Introduction to Stablecoins

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Bitcoin ushered a new era of cryptocurrencies and ever since their popularity have skyrocketed with the world seeing the myriad of use case that can emerge from the use of them. From inception, there has been quite a dramatic increase and decline in the value of these cryptocurrencies- hence it was tagged volatile. This has resulted in cryptocurrency holders become millionaires in one night and losing the investment in another moment. This however led to the conception that cryptocurrencies have poor monetary policies and cannot be termed money because it doesn’t meet the functions of money as a store of value. Therefore, it is seen more as speculative.

To bring stability to the prices of cryptocurrencies a new kind of crypto asset was formed known as Stablecoin. These coins are created to peg the value of every single cryptocurrency to an underlining reserved asset thereby becoming a foolproof against the volatility nature of the cryptocurrency market condition. Over 200 stablecoins [1] and each created with achieving price stability in mind but with different backing assets and different price stabilizing mechanisms. Some of these assets backing these stablecoins are money, gold, oil, real estate, other cryptocurrencies and algorithms and these led to the current categorization of these stablecoins as Fiat based, Commodity based, Crypto based and algorithmic based stablecoins [2].

Before delving deep, I will attempt to define the various types of stablecoins:

  1. Fiat based Stablecoins: this type of stable coin is backed by the traditional fiat currencies or real-world money e.g. US Dollar, British Pound or Japanese Yen (JPY) currency. They are the simplest of the stable coins and first to be introduced into the market. [3,4]
  2. Commodity Based Stablecoins: These are coins backed by assets ranging from precious metals, Oil, real estate. As the values of these commodities rise in the market, they tend to offer those holding this coins higher returns.
  3. Crypto based stablecoins: This is categories of stablecoins are backed by other cryptocurrencies.
  4. Algorithmic based stablecoins: These are coins not backed by any collateral rather controlled by algorithms for the supply of stablecoins. They employ the use of seignorage shares model.

TYPES OF STABLECOINS

Fiat based Stablecoins:

this type of stable coin is not backed by any on-chain assets but by the traditional real currencies like the US Dollar, British Pound or Japanese Yen. Examples of prominent coins in this category include Tether (USDT), True (USD), Paxos Standard and USD Coin (USDC). These stablecoins are managed by a central issuing entity making them highly centralized and are typically kept safe and secured in a bank [2].

The creation and exchange of this stablecoin is such that fiat currency is sent to a centralized party and the required amount of stablecoin is minted. In the case where the stablecoin holder returns the token, fiat is issued and the corresponding stablecoin is burnt or destroyed. The underlying asset and stablecoin token have a 1:1 backing ratio, meaning for every one unit of the stable coin, $1 or 1 British Pound, as the case may be, is backing it. It is also to be noted that the stability of this stablecoin is dependent on the value and liquidity of the fiat currency. [2]

Commodity Based Stablecoins:

These are coins also backed by real-world assets ranging from precious metals, Oil, real estate. This holders of this category of stablecoinsstand the risk of loosing the value of their token due to the volatile nature [5] of these commodities especially gold. When the values of these commodities rise in the market offers those holding this coins higher returns. Examples of commodity based stablecoins include Digix DAO, Gold Mint, Ekon Gold. In the case of stablecoins backed by gold, like the fiat-based commodity they have a backing ratio of 1:1, however, the gold is measured in grams. This means 1unit of the stablecoin is backed by 1gram of gold [3]. Another benefit of this coin is that its token holders can actually exchange the token for real gold.

Crypto based stablecoins:

This is categories of stablecoins are backed by locking up other on-chain cryptocurrencies assets. To mint this type of stable coin a user is required to lock up other crypto currencies in order to access these stablecoins. A higher amount of collateral is deposited before you one can receive the amount they are looking for. This solely due to the high volatility of the underlining crypto asset providing collateral. So, in fiat based a 1:1 ratio is required for backing but this is not feasible in crypto based stable coin as it is possible for the value of the underlining asset to drop drastically causing the asset to be under-collaterised leading to forced liquidation [2].

An example is, say a user borrowing $100 worth of crypto based coin and the underlying asset is BTC if a 1:1 backing ratio is employed and the value of BTC drops by 25% this results in a situation where the user cannot access the stablecoin due to not having enough BTC. This is situation is referred to under-collaterization.

Another scenario is user needs $100 worth of crypto based coin but is required to deposit $200 worth of BTC if the value of Bitcon plummets by 25% the user can still access the stablecoin requested for but at a higher price of $125.

This is over-collaterization. This makes that to mint a crypto based stablecoin requires over collateralization- a process where one has to lockup more collateral asset which it to help withstand the price volatility of the cryptocurrency market.


These collaterals are held by smart contracts making the entire process an on-chain operation. It is a highly decentralized system and transparent. Examples of crypto based stable coins include DAI, sUSD, Reserve token, Maker DAO, Havven, Sweetbridge.

There quite a number of projects in this category and they are different in the operations and strategy. Some stablecoin projects are backed by one crypto asset while others by multiple crypto assets and consequently different collaterization schemes. However, I will be highlighting a few below:

  1. The sUSD is a synthetic USD created by staking SNX or ETH in Synthetix. To mint 1 sUSD one is required to stake 7.50 SNX (synthetix network token) and that is a 750% over-collateral ratio [6]
  2. The DAI another example of stablecoin developed by MakerDAO adopting the over-collaterization requires a 150% collateral. Its underlying asset is the Ether. In the case where a user needs 100 DAI a corresponding deposit of $150 worth of Ether is deposited. [7]
  3. The Reserve Stable coin is backed by a basket of crypto assets managed by smart contracts. The basket consists of 1/3 USDC, 1/3 TUSD, 1/3 PAX making up 100%. it has a 1:1 correspondence with its basket of crypto asset. This means minting 100 Reserve token will require 100units deposit of the basket that backs the Reserve token. Conversely, to receive back the 100 units of the basket, the user will require to give back the 100 Reserve Tokens. [8]

Algorithmic based stablecoins:

These are the last category of stablecoins which do not adopt any form of collaterals rather they are improve price stability and balance the supply and demand of crypto assets using the seignorage model[9]. Depending on the demand for the stablecoin, the algorithm expands and contracts to meet the demand; when the price goes up, it supplies more token and when it goes down, it reduces supply. These operations are run on-chain by codes in a smart contract. This is a highly decentralized operation with codes fully open for inspection. Some of the prominent algorithmic stable coins are TerraUSD, Basis, Ampleforth, FEI, RAI and FRAX. The effectiveness of algorithmic stablecoins can be determined by the governance structure, incentives to users, accuracy in maintaining their pegs, and token adoption.

Algorithmic stablecoins are further categorized base on their token model; single and multi-token system. The Single token system operates a one token whose price is pegged to $1 while on the other hand the multi-token system separates the stablecoin from the governance token thereby having two separate tokens and the volatility of this stable coin is shifted to the non-stable asset.

Three models tend to stand out in achieving price stabilising.

  1. Rebase model. Rebasing concept is used to the ensure the stability of the stablecoin [10]. When a token holder has 200 tokens of a stablecoin at $1.00 it means the user has $200 worth of the coin. However, if the price of the coin falls by 50% to achieve stability, the system will automatically supply increase the number of tokens, therefore the user will have 400 tokens at $0.50. Conversely, this is true if the price of the token increase by 100% it means the system will try to achieve stability by reducing the number of tokens in the wallet by 50% still maintaining a $200 in the account. One vital information to note is that the with every change in the number of tokens it affects the number of tokens present in the user’s wallet. Examples of stablecoins exhibiting rebase is Ample forth.
  2. Coupon model : The coupon model is used by Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD). Here I will focus on how the coupon model works. The protocol initiates the coupon only when the price of the stablecoin drops below $1.00. To restore the price back to its pegged $1.00, users are issued coupons to incentivize them into buying in. This are usually to be redeemed within a timeframe, usually 30days and afterwards it expires. However, this model is not feasible as one cannot guarantee the users will buy in thereby leaving the $1 mark unreached and eventually lead the project into a huge pile of debt. [11]
  3. Bond Reward: Bond rewards is a tool that uses incentives as a price stabilizing mechanism. Basis Cash is one stablecoin that uses bond rewards as an incentive to its token holders. This is only called into action when the price of BAC is below the pegged $1.00 level. The system orders an auction of BAC bonds which can be exchanged subsequently when the price returns to $1.00. [12]

Conclusion

Stablecoins have come a long way. Having read through these overview stablecoin, one will realize that a lot stablecoin projects exist and there is generally not a best one however each of them are designed to meet specific needs and appeal to certain individuals and investors. Also, diligence is required to study any stablecoin before hoping into it. True, stablecoins have had their setbacks as some project had to fold, some in debt while others facing regulatory sanctions causing pain to investors. A consolation is that this is a necessary growth process and more stablecoins project should be expected on the horizons. They have given the world a relatively safe haven in the midst of the volatile crypto world and can become the piece which will satisfy the store of value function of money lacking by other cryptocurrencies.

REFERENCES:

  1. A Complete List of Stablecoins
  2. What are the Different Types of Stablecoins? 101 Blockchains
  3. What Are Stablecoins? - CB Insights Research
  4. Stablecoin - Wikipedia
  5. What is a Stablecoin and How it Work? 3 Different Types | First
  6. DeFi Pulse
  7. Dai (cryptocurrency) - Wikipedia
  8. 2021 Reserve protocol - Reserve
  9. What Are Stablecoins and How Do They Work? | Gemini
  10. Rebase Tokens - What Are They and How Do Rebase Tokens Work?
  11. The Coupon System of Stablecoins Needs A Disruption to Survive | by Variable Time Dollar | Medium
  12. Basis Cash-basis.10 without regulatory risk

Author: Altal

For the original version of this article, please, refer to: SVET Platform

Image: SVET is Light, by Svet and Victor

Date:18 January, 2022

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