Stablecoins Should Be Able to Withstand Market Shock - So Why Don't They?
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When you are considering living in a property, you have a decision to make - should you rent, or should you buy? It’s decisions like these that raise the lifelong recurring question of priority over which is more appropriate: long term investments, or short term ones? In these situations, it's crucial to pick when and where it is best to choose either kind. It’s the same with our finances in a modern decentralised world - Bitcoin, or Stablecoin? Try to hurtle towards success in a new cryptocurrency bull market, or stick to what works?
There is good reason to feel more inclined towards trusting fiat currency, or the value of a dollar over volatile cryptocurrencies. But how realistic is the stability of “stablecoins”, the decentralised tokens pegged to more consistent reserves of value such as fiat currency, diamonds or gold?
Different types of stablecoins might be stable, but this is characterised by a trade-off between the amount of innovation in their stability mechanism and how much actual stability they have in their value. The right balance must be found.
The Good and The Bad
The least innovative of stablecoin categories would be fiat-collateralized stablecoins, which are pegged to fiat currencies, usually at a ratio of 1:1. They also use traditional systems such as banks for keeping the fiat safe, while only relying on blockchain to merely issue the token that the fiat is represented by. This means that for every fiat-collateralized stablecoin, there is a fiat currency pegged to it in a bank account. Therefore, the value of simple tokenized fiat may be stable, as long as the currency they’re pegged to is.
Another type of stablecoin called “crypto collateralized” coins may sound better, but do they serve better? These tokens are pegged to other cryptocurrencies as collateral. With this kind, a set of protocols are required to make sure the price of the stablecoin remains at $1, due to the fact that crypto values are not that stable. However, an assortment of diversified crypto reserves allows the tokens to remain stable through market shocks. A mechanism of this kind involves over-collateralization. In this instance, a crypto-backed stablecoin could be pegged with a value ratio of 1:2. This would mean that for each stablecoin, a reserve of cryptocurrency worth twice the value of stablecoins is held, to help “cushion the blow” of dramatic market changes.
This method sounds attractive, but what flaws does it have? An example of a token with this mechanism in place would be MakerDAO’s DAI stablecoin. It is questionable whether DAI’s stability mechanism could really support the token should there ever be a rapid depreciation in value of any of their crypto reserves, such as Ether. A further questionable aspect of DAI is its scalability. Backing up each coin with crypto would take a lot of it to adequately serve as collateral, making it expensive to mint new coins.
The most innovative kind of stablecoins would be “algorithmic stablecoins”, aka non-collateralized stablecoins. These tokens are not backed by any collateral funds, but rather use manipulations of the total supply to maintain a peg. Once a coin is created and the peg set, the token’s price can then be algorithmically monitored on the exchange with an open source code that can be seen and audited by all. Instead of fiat, algorithmic stablecoins are backed by users’ expectations of the future value of what they’re holding. As the operation of these tokens is completely decentralised, their user base is limited to those who have an extremely strong inclination towards privacy and lack trust towards traditional financial institutions. In addition to this, despite their innovation, algorithmic stablecoins haven’t fully proven themselves able to withstand shocks in the crypto market.
A Solution Ahead?
At some point, someone needs to pull all the strings together. To create a stablecoin that can “meet in the middle” between innovation and fiat-backed stability. That’s what Simone Mazzuca has been trying to achieve through the creation of EURstablecoin, aka EURST - a fiat-backed stablecoin initiative created “to parallel the concept of fiat and cryptocurrency”.
However, despite being backed by fiat, EURST is not lacking innovation. While the fiat collateral will exist as $USD in a real-time audited and transparent reserve managed by a trusted third party custodian of Wallex Trust, the tokens will exist as cryptocurrency, built on the Ethereum network according to the ERC-20 token standard. While EURST is the issuer of the tokens, Wallex Trust holds an escrow account with a third party independent custodian who holds the funds, adding an element of reliability and trust for both crypto and traditionally-inclined users. Transparency is a foundational element of EURST - third-party audits will be made on a regular basis, and transactions of tokens issued and redeemed will be recorded on-chain.
“The existence of a physical, real-time audited and redeemable USD reserve will effectively peg the market value of EURST tokens to real currency Value of the 1EUR in USD.” - EURST Whitepaper
Among other components, a large part of what gives money its value is trust, and the rise of cryptocurrency has only made that more clear as time goes on. With the ongoing battle of the innovation vs stability trade-off happening among stablecoins, what does a solution look like? Indeed, it seems that a stablecoin like EURST, which pulls in useful elements from each of its kind is needed to bring the balance required to solve an array of problems related to cryptocurrency volatility.