Price volatility is a hallmark of the cryptocurrency space. This has been beneficial in one sense, with the large upsides attracting investment, but in many ways uncertainty around price has slowed development of some blockchain services.
At a very basic level, it is difficult for businesses to transact using cryptocurrencies, no matter how much some customers might want them to, because the exposure risk is too great. Similarly, the development of solutions for blockchain loans, insurance, or other financial services that rely on stability and legal compliance have been slowed. Put simply, how can a business transact through a medium that could drop 30% in value from one day to the next?
Stability is key, and many regard a price-stable coin as a vital development in the nascent cryptocurrency market. A so-called stablecoin is a cryptocurrency with a price that is pegged to a stable asset.
There are at least a dozen stablecoins on offer today, pegging themselves to fiat currencies or other digital assets, with the most famous (and notorious) being Tether’s USDT.
In September 2018, Gemini Trust Company launched an ERC-20 tokens pegged one-to-one with the US dollar for exchange on their platform, but with full regulatory oversight.
Some have suggested regulatory supervision over these projects and increased vigilance as shown in the recent case of NYAG vs Bitfinex represents a genuine game changer for cryptocurrency and its mainstream adoption. But if the idea isn’t new, then why is this development seen as so important? To answer that, we need to look at other stablecoin projects and examine why they haven’t engendered trust.
The biggest segment of the stablecoin market is so-called fiat-collateralized coins. These coins or tokens are essentially an IOU – every token is backed by a set amount of fiat currency in the reserves of the issuing company. In some cases, holders are able to buy or exchange their stablecoins for fiat currency directly from the issuer, and the ability to do this, combined with the knowledge that every last token is covered (or fully collateralized), keeps the price stable. This is a simple concept to grasp, with fairly straightforward mechanics, but the trade-off is that a degree of transparency must exist to ensure trust.
Tether, which we have written about before, is the big name in the space. First launched in 2015 with the name Realcoin, Tether issues USDT, a fiat-collaterarized stablecoin. What that means (in theory at least) is that for each of the 2.7 billion USDT tokens circulating at present, there is one US dollar in Tether’s bank account that a holder can exchange their USDT for. This notion keeps the price relatively stable around $1.
As the first stablecoin to gain major traction it has been genuinely revolutionary in allowing investors to secure their profits easily and move money across exchanges and currencies. To give an example of its scale, the 24-hour volume of USDT trades regularly exceeds 75% of the total supply, with many traders holding USDT for just a short period of time.
It is the grease that keeps the wheels moving on a number of exchanges, but this has brought scrutiny into how it is issued and used. The question of whether Tether actually holds enough collateral to cover the USDT minted has been asked by many for a long time, and the company has not convincingly answered it. After struggling to get an audit carried out, Tether recruited law firm Freeh Sporkin & Sullivan. FSS examined Tether bank accounts on one date, June 1st 2018, and determined that they held reserves of $2.55 billion (covering 2.54 billion USDT at the time). The report the law firm produced was full of qualifications, providing no guarantee whatsoever that USDT was fully secured on any date besides June 1, and quick to note that all information was provided by Tether. Additionally, Bitfinex and Tether are currently going through a brutal legal battle with the New York Attorney General who accused them of covering an almost billion dollar loss with customers' money in 2016. The situation looks like it'll become uglier before it becomes nice.
These reservations might not seem particularly important at first glance, particularly if you’re just using Tether to quickly swap between exchanges, but think of it like this. Tether creates USDT according to the extent of their USD reserves. This makes it quite unlike other cryptocurrencies, which issue new tokens according to strict and predictable rules. If USDT isn’t fully collateralized by dollars in the bank, Tether is essentially printing its own money, which has no backing at all. If Tether collapses (and many commentators believe it is a matter of when, not if), it will eliminate an extremely widely used pool of liquidity and could conceivably bankrupt exchanges that hold large volumes of USDT, including Bitfinex, Poloniex, and Bittrex.
As you’re probably gathering from all this, fiat-collateralized stablecoins like Tether are completely centralised and require an enormous amount of trust. Other fiat-collateralized stablecoins have sprung up, and most use transparency as their key selling point over Tether.
TrueUSD is an ERC-20 token backed, in the same way as Tether, one-to-one with US dollars. The process of acquiring TrueUSD is relatively simple: After sending USD to an approved partner bank and providing an Ethereum wallet address, TrustToken initiates a smart contract to mint the equivalent amount of TrueUSD, which is delivered to your wallet. The use of third-party financial institutions is the key difference between TrueUSD and USDT. TrustToken does not hold the money themselves; instead, banks and fiduciary institutions that have partnered with TrustToken hold the money in escrow. They also ensure their financial situation is transparent through a partnership with auditing firm Cohen & Co, which releases bi-monthly attestations of their escrow balance. TrueUSD has had some scepticism thrown its way too, notably for a lack of clarity around the process of redeeming TrueUSD for fiat currency- during its alpha phase, the minimum withdrawal is set at a rather pricey $10,000.
A similar approach is outlined by Alprockz, who are releasing ROCKZ, a stablecoin pegged to the Swiss franc. Their approach differs in two important ways to Tether. First, full transparency is promised, with frequent audits from a third party to take place. Secondly, Alprockz will issue ROCKZ to buyers, but will protect their money. When a user wants to buy ROCKZ, they will transfer money to Alprockz which will hold it under a fiduciary mandate, separate to the company’s operating accounts. This protects the buyer, and indeed the entire market, in the event of the company going bankrupt, as buyers will still be able to exchange their ROCKZ back into Swiss francs. It’s a nice idea but, as with everything in the cryptocurrency space, will need the right marketing and promotion to get it going.
Finally, the exchange Gemini launched its own US Dollar-backed coin, the Gemini Dollar (GUSD). The big news around this coin is that it has been approved by a government regulatory body, the New York Department of Financial Services. GUSD, an ERC-20 token, works similarly to other stablecoins, with a few differences. A series of smart contracts allows Gemini to control the supply of GUSD. A ‘Proxy’ layer controls the rights for creating and distributing GUSD, and operates over other layers. In theory, this gives Gemini ultimate control over what happens on other layers, including the implementation layer, which contains all the smart contracts you’d usually expect with an ERC-20 token. The use of a hybrid online and offline custodianship model controls the total supply of GUSD, providing a consensus mechanism rather than the company minting new coins as and when needed.
The issue of centralisation returns again though. A blockchain researcher recently wrote a piece after performing a code review on GUSD, confirming that Gemini has the ability to freeze any account and make tokens non-transferrable. There have also been instances in the news recently of large accounts being closed after attempting to redeem significant sums of GUSD.
There are a number of fundamental problems with fiat-collateralized coins. While some are clearly aiming for a greater degree of transparency, they all offer the same type of risk, just in varying degrees. They are centralized by their very nature and in the case of exchanges like Gemini have the power to close your account, making it difficult or impossible to redeem your tokens. Better than Tether? Yes, but the bar is low and many of the risks remain.
Crypto-collateralized: MakerDAO (DAI)
One way to get around the risk of centralisation is to take the entire process on chain, and this is exactly what crypto-collateralized stablecoins propose. As the name suggest, these coins are backed against the value of other cryptocurrencies. This may seem entirely counterintuitive- what good is pegging your coin to an asset that itself fluctuates wildly in value? Most projects have got past this through overcollateralization, i.e. holding more of the collateral currency than is required to cover the market cap of the stablecoin. A stablecoin collateralized with Ether, for instance, will hold enough to cover the market cap of the stablecoin, plus some more (as much as 2:1) to cover the dips.
One such project is MakerDao, and its DAI token. DAI is an ERC-20 token pegged to the US dollar, with no dollar reserves. It stability is not mediated by the legal system or trusted counterparties, with the value of DAI kept pegged to the dollar through a series of smart contracts. It isn’t completely intuitive how it works, so bear with us here.
The most important smart contract for understanding how MakerDao works is the CDP, or collateralized debt position. A user pledges collateral (usually Ether but MakerDao is moving to a multi-collateral approach) and receives Dai in return. To give an example, a user depositing $100 worth of Ether would receive $66 worth of Dai- this is how the overcollateralization works. If a user wants their Ether back, they return the full amount of Dai plus a little interest. Once they have Dai, it can be exchanged freely just like any other ERC20 token.
One question is why would anybody want to lock up their Ether in a CDP? The most prominent use case for entering into a CDP is for making a bet on the long term value of Ether. If you believe Ether’s price will increase, exchanging it for Dai allows you to take a liquid chunk of that value. Users deposit a volatile asset and borrow a stable one in return. Exchanging the Dai you just received for more Ether and adding that to the CDP is also possible, allowing margin trading to accomplished entirely on the blockchain.
In each scenario of Dai’s price exceeding or falling below $1, there is a mechanism for restabilising it. If Dai falls to 90 cents, for instance, it makes sense for CDP owners to purchase Dai and use it to unlock $1 worth of Ether, securing a profit. This is a rational course of action for the market to take, but it doesn’t account for the idea that traders might be more inclined to hold onto Dai if they believe it can go even lower than 90 cents. If on the other hand the price of Dai gets too high, CDP owners will be able to create Dai and immediately sell it at a profit on an exchange. These two mechanisms are envisaged to work in tandem, keeping the price stable.
It hasn’t been quite as simple as that though, with Dai trading at below $1 for the past few weeks at the time of writing. The solution has been to increase the stability fee, which essentially makes borrowing Dai more expensive. The stability fee is an annual interest rate, that users must pay back when their CDP has been paid off and they want their Ether back. These fee increases were ratified by holders of Dai in a vote, and it will be interesting to see if the new rate of 16% will help, or if further increases will be needed.
The main trade-off between using a crypto-collateralized token like Dai over something like Tether is that while the process is far more transparent in how it works, it’s also a great deal more complex. While something like Tether, for all its faults, makes intuitive sense, Dai is more difficult to understand for the masses and new entrants to cryptocurrency. Dai is also a great deal more susceptible to a black swan event, in which the price of Ether could decline until there wasn’t enough to cover all CDPs. MakerDao suggest that a mechanism called ‘global settlement’ would account for this, by basically buying back all the Dai in the market at a set price point, but until we see this in practice it is impossible to know how well it would work. It should be said that the $1 peg held well during 2018’s bear market and some deep sell-offs of Ether.
In conclusion, fiat-collateralized stablecoins seem doomed to have some degree of centralisation. This might not be a major issue, but with the biggest name in the space operating in a less than transparent fashion, it does not engender trust. Crypto-collateralization offers a solution in theory, but tokens like Dai are still low volume and we don’t really know how they will hold up if the market drops far enough.