Stablecoins and the foundation for a new digital economy
What’s $1 worth?
How much is $1 worth? Well, it depends on what you’re measuring it against. Against currencies, one dollar in 2020 is worth 0.84 euros, 105.86 Japanese yen, 73.35 Argentine pesos, 421,000 Iranian rials, and 0.000084 Bitcoin. This is what’s called an exchange rate. You might’ve come across it when you try to purchase something from someone in another country or sell something to someone in another country.
But has $1 always been equal to $1? For that we have to look at its purchasing-power, or what can you buy for $1. In the 1900s, $1 could buy you 10 movie tickets, 5 pounds of sugar, or 1 pound of chocolate. In 2020, $1 can’t even get you a breakfast meal at McDonald’s. To put that in equal terms, $1 in 1990 is worth about $30 today.
Looking at this we have to ask ourselves, is the dollar really stable? Surely not, if it’s value against other currencies [foreign exchange] and against its historic rates [purchasing power] is constantly changing. Well then, who’s been secretly changing its value against other currencies and itself? Now you’re asking the right questions.
The value of the dollar is maintained by the Federal Reserve, the most important bank in the world. However, unlike your neighborhood bank, you can’t open a checking account in this bank, or take out a loan from it.
Well, you can, sort of. Let me explain.
The Federal Reserve is like the boss of all the other banks, telling them how much they can take in, and how much they can give out. In short, the Fed calls the shots, and since the dollar is used throughout the world, it calls the shots not just within the US, but in the world economy.
That’s all great, but how does it change the value? Well, again, through the other banks it bosses around. The Fed can’t just announce one day that $1 can buy you 10 happy meals and McDonald’s has to comply, they can’t influence purchasing power directly. What they can control is supply. The Fed can change the number of dollars within the country by printing more.
Wait, how can more the value of something change just because there’s more of it? Well let’s say there’s a shop on the corner of the street which makes and sells a watch for $1000. That may be a high price for a watch but since there’s no other shop which makes such a watch, and people really want to buy it, some watches may find a buyer for $1,000. If more shops spring up and make the same watch, they can sell it for a cheaper price, say $900 or $850 and sell more pieces despite a lower price per watch. The more the watches supplied, the cheaper they are. The same goes for dollars.
Simply put, the Federal Reserve can increase the supply of dollars within the economy by printing more. Since there are more dollars today than there were yesterday, the value drops. So, while it may seem like you’re getting a bigger paycheck, the stuff you would like to purchase has gone up as well.
Wait, the Fed is eating into my paycheck? How? More on this later.
There are times when the Fed has been forced to increase the supply of money in the economy, and there are times when it does it for political reasons. That’s an issue for another day. Either through force or for political reasons, the main problem the Fed, for right or wrong, has the power to change the value of something everyone, around the world, uses. Something which represents our monthly paychecks, which we use to buy our groceries, and pay our bills? Is it correct that one bank can change how much we receive? Agree or disagree, this is what’s called centralized finance; one entity making an important decision for millions, if not billions. Centralization is not a problem with just the dollar. All currencies issued by countries are centralized. In fact, currencies issued by countries are called ‘fiat currency,’ here fiat means ‘a decree.’
So, what is the benefit of using ‘centralized currency.’ Well, because they are controlled by a central bank [the Federal Reserve for the dollar], they remain stable. But you just said, their value changes! Yes, their value changes, but $1 yesterday is still $1 tomorrow. And this change in value won’t come about for a few years. Their value is stable, and that’s why they are so widely used. Because there is no other alternative to a form of currency that remains stable for a particular period of time, fiat currencies are still used. However, with the growth of digital currencies, this is now changing.
Over the past few years, a new form of digital currencies has been gaining steam. Present at the intersection of digital decentralized currencies, of which Bitcoin is the most popular and traditional centralized stable fiat currencies, of which the US dollar is the most popular, are ‘stablecoins,’ digital currencies backed by real or digital assets. These digital currencies are increasingly popular in the cryptocurrency market. They offer the stability of fiat currencies and the programmability of crypto. The most popular stablecoin’s price is tethered to the US dollar, so much so that it is not only backed by dollars 1:1, but it is called Tether or USDT. This stablecoin is so popular in the cryptocurrency world that its traded more than Bitcoin and Ethereum, the two largest cryptocurrencies, put together
You might ask, why does the crypto world need a cryptocurrency representing the dollar when it has Bitcoin and Ethereum. What’s the need for stablecoins? Well, stablecoins are not just a digital representation of the dollar, they are the bridge helping the decentralized currency ecosystem truly create a decentralized financial ecosystem.
One thing you have to understand about crypto – they are not stable! Two years ago, Bitcoin was priced at $6,500, Ethereum at $270. In 2015, Bitcoin was $230 and Ethereum a little over $1.4. Think back to what you could buy for $1 in 2018 and 2015, milk, gas or a cup of coffee. Chances are it was the same amount as you can now, it sure didn’t go up by 5,100% like Bitcoin did or 26,000% like Ethereum.
The problem with cryptocurrencies, is what stablecoins aim to solve; the problem of volatility.
While stability isn’t the forte of cryptocurrencies, they do allow for “disintermediation.” Put simply it means avoiding the middleman. The digital currency ecosystem allows parties to bypass intermediaries such as banks, regulatory authorities, auditors, tax officials, and other middlemen. Millions of dollars can instantly be sent between countries through BTC. The use of cryptocurrencies do provide universal access, and ‘disintermediation,’ but where it falls short is in the main domain of fiat currencies, stability.
To understand this volatility, let’s look at an example. If Adam wants to buy goods from Ron for $100, he writes Ron a check for the amount. Ron receives this check and deposits it into his bank, the Federal Bank of Ron. The Federal Bank of Ron asks Adam’s bank, the Federal Bank of Adam, to confirm whether Adam actually has $100 in his bank account. Once confirmed, the Federal Bank of Adam sends $100 to the Federal Bank of Ron, depositing it into Ron’s account.
This is a fairly straightforward process, but becomes more complex as the amount transferred increases. With transactions as large as $100,000, and even $1 million, there’s a massive increase in fees and friction. Domestic and international wire transfer fees are based on a percentage of the amount transferred and have limits on how much can be transferred based on location of the receiver, currency and banks. Friction, in terms of the time taken for the transaction, the parties involved, and the regulations adhered.
In the digital ecosystem, ‘programmable money’ gets rid of much of this, but adds another problem, that of currency risk.
Let’s look at another example, with a higher transaction amount, and Bitcoin as a mode of payment. Adam & Co. enter into a contract with Ron & Co. to purchase $100,000 in goods. With Bitcoin trading at $10,000 at the time of the contract being drawn up, Adam & Co. will pay Ron & Co. 10 BTC for the goods delivered. If Ron & Co. take 3 – 6 months to transport the goods to Adam & Co. the price of Bitcoin has to stay ‘stable’ at $10,000 for the contract to still remain true to the $100,000 goal.
If the price increases to $12,000, Ron & Co. are receiving more in dollar terms than goods sent [10 x $12,000 = $120,000] and if the price decreases to $8,000, Adam & Co. are paying less in dollar terms than goods received [10 x $8,000 = $80,000]. One look at the Bitcoin charts will tell you, you can’t bet on Bitcoin remaining stable.
Even though digital decentralized currencies offer instant transaction, universal access, and most importantly disintermediation one thing they can’t guarantee is stability. What can provide stability is fiat currency.
Here lies the use-case of stablecoins, to provide the programmability of cryptocurrencies and the stability of fiat currencies.
So, how can we bring that sweet stability to crypto?
What’s ‘stable’ in stablecoins?
What makes stablecoins ‘stable’ is what they are collateralized with. Put simply this means what are they backed by? In order for stablecoins to remain ‘stable’ the assets which back them must retain their value over time. Because of this a variety of assets have been used as collateral; fiat currencies, commodities, cryptocurrencies, and even a basket of currencies.
However, the most common stablecoins are those backed by government-issued fiat currencies [like the US dollar, the Great British pound, the euro, etc.], of which US dollar-backed stablecoins are the most popular. These stablecoins are called fiat-collateralized stablecoins. What are the other forms of stablecoins? Hold on to this question, we’ll get into this soon!
Stablecoins are digital currencies allowing users universal access, programmability and electronic transfer, while also retaining value over time. Since they are backed by real-world assets, typically in a 1:1 ratio, they retain their value as long as the asset backing them retains value. Since the US Dollar is seen as the ‘global reserve currency,’ or the most important and powerful currency in the world it is the most-pegged fiat currency to stablecoins.
You may be thinking, dollar-backed stablecoins are stable because they are backed by dollars, but what is the US dollar backed by? Remember how I said we’ll get into how the Fed is eating into your paycheck, here it is. The Federal Reserve can print any amount of money it wants and distribute it into the economy. While this does not change the face value of the dollar, its intrinsic value, or what you can do with it changes, like I mentioned earlier.
This illustration below explains how the Fed injects money into the economy and how it takes money out, affecting the value of money.
This next sentence gets a bit tricky, so read it twice. By virtue of dollar-pegged stablecoins’ stability being dependent on centralized decisions of the Federal Reserve, independent and true stability is absent.
To put it simply, the developers of stablecoins have outsourced stability to the Fed, so they can focus on something more important - programmability. Read that again.
To achieve a ‘stable stablecoin’ one which is not tethered to government-issued currency, we look to programmable stablecoins made on blockchain technology in the decentralized currency ecosystem. The words programmable, blockchain and decentralized might sound scary, but trust me, you’ll get the hang of it. However, before we look at stablecoins on ‘programmable blockchain-based decentralized currency’ let’s look at stablecoins made by an app on your phone!
The Dollar & Co.
While the dollar may be front-and-center in the stablecoin market, there are other stablecoins which provide stability with the backing of a basket of reserve assets. In fact, stablecoins have grown in popularity so much that even billion-dollar social media companies are launching their own version of digital currencies backed by a real-world fiat currency, no different from a fiat-backed stablecoin. The prime candidate is Libra.
In 2018, Facebook began recruiting a blockchain team from various top digital payments companies including PayPal and Coinbase, a cryptocurrency exchange and. Fast forward to June 2019, Facebook announced Libra, a stablecoin with a FAT asterisk next to its name.
Unlike traditional dollar-pegged stablecoins like Tether, Libra was not backed by just one fiat currency but by a basket of currencies in no fixed setting. This setting would be determined by the Libra Association, a consortium of over 25 companies, which includes Facebook. Initially top payment companies like Visa, Mastercard, PayPal and Stripe were founding members of the Association but due to regulatory pressure, they decided to withdraw their membership.
You may ask, why would governments have a problem with a group of private companies determining the reserve setting of a private stablecoin? Well, while Libra only aimed to change the reserve of their stablecoin, this very change would lead to the creation of an entire stablecoin in itself.
Libra initially stated that five fiat currencies [the US dollar, the Great British pound, the Japanese yen, the Singapore dollar, and the euro] would comprise the reserve along with short term government debts. Although the Libra Association did not confirm a specific ratio, Facebook did confirm that the US dollar would represent 50% of the reserve, allowing more US influence, meaning that the remaining 50% would be a mix of four other fiat currencies, in a changing ratio. This meant that in order to maintain stability, the Libra Association could change the backing of their stablecoin. That gives them the same power central banks have, and central banks didn’t like this one bit.
Regulators foresaw that this Libra experiment would lead to private companies interfering with the economic policy of countries. Given the retail companies in the Libra Association, its diverse group of merchants across telecommunications [Vodafone], ride-sharing [Uber and Lyft], music streaming [Spotify], cryptocurrency exchange [Coinbase], payments [currently – PayU; previously – MasterCard, Visa, PayPal and Stripe] and social media [Facebook, and by extension Instagram and Whatsapp], customers would switch from domestic fiat currency to Libra. Simply put, Libra would be so widely used it would become more powerful than any government-issued currency, including the dollar. To give a group of private companies that kind of power, especially when the spearhead of the Association, Facebook, has proved in the past that they aren’t afraid to sell personal data, was too much for regulators.
Countries issuing fiat currency not a part of the reserve would see a decrease in usage of their currencies, decreasing their value, and eventually affecting their economy. Even the currencies within Libra [USD, GBP, JPY, SGD, and EUR] would see fluctuation with citizens using a consortium of currencies rather than just one currency.
With many countries outright banning Libra and placing numerous regulatory hurdles in its way, Facebook and the Association decided to step back and change the very foundation of the stablecoin. In doing so, they gave it the look and feel of a traditional stablecoin that you would see in the cryptocurrency world.
In April 2020, the Libra Association released version 2.0 of their whitepaper announcing the creation of two forms of stablecoins – single-currency stablecoins and multi-currency stablecoins. Four fiat currencies would back four separate Libra coins, a USD backed LibraUSD, a GBP backed LibraGBP, an SGD backed LibraSGD and a EURO backed LibraEUR. The Libra Coin, according to the whitepaper, would be a “digital composite of some of the single-currency stablecoins available on the Libra network.” Facebook used the word “stablecoins,” to satisfy central banks, what does that tell you?
To the larger technology, finance, and policy world, Libra has been forgotten as a failed experiment to bring the world programmable, non-volatile, stable currency, but it marks a watershed moment in the growth of the digital economy. Companies in the Libra Association were able to recognize that the next ‘big thing’ in the world of technology and finance would be digital currencies, this is what Libra got right. In fact, every major world power since Facebook announced Libra, has revealed plans to create a digital version of their currency. However, what Libra got wrong, and where it will inevitably fail, is implementation. Its implementation from a centralized source i.e. the Libra Association,[similar to government-backed currency implementation through a central bank] and implementation through the backing of centralized fiat currencies.
What Libra wanted to do was create a way for users to transact financially within a system which would decrease reliance on banks and governments, and instead work with companies within the Libra Association. Regulators were worried about
What Libra got wrong is what the decentralized finance ecosystem is getting right. For the past few years there has been a massive amount of development in decentralized stablecoins, or, simply put, programmable currency which can be used for regular financial transactions between two parties and no intermediaries, all on the blockchain.
More than Just the Dollar
Stablecoins go beyond the dollar. In fact, stablecoins go beyond all forms of fiat currencies. While traditional ‘stable’ fiat currencies are, at first glance, the bastion of stability especially in a market as volatile as the cryptocurrency markets, in reality, there’s actually more to stablecoins than just dollar-backed stablecoins.
To provide the stability of stablecoins, and the complete decentralization of decentralized currency, there are crypto-collateralized stablecoins. These stablecoins are backed by a reserve of cryptocurrencies. Wait, what? Cryptocurrencies? But aren’t they volatile? Since cryptocurrencies are volatile, these crypto-collateralized stablecoins are backed in a larger proportion than are issued, in order to remain stable despite volatility.
The most popular and successful example of crypto-collateralized stablecoins is DAI. DAI is a crypto-collateralized stablecoin, which mirrors the value of the dollar 1:1, without being backed by it. One DAI and one USDT are equal, and valued at $1 each. However, one is a backed by crypto and valued at $1, the other is backed by fiat and valued at $1. While both are equal, to each other and $1, their backing is not.
DAI was developed by the MakerDAO foundation in 2015 to provide stable transfer of cryptocurrencies in a volatile market. Since volatility cannot be separated from cryptocurrencies, MakerDAO did the opposite. They decided to separate the crypto from volatility and in exchange give a stablecoin pegged to the value of the dollar, this is the basis for DAI.
Put simply, DAI is backed by crypto, but is valued in fiat and is roughly equal to $1.
Now let’s get into the weeds of it. Built on top of the Ethereum blockchain, DAI is a ERC20 token backed by ETH, the second largest cryptocurrency in the market. Since DAI is backed by crypto, it can only be issued by depositing a cryptocurrency. Initially this was limited to only ETH, but with the launch of ‘Multi-collateral DAI’ the crypto-pool has been expanded.
In order for you to withdraw and hold DAI, you have to pledge [as collateral] a certain amount of ETH. This ETH is locked up in a smart-contract called a ‘collateralized debt position’ or a CDP [now called a ‘vault’]. The value of ETH deposited, in dollars, is usually higher than the amount of DAI withdrawn. This is a form of over-collateralization. The reason for this is because ETH is volatile, but DAI isn’t, it will always be equal to $1. Essentially, you’re trading the volatility of your ETH for the stability of DAI, and because you’re receiving a stable cryptocurrency you’re pledging a greater quantity of the volatile cryptocurrency. [Don’t worry, I didn’t get it the first time either.]
But wait, why would anyone give ETH for DAI? Well, one reason would be to transact. As mentioned earlier, transactions, especially those which are not immediate, cannot be done in Bitcoin or Ethereum because they are volatile, hence, cryptocurrencies which are price stable, like DAI, are used.
Let’s look at this through an example. Adam holds 2 ETH [at the time of writing one ETH is worth $400], and wants to enter into a contract with Ron to purchase goods for $600. He can send Ron the 1.5 ETH for the exchange, but because of the volatility of the crypto-markets, the dollar-price of ETH might not remain stable at $400. In order to transact in a stable and decentralized currency, and not sell-off his ETH, Adam can pledge his ETH to get DAI. Here, Adam will lock his 2 ETH into a vault, in exchange for 600 DAI. The DAI Adam receives is over-collateralized by 133% i.e. 2 ETH worth $800 for DAI worth $600, to account for any possible ETH fluctuation. Through this, Adam can not only transact with Ron and get the $600 worth of goods but when he pays back the 600 DAI, he can unlock his 2 ETH.
A few simple caveats here to understand the full picture. Since taking out DAI is a form of a loan, backed by the ETH, there are fees to be paid on defaults. Like with other forms of borrowing, if the principal amount is not paid back, the asset collateralized will be sold to generate an equivalent amount of funds. However, in such stablecoins backed by crypto, the risk of non-payment is less, and the risk of market volatility is more. In the above example, if the price of ETH drops to $200, then the amount collateralized will be $400. This is lesser than the DAI taken i.e. $600. In such a situation, the decentralized system will calculate a liquidation price. This price is based on the current trading price of the crypto [in this case ETH], the same crypto pooled in by other market participants, and a penalty rate. MakerDAO defines the “Liquidation Price” as,
“This is the lowest unit price the staked collateral can reach before the CDP becomes vulnerable to Liquidation.”
Each asset backed for DAI has a specific “liquidation ratio” i.e. the ratio of assets backed against DAI taken. Currently, the liquidation ratio for ETH is 150% which means that for every $1 of DAI taken at least $1.50 in ETH should be maintained. If the price of ETH falls, the collateralization ratio will also fall, incurring a liquidation price or penalty payable by the borrower. Therefore it is important for borrowers to maintain a liquidation ratio higher than the advised one. This will help protect them against market volatility, avoid liquidation fees, and penalties and have the opportunity to buy-back their cryptocurrency in the future.
The underlying infrastructure of DAI allows the market participant to take on the desired risk. From the issuance of DAI to its liquidation, everything is based on the preferences of the concerned individual, impacting the pool as a whole. If the backed cryptocurrency has low expected volatility, the liquidation ratio is lower, allowing less crypto to be pledged for DAI taken, and vice versa. If the individual is of the opinion that the crypto-collateralized is likely going to increase in price, they maintain a liquidation ratio closer to the advised one, hoping for a rise. But most of all, DAI allows participants to conduct real-world transactions in a stable currency, across geographies, bypassing borders and regulatory-authorities, in no time at all, all with no human interaction, and only through a decentralized blockchain infrastructure.
Sounds like a win-win!
Decentralized Stablecoins: Are They Worth it?
On the face of it, DAI seems complicated to understand and even more so to execute. A decentralized cryptocurrency pegged to $1 backed by a larger proportion of volatile cryptocurrencies which changes in price so quickly that liquidation is all but guaranteed. What is the point of this form of stablecoins, why not simply use a fiat-backed stablecoin, or rather fiat currency?
While one can argue that decentralized crypto-backed stablecoins are complicated, they present the next frontier of decentralized finance, operating on blockchain technology.
Stablecoins like DAI are stable through the algorithmic market-collateralization of its users. And this possible not because it is backed by a reserve asset which can increase or decrease in supply based on the decisions of a central bank.
Stablecoins are no doubt an essential component of the digital financial ecosystem. To this day, stablecoins are merely used as an on and off-ramp between domestic fiat currencies and the larger cryptocurrency ecosystem, but it is far more than that. A new dimension of stablecoins is evolving, one is stable and decentralized. These stablecoins are creating, through blockchain technology, the foundation of a decentralized financial system that will soon be the future of the digital economy. In short, stablecoins are creating a stable digital currency with no central bank, and that’s big.
Check out our videos for more information on stablecoins: