The different types of stablecoins

Regarding the history of Bitcoin's prices, we see high fluctuations. Broadly, cryptocurrencies have a high volatility. This can be a huge drawback when we want to use cryptocurrencies in a common way in our daily life. Indeed, every day, the price of your bread will change. Moreover, the possible capital gain you obtained yesterday, is maybe not longer relevant today. This is not sustainable.

That's where stablecoin comes up. Stablecoin is a cryptocurrency designed to minimize the volatility of the price of the current stablecoin. With stablecoin, the value remains the same after days, weeks, years... For instance, if we buy a token of a stablecoin today at 1 dollar, then we know that tomorrow, the price of our token will be the same, here 1 dollar. Thus, I can exchange it for the same purchase price. Stablecoins allow us to deal with volatility.

Different kinds of stablecoin exist. In this article, we will focus on three solutions: fiat-backed stablecoins, crypto-backed stablecoins and algorithmic stablecoins.

Fiat-backed stablecoins

One of the first solution, for creating stablecoin, is to use fiat money to back the cryptocurrency. In this system, each token generated will be equals to 1 dollar. So, if someone wants to buy some tokens, he will pay in dollars the corresponding number of tokens that he wants to obtain. Then, the system will generate new tokens corresponding of the request of the customer. Afterwards, the person will be able to exchange these tokens, and if someone wants to get back theirs dollars, he can just exchange his tokens to the system and get back the corresponding value.

To resume, if I want to buy 40 tokens, I will need to pay 40 dollars. After the payment received, the system will generate 40 tokens and assign them to me. Then, I can, for example, use 20 tokens to buy something. Finally, I can decide to get back my 20 dollars. So, I exchange the remaining tokens (here 20) to the system and get back my dollars.

One question remains, who will generate the tokens and who will keep all the dollars? Indeed, anyone can create and generate tokens, but how do we trust that entity. This problem is similar to the problem we have with banks. Indeed, when you put money on your bank account, you know that the bank will use your money. However, we want to avoid that. We want to be sure that if everyone who has tokens claims their dollars, they get them back. That's not the case with the bank. Indeed, with a bank, if too many people claim their money back, the bank cannot give it to them, because the bank doesn't have enough liquidity.

Therefore, in fiat-backed solution, trust is the key point. You need to trust the entity who will keep your dollars and who will not use them. Moreover, this entity doesn't have to generate free new tokens, which means tokens with no value behind. The storage can rapidly be a huge problem. Indeed, it is easy to generate new tokens. However, as more we generate new tokens, as more place we need to have. For example, if we have 1 000 000 tokens, we need to store 1 000 000 dollars. Moreover, the storage place need to be safe in order to avoid any incident. That's something we need to take in consideration. Finally, we can use other assets than dollars for the token's value. For instance, we can use gold. But the principle stay the same.

Crypto-backed stablecoins

We have seen that using tangible assets have a big issue with the trust of the entity who stores the assets. Another approach is to use cryptocurrency as backup instead of fiat currency. In this new approach, users will lock some cryptocurrencies (for example, Ethereum) into a contract and get in exchange tokens which his value is stable. With those tokens, users can use them as a way to exchange value... And, at any time, they can get back their cryptocurrencies by deposit the number of tokens generated when the contract was first initialize.

However, as we know, cryptocurrency value is volatile. So in order to keep the value of the tokens stable, we need to be sure that the value behind the tokens is always valuable. In order to generate a contract, users will have to deposit at least 150% value of the token's value they want to generate. For example, if I have 150 Ethers, I will at least only be able to generate tokens with a value of 100 Ethers.

To schematize this principle, we can see this as a bank loan. When you want to make a loan, the bank will ask you if you have assets in order to carry your loan. You can take out a mortgage on your home. If you repay the loan, then you can remove the mortgage. But if you can't, the house will be sold in order to pay back your loan. That is the same principle with this kind of stablecoins, but instead of the house in the mortgage, you put cryptocurrencies.

A question remains. When the value of cryptocurrencies increase, then there is no problem, because the value you put is always superior to the value of your contract. But if the price of cryptocurrencies drop, then how does it work? In this case, the system will sell your cryptocurrencies and give you the remaining value. For instance, if I deposit 150 Ethers and I get tokens with a value of 100 Ethers. Then, if the price of Ethers drops, in that case, the system will sell my Ethers and give me the value of 50 ethers missing.

Crypto-backed stablecoins are another solution. It has the advantage to be decentralize and transparent for his users. The main drawbacks are based on the use of collateral that can be used in case of liquidity.

Algorithmic stablecoins

Another approach for stablecoins is to create a cryptocurrency self-regulated. In the manner of central banks, this cryptocurrency will adjust the number of tokens in circulation. This will be regulated by the way of supply and demand. Here, two parameters have to be taken: the number of tokens and the demand of users. Indeed, the more people wants to buy tokens, the more we need to generate new ones in order to avoid the increasing of the price. The more people wants to sell tokens, the more tokens we need to destroy in order to avoid the decreasing of the price.

To schematize this idea, we can say that this kind of stablecoin is tracking an asset as, for example, dollars. Broadly, when the price falls below the price of dollars, then the algorithm reduce the token supply. That means, it reduces the number of tokens that exists. And when the price surpasses the price of the dollars, the algorithm generates new tokens.

Generate new tokens is not a big issue, because the algorithm can easily generate new tokens. The main issue comes when the price falls. Indeed, the algorithm need to destroy some tokens in order to increase the price of a token. That means that he needs to get back some tokens from users. Thus, the algorithm will pass a buy order in order to get the tokens needed for the regulation. However, this can be problematic, because users will maybe want to keep their tokens. A solution is to give them a compensation for the concerned users.

Conclusion

As we have seen, different approaches exist for stablecoins. In all of this approach, when we have a high volatility, we still have a problem because the system cannot react immediately. Additionally, in the case of hyper-inflation or in hyper-deflation of the value pegged, the stablecoins will be impacted. In order to avoid this risk, the stablecoins should have different assets to cover their values. Another issue is the trust we give to the system. In particular, in the fiat-backed stablecoins, where the entity keeps the assets and generates the tokens.

More and more, stablecoins are part of a portfolio for investors. In 2018, stablecoins compose 35,78% of a portfolio. In 2019, its compose 60,55% [1]. Stablecoins are needed because of the volatility of other cryptocurrencies. The speculation of the price is the main problem, because it is a new technology. But when cryptocurrencies will become stable, the stablecoins will maybe not be has much used, maybe they will evolve. Or perhaps the price of cryptocurrencies will still be volatile and we will still use these stablecoins.

References

[1] Binance Research (Etienne). May 15th 2019. The Evolution of Stablecoins. https://research.binance.com/en/analysis/stablecoins-evolution

[2] Binance Academy. Nov 16th 2020. What are stablecoins? https://academy.binance.com/en/articles/what-are-stablecoins

[3] Adam Hayes, Julius Mansa. Jun 30th 2020. Stablecoin definition. https://www.investopedia.com/terms/s/stablecoin.asp

[4] Paytomat. Nov 4th 2019. Algorithmic Stablecoins. https://medium.com/@paytomat/algorithmic-stablecoins-5e6d0b23ff7

[5] European Central Bank. Nov 2019. Stablecoins - no coins, but are they stable? https://www.ecb.europa.eu/paym/intro/publications/pdf/ecb.mipinfocus191128.en.pdf

Further information

[6] Jamie Redman. Feb 5th 2018. Study Finds Little Correlation Between Tether Printing and Bitcoin's Price. https://news.bitcoin.com/study-finds-little-correlation-between-tether-printing-and-bitcoins-price/

[7] Wikipedia contributors. Dec 9th 2020. Money creation. https://en.wikipedia.org/wiki/Money_creation