Week 38 — Stablecoins: Centralised Or Decentralised?

by Riya Kumari

If you were a whiskey store owner, would you receive Bitcoin as a mode of payment?

A couple of weeks back (when dining in groups was still allowed in Singapore 🙄), the Pratu team with mentor Kwai had quite an intense discussion about payments in general and so we talked about how infeasible it was to accept payment in Bitcoin for a normal business owner …

Because the price of Bitcoin fluctuates so drastically, so too will the value of your goods and services. Today your bottle of Whiskey may cost $70, but tomorrow it might cost $50. That’s a huge loss per unit for the owner!

Would anyone be able stomach that kind of risk? Probably not.

A Medium Of Exchange

In order for a token to transact the way like money does, it needs to serve as a medium of exchange, a store of value and a unit of account.

When designing a token, if you were to design it as a unit of account for transactions, you will need to factor in short term token stability. This will bring about a greater reliability in the way anyone can pay for their goods and services.

So, if you were to look at Bitcoin as a transacting medium, it would resemble more like electronic gold than electronic cash (as it was originally intended in Nakamoto’s 2008 whitepaper).

Because of the inherent price volatility of Bitcoin, it would not be an ideal medium to receive your salary in or pay your utility bill with.

This limitation has great implications when you are trying to design a decentralised ecosystem.

Stable Tokens

Stablecoins are becoming crucial when building a tokenised system because no one will want to enter a smart contract in which the value drastically jumps every second.

There are 4 main types of stable tokens that I will go through, namely:

  1. Fiat-collateralised or commodity-collateralised stable tokens
  2. Crypto-collateralised stable tokens
  3. Algorithmic stable tokens
  4. Central Bank Digital Currencies (CBDC)

Asset-Collateralised Stable Tokens

Literally, an asset backed token is backed by off-chain/ real world assets that have stable prices.

For example, USDT (Tether) is said to have a depository of 2 billion dollars of USD in their private accounts. However, they have admitted that only about 74% of USDT is backed by cash and cash equivalents. This is potentially risky as “extra” USDT can be used to buy Bitcoin and thus manipulate the price of Bitcoin. This is on top of the fact that USDT is the number three most traded token in the world.

Digix Gold Token (DGX) is another interesting stablecoin to mention. DGX is said to be pegged to gold instead of USD and unlike USDT, DGX hires external auditors to verify their gold reserves. The custodians and auditors create reports that are scanned and uploaded onto the Ethereum blockchain via IPFS. This creates an auditing trail where anyone can verify DGX’s claims.

Crypto-Collateralised Stable Tokens

These tokens are backed by a basket of crypto currencies to determine the value of the stable token.

Basically, these stable tokens are collateralised with BTC or Ether and the collateralisation of cryptocurrencies are more public and easily verifiable.

In the case of DAI, it is a stable token operated by MakerDAO and it is pegged at a 1:1 ratio with USD. It’s underlying cryptocurrency that it is backed by is ETH. If you currently hold ETH, you can enter into a smart contract with MakerDAO to generate the same amount of DAI. The smart contract is then locked until all the DAI tokens are paid back and the person holding the DAI tokens will be given the corresponding amount of ETH.

One concern that comes up is that if the value of the collateral asset drops too quickly, the token may become undercollateralised. DAI then has an in-built set of mechanisms in play that would balance out price fluctuations for continual operation.

It is however, very susceptible to black swam events where the price of DAI can crash where they are unable to buy back DAI fast enough to stablise the pricing.

Algorithmic Stable Tokens

Algorithmic stable tokens are pegged 1:1 to a certain central currency (USD). It is tied to a smart contract such that if the demand for the stable token rises or falls to not meet the 1:1 ratio, the smart contract kicks in to readjust.

Based on firsthand experience, these algorithmic tokens do not hold the 1:1 ratio all the time and it could be due to 2 factors, namely, the expansion and contraction method used and/or the oracle used to feed real-time pricing into the algorithm.

In essence, these stable tokens have not been proven to have solved the problem of controlling token supply in an attack resistant manner.

Central Bank Digital Currencies (CBDC)

Central banks have not been staying idle while the cryptocurrency world has been flourishing. In fact, they have been looking at tokenising their own currencies that come with it’s own stabilisation mechanisms. CBDCs act as the tokenised representation of a country’s currency, and so central banks will work closely with monetary policy makers in order to enact a policy.

Why would central banks bother with CBDCs? Well, the cost to print and manage money supply is high. On top of that, cross-border transactions are extremely costly, which we know blockchain networks cost way less to facilitate the transaction.

With CBDCs, nations can now disseminate money quickly and provide a new avenue for policy makers to execute their policies. CBDC is an interesting topic to research on it’s own and I might write something about it in the future!

But for now, CBDCs are being explored by many countries, the furthest ahead would be China with their digital Yuan already in distribution to 500,000 people. Rumours are that the digital Yuan experiment has not panned out the way that they envisioned it to be and thus they are responding by overtly lashing out against the cryptocurrency market.

Challenges Face By Stablecoins

Many stablecoin projects out there are highly experimental and those that are live suffer from price volatility.

I believe the first thing that any of these stablecoin projects should address is the oracle issue. Many of the existing or upcoming projects do not have a fully decentralised method to receive the pricing data between the stable token and the pegged asset. This slippage in information can cause big problems especially during a black swan event.

The creation of network effects for stablecoins is also a key obstacle that has to be solved. If businesses cannot use the stablecoins to pay employee salaries and suppliers, why would they want to accept stablecoins as a form of payment?

Although many projects out there like Stellar and Ripple claim to greatly lower the cost of cross-border transactions, the issue comes when you’re trying to swap your Ripple to USD Tether (USDT) and from USDT to actual fiat currency.

For small crypto to fiat currency transactions, cost is not a huge factor, but when you’re processing multi million dollar transactions, the cost becomes extremely high (probably due to money-laundering concerns)and most times it makes more sense to just go through normal cross-border transactions.

Lastly, the balancing act between autonomous monetary policies and exchange rate stability is something that all governments and stablecoin projects contend with.

Honestly speaking, I find the concept of DAOs (decentralised autonomous organisations) gimmicky and stupid. If stablecoin projects allow people to vote on a certain policy, most individuals have a really short-sighted view on things and will vote for the policy that suits them best at the present moment. I do however admit that centrally created policies can royally mess things up, so I do understand the difficult balance that has to be struck.

Hope I’ve blessed you in one way or another!

Till next week!

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