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Stablecoins: A Gentle Introduction, Part Two

In this document, we will examine the second of two main categorization mechanisms for stablecoins: the mechanism by which they maintain their price stability.

 

Stablecoins – artificially price-stabilized cryptocurrencies collateralized by secondary assets – utilize a variety of stabilization mechanisms by which to maintain their price pegging. Which mechanism is utilized relates to both the asset that is used as collateral and the level of decentralization that is sought.

 

Before we dive in, a brief recap of the main points from the previous document: there are two main categorizations we are using to analyze stablecoins:

 

– which assets they are collateralized with,

– and which mechanisms they use to maintain their price peg.

 

Part One dealt with the first of these two categories. In this document we’ll be looking at the second categorization tool – not what they use as collateral, but instead how they stabilize their price.

 

Centralized and fiat-backed stablecoins

“Centralized or fiat-backed stablecoins, which are run and entirely controlled by the private companies that issue them and receive traditional bank deposits in return for issuing their respective currencies to their customers, are currently the most popular stablecoin designs in the global cryptocurrency market”.

 

Centralized or fiat-backed stablecoins have a simple stabilization mechanism, which is both their biggest advantage yet also one that undermines any claims to their being ‘decentralized’ in the sense of being censorship and collusion resistant. This mechanism is the simple claim that for each unit of (e.g.) USDT – Tether’s stablecoin – there is one dollar in Tether’s bank account matching this. There are several advantages to such stablecoins: they are relatively simple to implement and are also relatively risk-free, as they rely partially on existing ‘legacy’ financial infrastructure. There are obviously issues considering centralized ones (aside from the obvious ones to do with having a currency reliant on a single party) as it relies on ‘legacy’ assets that lead to things like bank audits.

 

In reality, this hasn’t necessarily always proved to be easy to track – much like normal banking. Tether has come under increased scrutiny over the years amid claims that it doesn’t actually have enough money in its bank accounts to properly maintain USDT’s peg with the US dollar, and other centralized stablecoin providers have been forced to use the same terms of service as more traditional digital financial instruments like PayPal, meaning that the sale and transfer of their currencies can be arbitrarily denied at the whim of the company. Neither of these aspects make centralized stablecoins a ‘cryptocurrency’ in the traditional sense, as they neither implement a decentralized architecture nor are they collusion or censorship-resistant. Furthermore, their price stabilization depends entirely on trusting third parties (e.g. bank auditors, the company itself), with these processes themselves being opaque and ultimately lacking any accountability mechanism.

 

(More) decentralized architecture: stablecoins using crypto as collateral

On the other side of the spectrum are stablecoins that use cryptocurrencies as collateral and rely on a far more – if not fully – decentralized architecture. These coins, lacking both in a centralized party supplying the collateral for price pegging and a stable asset for collateral, have to employ a far more complex architecture and stability mechanism. The most well-known of these are Collateralized Debt Positions; stablecoins which “effectively loan their respective stable currencies into existence with the collateral they receive from their users in a fashion that similar to how commercial banks loan national fiat money into existence through fractional reserve banking” by depositing cryptocurrency in a smart contract.

 

A notable example: DAI

Users of these currencies – the most notable of which being DAI – are charged a ‘stability fee’ in order to take into account the instability of the underlying asset or assets. MakerDAO – the group behind DAI – require users’ debt-positions to be overcollateralized, the “collateral-to-debt ratio” to be 150%. Once this ratio falls below the ‘collateral liquidation ratio’, the MakerDAO smart contract will liquidate deposited collateral for either MakerDAO’s own token – MKR – or DAI depending on DAI’s current price (i.e. whether it’s at or below the price of the dollar). Deposited collateral is used to buy Dai if the price falls under $1, in order to reduce the overall supply in circulation. Furthermore, “the MakerDAO will burn the Dai that it buys with collateral or newly minted MKR tokens to reduce its supply and thereby raise its price back to its peg. When the price of Dai rises above $1, the MakerDAO smart contract will sell newly minted Dai for MKR tokens to bring Dai’s price back down to $1. Increasing the supply of MKR tokens when CDPs are undercollateralized and the value of Dai is below $1 reduces the value of MKR and thereby allows MakerDAO to “punish” MKR holders for bad governance decisions.”

 

Dai’s reliance on a complex cryptoeconomic system involving two tokens and various fees may be daunting for newcomers to cryptocurrencies, yet it remains as one of the most-used cryptocurrencies, with daily trading volumes often exceeding $15 million, and a relatively-user friendly interface (for a cryptocurrency). Although its price is relatively volatile in comparison to centralized coins like Tether, with its price dropping to $0.931 in November 2019, this was quickly corrected for. Given Dai’s intended use as a ‘daily’ currency – as opposed to a more speculative asset like Bitcoin or Ether – this price fluctuation would not be noticed in the sort of transactions it is intended for.

 

Furthermore, as discovered in March 2020, even when a large dip in the price of Ether caused a rash of liquidations to occur, the members of MakerDAO were able to retain a relatively stable price peg by reducing the stability fee from 8% to 4%. There are, however, efforts to show that Dai’s stability can be undermined; the work of Ariah Klages-Mundt and Andreea Minca shows that theoretically “arbitrage-like opportunities around stablecoin liquidations” can be profitably leveraged by an attacker. This being said, at the time of writing there have been no such reports, and Dai overwhelmingly fulfills its mission to be a stable, decentralized, transparent cryptocurrency.

 

Conclusion

There are several notable stabilization mechanisms for stablecoins, with the most notable being the aforementioned Collateralized Debt Position used by MakerDAO’s Dai. Although potentially susceptible to attacks as mentioned above, as of yet Dai has withstood numerous potential issues, retaining its price pegging throughout, standing as an example of the sort of stability mechanism that properly designed cryptoeconomic systems can facilitate.

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