What Is A Stablecoin?

What Is A Stablecoin?

Last Updated: 1st November 2018

A stablecoin is an asset that offers price stability characteristics, which makes it suitable for certain functions, such as a: medium of exchange, unit of account, and a store of value. These three characteristics are important for any currency to be used in any meaningful manner. As of now, cryptocurrencies such as Bitcoin are not very effective at being a unit of account or store of value, because of the considerable price volatility that these cryptocurrencies can be subjected to. This can make cryptocurrency adoption difficult, because actors such as businesses will not want to be exposed to extreme levels of currency risk when transacting in cryptocurrency. Adoption from a consumer standpoint is also challenging, because of concerns that exist with regard to fluctuations in purchasing power. Stablecoins present themselves as being a price-stable solution in an otherwise volatile environment.

Stablecoin models can take different forms, such as:

  • IOU Issuance Model
  • Cryptoasset-collateralized Model
  • Seigniorage Shares Model

IOU Issuance Model

The IOU issuance model involves a company holding assets in a bank account or vault, and then issuing tokens that will represent a claim to the underlying assets that are stored in that bank account or vault. These assets can be monetary i.e. fiat currencies such as the USD, and can also be physical assets such as gold. The value of that digital token derives from the fact that it is a representation of a claim on another asset that possesses a defined value. For example, a company could establish a bank account that contains a reserve currency in dollars. That company could then issue stablecoins that functioned as a digital representation of those dollar reserves, for example, a stablecoin being 1:1 against those dollar reserves. If an individual wanted to liquidate their stablecoins back into dollars, then the stablecoins would be destroyed and the dollars would be given back to the individual. One limitation of this model is that it is centralized, it requires trusting that the issuing party possesses the assets that are being represented, which exposes token holders to counterparty risk.

Cryptoasset-collateralized Model

One approach is to issue stablecoins that are backed by other decentralized cryptocurrency assets, such as Ether. The problem here is that the underlying collateral backing the stablecoin may be volatile. That is why this method involves the overcollateralization of the amount of stablecoins created, so that any price fluctuations in the stablecoin can be adequately absorbed. For example, a smart contract can be created in which $200 worth of Ether can be held as collateral for the issuance of $100 worth of stablecoins. The advantage to this model is its decentralized setup, the underlying collateral can be held trustlessly in a smart contract, so individuals are not relying on a third party to redeem their stablecoins. However, there is always the risk that the underlying collateralized cryptocurrency asset of a stablecoin could prove to be too volatile and drop incredibly quickly. If this occurred, then issued stablecoins could become undercollateralized, which may then destabilize the price of the stablecoin.

Seigniorage Shares Model

In this model, issued stablecoins are not actually backed by anything other than the expectation that these coins will retain a certain value over a period of time. With this model, the supply of stablecoins are algorithmically expanded and contracted by for example, a smart contract, similarly to the manner in which central banks control fiat currency money supply. If the total demand for a stablecoin increases or decreases, then its supply will automatically change in order to maintain a stable price. So if a stablecoin is trading above $1, this means that its supply is too low, so a smart contract would issue more stablecoins until its trading price reached $1. Conversely, if the stablecoin is trading below $1, then this indicates that supply is too high. In this instance, bonds and shares can be used to remove coins from circulation. The problem with this model is that contracting the money supply can be difficult. For example, deciding which individuals lose money, and why those individuals would even be motivated to give up their stablecoins in the first place are tricky questions to answer.