What Makes a Stablecoin Trustworthy?

Ah, stability — a relatively personal word when it comes to degrees of meaning, but nonetheless inarguable when it comes to easing of the mind. Your definition of stable might be very different from the next person’s. You might consider a relationship where you both argue and make up on a weekly basis as stable, others would call it toxic. Is one statement more accurate than the other? No — not really.

It is with this in mind that I find the stablecoin industry, and crypto in large, highly peculiar. One way to think about stablecoins is to think about a globalized ancient language, or rather the lack thereof. Back in the days of Moses and Jesus, humans did not have a common tongue — we instead fought and bickered with our hands and feet until it frustrated us out of our minds. Fast forward a couple thousands of years, and English now serves as the primary language for us to communicate, trade and prosper universally. English, has made the world we live in more stable. It is fair to say that stablecoins provide the same component to the digital currency world. However, what exactly makes them trustworthy, and how may that change one day?

At the present moment, there are primarily three ways a stablecoin earns trust — but if you fudge the definition and pull back some curtains, you can make an argument that there are actually a couple more formats. For the simplicity of our current argument, let’s say there are 3.

One: Stabilization Through Centrality

This is the one most people are familiar with, and the form which has popularized tokens like USDT, USDS and USDT. In an Americanized world, with the USD as a global benchmark, multiple projects have risen to prominence by pegging their stablecoin to the USD in a 1:1 ratio. In a centralized system, this is often backed by equal collateral. I give Stably (the makers of USDS) $1 of real fiat money, and they give me $1 worth of USDS. Simple, right?

Unfortunately, there are multiple ways to do this. Tether, for example, does this behind closed doors — whereas TrueUSD opens theirs for audit on practically a daily basis. For Tether to maintain stability, it has to convince the market that it carries collateral equal to daily trading volumes, currently in the 10-figure mark. On the other hand, TrueUSD simply shows an excel sheet more or less. Which one is more trustworthy? Once again, this depends on the person looking through the hourglass rather than the object behind it. Other forms of centralized, collateral backed stablecoins use other resources such as gold, oil, or even expensive art. As long as a certain value is agreed upon and in demand, you could use anything as collateral —even Pokemon cards!

The primary issue with centralized backing of stablecoins is well… their centralization. This kind of defeats the purpose of decentralization of monetary policy that many digital currencies promised, and trades it for an ease of mind for investors and speculators because they have a safe house to store assets without worrying about volatility. In addition, if the United States all of a sudden went into hyper-inflation mode and the economy tanked, the stablecoins which are pegged to it would also immediately start seeing problems as well.

Two: Stabilization through Decentralization

If your biggest issue with stablecoins is the centralization, we have great news — why not try stablecoins which are decentralized instead? MakerDAO is one of the primary examples of this, as they use two coins — DAI & MKR, to weave an ebb and flow of the market in order to balance their stablecoin and peg it to the USD in a 1:1 ratio. The brilliance here is the on-chain issuance of these stablecoins, which makes them fully transparent and auditable because they are on the blockchain. In a way, these are more ‘pure’ than centralized stablecoins because they stay true to the ethos of the blockchain technology upon which this is all built on. But on the other hand, they are much more volatile than centralized currencies because of the underlying collateral — usually a bread basket of ‘low’ volatility crypto assets – they have some systems in place to account for volatility, but they were close in overleveraging the backing crypto assets a few times. Despite the complicated mixing and matching of digital assets to ensure balance and a low risk profile, these stablecoins are still subjected to market dynamics and can be more difficult to control compared to their centralized counterparts.

In a simple example, we would lock up “x” amount of Ethereum (ETH) in a CDP, otherwise known as collateralized debt position (hello 2008 financial crash) and pool a bunch of these CDP’s together, known as pETH. This is now your collateral, and DAI is generated based on your pETH where interest (earnings) is accumulated over time. Ethereum is by far the most popular form of collateral due to its historical usability and stability. But more and more diverse CDP’s are emerging, similar to the mortgage backed crisis of 2008. Buyers beware.

Three: Stabilization through… magic?

Kidding, not magic, but algorithms instead — which, one can argue are kind of like magic. If you aren’t familiar with seigniorage, it is the process in which governments make money by printing money. Let’s say the US treasury prints a single $100 bill, how much does the paper, the ink, and the manpower plus machinery cost — $20? If that’s the case, the $80 in profit is seigniorage. A balance is struck through algorithms where the US treasury would print more money in the event that the USD is too high by selling shares, and by buying bonds when it’s the price is too low. So instead of backing a price through collateral, an algorithm can remove or add money into a system through an algorithm to maintain price stability. Now, by applying this into the stablecoin sector, one can see the clear advantages and disadvantages of not having any form of collateral to maintain peg consistency.

The good news is that your stablecoin isn’t at risk from poor governance by a central government, nor market volatility from a collection of digital assets. In addition, the collaterals are freed up to use elsewhere — generating a giant positive externality in opportunity cost. But the downsides are that users must “demand” this stablecoin in order for the algorithm to work. In fact, the algorithm merely controls the supply of coins in order to balance the price for a perfect peg, but it is futile in trying to control the demand. If no one wants this coin, the algorithm cannot offload collateral to balance the supply of it like you would be with decentralized assets — making them not just complicated, but also risky.

Looking into the future

Is there a perfectly designed stablecoin today? Maybe — but probably not. That is precisely the exciting part of this sector. Projects like Stably are able to maintain their childlike curiosity and innovation while being protected by the larger movement into stablecoins. Much experimenting of collateral and algorithms are required to find the ideal solution — but at the end of the day, maybe there isn’t one. Perhaps, as we stated above, there is no perfect stablecoin because stability is in the eye of the beholder.