The Risk of Uncollateralized Stablecoins

If you haven’t already, read this story to gain an understanding of the different types of stablecoins. This piece is the start of a series on the risks of different stablecoin models. This article is focused on uncollateralized, also known as algorithmic, stablecoins. There are many uncollateralized stablecoin projects in the works, most notably Basis.

Increasing Supply

Uncollateralized stablecoins control supply to keep the price stable. For this article, assume the stablecoin is supposed to be priced at $1. When price goes above $1, the algorithm increases supply by minting new tokens. The hope is that the new tokens will be sold off and bring the price back down. The big question here is, who gets the newly minted tokens?

Basis uses Share tokens. Holders of the shares get newly minted stablecoins when supply is increased. However, shares only get new tokens after the bondholders are paid, this concept is explained in the Decreasing Supply section. This payment of newly minted tokens is what gives the shares their value, however, this relies on increasing demand. If demand growth slows or even stops, no new stablecoins will need to be minted. This would cause the shares to lose their value.

Other projects employ different mechanisms for increasing supply. Kowala mints new tokens through block rewards. If demand increases and price goes above $1, the block reward is increased. Fragments issues new tokens to every holder, distributing new tokens proportionally to holders.

Decreasing Supply

Looking at the second situation, when the price goes below $1, things get complicated. If the price is below a dollar, the algorithm must reduce supply. A common way for uncollateralized stablecoins to reduce supply is through offering ‘bonds’, Basis calls them Bond tokens.

These bonds are sold on an open market for less than $1 (assuming the stablecoin’s price target is $1). They are paid for in the stablecoin and promise to return 1 stablecoin at an unspecified time in the future. For example, a buyer pays .9 Basis (stablecoin) for 1 Bond token. This lowers supply and should theoretically bring the price of the stablecoin back to $1.

The issue here is that buyers need to be confident that the bonds will pay out. Bonds are paid out when the supply increases (the stablecoin price goes above $1). Just as with the shares, the bonds rely on an increasing demand for the stablecoin. If demand growth slows or stops, bonds may not be paid out.

Again, other projects have different mechanisms. Kowala lowers the block reward when price decreases and also institutes an additional transaction fee that will be burnt, lowering supply. However, it takes time to lower the block reward, and this doesn’t actually lower supply, it just makes supply grow less.

Oracles

Uncollateralized stablecoins require an oracle. Oracles provide external information to the blockchain. Read the article below for a more in-depth explanation. Understanding Oracles In the case of stablecoins, the oracle(s) provides price data of the stablecoin. The algorithm that adjusts supply needs to know the price so it can make adjustments.

These oracles are fundamental to the system. The system requires these oracles to be honest and provide accurate information on the current price. If the data provided is inaccurate the algorithm will make the wrong adjustments.

There are many ways to implement oracle. There can be a trusted system, where price data comes from centralized places such as cryptocurrency exchanges. The data could also be sourced from a group and take the consensus of the group as the ‘truth’.

Oracles are challenging to get right and always represent a risk. This is a risk that fiat-collateralized stablecoins don’t face. Stablecoins like StableUSD do not rely on an oracle, there is no adjustment of supply to try and control price.

Broken Pegs

NuBits, created in 2014, is an example of an uncollateralized stablecoin. While it was able to maintain its peg for a while, it first broke in June of 2016. The peg was then regained until March of this year and has not recovered since. A peg break is the worst case scenario for any stablecoin. However, uncollateralized stablecoins are the most at risk because they rely on market confidence.

NuBits Chart via TradingView

 

NuBits now sits around 10 cents. There is no market confidence left. Once this happens, the coin or token is essentially dead. Two major peg breaks will be hard for any stablecoin to recover from. However, fiat-collateralized stablecoins can survive a peg break if they are redeemable.

If a fiat-collateralized stablecoin, such as StableUSD, loses its peg (goes below $1), users can still redeem their tokens for $1 each. There are dollars in a reserve backing the stablecoins. This incentivizes people to not sell below $1 because they can just redeem it for $1 at any time, regardless of the market value. StableUSD and other redeemable stablecoins do not fundamentally rely on market confidence because they can be turned into real U.S. dollars.