What It Takes to Make a Coin Stable
Currencies are supposed to be both a unit of exchange and store of value. If the price of a certain asset moves at a daily average of 10%, it is not a worthy store of value nor a medium of transactions. This is where stable-coins come into play.
What is a stable-coin?
Generally, it is a digital coin pegged to a real-world currency (or index) like the US dollar. For example, if the average Joe wants to create 100 tokens he must deposit USD 100 which are then stored somewhere in case he decides to redeem his coins later. After getting back those USD 100 the tokens are destroyed. Sounds simple but it is not. This creates the image that the token is merely a digital representation of the dollar and not a real cryptocurrency. So what are the options?
All stable-coins come with some kind of attachment
Tether (USDT) is pegged to the US dollar, some other coins are pegged to the Australian Dollar, Japanese Yen, etc, but they could also be fixed to another cryptocurrency like Ether (ETH) and Bitcoin (BTC). It is implied that all stable-coins are pegged. But there is a problem, stable-coins are an asset that tries to price itself, not through supply and demand but because it says so and that is against every market principle. But of course, that does not mean that a non-volatile cryptocurrency could not be achieved. Currently, there are three basic approaches to that aim, but none of them is perfect.
1. Fiat-collateralized - Starting with the basics. If you want a stable-coin, you can back the tokens 1:1 with USD. Tether is an example. This is the simplest and safest approach, but it requires a centralized entity to hold the cash andregular audits. Plus It is slow and costly redeemable. It is one of the safest options due to the fact that there are no funds held on the blockchain, thus they could not be hacked and stolen.
2. Crypto-collateralized - The need for a central governance of the money goes against the decentralized dreams of blockchain enthusiasts. So there is another option to secure the tokens with cryptocurrency or Maker. Unfortunately, here 1:1 would not be possible due to the volatile cryptocurrency prices. That is why this type of projects are often overcharged, for example, USD 200 worth of Ether (ETH) for USD 100 in stable-coins, in exchange for the stability of the whole system. That creates a more decentralized and transparent network for a quick and cheap redemption of tokens and fiat. This is probably not the safest option in case the price of Ether plunges the system would have to quickly liquidate all coins leaving many with losses.
3. Non-collateralized - Probably the most sophisticated approach of all. Even though the dollar has lost its peg to the gold-standard, it remained functional. So do we really need a collateral? Maybe the answer lies in systems like Basis, a stable-coin project that raised around USD 113 million but it does not have a fully operational platform yet. In its whitepaper it outlines a strategy that aims to control the supply of tokens in correlation with the money supply. That is achieved by providing investors with an investment type of asset called shares and bond tokens. Simply put, holders of bond and share tokens receive interest for funding the project while also maintaining the whole network. The Basis protocol algorithmically adjusts the supply of Basis tokens in response to changes in the rate between its token and an arbitrary asset pegged to it. For example, the Basis-USD exchange rate. This implements a monetary policy similar to that executed by central banks, except it operates as a decentralized, protocol-enforced algorithm, without the need for direct human intervention.
Of course, that system is not safe from failure due to the fact that it depends on the active participation of the holders of bond and share tokens as otherwise, the system would not function.
So do we need stable-coins after all?
Stable-coins are critical to the future of crypto. But after going through the available options, we must conclude that there is no ideal stable-coin, yet. That does not mean that there will not be a successful stable-coin project but it rather means that we should not be looking for an early winner. If crypto has taught us anything it is that future is hard to predict.