Stablecoins: The Solution to Cryptocurrency Price Volatility?

One of the latest trends in cryptocurrencies is a new breed of token that aims to tackle the problem of volatility in the market price of cryptocurrencies.1 They are known as stablecoins.

Referred to as the “holy grail of cryptocurrency,” stablecoins are touted as having the potential to promote widespread adoption of cryptocurrencies as a price-stable medium of exchange or store of value. Stablecoins are blockchain-based tokens that promise their users stability by either pegging the value of the token to a price-stable asset, such as gold or the U.S. dollar, or through complex economic models that assist in the management of supply and demand of the market.

Some of the popular stablecoins that have either already launched or are expected to launch in the coming months include Tether, MakerDAO’s DAI, BitShares, Basis, Carbon and TrueUSD.

At least one Canadian mining issuer is also trying to get in on the action by capitalizing on the growing interest in stablecoins. Canamex Gold Corp. (CSE: CSQ) has announced a non-brokered private placement of gold-backed tokens via an initial security token offering (STO), with a view to using the crypto-token model to fund the development of its Bruner gold project. The offering is believed to be the first time that a gold asset-backed crypto security token has been offered by a public company listed on a North American stock exchange.

Different stablecoins use different methods to achieve price stability. They can be broadly categorized into three main groups:

  1. the centralized IOU issuance model,
  2. the crypto-collateralized model, and
  3. the seigniorage shares model.

1. Centralized IOU Issuance Model

The first method to create a stablecoin is to issue a token that represents a claim on an underlying price-stable asset, such as gold or U.S. dollars. These types of stablecoins essentially represent an IOU.

Under this model, the stablecoins achieve price stability and derive much of their value from the fact that each token can be exchanged at a specified ratio for the underlying asset, similar to how the currencies of a number of countries used to represent an amount of gold under the gold standard.

The gold-backed tokens being offered by Canamex Gold Corp. are one example of a stablecoin based on the centralized IOU issuance model. Tether (USDT) is another. Each USDT stablecoin has a value equivalent to that of a single U.S. dollar. As a result, in order to ensure that the value of a single Tether equals that of a U.S. dollar, for each token that is issued, Tether Limited, the company behind Tether, must ensure that there is an underlying dollar available in the account maintained to fulfil the IOUs represented by the stablecoins.

The problem with this approach is that it is centralized.

Stablecoins issued under a centralized IOU issuance model impose substantial counterparty risk on the holders of the tokens. They require trust in the issuing party and the custodian arrangements that have been put in place to administer the collateral and fulfil the IOUs.

The limitation of this model has made itself clear with Tether, as Tether Limited has been subject to ongoing scrutiny due to the increasing supply of USDT and the lack of third-party auditing to confirm that the company possesses the funds necessary to cover the company’s circulating supply of USDT.

2. Crypto-Collateralized Model

Crypto-collateralized stablecoins are similar to stablecoins based on the centralized IOU issuance model, except that the underlying collateral is another cryptocurrency instead of a tangible commodity or fiat currency.

The crypto-collateralized model was pioneered by BitShares and is the model used by MakerDao and others. MakerDAO’s DAI stablecoin is pegged to the U.S. dollar, but backed by ether (ETH) held as collateral in an Ethereum smart contract.

The benefit of this model is that it is decentralized and does not require trust in a central party.

The collateral is held in a smart contract, where it can be accessed by paying back the stablecoin debt (e.g., the DAI) or can be automatically sold by the contract software if the value of the collateral falls below a specified threshold.

The disadvantage to the model is that the collateral backing the stablecoin is itself a cryptocurrency subject to volatile price fluctuations.

If the value of the crypto-collateral falls too quickly, the stablecoins issued could become undercollateralized. As a result, stablecoins based on this model need to be over-collateralized enough to absorb sharp price fluctuations in the value of the collateral (i.e. a higher valued cryptocurrency is used to issue lesser valued-stablecoins).

Another downside to the model is that crypto-collateralized stablecoins rely on complex mechanisms to ensure price stability that can be difficult to understand and may therefore be less attractive to many potential users.

3. The Seigniorage Shares Model

The third category of stablecoins is a non-collateralized cryptocurrency based on what has been referred to as the “seigniorage shares” model. It involves a system that algorithmically expands and contracts the supply of the cryptocurrency. Under this model, an initial allocation of stablecoins is created and is pegged to an asset, such as the U.S. dollar. The supply of the stablecoin then automatically changes in response to increases or decreases in the demand for the stablecoin.

The most common method for adjusting the supply of a stablecoin based on the seigniorage shares model is known as the “bonds and shares” method introduced by Basis. Under this method, an increase in demand causes the system to issue new stablecoins, thereby increasing the supply and ultimately lowering the value of the token to the targeted price. When the supply needs to be contracted to increase the value of the token, the system issues bonds with a par value of $1 that are sold at a discount to incentivize users to purchase them using stablecoins, which, in the process, removes the stablecoins from circulation.

When demand for the stablecoin returns to a point that the system needs to increase the supply, it pays out new stablecoins to the bondholders, in the order in which the bonds were purchased. Once all bondholders have been paid out, if demand requires a further increase in the supply of the stablecoin, the system then issues new stablecoins to those who own shares—the equity token of the system.

Shares represent a pro rata claim on future stablecoins that are issued when demand increases, similar to preferred shares that may represent a right to receive a portion of the dividends declared by the board of directors of a corporation from time to time. Additionally, the shares will also often also have voting rights attached to them.

The seigniorage shares model is based on the method used by central banks to maintain the stability of fiat currencies. The stablecoin projects that have adopted the seigniorage shares model are seeking to do what central banks do, but through a decentralized and algorithmic system.

The Future of Stablecoins

Stablecoins have the potential to act as an important catalyst to promote widespread adoption of cryptocurrencies as a method of payment for everyday transactions. While there are various factors that influence the success and popularity of a cryptocurrency, it is clear that addressing the problem of price volatility is crucial if a cryptocurrency is to serve as a reliable store of value to fulfil the monetary needs of businesses and consumers.

Although stablecoins remain highly experimental at this stage, there are a number of stablecoin projects that show promise for tackling the price volatility problem. The seigniorage shares model is perhaps the most promising and attractive model due to its decentralized nature and the lack of need for over-collateralization.

The centralized IOU model, however, has the potential to serve as an exciting, new financing tool for mining companies seeking to launch their own security tokens through an STO. With the announcement by the Canadian Securities Exchange (CSE) earlier this year that it intends to launch a platform for trading, clearing, and settling security tokens through blockchain technology, STOs like the one currently being conducted by Canamex Gold Corp. may be the first of many to come.

1 Bitcoin, for example, has seen incredibly high levels of volatility in recent months. Between mid-November and mid-December of 2017, the price per coin rose from approximately US$5,857 to over US$19,343, before falling to US$6,910 by early February of this year. The price of Ethereum is even more volatile. A single Ether can lose as much as 25% of its total value in a single day, only to regain it in the next.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.