What are Stable Coins?

A Stable Coin is a blockchain token^[1] that represents fiat value in the crypto sphere. That means that the value of the token should always be the same as the „stable“ fiat currency that it represents. For example, 1 Tether USDT should always be worth 1 Dollar USD, one Gemini Dollar GUSD should always be worth 1 Dollar USD and 1 DAI should always be worth 1 Dollar USD. Once the Stable Coins are issued they can be sent to user wallets (i.e. addresses) and, as intended, traded on the open market. Most Stable Coins use the fiat currency they represent as collateral that the Stable Coin can be later redeemed for. Others use cryptocurrency or similar collateral.

There are two main types of Stable Coins: Centralised Stable Coins issued by a company and Decentral(ized) Stable Coins issued by a smart contract^[2] on a blockchain and governed by a DAO^[3]. Let´s have a look at some of their advantages, disadvantages, and misconceptions.

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Centralized Stable Coins

Centralized Stable Coins are controlled by a company. The company decides how much Stable Coins to issue and redeem as it sees fit. For example, if more deposits are made, then more Stable Coins can be minted^[4]. If Stable Coins are redeemed, then that amount of Stable Coins can either be burned or held in a treasury ready to be issued when more fiat money comes in. This also means that for every Stable Coin there is the same amount of fiat value somewhere on a bank account, ready to be redeemed. The company has custody of all the collateral that is meant to back up the Stable Coin. The smart contract that mints the Stable Coin tokens is controlled by the company that issues the Stable Coin. Control means that these types of smart contracts can be updated and therefore changed by the company.

Risks

Centralized control implies that there is counterparty risk involved with Centralized Stable Coins. A Stable Coin is only as stable as the entity that issued it. For example, if you have a balance of Gemini Dollar but Gemini goes bankrupt, has bank or regulatory issues, then you might not be able to redeem Gemini Dollars. In addition, the market would likely discount the value of the Gemini Dollar, resulting in a loss.

Given the characteristics of Centralized Stable Coins, they can be muted. For example, in the event of an investigation into the suspicion of illegality the issuer might be forced to freeze Stable Coin holdings. A regulatory body could also declare that the Stable Coin itself is illegal, leading to the necessity to examine legal action to claim redemption.

Business models can also be a risk if the company that issued the Stable Coin decides to use the reserve for overnight „low risk“ loans. While the loans might seem low risk on the surface there could be an event where the loans default and the reserve that is supposed to be 1:1 with the issued Stable Coins is partially or completely depleted. Currently, none of the centralized Stable Coins take part in any kind of loans with Stable Coin collateral. However, this could change in the future and therefore would change the general model of 100% collateralization.

Decentral(ized) Stable Coins

The by far most used and successful Decentral(ized) Stable Coin is DAI which is used to represent value in USD. Each DAI token is equal to 1 USD that is to be paid out in ETH. For example, at the time of writing this article 1 ETH is worth 225 USD and 1 USD equals approximately 0.004456 ETH. If you were to redeem your DAI right now, then you would get 0.004456 ETH for every DAI.

Where does the money go?

Instead of depositing fiat currency to a bank account users deposit ETH into a smart contract as collateral for DAI. This loan is referred to as a Collateralized Debt Position (CDP). The CDPs are overcollateralized in order to keep enough ETH in the system at any time DAI is redeemed. For example, you deposit 1 ETH into a CDP and get out 50 DAI for free use. When you deposit 50 DAI back in the CDP you get your 1 ETH back and the 50 DAI are burned. This is the basic structure of how the system works, but who or what runs the system itself and how are they paid?

The incentive structure of the Maker DAO

Unlike the Centralized Stable Coins issued by companies, DAI is issued by a Decentralized Autonomous Organization called Maker DAO. The DAO is a set of smart contracts with predefined rules. Some rules can only be adjusted by holders of the token MKR. MKR is referred to as a „Governance Token“ since the holders govern by voting on those smart contract parameters using MKR. MKR tokens incite holders to keep the whole system running smoothly; they receive fees (stability fees) that CDP beneficiaries have to pay. If the holders of MKR fail to keep a good governance resulting in liquidation, then MKR would have to be exchanged for ETH and, at the same time, result in a price decrease.

Advantages

The main advantage to DAI is that anyone can interact with the Maker DAO smart contract. For people that already have ETH wallets and have some technical knowledge, it is very easy to lock up ETH and, in return, receive DAI. Since DAI is an ERC-20^[5] token in the Ethereum blockchain database, DAI can be used in other blockchain applications („dapps“) that run on the Ethereum plattform. This versatility also enables so-called decentralized leveraged trading: For example, if you lock up 1 ETH and get 50 DAI out of your CDP and then purchase more than 1 ETH using those 50 DAI, then you increased your total of ETH. However, things could turn out differently.

Risks

The counterparty risks involved with Decentralized Stable Coins are different from those named in connection with Centralized Stable Coins, and most of all a question of smart contract design and governance. When it comes to DAI, there could be a technical error in the smart contracts, the stability fees could get extremely high, or the private key to the wallet gets lost or stolen. Maker DAO is a very interesting project and DAI by far the most successful Decentral(ized) Stable Coin to date, still it has its own set of risks and it will be interesting to see if it can hold its peg to the USD.

Stable Coins are not as good as cash

A common misconception is that Stable Coins are as good as cash. While they might seem to have very similar characteristics as digital cash on the surface there are a few key things that make them very different:

All of the transactions can be tracked, at least from which address to which address and how much was transacted. With cash, there is no direct trace of who is being paid what and how much. In addition, Stable Coins are not a bearer asset, they are mutable. The issuer of the Stable Coin is the owner of the smart contract or similar mechanism that mints or mutes the Stable Coin tokens. The owner is able to decide “these Stable Coin tokens are no longer valid“ and mute them, mark them as being invalid. This applies for Centralized and Decentralized Stable Coins.

„Stable“ Coin

The term Stable Coin creates a false impression; the promised stability is not inherent. Regardless of the issuers’ or other influence, fiat currency is not stable. Stable Coins simply are another representation of a fiat currency. However, not safe at all.

Conclusion

While Stable Coins are an innovation that allows for some interoperability between blockchain applications and new trading options, they also bring with them new risks and questions: For example, what is a Stable Coin’s advantage over online banking or PayPal? Is it a good thing that almost any company could release their Stable Coin on the one hand and mute or invalidate it on the other, at any time? Why is such dependency more attractive than regulated and therefore limited dependency on a central bank? It remains to be seen how the acceptance of Stable Coins will develop.

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* Theo Goodman has been working as consultant, advisor and in various roles in crypto and IT businesses. He currently acts as digital creative studio Proof Of Work’s meme consultant.

^[1]  See for example: Otto, Ri-nova 2018, 14.

^[2]  A computer program.

^[3]  Decentralized Autonomous Organisation, not to be understood in a legal manner.

^[4]  Minting describes the computer process of creating and validating information, i.e. the information about the creation of coins.

^[5]  A standard that promotes the fungibility of tokens.