);

Stablecoin types

Stablecoins employ different models in order to maintain the peg. There are 3 main mechanics, each with its’ own advantages and disadvantages.

 

I.Fiat-collateralized IOU’s

In this model, an entity issues stablecoin units, proportionate to the amount of fiat currency (or another asset) they hold. If the ratio is 1:1, the stablecoin is fully collateralized, if it’s less – undercollateralized, if more – overcollateralized.

The peg is maintained through reliable convertibility of stablecoin units into fiat reserves.

Pros :

Straightforward – easy to understand and conceptualize

Stable – If trust and transferability between the stablecoin and the underlying assets functions properly, stability holds. Since the mechanism is a literal 1-to-1 IOU, the underlying stability mechanism reduces the chance of high volatility.

Reliable fallback –  if implemented by the issuer, insurance or government can provide a fallback in the case of a black swan event.

Scaleable – can easily scale.

Cons :

Centralized – issuer holds a significant amount of power which can impact the value of the stablecoin.

Counterparty risk – requires trust in different counterparties: issuer, auditor, escrow provider

Vulnerable to external shocks – even with fallback mechanisms, an external shock can be severe enough to damage the system and impact the value of the stablecoin.

Stablecoins of this type: Tether USDT, TrustToken (TUSD)

 

II. On-Chain crypto-collateralized

Instead of fiat reserves held in escrow, this model relies on cryptocurrency collateral, which is held on a blockchain. The collateral itself is a decentralized and auditable asset.

There is no central issuing entity, instead, stablecoin units are created through a smart contract system, governed by a DAO (Decentralized Autonomous Organization)

This model employs over-collateralization to mitigate the volatile nature of cryptocurrency collateral.

The peg is maintained through reliable convertibility of stablecoin units into fiat reserves.

Pros :

Trustless – does not require trust in a third-party.

Transparent – being implemented on a blockchain, the health and inner workings of the system are accessible to be viewed by anyone.

Stable – if implemented properly, different types of collateral, overcollateralization and fallback  procedures ensure a high level of stability

Scalable – can easily scale if the collateral and actors allow for it.

Cons :

Not capital efficient – overcollateralization does  require much more capital than traditional reserves, thus utilizing it inefficiently.

Vulnerable to extreme volatility – even with fallback mechanisms implemented, the volatile nature of cryptoassets makes the whole system vulnerable in the case of certain black swan events.

Complex – not as easy to understand as a fiat-backed system.

III.Seigniorage shares (algorithmic model)

Unlike previous 2 approaches, this model does not use any collateral, but instead, relies purely on the balance of supply and demand for the stablecoin.

The algorithm tries to manage the amount of stablecoin units in circulation by expanding or contracting the total supply, according to demand from the market.

If the demand goes up, new stablecoin units are issued and sold on the market, thus lowering price to match the peg. Profits (seigniorage) from this operation are collected by can be used as reserves to buy up stablecoin units from the market when the price is below the peg.

If, however, the reserves become empty and demand is not restored, special types of bonds or shares are issued in order to remove stablecoins from circulation, with a promise to pay them back in the future, plus interest.

Since there is nothing of substance to back the value of the stablecoin, this model needs constant demand in order to maintain the peg. Another fundamental problem is that supply is actually never decreased with finality, making the whole system inherently hyperinflationary and unstable.

Central banks operate in the same way, but unlike central banks, stablecoin projects don’t have the force of the state to ensure a constant demand for their stablecoin units.

This approach is highly experimental and there are not successful implementations to this day. Nubits (USNBT) is a good example of this model holding up for some time, but eventually failing.

Pros :

Trustless – does not require trust in a third-party.

Transparent – being implemented on a blockchain, the health and inner workings of the system are accessible to be viewed by anyone.

Does not require capital  – no collateral means there is no initial capital required to run start and run the system.

Independent – does not depend on the value of another asset. held as collateral, to maintain the peg.

Cons :

Unstable – requires constant demand to maintain stability, but has no means to ensure it.

Operates purely on faith – no real assets backing means the value is fully dependant on the faith from the market.

Extremely vulnerable to black swan events and volatility – no liquidation into collateral and lack of fallback procedures put the system at a high risk of a rapid loss of faith and price plunge.

Inherently inflationary – unlimited issuance of new stablecoin units and the lack of a reliable and permanent supply contracting mechanism makes the whole model inflationary and puts constant downward pressure on price, making it harder and harder to maintain the peg in the future.

Complex – not as easy to understand as collateral-backed approaches.