StableCoin : What's The Buzz with Stablecoins and Algorand

StableCoin : What's The Buzz with Stablecoins and Algorand

By Andrzej_0xa0 | Strong Fundamentals | 10 Jul 2020


Over the past months and weeks, we've learned about two major stablecoins that will be migrating to Algorand blockchain (USDC, USDT).

February 2020, Tether (the largest stablecoin by market cap) announced integration with Algorand platform , and a few months later, in June, we learn that USDC also expands its roots to more platforms, as a way to achieve interoperability between Ethereum and other blockchains, and the first choice for them on the way to this goal (as a multi-chain stablecoin) will be Algorand .

In this post I will have a look at different types of stablecoins, what challenges and advantages each of these types has, and why stablecoins are important for platforms such as Algorand, that are building DeFi ecosystem.

 

Generally, if cryptocurrencies are to become a useful medium of exchanging value, at some point the price volatility will become a big obstacle to achieving this goal, if it is not happening already.

We know that Bitcoin can have fluctuations of 10-20% throughout the day, and other cryptocurrencies are subject to even greater price movements, so for many people storing such a volatile assets, using it as a mean of payment or mean of value transfer, is a barrier hard to overcome, major roadblock to the mass adoption.

 

Stablecoins seem to be the answer to the volatility problem.

Stablecoins are cryptocurrencies with a stability in price terms, which means that the price of the stablecoin is pegged to a something more stable, like fiat money such as USD or CAD. They can be backed by fiat or other cryptos, but there are more scenarios here - I will explain it later. We hear more and more about stablecoins backed by cryptocurrencies, or precious metals, or not backed by anything, balanced algorithmically.

There are really interesting ideas and developments in this space, so I will expand it a bit further.

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Why does Algorand need a Stablecoin?

If a platform like Algorand is planning to build the rails for the decentralized finance (DeFi) it must provide a stable mean for value transfer. Lets take merchants or other retail business as an example, consumers do not want to be exposed to an unnecessary risk of price fluctuations.

There is of course a group of people for whom the volatility of cryptocurrencies is an advantage (like traders) but for the vast majority of people, storing an asset which can drop in price 20% one day, just to buy a coffee, is unacceptable.

Also.. you can not pay someone a salary in Bitcoin or in Alogs, if the purchasing power of such an asset is constantly changing, at least very few would accept such a solution. 

Long story short: There is a large number of users who do not want to speculate on the price, are risk-averse and the price volatility will be for them a big barrier, that will effectively deter them from the crypto world. You probably know many people like that in your surroundings. I do.

The idea of ​​cryptocurrency with a stable price has been discussed for a long time. Vitalik Buterin wrote about this back in 2014.

Over the past years, many different approaches to design a stable coin have been born and tried. The big challenge though is to balance:

  • the spirit of decentralization,
  • the effective use of collateral,
  • and how to make a given stablecoin really stable, namely secure to crashes and speculations on the market.

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Algorand seems to be a player treating regulated markets seriously, thinking about many applications on regulated markets (InsurTech, DeFi, CBDC) so will surly need a stable, regulated and reliable stablecoin. Hence, the availability of USDC on the Algorand blockchain is a big step forward in this direction.

At the same time, I am pretty sure, there will be use-cases in the future where decentralized stablecoin might be useful as well (backed by other cryptocurrencies or by Algos), so in the long run Algorand should probably be looking for alternative ways, as it comes to design its own stablecoin.

 I have mentioned these 3 types of stablecoins (fiat-collateralized, crypto-collateralized, non-collateralized) so let's digest them a bit, one by one, and review their pros and cons.

 

TYPES of Stablecoins

At a high level, we have these 3 families of stablecoins. There are more nuances, but at the end of the day, every single stablecoin I am aware of today, is going into one of these 3 buckets:

  • stablecoin backed with fiat money (fiat-collateralized) (*)
  • stablecoin backed with another cryptocurrency (crypto-collateralized)
  • stablecoin without collateral (non-collateralized)

*stablecoins collateralized with precious metals I would count into 1st category, because they follow similar patters as far as the design is concerned.

 

FIAT-collateralized 

While designing a stablecoin, best is to start with the most obvious approach, namely create a cryptocurrency that is literally form of IOU (I Owe You), which can be exchanged 1 to 1 for fiat money (e.g. in the case of Tether 1 USDT = 1 USD or Circle, 1 USDC = 1 USD deposited in bank account).

This is the simplest scheme for a stablecoin to follow, quite logical and easy to implement. However, it requires degree of centralization, because you must trust the custodian (bank in this case), that it actually holds the USD equivalent. In such a case, you would then also need to implement audits, that will periodically check the balances on the custodian side, which obviously generates additional cost, delays, and on top of that, has high maintenance costs.

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At the same time centralization gives the greatest price stability. The collateral / reserves are stored securely and will remain intact, even in the event of an attack on a given cryptocurrency. At the moment, this cannot be said for any other type of stablecoin, so Algorand choosing USDC (one of the better regulated and audited stablecoins) and USDT (Stablecoin with the highest capitalization) has made a good first step on the way toward building the fundamentals for upcoming DeFI applications.

To sum up the pros and cons for this type of stablecoin:

 
Pros:
  • Price stability (close to 100%)
  • Simple to build and understand the principles behind it
  • Secure, most resistant to hacks and price manipulation
  • Strictly regulated approach (+/-)
Cons:
  • Centralized - you need a trusted custodian to store the collateral (fiat)
  • Costly and slow (due to blockchain <> fiat world communication)
  • Strictly regulated approach (+/-).
  • Requires regular audits, as a mean to achieve transparency.

Tether was the first and still is the greatest representative of this category, although opinions are divided if Tether is 100% collateralised or a fractional-reserve stablecoin.

Hence, Algorand expanding and partnering with USDC seems to be a very good idea if thinking of fully regulated markets.

USDC is the fastest growing stablecoin, already supported by many companies in the fintech area, in their various products and services. USDC has recorded over $50B  in volume of transactions on the public blockchains. As more and more financial institutions and enterprises want to build decentralized finance applications, they will need a trustworthy infrastructure and a regulated, widely accepted stablecoin coin,  like USDC.

BTW, you will find a lot of useful resources about stablecoins and corresponding metrics on Messari platform.

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CRYPTO-collateralized

And now let's assume that we do not want to integrate with traditional financial rails, and get attached to one or another Fiat currencies. We are reinventing the money here, right? So why should we go and peg with centralized banks and fiat money?

If we move away from fiat world - we can also remove centralization from the stablecoins. 

The idea is: let's do the same as in the example above (fiat-collateralized), but instead of fiat, let's use another cryptocurrency. Doing so everything could remain on the blockchain, from a to z.

Yeah.. but wait.. Cryptocurrencies are unstable, which means your stablecoin would also be unstable :) Something is missing..

For now, the only way to solve this problem is securing the stablecoin with a higher deposit in cryptocurrencies so that it can absorb the price fluctuations.

example:

Let's assume that we have deposited $200 worth of cryptocurrencies (in Algos or Eth) into a smart contract, and then we created 100 stable coins (call it USDx), each worth of 1USD ($100 total). In this case, these stablecoins are over-collateralized (2x). This means that the price of collateral (Algo or Eth) may drop by 25% (or even up to 50%), and our stablecoin will still be safe, because the value of collateral will be 200USD * 75%  = $150, so we our USDx position is not at risk.

But why would anyone want to allocate their $200 in Algos or Eth to create a stablecoin worth $100? There are two incentives:

first, you can pay interest to the issuer (some DeFi platforms already do that)

second, you can create additional stablecoin as a form of financial leverage and allow the issuer to earn in this way. It is a bit complicated - so let me redirect you the example from Money On Chain platform as a further reading.

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The general approach in crypto-collateralised stablecoins is that you excessively (2x - 4x) secure the stablecoin with another cryptocurrency, and if the price drops below the level of collateral, the stablecoin will be liquidated. All this is being managed on the  blockchain, in a decentralized and automatic manner, leveraging smart contract capabilities.

Stablecoins built in this way are an interesting idea. We have seen this happening on Ethereum (Maker - DAI) and on Bitcoin (Rootstock - Money on Chain) and am guessing that some time from now Algorand will try to build their own solutions : stablecoin back by crypto.

Currently, to build more serious (=regulated=)  applications this type of approach may be too cumbersome. Stablecoins of this kind have several disadvantages, like:

  • being more exposed to price volatility than fiat-backed coins,
  • they might be unexpectedly liquidated (due to market crash or manipulation)

If you secure your stablecoin with crypto and the collateral drops hard enough, your stablecoin will be automatically liquidated (sold). At this point you are exposed to normal currency risk.

The only way to prevent this from happening is strong over-collateralization (200% or even 400%). Every single $1 of stablecoin secured with $2 or even $4 in crypto like BTC, ALGO or ETH, which ultimately makes crypto-collateralized coins being capital inefficient.

To sum-up pros and cons.

Pros:
  • More decentralized approach
  • You can quickly and cheaply move from stablecoin to crypto and vice versa (everything is done on the blockchain)
  • A more transparent model, anyone can easily audit if the reserves are in place and sufficient
  • You can use this mechanism to create a leverage.
Cons:
  • You can be automatically liquidated when the market collapses
  • Less stable price than in the case of Fiat-collaterialized coins
  • Depended on the reliability of cryptocurrency used as a collateral
  • Inefficient use of capital (2-4x more needed)
  • Pretty complex implementation, hard to understand for a person not interested in technical details.

The first stablecoin in this category was BitUSD  (by  BitShares  ), created by Dan Larimer in 2013, and these days DAI from MakerDAO is considered as the most promising stablecoin, secured by Ether. Thought, the market crash in March 2020 has exposed DAI's weaknesses (in result, Maker eventually also decided to peg DAI to USDC), so added a flavour of centralisation into these asset.

Will we see this kind of stablecoin on the Algorand blockchain, secured in the form of Algo tokens ?

Maybe & Hopefully.

 

NON-collateralized

OK.. Crypto-Collateralised or Fiat-collateralized :: but the real question is :: do we even need the collateral?

Digesting further the subject of stablecoins, we finally come to the topic of non-collateralized stablecoins.

Central Banks have managed to move away from the gold standard, and fiat money is no longer secured with Gold or anything else than trust. So perhaps this means that collateral is not required and the stablecoin could adopt a similar model to its own design ?

What Is Fiat Money?

Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money.

 

QUESTION: How to ensure the stability of a stablecoin that is not backed by anything?

This would require designing a smart contract, that acts as a central bank. The monetary policy of this contract would have only one, but major goal: to maintain a stable price of the currency for example always at 1 USD.

How to achieve it? 

In theory, it seems simple. Since the smart-contract issues the currency, it can also automatically control the money supply, adjusting it to the level of demand, so that it will always be at a value of 1 USD.

Example, let's assume, that such a stablecoin for some reason (demand) starts raising dramatically in price, hitting 2 USD. This means that the price is way too high - or in other words, the supply is too low. To counter this, a smart contract would have to generate new coins and sell them on the open market, increasing supply, and continue doing so until the price returns to $ 1. 

Again, this is nothing new, central banks (like SNB e.g. in Switzerland in 2011) have dome similar things in the past. They pegged CHF  to another currency (EUR) back in 2011 in order to protect the economy (exchange rates were subject to manipulation), and they used similar mechanisms to described above.

"Switzerland sparked fears of a new currency war on Tuesday after it pegged the Swiss franc against the euro in an attempt to protect its economy from the European debt crisis."

Of course, if we ever wanted a smart contract to regulate money supply, and act like a Central Bank, there are a number of questions to be addressed:

  • How to make such a smart contract trustworthy?
  • How to secure such a smart contract against attacks, hacks, manipulation?
  • How enable "restore from failure" mechanism, in case of collapse?

.. and many more questions .. So while these types of stablecoins are very fascinating, I have the impression that we are still a decade before we are ready for them. At this stage these are quite conceptual considerations, but it is possible that some projects will go this way, and advance if further.

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There are many questions on how to do it right. How much pressure can such a system withstand? At what point and whether to allow for a manual intervention? 

Just to use my imagination, and go a bit further: in the context of growing discussions about CBDC (digital currencies of central banks) - perhaps at the beginning we will see the creation of CBDCs backed with national currencies, but inefficiencies and delays of such a "peg" at some point will lead to removal of peg and CBDC will become algorithmically balanced virtual stablecurrencies.

Taking all this into account, NON-collateralized stablecoins are the most ambitious project, probably most fascinating as well. Even if the dollar or bitcoin collapsed, such a coin would have a chance to survive.

Summing up pros/cons.

Pros:

  • Cost-effective and collateral efficient, fast.
  • Most decentralized and independent (uncorrelated) 

Cons:

  • Most vulnerable to market manipulations
  • High complexity to implement
  • Difficult to restore in case of failure

 

The perfect stablecoin?

At the moment, it seems that these 3 main trends are and will be further explored by various projects, probably at even faster pace, as the DeFi trend evolves. These are not the only directions. There are stablecoins backed by gold or even stablecoins which are backed by basket of currencies (form of SDR).

Algorand and Circle are players who take regulations seriously. USDC is currently the second largest stablecoin in terms of market capitalization. This stablecoin was developed as a joint venture of the large cryptocurrency exchange Coinbase and Circle (backing Poloniex), so I guess many interesting solutions can be built on top of Algorand and USDC in the near future. 

Stablecoins are on the one hand pretty boring topic (because they are stable :-) and on the other hand extremely interesting (because they are much required for wider adoption) so I will definitely be curiously watching how Algorand and other projects develop their ecosystems and experiment with various stablecoins and respective applications in the DeFI domain.  

I think there is no one answer to the question of perfect stablecoin. The needs are different. The market are different. The users also vary in terms of maturity and requirements - this all makes me thinking that we will have multiple approaches to stablecoins running in parallel. 

 

Andrzej_0xa0 on Twitter

Sources:

https://hackernoon.com/stablecoins-designing-a-price-stable-cryptocurrency-6bf24e2689e5

https://algorand.foundation/tether_on_algorand

https://algorand.foundation/circle-usdc

 


Andrzej_0xa0
Andrzej_0xa0

Running Crypto Ultramarathons


Strong Fundamentals
Strong Fundamentals

On this blog I share my thoughts, analysis and deep-dives into projects in Crypto space, which in my opinion are building an interesting technology, have a healthy ecosystem, promising tocenomics and strong team with high ethics. So in general I study projects in #crytp + #blockchain space with something what I call #STRONG_FUNDAMENTALS @Andrzej_0xa0

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