Stablecoins — an Introduction

Stablecoins — Introduction
Stablecoins satisfy the need for price stability. A Bitcoin does not always have the same value — it rises and falls. For a supermarket it would therefore be unthinkable to display a price on a product in BTC. With a Stablecoin, however, this would not be a problem. In this article I explain what a Stablecoin is in detail and how the complex system behind it works.

What are Stablecoins?
The blockchain technology behind Bitcoin or Ethereum has created many new applications. The use of crypto-currencies in everyday life is very difficult due to the high volatility.

But for traders, this feature is very lucrative, because it allows for larger profit margins. For an investor who wants to store his assets in another currency, this is of course a disadvantage.

For these reasons, crypto currencies are hardly accepted in shops. Stablecoins offer the solution to this problem. They are also crypto currencies, but these are much less susceptible to price fluctuations. The idea behind a price stable crypto currency was discussed in mid-2014. The first projects were started in 2017 with the BaseCoin or MakerDAO.

The three most important properties of a StableCoin are: Means of exchange, unit of account and retention of value.

How do Stablecoins work?
Each project has developed its own mechanism, which I will explain in detail in the following sections:

Centralized IOU output with value
The model of centralized IOU output is used, for example, by the world-renowned Tether. A centralized company holds assets and issues tokens for them. A token is like a kind of promissory note (IOU). The digital token thus receives its value because the claim to another asset is linked to a certain value.

The problem here is centralization. This requires a certain amount of trust in the issuing authority. In addition, it is necessary to check whether the corresponding assets are actually in the possession of the company — this point is important for the later payout.

This model creates a counterparty risk for the holders. In the past, for example, in the case of Tether, it has been questioned publicly on several occasions whether the company is solvent at all.

More security through cryptocurrencies
The second approach is to create a stablecoin based on another asset. The concept was originally developed by BitShares, but this option is now also used by other coins of this type.

Here, the stable coin gains its security through another decentralized crypto currency. The securities are stored confidentially in a Smart Contract, so users do not have to rely on third parties.

However, there is also a disadvantage with this concept. Volatile cryptocurrencies are supposed to cover the Stablecoins, but they are very volatile. If the value of a crypto currency falls too quickly, the issued stablecoins can no longer be adequately secured. The solution to this would be over-collateralisation, but this in turn leads to an inefficient use of capital.

Stablecoins without collateral
There is also the concept of unsecured Stablecoins. Most implementations use an algorithm or other system for this. Depending on the current price, the coins are issued or bought on the open market. This results in a counter-regulation so that the price can be kept as stable as possible.

The advantage is that this system is independent of other currencies. In addition, the system is decentralised, as no third party has any influence on it. The system is controlled exclusively by an algorithm.

However, the so-called “Seigniorage Shares Model” requires continuous growth to maintain its stability. In addition, it is very difficult to analyse and predict the extent to which the system can remain functional at all. It cannot be determined at what value the system would collapse and how much it can withstand at all. In the event of a crash, there is no collateral security because the value is not tied to any other asset. This disadvantage should always be considered.

Which Stablecoins are available?
The coins are divided into different groups. Each coin has a different binding or coverage. The page Stablecoinindex shows a large overview of current stablecoins.

Tether, True USD, bitUSD, USD coin and the Gemini Dollar (GUSD) are covered by the dollar. The Digix DAO has a gold bond and bitEUR or the STATIS EURS (EURS) have euro coverage.

Conclusion: Should Stablecoins be purchased?
The idea behind the Stablecoins is very important and absolutely necessary. Cryptocurrencies are decentralized, but are far from being price-stable and therefore unsuitable as a store of value.

Unfortunately, each concept to the Stablecoins still has advantages and disadvantages. A really optimal solution does not yet exist. The seigniorage shares model sounds promising at least as soon as a solution for the security risk has been found.

Tilmar Goos HWZ Zürich

Redefining Finance with SEBA Bank AG | PhD Accounting, Data Science, Blockchain & Digital Ethics