From the CMC editorial desk: With lots of talk recently about stablecoins, we ask our friends at MakerDAO to explain stablecoins – what they are, what they’re good for, and how they’re designed. Read on to get a sense of stablecoins!

When Satoshi Nakamoto revealed the Bitcoin protocol, it unleashed a powerful vision for a decentralized future. This revealed a future with true peer-to-peer exchange through a distributed database using modern cryptography. Today, people from around the world celebrate the great potential that blockchain has to revolutionize the global economy. This has paved the way for us to build platforms for ultimate truth and trust, as well as facilitate collaboration and transactions.

So many of the modern services we use are run by centralized entities, powerful intermediaries we rely on to authenticate information and settle transactions. These intermediaries are often inefficient middlemen, or even worse, corrupt entities. Blockchain changes all of that. Blockchain has the potential to disrupt many of the core functions that we rely on, enabling truly secure, efficient and decentralized platforms and technologies, independent of any centralized party.

We have seen many new cryptocurrencies come out of this once novel concept. In fact, Bitcoin, Ethereum and other cryptocurrencies have grown exponentially over the past few years. The combined market cap has expanded over to over $300 billion (at various points in time), with some predicting that the total market capitalization could hit $1 trillion by the end of 2018.

However, despite this rise in price and interest, cryptocurrencies are still primarily used for speculation. The frequent spikes and crashes, as well as day-to-day fluctuations, have many concerned about actually using these currencies in everyday transactions, such as buying goods or services.

For there to be a modern financial system on the blockchain, there needs to be a stable medium of exchange, a truly stable currency.

Introducing the stablecoin, a fundamentally new approach to the idea of digital money.

Stablecoins: Unlocking the Power of the Blockchain

A stablecoin is a cryptocurrency that has low volatility against the world’s most important national currencies, potentially unlocking large benefits for a decentralized Internet. In short, a stablecoin is a cryptocurrency with a fixed price, vis-à-vis other currencies, assets or algorithms.

No longer do people have to worry about the daily fluctuations of their cryptocurrency when deciding to make a purchase. In the short-term, stability allows for people to transact in a practical way, and the long-term stability enables other important financial functions such as loans and credit.

A Global Currency

A stable digital and decentralized currency could become a global medium of exchange. For those who don’t want to rely on the centralized forms of currency, stablecoins are available for trustless, cross-border transactions.

This will be especially important for people living in countries with unstable monetary systems, such as Argentina, where residents are often exposed to rampant inflation and uncertainty. Even when these citizens seek to move their capital to more stable stores of value, restrictive capital control laws often prevent them from using non-native currencies in transactions outside the country.

Stablecoins usher in a new option for those who want to transact through a global currency, allowing access for all, but especially the unbanked, to the world’s financial systems.

Decentralized Financial Services

The adoption of stablecoins will support capital market formation and usher in new applications for decentralized finance on the blockchain, such as lending and derivatives markets.

For example, decentralized cross-border lending can occur through the introduction of a stable cryptocurrency. This removes the problems seen with popular but highly volatile cryptocurrencies which create an uncertain lending environment as borrowers and lenders cannot comfortably plan for the future. This has the potential to transform many industries including supply chain, exchanges, shipping and more. Another example is financing and financial planning.

Ultimately, decentralized currencies have the potential to pave the way for a modern financial revolution that will remove inefficiencies, reduce risk stemming from centralized parties and change the way we transact.

Strengths and Weaknesses of Various Models

Naturally, interest in stablecoins have growth in recent months. New models for stablecoins, such as seigniorage shares and faith-based models, have been introduced and debated. Here the post explains these various models and explores each model’s potential for long-term viability.

The major classifications of stablecoins have their strengths and weaknesses, and carry varying amounts of risk. Some are significantly more risky than others; several others break from the critical motivators behind blockchain. At this point, there isn’t a clear universal “winner,” meaning as a consumer or dapp, it’s important to understand the benefits, risks and tradeoffs of your stablecoin.

Here we examine a few different models and analyze essential factors of successful stablecoins. In this post, we will explore three important classifications of stablecoin. The basis of each type has fundamentally different underlying principles, and they contain very different levels of risk. Particularly when exposed to extreme market fluctuations, negative investor sentiment, geopolitical instability, or the failure of centralized custodians.

Key Factors for Evaluating a Stablecoin

When choosing a stablecoin, we consider the following principles:

Transparency — How transparent is the system? Does the system rely on the trust of a central actor? If so, are the procedures to view the inner-workings of that central system reliable?

Auditability — Can everyday users audit the systems financial fundamentals. Can the collateral be confirmed?

Stability Mechanisms — Assuming regular market operations, what factors keep the coin stable? Are they algorithmic based? Collateral based? Fiat based? What are the strengths and weaknesses of each system?

Fallback procedures — In the event of a failure in the particular system, how stable are the underlying assets. Do protections exist to return users funds?

Scalability — Can the system grow to support a broad ecosystem?

Additionally, for each principle, it’s necessary to consider a few factors on how to measure each aspect. Firstly, it’s essential that the system should not have a high maintenance cost. If excessive fees or high overhead costs exist, the system loses efficiency and thus risks instability.

Secondly, It’s also crucial that all market participants can audit the system quickly and reactions can occur at a reasonably fast pace. Efficient market operations depend upon the speed of comprehension and reaction, especially in the event of a “black swan” or unanticipated market event.

Lastly, since many stability mechanisms rely on actors to make decisions based on market information, improving the transparency of the system is an important mechanism. Without a high level of openness, the ability to make accurate decisions based on facts suffers.

Current Models of Stablecoins

There has been a recent surge of new stablecoins entering the market, the vast majority of which fall into three primary categories:

IOU models — These models rely on centralized trust and centralized issuance. In this approach, a central actor holds an asset and issues an “IOU” that is redeemable for the underlying asset.

Seigniorage Shares — This system creates algorithmically backed stablecoins. This approach algorithmically expands and reduces the supply of the price-stable currency. In essence, similar to how central banks often maintain stability with fiat currencies.

Collateralization — This approach is on-chain, trustless issuance. In this approach, the system issues the stablecoin when assets are pledged as collateral on-chain. This type of coin maintains stability by overcollaterization, market efficiencies, complimentary incentives, profit motives and fallback procedures such as global settlement.

Type #1: IOU Models

A basic stablecoin is a simple IOU. In this model, a central entity holds an asset and issues a coin redeemable at a 1:1 ratio for the underlying asset. Reliable convertibility of the token for the asset keeps the token pegged. Much like a gift card, or gold held in Fort Knox, the ability to transfer the stablecoin into the base asset keeps the peg maintained.

If, however, the token cannot be claimed for the underlying asset, or there is low confidence that the central entity has enough assets to either cover the amount of IOU’s issued or operate a fractional reserve based system, this model becomes risky. This model is prone to destabilization from external factors such as geopolitics, local regulations, and other forces.

This approach requires trust in a centralized entity, like a bank or a financial institution. It’s important that funds remained escrowed, separate from the operations of the bank. Assets should to be auditable with sufficient proof to show that the centralized entity has enough assets to cover outstanding IOUs.

Counterparty risk is the risk that the other party (the counterparty) of a financial contract will not live up to its contractual obligations.

Counterparty risk for coins operating under the IOU model is high. One of the popular coins in this category has faced many questions about the solvency and legitimacy of the operation. It becomes a problem when independent users of a platform cannot confirm how much is in reserve for each of the coins issued.

For this reason, the importance of audibility of the system becomes essential. Fortunes have been lost due to the weaknesses of a central counterparty, as was the case in the fall of Mt. Gox.

In analyzing the core principles:

Transparency — Since IOU’s typically rely on a central party, they frequently do not have complete transparency as institutions may not disclose verifiable audits. Critics of this model often cite that the centralized approach means there is little evolution over what banks currently offer.

Auditability — Since the underlying stable assets are not on a blockchain, an audit by a “real world” accounting firm will be required. Even with an auditable system, it still transfers the required trust to the auditors instead of the blockchain.

Stability Mechanisms — Assuming regular market operations, this model is very stable. Specifically, when trust and transferability between the stablecoin and the underlying assets functions properly, stability holds. Since the mechanism is a literal 1-to-1 IOU, the underlying stability mechanism reduces the chance of high volatility.

Fallback procedures — In the event of a black swan event or a financial crisis, government and central assurance can provide a fallback. For example, insurance agencies may be contracted to pay out losses due to theft, or a government may offer support. In practice, however, fallback procedures have not always held up. An example of this occurred when Lehman Brothers fell during the 2008 economic collapse, and funds lost assets held under management.

Scalability — IOU systems can grow to support a vast ecosystem. Central banks can operate at a nation-scale level, but the scale of their mistakes grows as well. Also, since these operations rely on human input, their scalability often hinges on the ability of staffers to run a large scale operation.

Type #2: Seigniorage Shares

Seigniorage share stablecoins are based on the basic model that when demand for the stablecoin increases, the system issues new coins, so the price stays stable. Of course, this is just the framework, as they can get a lot more complicated.

While it’s easy to understand how the price can stay flat when the demand goes up, what happens when demand drops?

These stablecoins are not actually “backed” by collateral. They can’t be traded in or redeemed for any other asset. They maintain their stability due to the expectation that they will retain a certain value.

Typically, when demand for an asset increases, so does its price. When demand decreases, its price drops, given that demand is moving quickly relative to supply.

If, however, the rate of demand increase matches the rate of supply increase (and vice versa), the price stays flat.

Since the system creates new stablecoins when demand increases, the system must contract supply when demand decreases. Many projects use a bond issuance system to incentivize users to “turn in” their coins for a bond that might provide a return of stablecoins issued in the future.

Critics of this model argue that’s it’s difficult to create an algorithm that decides issuance and contracting rules that is resilient to manipulation. Consistently being able to contract the money supply while maintaining value is difficult and requires participants believe that demand will increase in the future.

In analyzing the core principles:

Transparency — Assuming they are purely algorithmic-based operations, these systems can be completed on-chain and therefore offer a level of transparency. If they are not algorithmic backed (like a central bank or Federal Reserve) then their transparency hinges on the decision-makers’ desire to publish their actions to the market.

Auditability — If the underlying stable assets are on a blockchain, then they can be audited.

Stability Mechanisms — Assuming that the demand for the stablecoins is consistent or increasing, this model is stable. In periods of high volatility or decreasing demand, the long-term stability is unclear.

Fallback Procedures — In the event of a black swan event, fallback procedures are currently experimental. There is not yet a tested, proven choice for a mechanism to maintain stability in a market collapse. By definition, these coins rely on predictable, rational, open market operations.

Scalability — These systems can operate at scale only if the activity and actions of all system actors remain consistent and reasonably predictable. For example, if demand drops for a given side of the ecosystem, the system’s ability to scale drops.

Type #3: On-Chain Collateralization

In this approach, users collateralize an on-chain system, which issues coins relative to the value of the underlying collateral. This process is similar to an escrow, or a “lock up.”

Since the collateral backs the stablecoin, coin stability links to the total value of the underlying assets. If those assets, collectively as a portfolio, are stable, the ability for the portfolio to quickly change in value reduces, further increasing stability.

The system becomes more stable when it becomes overcollateralized with low volatility portfolio of assets and offers proper fallback procedures.

In these implementations, the collateral backing the stablecoin is itself a decentralized, auditable asset. This offers advantages of transparency and auditability. However, if the system’s collateral loses too much value, then it’s possible for the system to become under-collateralized, in which case, the stability depends on the fallback procedures in place.

As the underlying portfolio of collateral increases its stability, so the stability of the system increases as well.

While each of the examples below maintains different approaches for handling market collapse, the general idea with collateral-backed currency tokens is that the underlying collateral keeps them stable in everyday operations, and various redemption or dilution methods keep the system stable in periods of extreme volatility.

In analyzing the core principles:

Transparency — Since the development of these systems are entirely on-chain, they offer a high level of transparency

Auditability — Since the collateral is held in a smart contract, users aren’t relying on a counterparty to audit the system, they can do so directly with on-chain audits.

Stability Mechanisms — This implementation is stable if the underlying asset is stable. They can increase stability with over-collateralization or robust fallback procedures.

Fallback procedures — In the event of a black swan event, fallback procedures generally rely on allowing flexibility in the price of the underlying asset, or exchanging the stablecoin for collateral. In both instances, the damage is minimized by the speed that the system can act.

Scalability — These systems can operate at scale only if the underlying collateral can scale and scale of all system actors remains consistent.

As demand for stablecoins increase, it’s essential to understand the stability mechanisms that underpin each stablecoin. For a true stablecoin system to succeed and scale, it must be free from the risk of centralized parties, maintain the ability to be audited, and have sufficient fallback measures for extreme events. The real promise of the blockchain will be unlocked upon a successful stablecoin implementation, unleashing a new wave of financial innovation.

Designing a stablecoin

A stablecoin should live completely on the blockchain; a stablecoin’s solvency should ideally not rely on any trusted counterparties and be unmediated by any locality. No one should be able to alter the core mechanics of the stablecoin, making it a safe and predictable form of money.

Here, we will explain by illustrating our approach when designing Dai, which is a fully decentralized, asset-backed currency whose value is stable relative to the US Dollar. The price stability is maintained through an autonomous system of smart contracts, which responds to varying market dynamics.

Some important features to note:

Each Dai is worth $1.

All stablecoins are backed by real assets, a surplus of collateral that has been escrowed into audited, ownerless, and publicly viewable Ethereum smart contracts.

Its solvency doesn’t rely on trusted counterparties.

It’s a currency that lives entirely on the blockchain.

Its stability is unmediated by locality.

Once generated, the stablecoin can be used in the same manner as any other currency: it can be freely sent to others, used as payments for goods and services, or held as long term savings.

How does it work?

Each stablecoin is fully backed by a valuable asset held in a secure smart contract platform. In our case, anyone can lock their tokens up as collateral and issue Dai against them.

Everyday users should not need to understand the internal mechanics in order to use a stablecoin. People can freely use it as a traditional currency because price stability is managed through an autonomous system of smart contracts specifically designed to respond to market forces and an ecosystem of economic incentives.

As an example, anyone can open a Collateralized Debt Position (CDP) on the MakerDAO platform. This CDP is a smart contract which gives users Dai in exchange for locking up valuable collateral. The assets are held in escrow until the borrowed Dai is returned by the user. Put another way, Dai is created when users lock up collateral and Dai is removed from circulation when users free up their collateralized assets. This system of exchange is essential in regulating the total supply in the market and guarantees the value of circulating Dai.

It’s important to note that it is designed such that the amount of collateral in a CDP is always set to be significantly higher than the amount of the debt, so stability seekers who wish to use it as a predictable store of value can be confident that 1 coin is worth 1 USD in underlying assets.

Should the value of the underlying collateral increase, the system was designed such that CDP owners are able to mint more from the same amount of staked assets. This influx of additional coins into the market during bull runs keeps the supply higher during periods of increased demand.

Third party network participants are also important to maintaining its price. These are generally automated programs that take advantage of arbitrage opportunities to keep Dai near its peg. They also participate in CDP auctions ensuring the orderly wind-down of liquidated contracts.

Stablecoins are a key solution for those who seek stability. In the short-term, stablecoins enable people to transact in a practical manner and in the long-term, it enables a wide range of services on the blockchain such as loans, supply chain and prediction markets. With stablecoins, a robust financial ecosystem on the blockchain is well within reach.

Learn More:

Maker believes in a future that leverages the power of decentralization for trustless transactions.

Maker is carrying out a vision of creating a decentralized stablecoin that will unlock the unique benefits of a complete financial ecosystem on the blockchain.

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