The World of Stablecoin : Mapping Stablecoin

by | Oct 13, 2018

What’s Stablecoin?

Don Tapscott, known among the blockchain industry as the author of ‘Blockchain Revolution’, breaks down crypto-assets that utilize blockchain technology largely into seven types

  1. Cryptocurrencies : Tokens like Bitcoin that are used for P2P transaction on the blockchain
  2. Platforms : Tokens like Ethereum that are used for dApp or Middleware
  3. Utility Tokens : Tokens like Augur that are needed for service operations
  4. Security Tokens : Tokens that increase in value like securities
  5. Natural Asset Tokens : Tokens that prove possession of natural assets such as oil and minerals
  6. Crypto-Collectibles : Tokens issued for collection activities, like Cryptokitties

And 7. Crypto-Fiat Currencies and Stablecoins

Stablecoin holds different attributes compared to the six tokens mentioned above. At a glimpse, it is difficult to discern its difference from cryptocurrencies. Unlike crypto-currencies which are used for P2P transactions, Stablecoins are tokens issued to maintain price stability. They are created to sustain a certain price level regardless of any circumstance.

The value of Stablecoins maintains stability by being pegged to a certain fiat currency like the USD or the value of particular assets such as the IMF special drawing right. In other words, if a 1 token was issued to have a value of $1, that token’s value will be targeted to $1 by protocol regardless of any changes in the market.

Stablecoin — Necessary?

Why are people so interested in Stablecoins that only have a simple function of maintaining price?

In a nutshell, most crypto-assets today are too volatile, which calls for the need for a stable payment means for sound economic activity on the blockchain.

If I was your employer and have to pay your salary, would you prefer to be paid in Bitcoin or fiat currency?

Among the people I asked this question in person, those who chose Bitcoin reasoned that Bitcoin’s price is undervalued right now, therefore it would be more profitable for them in the long run because they believe Bitcoin’s price will rise.

Those who preferred fiat believed that Bitcoin’s value has already dropped significantly and it could potentially drop further, making fiat the more stable choice. As such, if crypto-assets remain unpredictable, financial transaction on the blockchain may or may not occur based on people’s preference.

Additionally, most crypto-asset holders are reluctant to use crypto-assets for transactions. Instead of using them as currency, people buy/hold on to crypto-assets with the expectation of rise in value, an opportunity to reap some gains.

The typical currency holds the functions as a medium for exchange, store of value, and unit of account. As a medium of exchange, currency has to enable the receipt and delivery of value. As a store of value, currency must have unwavering purchasing power just by holding on to it. With these two functions, members of a society can evaluate the currency’s value based on a common standard, thereby enabling unit of account.

However, most crypto-currencies today do not have effective store of value and unit of account functions due to price volatility.

To resolve this problem, Stablecoin possesses superior store of value and unit of account functions than other crypto-assets by stably maintaining value of the token itself. It can become a crypto-asset that can actually be used as currency.

Using Stablecoin that can effectively perform the functions of a currency can realize functional economic activity with crypto-assets which was hard to do on the blockchain.

Making a security deposit with Stablecoin ensures that the value of the deposit will remain the same when a person gets the deposit money back. This means long-term Smart Contracts can be made (store of value function) and if wages are paid with Stablecoin, the transaction of value can be agreed upon via currency, forming a transaction that both the employer and employee can be happy about.

Using Stablecoin can allow financial services and sound economic activities to operate on blockchain in the long run, and ultimately allow a smoother mass adoption of the technology.

Types of Stablecoin

Stablecoin is largely categorized into Fiat-CollateralizedCrypto-Collateralized, and Non-Collateralized Stablecoin.

Fiat-Collateralized Stablecoin can be used by depositing fiat currency into a certain institute and receiving stablecoin equivalent in value to the deposited sum.

Crypto-Collateralized Stablecoin is used by receiving a loan based on the protocol’s set collateral loan ratio after entrusting crypto-currency like Ethereum on a smart contract.

Non-Collateralized Stablecoins are issued and can be used without collateral.

The following is a list of Stablecoins that represent each type of Stablecoin.

Stablecoins marked in blue are coins that have already been launched on the mentioned date in parentheses.

How does Stablecoin maintain value stability?

Fundamental economics of Stablecoin

Each Stablecoin uses a different method to maintain price stability. However, all Stablecoins in common use the Quantity Theory of Money to control currency supply with the ultimate goal of maintaining price stability. Many Stablecoin projects actually mention on their white paper that they designed the coins referring to the Quantity Theory of Money.

Quantity Theory of Money

The mathematical formula of the theory is as follows:

M x V = P x T

M = Money supply, V = Velocity of money, P = Average price level, T = Transaction volume

The Quantity Theory of Money argues that in the long run, currency value, alike commodities, can change in accordance with supply. If the exchange rate today is $1 = ₩2000 (weaker KRW), the exchange rate could become $1 = ₩1000 (KRW appreciates) by decreasing circulating KRW by half.

Based on such theory, Stablecoins maintain price stability by increasing or decreasing money supply.

If the token’s value drops below a certain price, the network users will drive the coin to be scrapped to decrease the total supply of the token and stabilize the price. If the token’s value rises above a certain level, users push for more supply to bring down the token’s price.

Yet, the Quantity Theory of Money came about around the 16th century and has many holes. One of them is that money velocity (V) and transaction volume (T) are assumed to be constant in the long term. Consequently, M and P are perfectly proportional. Because this theory was developed based on an advanced economic structure, it assumes that money velocity and transaction would be consistent. However, for most blockchain projects that are rapidly changing and have not reached maturity, it is difficult to calculate token velocity and transaction volume or assume that they would constant. Considering V and T as variables, another economic theory has to be applied.

The Impossible Trinity

Moreover, each Stablecoin has different characteristics. Some Stablecoin might have fixed exchange rate while another Stablecoin could have a protocol that performs the role of a self-enforced monetary policy. This means that a certain Stablecoin has attributes that other Stablecoins have, and vice versa. The reason why there is no Stablecoin that holds all traits is because it is impossible according to the Impossible Trinity.

The 1999 Nobel Prize laureate for economy Professor Robert Mundell argued that it is impossible for fiat currency of nations to possess all three traits of currency — free capital flow, fixed exchange rate, and sovereign monetary policy. In fact, most countries have only two out of the three traits.

In the case of Korea and the United States, although both have free capital flow and sovereign monetary policies, they do not have a fixed exchange rate system. Because these two nations have a floating exchange rate, the exchange rate fluctuates every second.

In contrast, China has a semi-fixed exchange rate system (more exactly the ‘managed flexible exchange rate’) and a sovereign monetary policy, but limits international free capital flow.

Lastly, EU member states are examples of countries that have free capital flow and fixed exchange rate, but relinquished sovereign monetary policy. EU nations have free capital flow amongst themselves, and because they use a common currency, transactions are done with a fixed exchange rate even though they have different economic systems. Yet, because the EU controls the euro, each member state does not have a sovereign monetary policy.

Korea actually had free capital flow, fixed exchange rate, and sovereign monetary policy until 1997, when its foreign reserve was depleted and had to be salvaged by the IMF. Afterwards, Korea switched to floating exchange rate.

Each Stablecoin also takes on two out of three traits listed below.

As a token used on the blockchain, all Stablecoins have free capital flow. Therefore, a trade-off occurs between having fixed exchange rate and sovereign monetary policy.

Fiat-collateralized Stablecoins have free capital flow and fixed exchange rate but does not have a sovereign monetary policy. Crypto-collateralized stablecoins and non-collateralized stablecoins have fixed exchange rate but have sovereign monetary policy.

Fiat-Collateralized Stablecoin

Crypto-collateralized Stablecoin, the first to appear among Stablecoins, uses a method of giving tokens equivalent to the amount of fiat deposited to a certain entity. Because the organization holds fiat equal in value to the issued token, the token maintains a certain value.

For instance, if an organization issues tokens or exchanges fiat currency based on an exchange rate of 1 token = $1, users can be assured that the fiat-collateralized Stablecoin maintains this exchange value although the token is traded at 1 token = $0.50 in the market.

As explained earlier, while it has fixed exchange rate, crypto-collateralized Stablecoin cannot implement a sovereign monetary policy. The institute can only issue one token for one dollar or exchange one token to one dollar.

The following is the most popular fiat-collateralized Stablecoin Tether’s fixed issuance and exchange structure (1 USDT = $1).

In reality, fiat-collateralized Stablecoin maintains price stability by arbitrage based on the already explained principle.

If 1 USDT is traded at $1.50 on the exchange, a user would transfer USD with Tether based on $1=1USDT rate, and receives USDT from Tether. If the user trades 100 USDT on the exchange at 1 USDT = $1.50, the user reaps 50% profit. As more users repeat such arbitrage, USDT supply will increase on the exchange, and based on the principle of Quantity Theory of Money, the coin’s value will be corrected to 1 USDT = $1.

Let’s say 1 USDT is traded at $0.50. Users would buy USDT at the exchange with USD. They would be able to buy 200 USDT with $100. The users can request Tether to exchange their 200 USDT into USD, in which case they would receive $200. As more and more users take advantage of this arbitrage the USDT supply compared to demand would dwindle, and the price would return to 1 USDT = $1.00 level.

The most popular fiat-collateralized Stablecoins are Tether and TrustToken.

Fiat-Collateralized Stablecoin — The Pros

1. As the market price is maintained relatively stable, users can use the coins for transaction with minimal risk of price volatility.

As mentioned above, even though the coin’s market price deviates from the fixed standard, users can always receive issued coins or fiat exchange by a fixed rate from the managing organization. For this reason, fiat-collateralized Stablecoins have relatively lower risk of price volatility than its peers. As it will be explained later, other types of Stablecoins may clear out your collateral asset based on their protocol or increase transaction fees, but fiat-collateralized Stablecoins relieves users of such concerns.

2. It is simple to use

Fiat-collateralized Stablecoins have simpler functioning principles than other Stablecoins (as it will be discussed later). Users only have to exchange coins and fiat at the managing organization. In the users’ perspective, there is no need to learn about the complicated dynamics of blockchain technology. They just simply have to get coins issued and use them.

3. Because only P2P transactions are recorded on the blockchain, there is relatively little risk regarding blockchain technology.

Unlike other Stablecoins that use Smart Contract and Oracle, fiat-collateralized Stablecoin utilizes blockchain only to record transactions, making it less reliant on technology and less susceptible to any potential technical problems.

Fiat-Collateralized Stablecoin — The Cons

1. Because it is centralized, there remains counterparty risk (risk to your transaction counterpart)

As you might already have realized, fiat-collateralized Stablecoin relies heavily on the managing organization. If the organization embezzles the fiat reserve or does not fulfill its commitment to return the fiat deposit to the users, the network will become paralyzed and USDT price would become worthless data. Furthermore, the system’s dependency on a certain organization or user does not follow the innate philosophy of Bitcoin and blockchain technology which were created for a Peer-to-Peer Payment system.

2. There is little transparency

To prevent counterparty risk and to check the managing organization, transparency is crucial. This difficult to track continuously unless the organization informs the users on how much the organization is holding and how much coins of the equivalent value have been issued.

Counterparty Risk

Counterparty Risk may not be a big issue when the counterpart has absolute faith or looking at it theoretically. However, the problems that Tether has faced so far shows that problems regarding counterparty risk needs to be scrutinized. Tether has had its share of troubles, which have made people to recognize the limits of fiat-collateralized Stablecoin have negative opinions about them.

Hacker Attacks

– Tether was hacked on August 2nd 2016 and 75 million dollars worth of USDT were stolen. Another hacker attack caused theft of 30 million dollars worth of USDT, summing up the total loss to 100 million dollars. Considering that the total issued volume of USDT was about 260 million dollars as of July 2018, 1/26 has been stolen.

Discontinued Cooperation with Banks

On April 18th 2017, Tether announced that it will discontinue cooperation with two Taiwanese banks causing token issuance and fiat exchange to foreign users to be blocked even today. Currently Kraken and Bitfinex are the only crypto exchange where you can exchange USDT for USD.

Suspected Illegal Issuance

The green line represents the USD price of USDT, the blue line shows USDT’s market cap, and the yellow line is USDT’s BTC price. Source : Coinmarketcap.com (as of April 18th 2018)

In addition, the most critical allegation surrounding Tether is suspected manipulation of BTC price at the end of 2017. When Bitcoin was being traded at an all time high, Tether’s total market cap surged. As a Stablecoin, increase in market cap means more tokens have been issued. People questioned how issuance could have increased when Tether discontinued its cooperation with banks.

Lack of Transparency

This allegation among users was not extinguished because Tether did not provide a clear answer or set forth a transparent report.

Tether states that it is audited by a third party organization to maintain transparency. However, Tether fueled suspicion by releasing audit reports after covering up certain portions. Also, Tether abruptly stopped working with Friedman LLP in January 2018, which has performed the audits.

This post is a satire on the conflicting position of Tether.

Tether has also provided conflicting information to the users. While the white paper states that all USDT can be redeemed for USD, the legal section on the Tether website states that “Tether Limited has no obligation of redemption of USD” (as controversy and criticism arose from this clause, Tether revised the sentence to be more “gentle” on January 3rd 2018).

TrustToken — a Viable Contender

A fiat-collateralized Stablecoin that has improved on the problems Tether has is TrustToken. TrustToken claims it will solve the problems Tether faces with more transparent operations.

TrustToken resolves the flaws of Tether by cooperating with more trustworthy banks and third party entities and managing the Stablecoin TrueUSD which is pegged to USD. It plans on launching a token called TrustToken and synchronize its coins to include TrueUSD with real assets.

How to buy TrueUSD
USD exchange method

TrustToken’s solution can mitigate counterparty risk, but it may not be able to completely solve the problem. It also does not comply with blockchain’s decentralization philosophy because it inevitably has to rely on a certain organization.

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