Cryptoeconomics of Stablecoins
“Stablecoins are not perfect. They introduce a degree of centralization and/or delicate pegs depending on their types. “
By Block Society
It was not until recent that stablecoins rose in popularity. Following the debut of the controversial Tether stablecoin in May 2015, several other projects have followed suit such as Paxos (PAX), TrueUSD (TUSD), Gemini Dollar (GUSD), USD Coin (USDC), and Dai (DAI). To some, stablecoins represent the holy grail of blockchain since volatility would theoretically be nonexistent and the value is always pegged (typically to the dollar). There are multiple ways to achieve said stability: algorithmic banking, smart collateral, and monetary reserve. A stablecoin based on algorithmic banking has not soared into popularity yet. Dai, in conjunction with MakerDAO, is the most promising stablecoin based on smart collateral. Stablecoins backed up by monetary reserves have been the most successful by far. It is important to recognize the advent of stablecoins since Facebook is going down this route as well in the near future.
Equally as important is recognizing where stablecoins lie in the cryptoeconomic framework. One would notice that most, if not all, stablecoins have been built as decentralized applications (dapps) on smart contract platforms. An ERC stablecoin on the Ethereum blockchain has been the most popular choice. A significant underlying reason for this trend is the convenience of incorporating a smart contract platform’s network (e.g. Ethereum) for transaction fees. If someone makes a transaction with a stablecoin backed by a monetary reserve, a fee needs to be paid to the validators (e.g. miners). If a stablecoin was built on its own ecosystem, then the monetary reserve that backs up the stablecoin in the first place would need to also pay the transaction fee which in turn risks the monetary reserve’s depletion. Concretely, there needs to be inflation for the validators’ benefit. Ethereum already has an in-built inflation system that covers transaction fees. Assuming a standalone stablecoin network, the validators would face an impossible inflation economics due to the expected inflation of most fiat currencies in conjunction with no additional fiat issuance within the existing monetary reserve. It would be infeasible to build a secure, mass-adopted, and standalone network that utilizes transaction fees based on the monetary reserve that backs up the stablecoin; after all, either the stablecoin sponsor would need to somehow pay the inflation differential – a prohibitively expensive proposition – or validators would demand a high premium for each transaction fee which in turn inhibits adoption.
Would the cryptoeconomics of a standalone stablecoin fare better with an algorithmic bank? Only time will tell as it is presently a challenging task to ensure the price stays pegged via supply/demand adjustments. For example, the Basis whitepaper states1:
“If Basis is trading for less than $1, the blockchain creates and sells bond tokens in an open auction to take coins out of circulation. Bond tokens cost less than 1 Basis, and they have the potential to be redeemed for exactly 1 Basis when Basis is created to expand supply. This incentivizes speculators to participate in bond sales and thereby destroy Basis in exchange for the potential that bond tokens will pay out in the future.“
Notice that when the price drops below $1, the only drive for it to increase back to $1 is the speculation that it will, indeed, return to $1 due to higher demand at some point. This is a weak economic proposition.
As for the smart collateral that Dai uses, it still operates on an experimental framework with multiple moving pieces and so the risk remains high compared to reserve-backed stablecoins. Some downsides of using this paradigm is the fact that using Dai costs interest2, the stability fee is increasing3, and the use case of depositing ETH as collateral is clearer than borrowing Dai3. Only time will tell if Dai/MakerDAO becomes a success or goes down the path of NuBits (USNBT).
It is worth mentioning that since stablecoins are inherently non-speculative, it is all the more important to ensure rewards are appropriately doled out to validators. In speculative non-stablecoin blockchain projects, validators may be willing to settle for much less.
It may be possible to envision a scenario in which “fedcoins” – stablecoins backed by a government – could actually succeed on their own without any smart contract platform. In this scenario, the government issues as much fiat as needed via inflation to support the network’s transaction fees. However, this would still be a far-fetched scenario for multiple reasons such as how it would be unfavorably viewed as encroaching on the private sector. Similarly, a “fedcoin” built on a smart contract platform may also be viewed as private sector favoritism unless an equitable process exists for blockchain projects to apply. However, all of this is purely theoretical and does not have basis for at least the next decade.
Stablecoins are not perfect. They introduce a degree of centralization and/or delicate pegs depending on their types. They also lack certain advantages such as the inability to cater to a more global currency outlook as they are bounded to specific fiat currencies. They also lack decentralized governance that inspires and advances many cryptocurrency projects.
In summary, there will be opportunities for both stablecoins and traditional cryptocurrencies to coexist and by no means are they competing against each other. Understanding the economics behind stablecoins would enable us to better understand where and how stablecoins would succeed in areas where traditional cryptocurrencies fall short and vice-versa.
- Al-Naji, Chen, Diao (2017, June 20). Basis: A Price-Stable Cryptocurrency with an Algorithmic Central Bank. Retrieved from https://www.basis.io/basis_whitepaper_en.pdf
- Manrique, Sharon (2018, February 7). What is DAI, and how does it work? Retrieved from https://medium.com/mycrypto/what-is-dai-and-how-does-it-work-742d09ba25d6
- (2019, April 20) Maker DAI Has an Insane Incentive Misalignment Says ETH Researcher. TrustNodes. Retrieved from https://www.trustnodes.com/2019/04/20/maker-dai-has-an-insane-incentive-misalignment-says-eth-researcher-fees-hiked-to-14-mkr-falls