Stablecoins: Strengths & Weaknesses

February 11, 2019

Contributed by @BrianDColwell.

Previously in Part 1: Stablecoins: Use Cases

“Price instability and market speculation have contributed to extreme volatility in cryptocurrencies, creating an ecosystem that is not supportive of vital financial functions. For there to be a modern financial system on the blockchain, there needs to be a stable medium of exchange. There needs to be transparency and accountability, as well.”

Previously in Part 2: Stablecoins: Collateralization Types

“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.”

But not all stablecoins are created equal…

With a total addressable market of ALL the money in the world, a fiat-free, digital currency that’s price stable, such as Dai from MakerDAO, represents the opportunity to finally end hyperinflationary policies, economic controls, and mismanagement of national economies by weak governments around the world.

Now let’s explore the strengths and weaknesses of the various types of stablecoins.

Part 3: A brief explainer on stablecoin strengths & weaknesses

The first issue with which all stablecoins must first contend is referred to as “the oracle problem.” This issue revolves around transparency of market conditions and ease of acquiring information about the exchange rate between the stablecoin and the asset against which it is pegged.

There are three primary approaches to resolving this problem:

  1. Use a trusted data source, a centralized solution
  2. Use the median from a set of data feeds, also a centralized solution
  3. Use a Schelling point scheme, a decentralized solution

The best understood solution to the oracle problem that also provides a decentralized data feed uses a mechanism that relies on Schelling points.

Schelling points, named after theorist Thomas Schelling who introduced them in his book, The Strategy of Conflict (1960), provide a target for coordination, a solution that people will tend to use in the absence of communication. Schelling points are important to understand in Game Theory and have proven useful in negotiations and situations where one cannot completely trust a negotiating partner’s words.

And, of course, another challenge facing stablecoins is privacy. It’s argued that traceability impacts fungibility, and privacy is often viewed as an essential element for large-scale business adoption. That said, one can also argue that the security breaches of 2018, which included Facebook, have proven that complete privacy of data isn’t an essential need for consumers, and that transparency and auditability are also important for business adoption.

As discussed in Part 2 of this series, most stablecoins fall into three categories based on how they are collateralized. Now let’s consider stablecoin strengths and weaknesses by collateralization type.

Stablecoin strengths & weaknesses by collateralization type:

  1. Fiat-collateralized (Centralized)
  2. Crypto-collateralized (Decentralized)
  3. Non-collateralized (Algorithmic)

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.”

Pros:

  1. The 1-to-1 IOU stability mechanism reduces the chance of high volatility
  2. Relatively simple and easy to understand
  3. Less vulnerable to hacks, since no collateral is held on the blockchain
  4. Bridges gap between cryptocurrencies and fiat
  5. Scalability : IOU systems can grow to support a vast ecosystem
  6. In the event of a black swan event or a financial crisis, government and central assurance can provide a fallback (but is this a pro, or a con?)

Cons:

  1. Centralized operation and issuance
  2. Geopolitics: Highly regulated, beholden to a central bank or government, and vulnerable to government intervention
  3. Lack of transparency: Essential regular audits to ensure transparency and reserves
  4. Counterparty risk:
  5. Need a trusted custodian to store the fiat, trust in custodial solvency and legitimacy
  6. The need to trust the “independent” auditor
  7. What if the issuer chooses not to maintain the buy wall at some point?
  8. Expensive liquidation into fiat
  9. No innovation over what banks currently offer

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.”

Pros:

  1. Decentralized and thus censorship resistant
  2. Transparency creates certainty and auditability
  3. The only form of stablecoin without systemic risk
  4. No counterparty risk
  5. No geopolitical risk, locality risk
  6. Usually can be liquidated quickly and cheaply into the underlying crypto collateral
  7. Can be used to create leverage, opening up the entire supply of money

Cons:

  1. Volatility in the collateral backing the stablecoin may be able to destabilize the peg (often mitigated by over-collateralization)
  2. Can be auto-liquidated during a price crash into underlying collateral
  3. Scalability : These systems can operate at scale only if the underlying collateral can scale and scale of all system actors remains consistent
  4. Inefficient use of capital
  5. Less price stable than fiat

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 as Seigniorage is the profit made by a government through issuing currency, especially the difference between the face value of coins and production costs.”

Pros:

  1. No collateral required
  2. Independent money issuance
  3. Transparency and auditability
  4. This stablecoin is, ultimately, a Schelling point. If enough people believe that the system will survive, it will.

Cons:

  1. Complex math makes analysis difficult: How much downward pressure can the system take? How long can it withstand that pressure?
  2. Experimental fallback procedures
  3. Requires continuous growth, or else will not be able to maintain its peg
  4. Peg vulnerability during bear markets and flash crashes: if selling pressure is maintained for an extended period of time, price will drop below what the system can absorb, triggering a death spiral
  5. Resembles a pyramid scheme: low coin prices are strengthened by the promise of future growth, but that growth must be subsidized by new entrants buying into the scheme
  6. Issuing money is easy, but consistently being able to contract money supply while maintaining value is difficult

Conclusion:

“When one studies the history of money one cannot help wondering why people should have put up for so long with governments exercising an exclusive power over 2,000 years that was regularly used to exploit and defraud them. In fact, history is largely a history of inflation, and usually of inflations engineered by governments and for the gain of governments…

Governments have at all times had a strong interest in persuading the public that the right to issue money belongs exclusively to them, and the monopoly of money has buttressed government power. It is perhaps significant that Adam Smith does not mention the control of the issue of money among the ‘only three duties [which] according to the system of natural liberty, the sovereign has to attend to’.” — F.A. Hayek

No one can pretend to know the future of cryptocurrencies, but what seems obvious is that stablecoins are a step in the right direction–a step towards a future where the government monopoly of money issuance is destroyed by fair markets through real competition.

Resources:

Thanks for reading!

In case you missed them, don’t forget to check out Part 1 and 2 of this series:


February 11, 2019