The Current 3 Stability Methods
All three types of the current stablecoin protocols and their various alternatives are flawed. This is true of both centralized and decentralized currencies, from fiat currencies to gold. These stablecoins are mostly based on pre-determined protocols and are reliable during optimal conditions. However, none of them will resolve all the issues confronting them when unpredictable market conditions arise or they are faced with uncertainty or significant volatility.
Here is a closer look at the current stablecoin methods and where they break down:
- Centralized and Fiat-collateralized
- Decentralized and Crypto-collateralized
- Decentralized and Non-collateralized
The protocol for this type of stablecoin is straightforward and can be described as a 1:1 transaction. A user deposits $1.00 (in fiat currency) into a holding company that acts as a centralized party. In return, the user receives 1 stablecoin that acts as a note and is equal to the $1.00. At any time, the user can return the note (stablecoin) to the company and have their $1.00 in fiat currency returned.
Although this method is simple and robust, it presents significant risks. A company that acts as a centralized party may fail to return the funds when requested or may create more stablecoins than actual money in the bank. The fiat and/or underlying assets may also be prone to volatility and instability.
This type of stablecoin is highly regulated as e-money institutions and overseen by bureaus such as the Financial Conduct Authority (FCA) and the Department of Financial Services (DFS). Therefore, a backdoor to control the coins is required.
There are significant issues for stablecoin companies that have created digital coins where their stability comes from being pegged against fiat currencies, such as the US dollar, Euro, Yuan, etc. We believe that in the future, governments will step forward with their own digital coin, instead of letting the market be controlled by private companies. Therefore, once this happens in the US, all stablecoins remaining in the market that peg against fiat USD will likely disappear since there’s no logic for the public to keep buying coins pegged against the USD from a private company when it can be bought directly from ‘Uncle Sam’. (See reference section links to governments that are exploring this option of Central Bank Digital Currencies.)
Unlike the centralized and fiat-collateralized method described above, with this type of stablecoin, users make their initial deposit with a cryptocurrency. This allows the transaction to be managed by a smart contract and helps remove the issues surrounding centralization. However, by removing these issues a new problem is created relating to collateral.
This stablecoin protocol works in a manner similar to a mortgage loan; users deposit their cryptocurrency as collateral and borrow against that stablecoin. Because the collateral is based on cryptocurrency and has to withstand price-volatility, the protocol must manage a loan to value ratio to keep a buffer, and lending is based on a low ratio such as 1: 2.
This protocol either works or completely fails and crashes. For example, if the value of the cryptocurrency-based collateral drops by more than 50% (which has happened more than once) the collateral funds cannot support this volatility and the coin will not be able to maintain its stability or its original value and has a high potential to collapse. At this point, the company managing the stablecoin will demand coin holders to return the stablecoin if the collateral value drop is 25% and the ratio reaches to 1:1.5. If the coin holders do not do this, then the company will resolve the issue through a foreclosure auction on the collateral offering it to the highest bidder—exactly like banks who take possession of homes that have not paid their mortgages on time.
This method is non-collateralized, using neither fiat nor crypto to support the currency. It is backed by a strong confidence in the coin’s stability. In order to make this method work, two things need to take place:
- The system needs to prevent the stablecoin from increasing in value above $1.00. This is fairly easy to accomplish. If the coin increases above $1.00 in value, the system can create additional stablecoins to reduce the price. By doing so, the price drops back to its original value.
- The system must also prevent the stablecoin from decreasing in value below $1.00. When decreasing value occurs, the system needs to burn coins and here is where a problem exists.
In order to remove coins from circulation, the users holding these coins need to agree to return them to the system in exchange for a future bond to guarantee they can purchase the coins at a reduced price. If—and when—the price of the coin rises above $1.00, the system creates additional coins and users can purchase these at a discounted price.
This method has a fair number of skeptics, as it is predominantly dependent on trust and leaves itself open to panic. This becomes problematic because panic tends to quickly and irreversibly degrade the value of the coin. For example, what if the system needs to reduce the number of coins in circulation to balance the price of the coin back to $1.00 and there are not enough users willing to participate in the future reward program? Or, what if the coin becomes so popular that organizing a buyback takes a few days?
These scenarios can potentially create instability in the coin’s value, furthering the uncertainty that generates public concern, rumors, and panic. This increasing sense of doubt is like a domino effect, often leading to a “run on the bank” scenario. All coin holders will start to minimize their losses by selling their coins at a deep discount fueled by fear of continued negative fluctuation. As this scenario escalates, competing stablecoin companies—or malicious individuals—are prompted to capitalize on these circumstances by spreading further rumors and uncertainty about the future stability of the coin (often referred to as FUD : Fear, Uncertainty and Doubt). Under any of these conditions, these stablecoins value will be on a rollercoaster that only needs to go down too far just one time in order to crash and not recover.
Fiat currencies and commodities can drop in value and even crash completely due to inflation. For example, inflation stood at 31% in Argentina in the third quarter of 2018, effectively boosting interest rates in the South American country to 30%. But a high rate of inflation can happen to any country, even in the US where during the ‘70s and ‘80s the inflation rate crested 10%. Traditionally stable commodities such as silver and gold are not immune to volatility either and their price can dramatically increase or decrease based on various market forces.
In 1929, the world economy plummeted into what’s known as the First Great Depression, which was the worst economic downturn in the history of the industrialized world, lasting for ten years. It began after the stock market crash of October 1929, which sent Wall Street into a panic and wiped out millions of investors. Since then, the world economy has been impacted by the 2007 financial crisis, where the US Treasury and Federal Reserve intervened to try to halt an economic collapse. Despite efforts, we still saw a recession take place in the following years which impacted many nations worldwide. Today, there continues concern that the world may fall into a Second Great Depression. For this reason, stablecoins that are governed, by a protocol that is designed to try to stabilize the coin carry a significant risk of crashing to a zero value contributing to economic turmoil.
Not only is the future unpredictable, but as things become more complex, we are now facing the risk that countries and companies can attack each other by finding financial and technical weaknesses in digital currencies. Can you imagine a scenario where a government like powerful groups from another nation sells a significant amount of stablecoins for the sole reason of significantly damaging US businesses and citizens? Or can you imagine that there is a popular stablecoin that dominates the US market and then China buys 51% of the supply of the stablecoin and takes control of the underlying blockchain?
