Stablecoins: Collateralization Types

December 13, 2018

In the previous blog post we dug into primary stablecoin use-cases and real-world applications. In all cases, volatility hinders the ability for cryptocurrencies to be used as money, whether as a means of exchange, unit of account, or even as a store of value, creating an essential need for stablecoins.

“Ultimately, decentralized and stable cryptocurrencies pave the way for a modern financial revolution that will remove inefficiencies, reduce risk stemming from centralized parties and change the way we transact.” — Rune Christensen, Founder of MakerDAO

A successful stablecoin implementation would be a major catalyst for disruption to global financial infrastructure, challenging weak governments and mismanagement of national economies. Furthermore, stablecoins allow for decentralized insurance, prediction markets, transparent credit and debt markets, and create a level playing field between small and large businesses in global finance.

Despite the plethora of stablecoins coming to market in 2018, and the confusion created therein, the vast majority fall into three categories based on how the stablecoin is collateralized:

1. Fiat-collateralized (Centralized)

1. Crypto-collateralized (Decentralized)

Non-collateralized (Algorithmic)

A brief explainer on the types of stablecoins

1. Fiat-collateralized (Centralized)

Backed by fiat currencies, these centralized stablecoins rely on a single actor to issue IOUs redeemable at a 1:1 ratio for the underlying asset, with reliable convertibility of the IOU helping to maintain the 1:1 peg.

Fiat-collateralized, or fiat-backed, stablecoins store their value in fiat currencies such as the US dollar or Euro. Not only does this fiat backing support a relative level of stability, but active measures are also taken to maintain the peg. For these stablecoins, fiat-collateralization represents a huge opportunity for mass adoption.

The biggest risk to this stablecoin model is counterparty risk. These stablecoins require trust in a centralized entity, such as a bank, and are thus susceptible to destabilization and loss of peg from external geopolitical factors. We can refer to Mt. Gox to recall the weaknesses of trusting in a central counterparty.

In addition, the fiat-collateralized stablecoin model becomes dangerous when there is a lack of trust in the central party’s ability to cover IOUs issued, as was the case with Tether earlier this year. Of course, these issues can be resolved if assets are auditable and there is sufficient data to show that the centralized entity has enough assets to cover outstanding IOUs.

2. Crypto-collateralized (Decentralized)

Backed by crypto assets, these decentralized stablecoins rely on trustless issuance, also referred to as on-chain issuance, and maintain their 1:1 peg against assets via overcollateralization, incentives, and other methods.

Crypto-collateralized stablecoins give life to the ability to use crypto assets as debt collateral, which then become collateral for stabilizing the system and smoothing out volatility. These stablecoins counteract price volatility by ensuring that each coin is fully backed with this reserve.

Importantly, on-chain issuance allows for complete transparency and auditability of these reserves. Collateral is held in a smart contract and accessible only by clearing the stablecoin debt. Alternatively, the smart contract can be closed and the collateral sold by the stablecoin system if excess collateral falls below a certain predetermined level.

The biggest risk to this stablecoin model is the volatility of the underlying collateral. If the collateral loses too much value, the system become under-collateralized and fallback procedures could be enabled, such as stablecoin liquidation.

Ultimately, collateral portfolio volatility determines crypto-collateralized stability. As a result of cryptocurrency and collateral volatility, crypto-collateralized stablecoins require over-collateralization so that fluctuations in collateral values can be absorbed.

Maker’s Dai

Dai is a fully decentralized and asset-backed stablecoin with solvency not determined by any trusted party or locality. No one can alter the core mechanics of Dai and the price of Dai is stable relative to the US Dollar via an autonomous system of smart contracts which responds instantly to varying market dynamics.

In a totally unique approach, MakerDAO also uses a governance token, the Maker coin (MKR), to govern the system and fill shortfalls in collateral in the case where the price of Ether crashes by issuing and selling new MKR coins.

3. Non-collateralized (Algorithmic)

Algorithmic stablecoins, also referred to as Seigniorage Shares and Future Growth-Backed stablecoins, are algorithmically-backed with expansion and reduction of coin supply mathematically determined. There is NO collateral backing issuance. Ironically, central banks typically maintain the stability and supply of their fiat currencies through similar mechanics.

The algorithmic stablecoin innovation was envisioned by Robert Sams in 2014. His idea was to control monetary supply, and thus trading price, by modeling a smart contract as a central bank with the single mandate to issue coins that will trade at $1.

However, these stablecoins are not actually backed by anything other than the expectation that they will retain a certain value. How does this work?

In the case of algorithmic stablecoins, increased demand causes the system to issue new coins, thus increasing supply and lowering price back to the peg. This works conversely, with “bonds” being used to remove coins from circulation.

Any time the price of the stablecoin is less than $1, the system starts offering “shares.” In order to buy the shares, though, stablecoins are needed. Speculators buy these coins on secondary markets at just below $1. Essentially, speculators are offered a small portion of future growth in the stablecoin’s market cap in exchange for providing the capital to peg the currency.

This is why non-collateralized stablecoins are often referred to as Seigniorage Shares, as Seignorage is the profit made by a government through issuing currency, especially the difference between the face value of coins and production costs.

The biggest risk to this stablecoin model is that value is based on the promise of future growth. Consistently contracting the money supply while maintaining stability is very difficult and requires that participants believe demand will increase in the future. If demand stops growing, the stablecoin will not be able to maintain its peg.