LeoGlossary: Algorithmic Stablecoin
Stablecoins are becoming an important component to cryptocurrency and the financial system that is being built. This include decentralized finance (DeFi) through the associated applications.
One of the key components is the price stability as compared to other coins and tokens. Cryptocurrency is known for its volatility, a factor that makes it less desirable as a medium of exchange. This is where stablecoins can provide functionality.
Basic Structure
A stablecoin is a digital currency that is pegged to something else. This is most often the U.S. dollar although there are other currencies starting to be used. Also, the token be pegged to something outside fiat currency. There are some who proposed stablecoins based upon Bitcoin or gold.
Due to the low transaction fees associated with blockchain, stablecoins are emerging as a vehicle currency for transactions occurring on these networks.
The goals of a stablecoin are:
- capital efficiency
- decentralization
- peg stability
Stability is derived by using a unit of account, typically USD, to peg to. The reserve serves as a mechanism to provide the market with trust in the value of the currency. With USD denominated stablecoins such as Tether or USDC, they are backed on a 1:1 basis with either cash or U.S. Treasury bills.
The problem with asset backed stablecoins is they are centralized. Both Tether and USDC have organizations behind them. They are the ones who make the decision regarding the currency. Another issue is the problem with counterparty risk. The assets back the stablecoin are held with a custodian, something that could prove problematic in the case of insolvency.
Finally, there is the question of audits. Tether is long reported not to have the backing it claims. Risk is introduced here as people learned with Enron. Audits are only as good as the ones conducting them.
Algorithmic stablecoins seek to address these issues.
Two-Coin System
TerraUSD was the best known algorithmic stablecoin and created a stir when it collapsed. Before getting into the protections, it is helpful to know how a two-coin system works.
The first component is we have to deal with two coins that are base layer. This means they operate on the blockchain and are not written on a second layer (or sidechain). The latter will introduce other areas of risk.
By being resident in the base layer code, the risk with smart contracts is removed. Decentralization is also contingent upon the node system for the network as opposed to a company or entity setting up the stablecoins.
The "backing" is not a reserve like most stablecoins. With an algorithmic stablecoin, the market capitalization of the two coins are compared. The value of the first coin is used to "back" the stablecoin.
This is how TerraUSD was set up. The problem there was the market capitalization of the stablecoin exceed the other coin. It is easy to see how this is an unworkable situation.
Another issue was the lack of fundamental value for the coins themselves. There was no utility for either which caused them to crack when the system came under stress. Without safeguards in place, the stablecoin imploded, causing the loss of billions of dollars.
Currency Value
Like any currency, the value of an algorithmic stablecoin comes from the utility or economic productivity that is generated by the coin. If TerraUSD was funding the economic output in the hundreds of billions, there would be utility for the coin. That was not the case.
One of the major goals is to create value on the stablecoin itself. This comes from the economic activity associated with it.
We can look at a few areas:
- payments
- funding and investing
- collateralization
- derivatives
As these are built out, the stablecoin has more value simply due to the utility tied to it. Once this is achieved, the backing is not relevant.
The other base layer currency is framed as a value capture token. This is BTC, ETH, or ADA. It is what most people think about when they hear cryptocurrency.
Again, value comes from the activity taking place on the network. Without there, there is little reason to hold the coin other than speculation. While this will suffice when people are bullish, if things start to head down, the reason for holding disappears.
The solution is to provide a reason for holding the other base layer coin. Since volatility likely eliminates price stability, something else has to come into play.
Probably the most basic reason to hold this type of coin, outside speculation, is to access the network. Most cryptocurrency coins that reside at the base layer are access tokens. They allow for people to write to the network.
On Ethereum, as an example, transaction fees (also called gas) are paid with ETH. Anyone who is transacting with that network will pay some ETH on each transaction.
Using TerraUSD as an example, there was little reason to hold the other coin, LUNA. It did provide some governance for the ecosystem yet that was not enough to withstand the market activity when investors saw things collapsing.
Safeguards
Probably the best example of how this system can operate is with the Hive Backed Dollar (HBD) on the Hive blockchain.
The design of this is similar to TerraUSD. HBD is backed by the market capitalization of $HIVE. The unit of account is USD where each HBD can be converted to $1 worth of $HIVE. Here the unit of account is standard and the variable is the amount of the $HIVE that is distributed. Obviously, the higher the price, the less that is paid for each HBD.
One of the safeguards is the 3 day conversion window. When using the conversion mechanism, half the transaction is completed immediately. The remaining is paid out in 3 days. This is a security mechanism to prevent a money attack where massive amounts of HIVE are created out of the stablecoin, setting off a market panic due to large expansion.
Another is the haircut rule.
With HBD, there is a ratio established where if the market capitalization is is 30% of $HIVE, production of HBD will cease. This will remain under the ratio is back in alignment.
This means that conversations occurring during an attack will stop, causing the total HBD to stall and, eventually, reduce.
TerraUSD has no provisions of this nature in place. The market cap of the stablecoin was able to meet that of the other coin. With Hive, the conversion stops long before that point, keeping the amount of the stablecoin at a much lower level.
Weakness of Algorithmic Stablecoins
The main argument against algorithmic stablecoins is they are undercollateralized. This is something that is being repeatedly shown although projects such as Maker DAI utilizes overcollateralization as part of its design.
Here we see how financial engineering is involved in all of this. The solution is to tie the stablecoin to economic productivity. Then the value resides on the stablecoin itself and not the backing agent.
There is no reserve fund established and held by a trusted custodian. Many feel this is a weakness.
Benefits of Algorithmic Stablecoins
One of the major benefits of an algorithmic stablecoin is the elasticity that is provided. Even if tied to a unit of account, like the USD, it is not dependent upon the supply of either cash or equivalents to meet demand.
Algorithmic stablecoins can expand as the market (community) sees fit. If there is a need for more circulating supply, conversion of the other coin can take place. The reverse is also true if there is too much supply outstanding.
A view is that the global financial system is suffering from a shortage, especially of dollars. This is exhibited in the Eurodollar System which endured balance sheet constraints since the Great Financial Crisis (GFC). This has caused some to look elsewhere for solutions. Digital assets could provide that in the estimation of many.
Unit of account is important for a couple reasons. To start, the understanding of a dollar resides with much of the world. That means people are familiar with the exchange ratio to their local currencies.
Another is the fact that the central bank monetary policy can be used to had price stability. The U.S. dollar is often used since the Federal Reserve has the greatest reach. When looking at the economic productivity, nothing is close to the US dollar. This means the stability tied to that currency is greater than most.
An algorithmic stablecoin is not dependent upon the supply of dollars for the backing. It is only concerned with the unit of account. There is also no counterparty since nothing is with a custodian. The other coin resides on the open market.
General:
Posted Using LeoFinance Alpha
