Table of Contents
Definition of a Stablecoin
The Path to Decentralization
Stablecoins were initially created to allow day-traders, investors who earn an income from trading cryptocurrencies on a daily or hourly basis, to store the value of their deposited funds or accumulated wealth on unregulated and unlicensed exchanges that have no fiat-on ramps i.e. do not allow their customers to connect their bank accounts to their platforms.
In the future, some decentralized stablecoins such as Reserve may be so efficient that traders may lose almost no financial value other than transaction fees on the blockchain on which their transactions are taking place when they convert their speculative assets into stablecoins.
But the various legal problems associated with exchanging traditional digital money with centralized stablecoin issuers has prompted numerous entrepreneurs to take on the challenge of creating decentralized solutions that provide the on-chain financial stability that most cryptocurrency day traders are looking for.
Besides banning users from politically hostile countries, centralized stablecoins also prohibit the use of their cryptocurrencies for a range of financial activities that are perfectly legal in the US and in most jurisdictions. Circle, for example, lists the following legal activities in section 24 of its terms of service that it prohibits regardless of whether or not they’re legal in any of its users’ jurisdictions:
b) weapons of any kind, including but not limited to firearms, ammunition, knives, explosives, or related accessories;
c) controlled substances, including but not limited to narcotics, prescription drugs, steroids, or related paraphernalia or accessories;
d) gambling activities including but not limited to sports betting, casino games, horse racing, dog racing, lotteries, games of chance, sweepstakes, games of skill that may be classified as gambling (i.e. poker), or other activities that facilitate any of the foregoing;
h) debt settlement, refinance, or credit repair services;
i) court ordered payments, structured settlements, tax payments, or tax settlements;
k) lottery contracts, layaway systems, or annuities;
The restrictions listed in subsections h), i) and k) of Circle’s terms of service are particularly problematic, because they effectively make it impossible for Circle to be used as real-world money. Perhaps, centralized stablecoin issuers are taking a very conservative approach to regulating the behavior of their users to avoid all the potential legal problems that may be brought about by the fact that various US states and jurisdictions throughout the world often produce contradictory legal rules.
These are the kind of legal limitations that ensure that centrally issued stablecoins will always be nothing more than digital IOUs used on exchanges. Decentralized stablecoins, on the other hand, face none of these legal restrictions and have the potential to achieve global adoption outside of the sequestered economies of cryptocurrency exchanges.
Types of Stablecoins
Most decentralized stablecoin monetary systems fall into one of two design categories: collateralized and non-collateralized economies. But if we want to gain a better understanding of how these non-fiat backed stablecoins actually work we can divide them into 5 primary sub-types: elastic supply, bond-redemption, collateralized debt position, self-collateralized, and collateral redemption coins. The following diagram is a non-exhaustive list of decentralized stablecoin projects based on the types of stabilization mechanisms they have adopted:
1. Elastic Supply Coins
The majority of decentralized stablecoin projects use an elastic supply monetary policy in which a high interest rate is offered to users to incentivize them to hold the stablecoin in question when its value dips below its currency peg. A stablecoin monetary system that uses an elastic supply stabilization mechanism contracts the supply of its stablecoins when low demand causes the value of its stablecoin to fall below its peg and expands its stablecoins’ supply when the value of its stablecoin rises above its peg due to a sudden increase in demand.
Nu’s Elastic Supply Economy
The first stablecoin to use the elastic supply model was Nu: a hybrid proof-of-stake and proof-of-work blockchain that was created as a fork (modified copy) of Peercoin. Nu’s economy utilizes two native cryptocurrencies: Nubits, a stablecoin pegged to the US dollar, and NuShares, which have a fixed supply.
The holders of NuShares mint new blocks with their coin stake through Nu’s proof-of-stake protocol and are responsible for making governance decisions e.g. setting the interest rates for parking (locking in) Nubits whenever the price of Nubit falls below $1, and deciding how many new Nubits must be minted and given to a custodian (a non-shareholding market participant), who has the responsibility of creating large sell walls (sell pressure) when the price of Nubits rises above $1.
Weaknesses of Elastic Supply Monetary Systems
Nubits was unable to recover from its second depegging and has lost most of its value and all its credibility among its former users, some of whom called it a scam and threatened to sue its creators. Nubits may have ultimately lost its peg because the selling pressure of Nubit holders wishing to purchase volatile cryptocurrencies like Bitcoin was higher than the buying pressure of users who wanted to cash in on the interest rates offered for “parked” Nubits and the buying pressure created by Nubit custodians chosen by NuShare holders.
Elastic supply stablecoin economies use parked stablecoins and newly minted stablecoins provided to elected custodians as the “collateral” for their buy and sell walls on exchanges. Parking interest rates and newly minted coins may not generate enough capital at a fast enough rate to maintain a stablecoin’s peg in an elastic supply monetary system and the rate at which such “collateral” is generated during depegging events is very difficult to quantify.
The dynamic supply rate and the complete absence of crypto-collateral assets in elastic supply monetary systems makes them more cost-effective for stablecoin users than monetary systems that rely heavily or entirely on collateral assets to maintain the price of their stablecoins. This fact may explain why elastic supply monetary systems remain the most popular choice for an economic system among stablecoin startups building decentralized economies even though Nubits, a stablecoin with an elastic supply monetary system, was the first stablecoin to permanently lose its peg.
Most national monetary systems have no financial assets reserves whatsoever and rely almost entirely on a flexible interest rate and an elastic supply policy to maintain the value of their currencies while promoting economic growth. In the short-run most if not all stablecoins may not have high enough demand and supply rates to maintain a relatively stable price and may have to rely on a fully or overcollateralized pool of collateral assets to achieve price stability.
2. Collateralized Debt Positions (CDPs)
In Collateralized-Debt-Position (CDP) based monetary systems users deposit collateral into a smart contract and then receive a certain number of stablecoins equal to the value of the collateral deposited. CDP-based stablecoin economies 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.
Unlike traditional bank loans, the majority of CDP loans are backed by full-reserve or overcollateralized reserves of volatile crypto-assets, because speculative cryptocurrencies such as Ether and Bitcoin can rapidly depreciate in value at any point in time. Cryptocurrency exchange hacks, government bans on cryptocurrencies, and other unexpected or unexplained events can dramatically reduce the value of the collateral assets that back up a crypto-trader’s collateralized debt position.
The users of CDP loans are charged a daily and sometimes hourly interest rate that is calculated at and presented as a per annum rate. The interest that CDP holders pay is often referred to as the “stability fee”.
Most CDP monetary systems are built on the Ethereum blockchain and even though users can deposit a variety of assets including standard Ethereum tokens such as ERC-20 and ERC-721 (non-fungible tokens), the primary asset deposited into the smart contracts of each CDP-based stablecoin is Ether. CDP monetary systems are multi-collateral smart contracts that accept any token or tokenized asset created on the blockchains on which they were built.
MakerDAO’s CDP-based Economy
MakerDAO, the most prominent example of a CDP-based monetary system, uses two native cryptocurrencies: Maker (MKR), a volatile currency that represents ownership shares and governance power, and Dai — a stablecoin pegged to the US Dollar at 1:1 ratio. Like most CDP-based monetary systems, MakerDAO requires its users to overcollateralize their debt-positions. The average MakerDAO loan is overcollateralized with a collateral-to-debt ratio of 150%. As soon as the current collateral-to-debt ratio falls below the collateral liquidation ratio, MakerDAO’s smart contract will liquidate i.e. sell off all of its borrowers’ deposited collateral for Dai or MKR depending on the price of Dai and whether or not it’s at, below, or above its US dollar peg when issued loans are liquidated.
MakerDAO’s Price Stabilization Mechanisms
When the price of Dai is below $1, the MakerDAO smart contract will sell the deposited collateral to buy Dai in order to return Dai’s price to $1. And when MakerDAO’s CDPs are undercollateralized its smart contract uses newly minted MKR tokens to buy Dai instead of relying entirely on sold collateral to raise the price of Dai back to $1.
In either one of the cases in which Dai’s price is below $1, 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.
MakerDAO’s Stabilization Fees
Maker DAO charges its users a stability fee every time they return their borrowed Dai for their deposited collateral. The stability fee involves burning MKR tokens to reduce their supply and thereby increase their value in the long-run. In other words, the stability fee is the total value of MKR tokens that are burned as payment after borrowers return their borrowed Dai to receive their deposited collateral. The penalty fee, on the other hand, is the portion of returned Dai during the closing of a CDP that is used by MakerDAO’s smart contract to buy and burn MKR tokens. Borrowers pay the stability fee with MKR tokens when they close a CDP position and pay a penalty fee with a portion of the Dai they could have exchanged for their deposited collateral when the collateral-to-debt ratio falls to the point that it reaches the penalty ratio.
In addition to its stability fee (interest cost) on all issued loans, which can only be paid in the MKR token, MakerDAO charges its borrowers a liquidation penalty fee when the value of its users deposited collateral depreciates that is not only below the standard threshold ratio/liquidation ratio of 150%, but also below the minimum collateral-to-debt threshold of 135%. The penalty ratio fee incentivizes borrowers to pay their loans as soon as possible when the value of their deposited collateral is rapidly depreciating.
An Ether CDP could, for example, have a collateral-to-debt ratio of 150%, a liquidation ratio of 140% and a penalty ratio of 110%. The borrower in this case deposits $150 worth of Ether to borrow $100 worth of Dai. If the value of the deposited collateral falls to $140 worth of Ether, MakerDAO’s smart contract will sell off the deposited collateral for Dai or MKR until the loan is paid in its entirety. If the price of Ether continues to fall until the value of the deposited collateral depreciates to $110 MakerDAO will penalize the borrower at a rate of say 10%, for example, of the value of the returned Dai and take a portion of the returned collateral, in this case $10, to sell it off for more Dai or MKR depending on the price of Dai. The borrower will then receive any remaining collateral after the stability and penalty fee have been paid. If the stability fee is 2% then $2 plus $10 will be subtracted from the $110 worth of collateral leaving the borrower with $98 worth of Ether after all returned Dai is burned by the smart contract.
Dai Saving Rate
The DSR will be one of the new features included in multi-collateral Dai when MakerDAO launches and it functions in the same way as locked Nubits. Anyone who holds Dai can lock or unlock Dai into a Dai Saving Rate contract at any point in time. And like locked Nubits the locked Dai continuously accrues an interest rate. But since Dai operates on the Ethereum blockchain users have to pay an Ethereum gas fee each and every time they want to lock or unlock Dai from the DSR contract.
The DSR will be incorporated into MakerDAO’s price stabilization system in such a way that it does not have an inflationary effect on the total amount of Dai in existence at any given time. The DSR interest is funded with the revenue generated by the stability fee that Maker token holders set on CDPs. If the stability fee is, for example, 3% then Maker token holders would likely set the DSR to 2% to ensure that Dai is always overcollateralized.
Maker token holders also have a few additional governance tools to manage the DSR mechanism such as the Rates Policy Oracle, which they can elect in order to give this oracle the ability to modify the DSR within a predefined interval that they will set before or as soon as they elect said Oracle. The Rates Policy Oracle will be operated by one or more Governance Risk Teams who will have been elected by MKR holders.
When working with the predetermined DSR interval, the Risk Teams will also be able to use the Rates Policy Oracle to adjust the DSR interest whenever the price of Dai Changes:
If the price of Dai falls below $1, the Rates Oracle will raise the DSR to increase the demand for held Dai and lower the demand for CDPs in order to raise Dai’s price back to its peg by reducing the amount of Dai in circulation.Conversely, if Dai’s price rises above $1 then the Rates Oracle will reduce the DSR to lower the demand for holding Dai and increase the demand for CDPs in order to increase the supply of Dai.
Furthermore, if the price of Dai falls to a dangerously low level the Maker Governance Risk Teams, who will also be elected by MKR token holders, can shut down the DSR mechanism until its parameters are changed or its entire mechanism design is replaced by another stabilization mechanism in a collective vote held by MKR holders.
The DSR and stability fee move in the same direction, which means that when the price of Dai falls both the stability fee and the DSR will increase in value and the parameters of both of these stabilization mechanisms will fall in value when the price of Dai rises. MakerDAO thereby maximizes the effectiveness of its price stabilization policy by simultaneously deploying the DSR and stability fee whenever Dai’s slips away from its pegged price.
Weaknesses of CDP-based Monetary Systems
CDP-based monetary systems are considerably less risky than elastic supply economies, which could be undercollateralized at any point in time, but CDP-based economies are also collateral inefficient and create a diminishing rate of return for each round of borrowing in a leveraged position.
A borrower, for example, could deposit $150 worth of Ether for $100 worth of Dai when the collateral-to-debt ratio is to 150% by MKR holders and then use the 100 Dai to buy $66 worth of Ether. At this point in time the borrower would have $166 worth of Ether. He could then deposit $66 worth of Ether for $44 worth of Dai (44 Dai) and continue increasing the size of his leveraged position at a rapidly diminishing rate.
This graph shows how MakerDAO’s collateral-to-debt ratio produces a diminishing rate of leverage
MakerDAO’s current design not only makes it more expensive for traders to profit from decentralized leverage, but it also makes it harder for them to profit from arbitrage opportunities, which arise from the fact that the price of any financial asset periodically varies from one exchange to another.
MakerDAO’s 150% collateralization ratio forces arbitrageurs to incur a 33% capital cost when opening CDPs i.e. $1.5 worth of Ether will get them only $1 worth of $1 of Dai. In other words, they must pay a 33% capital cost every time they deposit $1 worth of Ether for $0.66 of Dai, which is 33% less or $0.33 of less Dai than a 1:1 or 100% collateral-to-debt ratio would give them.
As we shall see later on, collateral redemption stablecoins such as Reserve create the same arbitrage opportunities traders enjoy when they trade Tether or other centralized (fiat-backed) stablecoins that have a 100% collateralization ratio. Stablecoins that have a 1:1 collateralization ratio are conclusively more scalable, because they always produce an equal increase in supply whenever their market demand grows as illustrated by the following diagram of the stablecoin scalability cycle:
3. Self-Collateralized Stablecoins
Unlike CDP-based economies, self-collateralized stablecoin economies only allow their borrowers to use the volatile cryptocurrency created by their respective smart contracts or blockchains as collateral in their debt positions. Self-collateralized economies use debt positions in the sense that they loan their stablecoins into existence when their users deposit the volatile collateral generated by their smart contracts or blockchains.
Bitshares’ Self-Collateralized Economy
Bitshares is a blockchain and a decentralized exchange that was invented in 2013 to give cryptocurrency investors the ability to create market pegged assets (stablecoins) by buying up a certain number of Bitshares, its native volatile cryptocurrency, to generate a certain amount of a stablecoin that is equal in value to the deposited collateral.
Bitshares’ Smart Coins
Bitshares’ users have created a variety of market pegged assets i.e. cryptocurrencies pegged to the value of another currency or asset that are sometimes referred to as smart coins. Bitshares has developed a variety of smart coins over the past few years including: BitUSD, BitCNY, BitEUR, and BitGold.
To create 100 BitUSD, for example, a user would need $175 worth of Bitshares as collateral. Users who have a collateral-to-debt ratio of less than 175% would have their Bitshares liquidated in a forced settlement i.e. confiscated by the Bitshares blockchain and sold to Bitshares holders with larger collateral-to-debt ratios.
Weaknesses of Self-Collateralized Coins
Like Bitshares, most stablecoins with self-collateralized stablecoin economies tend to be even less collateral efficient than CDPs. Synthetix, for example, has a default minimum collateral-to-debt ratio of 500%, which can, however, be changed by Synth token holders.
The probability of the collateral token falling in value in a self-collateralized monetary system is greater than the probability of a collection of collateral assets losing their value in a multi-collateral CDP and traders holding leveraged positions may be acutely aware of this fact, which may make them very sensitive to collateral price dips in self-collateralized economies. Even CDPs that currently accept only 1 collateral token, cryptocurrency, or asset can transition with some difficulty to a more secure multi-collateral economy and become more resistant to sudden price gauges caused by panic selling. Self-collateralized economies, on the other hand, are by nature only able to support a single collateral asset, because their monetary systems were designed for the sole purpose of increasing the value of their respective collateral assets.
But its important to note that leveraged positions can destabilize any stablecoin economy regardless of how its monetary system is designed. Ironically, the higher a stablecoin’s collateralization ratio and the less collateral efficient it is the less likely it is to be affected by panic selling caused by the holders of leveraged positions trying to minimize their losses as fast possible. The destabilizing effect of leveraged positions in stablecoin monetary systems may explain why self-collateralized coins tend to have the least collateral efficient economies.
4. Bond Redemption CoinsBasis’ Bond Redemption Monetary System
Basis’ Stabilization Mechanisms
When the price of Basis falls below $1, the Basis blockchain asks Basis holders to burn their Basis in exchange for Basis Bonds that can be redeemed for Basis stablecoins at a 1:1 rate when the price of Basis rises back up to $1.
demand_before = $1.00 * X (X = 100 i.e. the amount of Basis currently in circulation)
demand_after = $0.80* Y (Y = the target amount of Basis)
demand_before = demand_after
$1.00*100 = $0.80*Y, 100 = 0.80*Y
Therefore Y = 100/0.80 i.e. Y = 125
Where the change in Y represents a change in magnitude of 25 or 25 more bonds
Users can burn Basis after exchanging them for anyone of the 25 newly minted bonds to restrict the supply of the Basis stablecoin in the short-term in order to raise its price back to $1 and make a profit of $0.2 for every Basis they burned before its price rises back to $1 and new Basis are minted and deposited into their accounts. Conversely, when the price of Basis rises above $1, the blockchain will keep minting and sending new Basis stablecoins to the holders of Basis Shares until they create enough selling pressure to bring down Basis’ price back to $1.
Basis Bonds are like a hybrid form of an option and a futures contract. Like options, Basis Bonds have a strike price i.e. a price at which the options contract, itself a tradeable financial asset, is redeemed for another financial asset: in this case Basis Bonds are redeemed for Basis when the price of Basis reaches the strike price of $1. But Basis Bonds are also like futures contracts to the extent that they are an agreement between speculators who buy them and the blockchain’s smart contract that issues them that speculators will receive a financial asset — in this case the Basis stablecoin — at a specified time in the future at a specific/pre-determined price.
On the other hand, Basis Bonds most closely resemble government issued bonds, because Bond holders are paid in a first-in-first-out (FIFO) order. Bonds bought earlier are thus worth more than bonds bought later, because bond holders would likely want to have their bonds redeemed for Basis as soon as possible if they believe that the price of Basis will rise back to $1.
Basis Bonds are sold in an open auction run by its blockchain for interested investors to purchase and they therefore exist as a stand-alone cryptocurrency that can be transferred from one account to another. This means that speculators who no longer believe that the Basis stablecoin will rise back to $1 when it falls below its peg may sell their bonds to other speculators who believe otherwise.
Strengths of Bond Redemption Monetary Systems
Bond redemption monetary systems are collateral efficient and unlike elastic supply economies they don’t have to increase their long-term supply in when creating short-term demand in order raise the price of their stablecoins in the short-term. Moreover, bonds unlike interest rates for parking, don’t create a net increase in a stablecoin’s supply i.e. when bonds are redeemed for new Basis, there is no net increase in the supply of Basis stablecoins, whereas when new Nubits are minted for parking fees the total amount of Nubits that exist after parking fees have fallen to 0% and the price of Nubits has risen back to $1 is greater than the amount of Nubits that existed before parking fees were raised to create investor demand for Nubits.
The continuous increases in supply in elastic supply economies when the price of their stablecoins fall below $1 creates an inflationary effect that produces a negative feedback loop in which the increase in supply of Nubits lowers the price of Nubits, which leads to an increase in parking interest rates, which in turn increases the supply of Nubits and the price of Nubits would once again fall in response to yet another increase in supply. So long as the demand or buying pressure created by an elastic supply economy’s parking interest rates in the short-term outweighs or counteracts the selling pressure created by an increase in the supply of its stablecoin in the long-run its stablecoin’s price will be stabilized. Bond redemption stablecoins eliminate the long-term inflationary pressure of elastic supply economies by replacing parking interest rates with bonds as the primary stabilization mechanism.
Weaknesses of Bond Redemption Monetary Systems
First of all, bond redemption stablecoins requires share token investors to believe that there always enough demand for Basis to generate new Basis. The less often the price of Basis rises above $1 the less money the holders Basis Shares will make. Mass adoption, if possible, would make the price of Basis so stable that the only way that the holders of Basis Shares could earn a profit is creating artificial demand for Basis and pumping its price in order to earn an income in the form of newly minted Basis. The holders of Basis Shares, therefore, have a financial incentive to destabilize the price of Basis.
Secondly, the holders of Basis Shares can sell off their newly minted Basis stablecoins during periods of excess demand in order to bring down the price of Basis back to $1, but they also have a financial incentive to let the price of Basis rise as much as possible for as long as possible in order to maximize the amount of newly minted Basis stablecoins they receive from the blockchain and sell for short-term profits. Shareholder’s desire to maximize short-term profits from newly minted Basis may lead to short-term price volatility, because it may take some time for non-shareholding speculators to realize that it may in fact be futile to try to profit from Basis’ price movements.
Thirdly, bond redemption economies may leave investors with worthless bonds, because their stablecoins need to be in constant demand in order for their bonds to be an effective price stabilization mechanism. Moreover, the value of the Basis Bond is tied to the value of the Basis stablecoin and if the price of Basis falls far enough from its peg the majority of speculators may lose confidence in Basis’ ability to return to its peg and the minority of the speculators who bought Basis Bonds may end up with worthless bonds if the blockchain continues to lower the price of bonds for sale in its bond auction.
Basis uses a bond price floor and a bond expiration date to prevent bonds from losing their all their value, but the price floor cannot change the fact that the price of bonds is tied to the price of Basis and a 5-year expiration time period may or may not be a long enough to create a strong enough incentive for investors to buy bonds as soon as possible. The creators of Basis have not yet revealed how they arrived at the conclusion that the best expiration date for Basis Bonds is the end of a 5-year timespan.
Moreover, a sharp drop in the price of the Basis stablecoin may create a negative feedback loop in which the falling price of Basis causes speculators to shy away from buying bonds, which would in turn allow the price of Basis to drop even further and as the price of Basis continues to drop the price of bonds will once again fall until the value of Basis is so low that all speculators lose interest in buying bonds, which is when the entire monetary system will cease to function.
And lastly, it is very difficult to ascertain the amount of price-stabilizing collateral that bought bonds generate in the Basis economy. In anticipation of the possibility that purchased bonds may not produce enough short-term “collateral” to stabilize the Basis economy, the founders of Basis planned to use some of the $133 million they raised during their venture capital fundraising rounds to subsidize their trades against speculators trying to earn a profit anytime Basis’ strays away from its peg.
Even if Basis — with its current design — could survive without having Basis Shares being freely traded, it may not be able to raise enough collateral in the form of bought bonds to stabilize its price in the short-term, which is why the founders of Basis decided to wind down its operations.
5. Collateral Redemption Coins
In much the same way that CDP-based monetary systems loan stablecoins into existence with deposited collateral, monetary systems that use a collateral redemption policy generate their stablecoins when users deposit collateral into their collateral pools. But unlike, CDP-based economies in which users can only ever retrieve the entirety of their deposited collateral, collateral-redemption based economies allow their users to retrieve individual units of their deposited collateral at any point in time without having to pay a stability or penalty fee.
A user in a collateral-redemption economy can, for example, deposit $500 worth of Ether and $500 worth of Bitcoin for 1000 stablecoins and then retrieve only $3 worth of Ether and $2 worth of Bitcoin from the smart contract’s collateral pool after depositing 5 stablecoins, which are in turn burned in order to maintain the desired collateral-to-debt ratio. And unlike self-referential CDP-based stablecoins such as Bitshares, collateral-redeemed stablecoins allow their users to deposit a wide variety of tokens from a single blockchain or a variety of native cryptocurrencies from different blockchains if they have interoperable smart contracts.
Self-collateralized based monetary systems also allow their borrowers to redeem their debt for individual units of their deposited collateral, but their borrowers cannot deposit exogenous capital i.e. collateral that is not natively created by the smart contract or blockchain on which the stablecoin is built on. Collateral redemption monetary systems also differentiate themselves from CDP-based and Self-Collateralized-based economies by providing their borrowers with profit-seeking incentives to deposit collateral when their collateral pools are undercollateralized rather than punishing their borrowers with the threat of liquidating i.e. selling of their debt.
Reserve Protocol’s Collateral Redemption Monetary System
The Reserve Protocol is the first stablecoin to implement a collateral redemption monetary system. Like the majority of stablecoin designs the Reserve Protocol will be built on the Ethereum blockchain and will use only two native cryptocurrencies: The Reserve stablecoin and Reserve Shares. The Reserve Protocol also maintains a collateral-to-debt ratio of 1:1 or 100% i.e. the amount of Reserve stablecoins in circulation is always equal to the amount of collateral stored in Reserve’s collateral pool smart contract, which is referred to as the Vault.
Reserve Protocol’s Price Stabilization Mechanism
When the price of Reserve falls below its $1 peg to a price of, for example, $0.95 speculators can redeem their Reserve tokens for $1 worth of collateral and earn a profit of $0.05 for every Reserve token they redeem. They will continue buying Reserve tokens until the price of Reserve rises back to $1 and they’re no longer able to profit from the price difference between the Reserve tokens and the collateral backing it. As long as Reserve’s price is below $1, the protocol will burn Reserve tokens in order to reduce its supply and thereby raise its price back to $1.
When the price of Reserve rises above its $1 peg to a price of, for example, $1.05 the Reserve Protocol will sell newly minted Reserve Shares for collateral in order to maintain the Vault’s 1:1 collateral-to-debt ratio.
If the value of the Vault’s collateral assets falls to 95% of the nominal value of outstanding Reserve stablecoins (the total value of Reserve tokens in circulation) then the Reserve protocol will initiate a price band even if the price of the Reserve token is exactly $1. If value of the Vault’s collateral falls and the price of the Reserve token falls below its $1 peg then the protocol will use newly minted Reserve Shares as collateral.
Furthermore, if the price of Reserve falls to $0.95, for example, while all the collateral assets including Reserve Shares have fallen in value, then the protocol will create a price band with a range of $0.05 in which every $1 worth of Reserve tokens will be redeemed for $0.95 worth of collateral and each Reserve token will be sold for $1.05 worth of collateral. In other words, borrowers can only redeem $0.95 worth of deposited collateral for $1 worth of Reserve tokens and they have to deposit $1.05 worth of collateral to receive 1 Reserve token.
The Reserve token will also have a variable transfer fee that will be initially set to 0, but can be changed by the holders of Reserve Shares. The Reserve tokens collected through the transfer fee may be a source of revenue for the holders of Reserve Shares.
Reserve Protocol’s Collateral Maintenance Mechanism
To prevent short-term price volatility, the Reserve Protocol will sometimes overcollateralize its collateral pool by selling newly minted Reserve Shares for more collateral assets. Overtime, when the Reserve Protocol’s creators believe that the Reserve token is sufficiently stable they will allow the protocol to return excess collateral to the holders of Reserve Shares to maintain the collateral pool’s 1:1 collateralization ratio. Conversely, when the value of the Vault’s collateral depreciates and its collateral-to-debt ratio falls below 100% the Reserve Protocol sells newly minted Reserve Shares for collateral.
Reserve’s team plans to have at least three non-correlated crypto-assets at the when the Reserve Protocol is launched, but the Vault can if need be hold even a single collateral asset. The more non-correlated assets that speculators deposit the less likely it is for the Vault to be undercollateralized at any point in time.
Weaknesses of the Reserve Protocol
Firstly, when the Reserve Protocol first launches new Reserve Shares will be minted whether the vault is undercollateralized or overcollateralized and this initial design mechanism will create an overall inflationary effect that may lower the price of Reserve Shares in the short-term depending on whether or not the collateral assets appreciate in value.
But when the protocol matures to the point that the holders of Reserve share holders believe that the vault no longer needs to be overcollateralized no new shares will be minted in order to maintain a collateral-to-debt ratio greater than 100% and share tokens will, therefore, no longer suffer from monetary inflation.
The Reserve Protocol will, however, repurchase Reserve Shares with excess collateral when the Vault is overcollateralized until the total number of share tokens in existence matches the amount of Reserve Shares produced at the protocol’s genesis i.e. the date at which the protocol was first launched. After which the protocol will stop buying Reserve Shares from the open market and it’s therefore not designed to burn enough Reserve Shares to raise the price of share tokens in the same way MakerDAO buys and burns Maker tokens with newly minted Dai when the price of Dai rises above $1.
If the mass adoption of the Reserve stablecoin does not psychologically entice speculators to buy up Reserve’ share tokens then the holders of Reserve Shares can only make money when excess collateral is returned to their accounts unlike the holders of MakerDAO, who can reasonably expect the price of Maker tokens to rise in value when demand for its CDPs rises. In other words, if the excitement and FOMO created by Reserve’s mass adoption does not encourage speculators to buy Reserve Shares then the holders of these share tokens will have to rely on the Vault’s collateral assets appreciating in value as their sole source of revenue in Reserve’s economic system.
When I spoke to the Reserve team on Telegram and asked them about their decision to directly provide the holders of Reserve Shares with excess collateral from Reserve’s Vault, they said that burning Reserve Shares bought with excess collateral may produce negligible increases in their value especially when the protocol first launches.
They also argued that Share token holders would be overly reliant on Reserve’s economic system if buybacks continued past the point at which the Reserve stablecoin’s supply falls below its genesis supply point and that they would experience a net loss if the amount of shares minted in negative years (when Reserve’s price is less than $1) outweighs the amount of Shares burned in positive years (when Reserve’s price is greater than $1).
They further argued that a share price increase caused by pure speculation or as they put it — an increase in the net present value of time and risk discounted future cash flows — may outweigh the net losses caused by share token inflation. The fear of missing out when the Reserve stablecoin becomes widely adopted may even raise the price of the Reserve Share before the collateral stored in the Reserve Vault appreciates in value. This is a fair argument to make, but it rests upon a subjective outcome whose likelihood cannot be quantified.
The last and perhaps the most subtle argument Reserve’s team made against solely relying on share buybacks to raise the value of share tokens is that providing share token holders with collateral assets that have appreciated in value doesn’t require the holders of Reserve shares to make any assumptions about how speculators and their fellow share token holders will react to Reserve’s economic systems and its economic incentives.
Secondly, the fact that Reserve Shares are never burned means that speculators have no financial incentive to buy Reserve Shares whenever the value of Reserve’s collateral assets depreciates or remains roughly the same. Another argument Reserve’s team makes is that Reserve Share investors will earn healthy profit when the collateral assets stored in Reserve’s Vault appreciate in value, but there is an opportunity that said investors must forgo when they buy Reserve Shares instead of directly buying the assets stored as collateral in Reserve’s collateral pool. Furthermore, the cost of investing in Reserve Shares and thereby giving some of one’s hard-earned money to the Reserve’s founding team may be greater than the cost of directly investing in the assets stored as collateral in Reserve’s vault.
Reserve’s founders also argue that their decision to use tokenized stocks, bonds, and real-estate as collateral as they progressively decentralize the Reserve Protocol ensures that the Reserve Vault is sufficiently collateralized and that Reserve Share investors will profit when these assets appreciate in value, because the price of such assets generally tends to rise over time. But even if the tokenized assets appreciate in value that does not change the fact that Reserve Share investors could have still directly bought the assets used as collateral instead of the share tokens. On the other hand, they also argue that the collateral in Reserve’s system is mostly funded by stablecoin purchasers, not the Reserve Share purchasers.
Multi-Currency versus Single-Currency Stablecoins
Some stablecoin companies such as Bitshares, Celo, and Synthetix believe that the aggregate demand for multiple stablecoins may be greater than the demand for a global stablecoin and that creating regional stablecoins will accelerate the rate at which people across the world adopt their stablecoin systems.
The utility of regional stablecoins depends on the demand for such stablecoins among day-traders on cryptocurrency exchanges and the inflation rate of the regional currencies said stablecoins are pegged to. The most successful regional stablecoins (smart coins) in Bitshares ecosystem were BitUSD — a stablecoin pegged to the US Dollar — and BitCNY — a stablecoin pegged to the Chinese Yuan — because the fiat currencies to which they are respectively pegged to are widely used across the world due to their low inflations rates, and the large populations and political power of their issuing nations. Bitshares’ other stablecoins experienced less adoption and greater price volatility.
Conclusion
Collateral-backed stablecoins are less risky than their non-collateralized counterparts, but regardless of how they design their respective monetary systems stablecoin start-ups may may have to choose between the utility of a regional currency and the effective stability of a global currency depending on the aggregate demand of multi-currency stablecoins in the long-run.
NB: I have updated this article based on feedback from the Reserve Protocol’s team and I will occasionally make additional updates as the various stablecoin protocols evolve.
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