that ensures price-stability by algorithmically expanding and contracting supply. Terra’s Stability Reserve makes a decentralized guarantee of solvency, protecting it from the speculative and regulatory risks that other currencies are exposed to. Terra is backed by Luna, a decentralized asset that derives its value from transaction fees collected on the Terra network
- Digix — Represent physical gold with DGX tokens, where 1 DGX represents 1 gram of gold on Ethereum. The transparency, security, traceability of the blockchain claims to ensure that DGX tokens can be transacted and transferred with full visibility and auditability.
With no obscure collateralization project being able to gain any significant traction relative to the stablecoins described above, we have chosen to limit our research on these rare stablecoins until a later date. It’s important to note that while we are open to hearing about unique collateralization methods, it’s irrelevant to present a deep-dive on these methods until they prove to add recognizable competitive benefits to the most commonly used stablecoins today.
Stablecoin Use Cases
Now that we’ve covered the different design structures, it’s important to focus on how stablecoins can and should add value to different ecosystems we commonly encounter. Please note that while we understand there are plenty of niche uses for stablecoins beyond what we’re presenting, we’ve decided to condense our thoughts into concepts that are most feasible in the short-term.
The vast majority of ICOs we encountered last year heavily relied on the fact that the primary utility of their token was to reward users for participating in their network. It became readily apparent that this is a weak utility use case as these reward models add a perpetual amount of sell pressure as the dApp or protocol scales. While utility staking mechanisms were a nice bandaid to *theoretically* help incentivize holding and mitigate the amount of dumping on secondary exchanges, the lack of adoption and tangible usage of the staking mechanisms quickly made most of the existing utility models obsolete.
These insights lead us to the idea that rather than creating an obscure utility token to fulfill the promise of a new dApp, stablecoins provide an easy reward solution to any new token-startup. Assuming the stablecoin can maintain the stability it promises, rewarding consumers in dollar equivalents becomes much easier to digest for the average individual. Additionally, as the larger stablecoins continue to gain adoption from traditional retailers, this increased liquidity would serve as an added benefit when users accumulate rewards from the usage of a specific network.
It’s important to note while accumulating stablecoins seems easy enough for a high level, there are still some risks and barriers that need to be explored. First and foremost, most stablecoins require users to pass KYC/AML in order to redeem the underlying asset. With this being said, the amount of anonymity any project rewarding users in stablecoins can promise its users looking to liquidate to fiat becomes slim to none. It’s entirely possible for an anonymous user to transfer their stablecoins to secondary exchanges, but without providing their identity to the issuing entity, it’s unlikely that they will be able to redeem USD.
Secondly, many ICOs loved the idea of rewarding users in their currency because it was, more or less, free. Similar to “unpaid internship credit”, it’s very obvious why many projects would prefer to pay consumers in the form of a self-created currency rather than one with tangible monetary value. For this reason, a potential threat associated with this model is the need for a project to allocate capital for the purchase or issuance of the stablecoins they plan to distribute as rewards.
Finally, seeing as many of these stablecoins are being built on Ethereum, it’s safe to assume that any dApp planning on using stablecoins as rewards (for the time being) will need to utilize an Ethereum compatible wallet. This could become problematic if a project wishes to build on other networks such as Stellar or NEO but wishes to utilize a stablecoin-based reward system. From our perspective, interoperability will mitigate this risk in the long-term but it is an important consideration to bring to mind as the industry adapts.
Similar to the reward model described above, many of the security tokens we’re currently working with are leveraging the promise of being able to grant token holders with future dividends. In this model, we believe that the issuance of stablecoins would be a strong alternative to having to collect each holders banking information for the issuance of cash dividends.
As token-startups *hopefully* begin accruing value in the form of tangible revenue, a more traditional evaluation model will be considered when investing in security tokens. Assuming security tokens will ultimately represent the amount of outstanding stock in a tokenized company, choosing to issue cash dividends in the form of stablecoins will allow a traditional investor to utilize the same formulas when calculating expected dividends per share.
Combined with the fact that most of the security tokens we’re currently working with are utilizing an ERC standard, it’s safe to assume that the token owners will be storing their security tokens in Ethereum-compatible wallets. Supplemented by the fact that security tokens require the issuing entity to keep an active cap table of its existing owners, the dividend distribution process should theoretically be expedited by the issuance of stablecoins to the same wallet an owner is holding his security tokens in.
As stated above, the biggest risk with this model is ensuring that each and every individual holding a security token has been whitelisted by passing KYC/AML requirements prior to the issuance of any security tokens or stablecoin dividends.
As one of my blockchain colleagues once said: “magic internet beans don’t pay for developers”. While many projects have wanted to leverage their currency as a means of compensation post-fundraise, this also adds sell-pressure in the long-term. The ability to effectively onboard strong talent is immediately diminished when token-startups attempt to build out their team on the promise of utility token compensation with limited liquidity and long vesting.
We believe that offering a hybrid solution to compensate employees is the most practical way for a new team to onboard strong talent. There’s certainly nothing wrong with compensating employees in the form of outstanding shares of the company they work for, but it becomes tricky when a developer needs to keep the lights on and the “outstanding shares” of a company are illiquid with no opportunity to cash-out within the first year.
By offering stablecoins as payment(s) on a monthly or even weekly basis, new team members can be confident that the project is strategically utilizing the capital from its fundraise by providing immediately liquid, fiat-backed currency to compensate its employees.
With stablecoin payments, employees have the freedom to diversify their cryptocurrency holdings however they see fit. If the employee has a more risk-averse appetite for the ever-changing volatility of currencies such as Bitcoin or Ethereum, they can easily set up an account on the issuing entities exchange to redeem their stablecoin for USD. On the flipside, riskier players can now leverage their payment(s) on secondary markets while the parent company executives can sleep well at night knowing that the compensation rates will be the same now as they will be three, six, or even eighteen months down the line.
Hedge Against Volatility / Shorting Digital Assets
One of the most common use cases for stablecoins is the ability to hedge the high volatility in cryptocurrency markets by allocating a portion of a portfolio into a stablecoin. Since the value of the stable coin is pegged and has little fluctuation in price, stable coins offer an attractive opportunity for investors to mitigate their losses during a bear market without having to re-enter the slow and costly process of transferring back to the traditional banking system.
In addition to hedging, actively investing in stablecoins can, in effect, act as an abstracted mechanism for shorting. If an investor has an inclination that the digital asset market is overvalued and believes that the market will go down, the investor can exchange a large portion of their existing holdings for stablecoins and ultimately buy back the digital asset at a lower price (thus allowing them to buy more of it and increase their original position). Since the digital asset market is in its nascence and there are few opportunities to short other assets outside of Bitcoin, Ethereum and a select few others offered on BitMex, stablecoins offer the next best opportunity for investors.
While we attempted to highlight the benefits and potential use-cases associated with stablecoins, there are a few important risks as a whole. A few of these examples are highlighted below:
- Limited Collateralization Gateways — All of the projects listed above have very few entry and exit points with little interoperability outside of secondary exchanges. In many cases, users would be required to create a unique account on an obscure exchange (often created and maintained by the issuing entity) to redeem the underlying asset(s)
- Blockchain Experience/Knowledge — While the process for purchasing a stablecoin off a secondary exchange such as Binance or sending them to your MyEtherWallet (MEW) may be pretty intuitive to traders who have been active in the space for a long time, the operation of an Ethereum compatible wallet can be pretty overwhelming to new users.
The current benefits of utilizing a fiat-backed stablecoin are dwarfed by the setup and maintenance process required to access them in the first place. It’s safe to assume that a user must have knowledge of Ethereum and the underlying withdraw/deposit process (including the purchase of ETH to facilitate future transfers with gas) in order to use these assets.
As stablecoins continue to be a strong source of discussion within the blockchain community, we hope this article can provide some clarity to new users unfamiliar with the topic, and a point of contention amongst individuals more familiar with stablecoins that are also focused on expanding their limited use-cases. Over the course of the next year, we hope to put some of these use-cases to the test by implementing them within our clients’ ecosystems. As time evolves, it will become increasingly clear which stablecoins are most feasible for the average layman. We look forward to updating our community and potential future clients on the success of these implementations and to providing you with more useful information in the near future.
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Fitzner Blockchain Consulting is a leading management consulting firm that specializes in blockchain-based systems and their design