Cryptocurrencies are one of the greatest innovation of our times. In fact, they have the potential to completely change the world economy as we know it. However, before they can be accepted by the mainstream, they need to get over one of their biggest obstacles.
The fact remains that with these frequent rise and fall in price and interest, cryptocurrencies right now seem pretty unusable for everyday transactions. This is the reason why “stablecoins” are gaining more and more popularity. In some sections, they have been called many things from “the holy grail of cryptocurrencies” to the “foundational component of the next-generation economy.” They have been embroiled in controversy and they have been dissected and studied by some of the smartest minds in the cryptospace.
So, what are “Stablecoins”?
Stablecoins are digital tokens which are intended to provide measurable stability and security. In layman’s terms, their value remains constant and stable.
Throughout this guide, we are going to look deeper into the importance of stablecoins and the top 5 stablecoins of 2018.
The Importance of Stable Economies
When one says price stability, they usually think of downtrends, however, that’s a common misconception. True stability means that the asset is immune to both downtrends and uptrends. Inflation is an increase in the general price of the asset in an over time, which results in the weakening of the value of the money and purchasing power. On the other hand, deflation is a decrease in the price of the goods which also means that there is an increase in the purchasing power of the currency.
Too much of both is a bad thing. Why? Well, consider this:
- Rapid inflation leads to extreme economic retardation and leads to complicated economic decision making. Since inflation leads to the decrease of the strength of the currency, it can diminish the value of savings.
- Rapid deflation also leads to the slowdown of economic growth. Because the general price level of products goes down, it leads to the postponement of consumption and investment.
In order to achieve a high level of economic activity and employment, price stability is an absolutely essential element. Using price stability, one can easily recognize changes in the relative prices (i.e. prices between different goods). This, in turn, improves the transparency of the overall price mechanism. Plus, it also removes speculation in the market and helps people make more informed investment decisions. Reducing inflation risk also helps to reduce the real interest rates and increases incentives to invest.
On the other hand, in a deflationary environment, economic policies may not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. In many ways, it is far more difficult for economic policy to fight deflation than to fight inflation
So, how do you define price stability?
The quantitative definition of price stability was established in 1998, the ECB Governing Council “Price stability is a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability must be maintained over a medium-term perspective.” In addition, in May 2003 the Governing Council also clarified that, in the pursuit of price stability, it aims to maintain inflation rates “below, but close to, 2% over the medium term”.
Why does it specify “below, but close to 2%”? An inflation rate below but close to 2% shows that the economy can benefit completely from price stability.
The Dangers of Unstable Currency
The picture above of the 1 trillion Zimbabwean dollar note became viral some time back. The story behind this is the perfect example of the dangers that price instability can bring into the market. Let’s go back to the 1980’s. Zimbabwe was actually facing a good period of economic growth. In fact, so much so, that the Zimbabwean dollar was actually measuring up pretty well against the US dollar.
Unfortunately, something was going to happen that would change everything for the worse.
From 1991-1996, the Zimbabwean Zanu-PF government of President Robert Mugabe embarked on an Economic Structural Adjustment Programme (ESAP) that had serious negative effects on Zimbabwe’s economy. In fact, the according to an OED audit:
- The program didn’t reduce poverty and unemployment as it was hoped. In fact, it increased it even more
- Critical fiscal reforms made slow and uncertain progress, keeping budget deficits high
- Because budget deficits were high, there was uncertainty and shortages of capital for private producers which delayed investment in new opportunities and job creation
- Since a majority of the Zimbabweans were working in the informal and rural sector, the program couldn’t connect with them because it was mainly focusing on the formal urban sector.
Over the 5 year period when this plan was running, Zimbabwe went through its worst recession since their independence which was further exacerbated by the drought. In fact, in November 2008, the hyperinflation rate went up to as much as 79,600,000,000% per month, which resulted in $1 USD becoming equivalent to the staggering sum of Z$2,621,984,228.
Now, these are just numbers, right? We are assuming you need a better idea of what happened because of the hyperinflation. Well, let’s look through them
- Zimbabwe’s banking sector collapsed.
- The farmers were unable to get any loans from the bank and as a result, for a 10-year period from 1999-2009, there was a sharp drop in food production.
- Unemployment rose to 80%, which is ironical when you consider that this was supposed to save the economy. In fact, in 2017, the unemployment rate rose upto 95%.
- Life expectancy dropped drastically. In Zimbabwe, female life expectancy stands at 34 years, while for males it is 37 years. According to a report issued by the United Nations, Zimbabwe has the lowest life expectancy in the world.
- Zimbabwe was eventually forced to give up their currency for the USD.
According to the World Bank Group, Zimbabwe’s experience provides two important lessons for other highly dualistic economies undergoing major reforms, among them the need for:
- Careful targeting of social programs should be aimed for. Zimbabwe’s experience highlights the inherent difficulties in targeting social programs to reach the poor. It shows the importance of avoiding an urban bias, of devising simple eligibility criteria for social safety net beneficiaries, of devolving initiatives to the community level, and of engaging a wide range of interested parties, including disadvantaged groups and community leaders, in partnership.
- Secondly, and more importantly, macroeconomic stabilization, particularly tighter fiscal policy, which requires sustained reduction of public expenditures through faster privatization of parastatals and civil service downsizing. The latter also requires integrating retrenchment initiatives and strategic planning to ensure efficiency gains.
Why the Cryptospace Needs Stablecoins
In order to understand this at a deeper level, one needs to know the history and story of money. Money was first invented as a means to solve the problem of double coincidence of wants. What does that mean?
This is a scenario that happens in a barter company. Basically, if Alice and Bob both have items of similar value but they don’t want to trade with each other because they don’t like what the other person has. For situations like these, a medium of exchange was needed which would be recognized as valuable and can be used by individuals for transactions.
Secondly, if a particular currency is perceived as valuable, it can assign a true monetary value to a particular product. This helps us understand how valuable a product really is because having explicit prices on a product is more beneficial than a barter economy.
Finally, the last use of money is as a store of value. Earlier people used to store huge quantities of goods in their storeroom. However, the problem with that is goods deteriorate over time. This is the reason why materials like gold and silver act as a great store of value.
Along with all this, there is one more bonus property of money. The more one collects over time, the more purchasing power that person has and consequently, more power and social influence.
So to summarize whatever knowledge we have gained above. What are the requirements of an ideal currency? Well, a good currency should fulfill the following roles:
- As a Medium of Exchange: One should be able to use the coins as a means of transaction
- Unit of account: A unit of account in economics is a nominal monetary unit of measure or currency used to represent the real value of an economic item. In simpler terms, people can tell whether a particular item is expensive or not because of the monetary value that is attached to it.
- Store of Value: Pretty self-explanatory. This basically means that the asset can be saved for a long time and it can be later on retrieved with its value not depreciating significantly. In fact, it may even appreciate in value.
Ok, so how cryptos fare in this regard?
As you may have guessed till now, not that well.
Cryptos do a pretty good job as a medium of exchange. They are a largely desirable asset, which is why people are willing to transact with it.
However, as a unit of account and store of value, it just doesn’t cut it. Think about it, if a particular product is valued at 0.03 BTC. Can you really tell how valuable it is? When you know that something priced at $100, you know what that means. You know whether that is too much or too less for a product.
Eg. $100 for a good suit is cheap. However, $100 for a bar of chocolate is ridiculous.
However, you can’t really do the same with cryptocurrencies because of the price volatility. The same logic extends to the next point.
Why are cryptos not a good store of value? Would you want to safely invest your hard-earned money in an asset which may be worth half of its present valuation in 24 hours?
In order for cryptos to come as close to an ideal currency is via stablecoins. In fact, why not explore this area some more? What are the problems that we face because of the volatility of cryptocurrencies and what are the benefits that stablecoins will bring in?
- While it is true that hardcore traders take advantage of the volatility to make profits, the fact remains that they need to be constantly vigilant to make sure that they don’t lose all their money. Also, remember that most crypto exchanges don’t really support fiat money. That is why it is important to have a stablecoin that can store the value over a long period of time.
- Cryptocurrencies are not ideal for time-based contracts. If someone were to bet 1 BTC on an event occurring in a year’s time, then they are exposing themselves to two major risks. Firstly, the event may not occur at all, and secondly, the value of BTC may drop down in that time. This volatility makes it extremely difficult to do a proper risk assessment.
- In order to get mainstream adoption, the first thing that they need to do is to earn the trust of the people. They won’t be able to get the trust if the value of the cryptos keeps randomly fluctuating.
So, what should the ideal decentralized international currency look like? Bitcoin was long considered to be the perfect currency, however, one thing that we must remember is that Bitcoin has a fixed supply. Fixed supply currencies will always be volatile because the world is dynamic and demand for that currency changes over time.
This is the reason why stablecoin is the closest thing that comes to an ideal currency. But, in order to understand that, the first thing that we need to do is understand the concept of pegs.
Pegs – The Backbone of Stablecoins
According to Wikipedia: “A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.” The concept of pegs or fixed exchange rates lies at the very heart of stablecoins.
In simpler terms, a peg keeps the value of a currency stable by directly fixing its value in a predetermined ratio to a different more stable or more internationally recognized or valuable currency (or currencies). This method is extremely useful for small economies, economies which borrow primarily in foreign currency, and in which external trade forms a large part of their GDP.
That sounds pretty cool, but how does it exactly work?
To implement this, the first thing that the country needs to do is to first get huge reserves of foreign currency. According to Richard Chen,“This is because if the country needs to appreciate its own currency to maintain the peg, then it can buy its own currency on the market using its reserves of foreign currency. The country can also raise interest rates and contract the money supply to attract foreign demand for its currency, thereby causing appreciation.”
In the same manner, if the country needs to depreciate its own currency to maintain the peg, they can sell off their own currency on the market to lower the interest rates and increase the available supply of money.
The Different Kinds of Pegs
There are two important pegs that have been used through the ages that you must acquaint yourself with. They are:
- Classic gold standard
- Brenton Woods Standard
#1 The Classic Gold Standard
The classic gold standard was followed by most of the countries between 1880 and 1914. This system was first introduced way back in 1821 in the UK. The system was pretty straightforward. The external value of all currencies was denominated in terms of gold, eg. 1 USD, during this time period, was denominated as 0.048 troy oz. of pure gold. To make this system work, central banks were ready to buy and sell unlimited quantities of gold at the fixed price. However, the economy is an ever-changing, dynamic entity and this system was way too rigid for it. It was after the second world war that various countries realized that a new system was required. That system was called “The Brenton Woods System.”
#2 The Brenton Woods System
One of the major factors behind the second world war was the economic imbalance that was caused during the inter-war period. Along with the afore-mentioned rigidity of the gold standard, people realized that time was ripe for a change.
So, to make this new system, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference. Since the US had the majority of the world’s gold reserves after the world war, the other countries decided to peg their currencies to the USD while USD itself remained pegged to gold. This seemed like a good idea, however, things didn’t quite work out.
The value of the dollar went down over a period of 25 years as the other countries exchanged their USD foreign reserves for gold, slowly draining Fort Knox of gold.
Eventually, it grew so bad, that President Richard Nixon was forced to terminate the convertibility of USD to gold in a famous announcement that you can watch here:
The USD has remained a free-floating fiat currency ever since.
So, how are these pegs maintained? Before we get into that, we need to understand a simple concept in game theory called, “Schelling Point.”
Game Theory: Schelling Point
The study of strategic decision making is called game theory. It was first devised by John Van Neumann and Osker Morgenstern in 1944 and was considered a breakthrough in the study of oligopoly markets.
NOTE: Oligopolies are marketplaces which are dominated by a few markets and the barriers to entry are high. Also, the products in oligopolies are similar but not identical. A fine example of an oligopoly is the laptop industry where the market is dominated by a few companies like Apple, Lenovo, HP etc. Since the products are similar, these comapnies don’t have that much leeway when it comes to pricing, meaning, the products are somewhat similarly priced.
A game theory model has at least 3 major components:
- Players: These are the main decision-makers in the system. Think of the managers in the firms
- Strategies: These are the decisions that have been taken to further the progress of these companies.
- Payoff: These are fruits of the labor i.e. the outcome of the strategies.
When it comes to game theory, there are two types of games.
- Zero-sum game: It is a game in which the gain of one player comes at the expense of another player.
- Non zero-sum game: A game where the gain of one player doesn’t come at the expense of another player.
One of the most important concepts of game theory is the Schelling point.
The great economist Thomas Schelling conducted an experiment with a group of students asking them a simple question: “Tomorrow you have to meet a stranger in NYC. Where and when do you meet them?” He found out that the most common answer was, “Noon at the Grand Central Terminus.” This happened because the Grand Central Terminus, for New Yorkers is a natural focal point, the focal point is also known as a “Schelling point”.
Keeping this in mind, how exactly do you define a Schelling Point?
A Schelling Point is a solution that a person automatically comes up with, in the absence of communication because it feels special, relevant or natural to them.
This can actually be demonstrated with a simple game. Consider the following series of numbers”
7816239, 676716313, 100000000 and 871823719.
Which number are you going to choose? Doesn’t take much time to come up with, does it?
This is because while the other numbers are seemingly at random, this number at least has some unique quality to it. That number, in the given series, is a Schelling Point.
Throughout our history, human beings have unknowingly subconsciously converged in various places such as bars, churches, community centers etc. because in a society those places are common Schelling points.
Let us give you another example of the Schelling Point in action. We will be taking the example of the infamous chicken game, made famous by James Dean in “A Rebel Without A Cause”. The concept is pretty bullheaded and simple. You have two cars or bikes racing towards each other in an impending head-on collision. The one who first veers out of the way is the chicken and the loser.
(Yes, we know that this isn’t the version of the game used in the movie and there are several variations of it. However, this is the most common one.)
There are three instances, where this game can end in a fatal crash.
Case 1: Both riders head towards one another.
Case 2: Rider A swerves left and Rider B swerves right.
Case 3: Rider A swerves right and Rider B swerves left.
According to Thomas Schelling, there is a very easy solution to this game. Both the riders should close their eyes while driving!
If the riders cut off communication with each other, then their instincts will take over. In the United States, people drive on the right side of the road. So, if they let their instincts take over, the rides will subconsciously veer their bike towards the right side. That is their Schelling point.
Ok, so the concept sounds pretty darn cool, however, what does that have to do with pegs? Well, as you are going to find out, it has more to do with maintaining pegs than anything else.
How to Maintain Pegs?
Even though most countries and banks have moved away from pegs, the stablecoin industry majorly works on the idea of pegs. There are many critics who are saying that pegs are a dangerous model to use for stablecoins, however, the truth is that a peg can easily be maintained as long as it is within a certain bandwidth of market behavior. In other words, “within at least some market conditions, it’s possible to maintain a peg.”
There are 4 things that pegs must consider in order to maintain itself:
- Is the peg strong enough to withstand volatility?
- Will it be really expensive to maintain the peg?
- How easy is it to analyze the band of behavior from which it can recover?
- Can the traders observe true market conditions in a transparent manner?
The final two questions can be easily answered via the Schelling Point game theory. As Haseeb Qureshi puts it, “If market participants cannot identify when a peg is objectively weak, it becomes easy to spread false news or incite a market panic, which can trigger further selling — basically, a death spiral. A transparent peg is more robust to manipulation or sentiment swings.”
Before we get into the different types of Stablecoin, let’s explore an interesting vulnerability that stablecoins could be exposed to. This vulnerability is called “the impossible trilemma” or, more sensationally, “the unholy trinity”.
The Unholy Trinity: Can Stablecoins be Vulnerable to This?
Before we continue any further, it is important to know a concept in international economics called the “Unholy Trinity”. The unholy trinity basically says, that it is quite impossible for a currency to have all the three following properties:
- A fixed foreign exchange rate (peg).
- Free capital movement (absence of capital controls)
- Sovereign monetary policy.
Fixed exchange rate is the peg that we have already talked about till now.
Free capital flow means citizens will have the freedom to invest abroad and diversify their holdings. This also means that foreign investors can invest in the country as well.
The sovereign monetary policy means that the central bank can increase the money supply to reduce interest rates when the economy is down and they can reduce the money supply and raise interest rates when the economy is up.
As we have already mentioned, the reason why this is called names like “unholy” and “impossible” is because executing these three properties at the same time opens up a pandora’s box of cataclysmic financial disasters, as we found out during the 1997 Asian financial crisis.
In the 90’s East Asian countries like Thailand were absolutely flourishing. Their currency was pegged to the USD, and they were making their own independent policy, AND they enabled free capital flow. This is the reason why, foreign investors came into the market and were able to invest a lot of money into these countries.
When the conditions were good, these foreign investors reaped humongous rewards for their investments. However, the moment conditions became less favourable, these investors pulled out immediately and that caused absolute economic haywire. In fact, the damage that was done to East Asia economically was akin to a full-scale war. Thailand ran out of their USD reserves and were forced to let their currency float and devalue.
After the floatation of the Thai baht on July 2, 1997, as it quickly triggered financial turmoil across east Asia. Indonesia, Korea, Malaysia and the Philippines were hit the hardest—by December 1997, their currencies had depreciated (on average) by about 75 percent!
So, to avoid this catastrophe, the only thing that once could is to avoid 3 specific options.
Option #1: Free Capital and Fixed Exchange
The countries in the Eurozone are following this option. The banks in these countries have let go off the option of enacting they own monetary policy. All the countries in the Euro zone are bound by one currency i.e. Euro. Along with that, there is also free capital flow in and out of all the member nations.
The main problem of this system is that because individual member nations can’t enact their independent monetary policies, they need to come together and create a “one-size-fits-all. However, as we all know, such a system is extremely inefficient. Let us explain why by taking the example of Greece.
As you all know, Greece is facing an economic crisis of staggering proportions. They have accumulated so much debt that it seems impossible for them to pay it back. The Euro zone economic policy is, in part, responsible for this situation.
Debt, in itself, is not a bad thing. So many companies have started out with a debt and have given back their investors ten-folds the amount of money. However, when it comes to taking loans there is a steadfast rule. A rich person will easily be able to get a high loan, while a person with lesser riches will have a harder time. Reason being, the bank trusts the rich person enough to know that they will pay back the money.
For first world countries, like most members of the Euro zone, it is relatively easy to obtain money because they qualify as rich countries. However, even among rich countries, the fact is that different countries function differently. What works for country A can be different from country B. There are differences in culture, work ethic, overall efficiency. This is exactly the reason why a “one-size-fits-all” policy failed to work in the Euro zone.
However, that’s not it. There is another vulnerability that this option has. This option is vulnerable to the Soros attack. So, what exactly is the Soros attack?
In 1992, George Soros, a Hungarian-American investor made over a billion dollars.
However, in the process, he somehow managed to break the Bank of England and he did so by making, what some people call, the “Greatest financial bet of the 20th Century.”
This is what happened as per Wikipedia:
“Soros had been building a huge short position in pounds sterling for months leading up to September 1992. Soros had recognized the unfavorable position of the United Kingdom in the European Exchange Rate Mechanism. For Soros, the rate at which the United Kingdom was brought into the European Exchange Rate Mechanism was too high, their inflation was also much too high (triple the German rate), and British interest rates were hurting their asset prices.”
The Bank of England realised that raising interest rates during a recession would be political suicide which is why they broke the peg and let the Pound float with the German Deutsche Mark.
Option #2: Free Capital and Sovereign Policy
In this situation, investors can invest wherever they want and the central bank has the option to enact their own monetary policies as and when they see fit. The best example of this is the United States of America. The US makes its own monetary policies and their citizens can invest wherever they want. However, they have a floating exchange rate instead of a fixed one.
Option #3: Fixed Exchange and Sovereign Policy
Finally, we have the last option.
In this situation, you can have a fixed peg and the central bank can issue their monetary policy, however, there is no free capital.
China is an example of a country that uses their own monetary policy while maintaining an exchange rate. However, they control the amount of capital flowing inside and outside the country.
Alright, so now that you have educated yourself with all the option, which one do you think works best for stablecoins.
Since stablecoins already have a fixed peg, Option #2 is automatically out of the contention. So, it really comes down to Option #1 and #3.
Option #3 is also a no-go because given their participants the freedom to invest wherever they want is the very essence of a decentralised ecosystem.
That leaves us with Option #1. But, this, however, leaves Stablecoins open to the host of vulnerabilities and economic calamities that we have already talked about, especially, the Soros attack. In the future, it is inevitable that we will go through periods of recession. Since stablecoins won’t control its monetary policy, if someone attempts a Soros attack during a recession, the Stablecoin’s smart contract would immediately contract the money supply to counterattack, which will make the recession even worse.
According to Richard Chen, “Thus, stablecoins are subject to the impossible trilemma and, in achieving their stability, make a conscious choice to give up monetary policy. This is politically popular in the short-term, but without the ability to use monetary policy to alleviate an overheated or depressed economy, it would be difficult for stablecoins to become a world currency in the long-term.”
The Three Kinds of Stablecoins
There are three kinds of stablecoins:
- Fiat Collateralized Stablecoins
- Crypto Collateralized Stablecoins
- Non-Collateralized Stablecoins
#1 Fiat Collateralized Stablecoins
Fiat collateralization is probably the most simplistic and widely used version of stablecoins. It works in a straightforward way, a certain amount of Fiat like currency, silver, gold, oil etc. is kept as collateral and coins are issued 1:1 against it.
Tether is probably the best example of this and it also happens to be the most widely used stablecoin.
#2 Crypto Collateralized Stablecoins
Crypto-collateralized stablecoins are actually pretty similar to fiat-collateralized coin, except for one difference which is pretty self-explanatory. Instead of using fiat as a peg, they use another cryptocurrency.
But, you might be thinking, it makes sense to use fiat as a collateral because they are pretty stable, however, cryptos are unstable. So, how exactly does it make sense to use them as collateral?
The answer to that question is “over-collateralization”. What does that mean?
So, if you want $100 worth of stablecoins then you will need >$100 worth of cryptocurrencies. It is not a straightforward 1:1 ratio.
Dai is an example of this kind of stablecoin.
#3 Non-Collateralized Stablecoins
Finally, we have the non-collateralized stablecoins i.e. coins which are not backed by anything. A privately issued, non-collateralized, price-stable currency could pose a radical challenge to the dominance of fiat currencies.
But, how exactly does one execute this?
Hedge fund manager and macro specialist, Robert Sams came up with the idea of Seignorage Shares way back in 2014. So, what exactly did he do?
He created a smart contract which would act as a central bank with only one policy, issue a currency which will always trade at $1. So, how does this smart contract deal with price fluctuations? What happens if the coins suddenly start trading at $2?
For this, you must know one of the oldest principles in microeconomics? Supply and demand.
The theory is pretty simple.
More the supply of the asset and lesser the demand, lesser the price.
Lesser the supply of the asset, more the demand, more the price.
The supply-demand graph goes something like this:
Coming back to seignorage shares, whenever the price is high the smart contract simply creates more coins to increase the supply and reduce the price of the assets.
So, what happens if the price goes down?
The smart contract will then buy coins in the open market to automatically reduce the supply and increase the price. This method is also known as an “algorithmic central bank.”
Ok, so now that you have a fairly good knowledge base on how stablecoins work, let’s look into the top 5 stablecoins of 2018.
Tether is a cryptocurrency token issued by Tether Limited. Tether Limited is incorporated in Hong Kong with offices in Switzerland. Tether is a cryptocurrency token pegged or “tethered” to the US dollar, so 1 Tether (USDT) is always equivalent to 1 US dollar (USD). Tether, in its very essence, is the crypto-equivalent of cash. Plain and simple. Since it’s pegged one-to-one to the US dollar, Tether is a fiat-collateralized stablecoin.
Tether’s purpose, as a stablecoin, is to provide stability to the cryptomarket. In crypto-only exchanges like Bitfinex and Binance which doesn’t allow fiat currencies, Tether allows one to store their crypto profits in a relatively stable commodity in the long run. On the other hand, most exchanges provide trading pairs with USDT, which is pretty much like buying crypto straight with your cash. This complete negates the volatility you’d have faced if you used something like Bitcoin and Ether as the base currency.
Note: While the most popular cryptocurrency by Tether Limited is their Tether token backed by US dollars (USDT), they’ve also released another option to purchase Tether backed by the Euro (EURT).
According to supporters of Tether, the USDT token can open up the doors to widespread crypto adoption by negating the price volatility.
Tether Stablecoin: Behind the Scenes
The Tether token used the Bitcoin blockchain by using the Omni Protocol. The Omni Protocol basically allowed the company to design, create, and trade Tether. Tether, later on, moved to Ethereum on September 2017, via a collaboration with Ethfinex. Making the token ERC20 token will reduce transaction fees and increase confirmation times.
So, what is the life cycle of the Tether tokens? Check out the diagram below:
- The user sends fiat currency to the Tether Limited bank account
- Tether Limited gives back the users a corresponding amount of Tether tokens. So, if the user deposits $500, they get back 500 USDT
- The users then transact using USDT.
- The USDT is then returned to Tether Limited to redeem the fiat currency.
- Tether Limited burns the USDT which have been sent back to them. The token burning keeps the supply and the price under control.
Tether: Proof of Reserves
Tether has a “transparency” page which proves how much funds they are holding in their account. This is a necessary step because it is necessary for Tether Limited to prove that they have the required funds needed to back their tokens. As of writing, the balance looks like this:
According to the company’s balance sheet table:
- The total assets represent how much asset Tether currently holds
- The assets are balanced out by their liabilities, i.e. how many USDT tokens are in circulation.
- Shareholder Equity is the amount of money they would have remaining if their assets were liquidated and they repaid remaining debts.
- Total Assets – Total Liabilities = Shareholder equity
They also claim to do periodic audits to show that they are running a clean operation. However, this is where we start encountering our problems with Tether.
Tether did their audit report quite some time back, however, as it turned out, the page 4 of their audit report had some statements that were blacked out.
They said that they blacked out numbers for privacy concerns, however, that doesn’t make the system truly transparent now, does it? There are several other dicey things that are going on with Tether, however, before we look into them, let’s go through some of the positive qualities that Tether brings into the ecosystem.
The Pros of Tether
- Firstly, it is an extremely simple and straightforward technology which easily accessible to beginners. As Andreas Antonopoulos once said (though not in the context of Tether), “In technology, it is often not the best technology that “wins”, but the one that achieves broad enough adoption and recognition early enough. Good enough beats best if deployed broadly.”
- Tether has incredibly low fees when compared to alternative options. Once the Tether token is in a Tether.to wallet, there are no fees to transfer.
- Tether is on the Ethereum blockchain as an ERC20 token. The ethereum blockchain is well developed and proven
- Despite being highly controversial, Tether has some powerful partners in Poloniex, ShapeShift, Kraken, Bittrex, and HitBTC.
- Provides extremely easy liquidity. Users can buy and sell as many USDT as they want.
Disadvantages of Tether
Tether and Bitfinex
Well, we have already talked about the auditing issues, however, the topic that we want to touch over here is Tether Limited’s relationship with Bitfinex. The two have been accused of partnering up for the following:
- Fraudulent USDT issuances
- Money laundering
- Mutually covering up their collaboration
Even though both these companies have vehemently denied these accusations, some major news has been revealed which puts both of them in a really bad light. The Paradise Papers documents leak (a massive trove of highly sensitive financial data on the world’s richest and most secretive citizens) revealed that both Tether and Bitfinex share top executives. Namely, Giancarlo Devasini, an executive director at both the exchange and the stablecoin project, and Phil Potter, the Chief Strategy Officer (CSO) at both companies too.
These connections were unknown before and brings up all kinds of uncomfortable questions. The fact is, Bitfinex is one of the biggest crypto exchanges in the world and a major legitimizer of USDT. The main problem with this huge influx of tether tokens is that it inevitably manipulates Bitcoin’s price.
In fact, many have actually accused them of “artificially propping” the value of bitcoin. This report closely studied the bitcoin prices for a set period of time and shows some pretty damning results:
- Firstly, they found out that the 50% of BTC total rise took place within 2 hours after a new delivery of Tethers.
- The report asserts that it is likely that Tether is being used to manipulate Bitcoin prices.
- 80% of Bitcoin’s current value might be derived from Tether-based price manipulation.
Oh, and we are not done yet.
There is another very serious accusation which has been thrown at Tether and Bitfinex. Tether is supposed to be backed 1:1 by USD however, as the amount of Tether tokens in circulation increase, the amount of USD backing it should increase as well.
The circulating supply for Tether is right now at 2,756,421,736 USDT, which means that it is pegged to 2,756,421,736 USD. $2.75 billion is a lot of money and people don’t believe that Bitfinex/Tether has that much money. Plus, also keep in mind that Bitfinex/Tether has explicitly stated that they are not going to revealing their bank details adding further fuel to the speculation.
Tether and Bitfinex released a report to throw light on the financial situation which left a lot of people underwhelmed. Turns out that the report wasn’t a formal audit, and it was conducted by a relatively small accounting company. Plus, just to add salt to the wound, the accountants didn’t have access to all relevant information, either, as some data was redacted.
Following this PR disaster, both Bitfinex and Tether hired the public relations team 5W Public Relations to handle the growing fallout. 5W Public Relations has been adamant about not revealing who these companies’ bank accounts are located with which makes sense because Tether has had numerous accounts shuttered this year (like their Wells Fargo account).
Can Tether Lead To Apocalypse?
So, what happens if the crypto world discovers that Tether isn’t really backed by real USD reserves? Well, that will pretty much set up a chain reaction of cataclysms:
- Bitcoin’s price will plummet on exchanges that don’t use BTC/USDT trading pairs.
- The investors will flood bitcoin and other cryptocurrencies from USDT-reliant exchanges to exchanges that don’t have USDT trading pairs.
- Exchanges, like Bittrex, which are heavily reliant on USDT will instantly lose all its liquidity.
This all sounds pretty catastrophic ever? But what will be the long-term implications of this possible doomsday scenario?
Well, the cryptocurrency arena has gone through plenty of doomsdays before with the Mt. Gox exchange collapse and then the DAO attack. Many people lost their investments and the price of crypto-assets dropped drastically as a result. However, things to do recover and heal with time. We can’t say that crypto prices won’t go to 0 overnight, anything is possible, however, the crypto market is resilient.
MakerDAO is the company behind the Dai stablecoin. Dai is valued at 1 USD, pretty much like Tether and, quite like Tether, it is unmineable as well. However, that’s where the comparison ends. Dai is a crypto-collateralized as opposed to Tether.
The MakerDAO Team
MakerDAO is lead by Rune Christensen, its CEO, and founder. He studied International Business from the Copenhagen Business School. Former Amazon software engineer Andy Milenius is the CTO of the company. The former CEO and Executive Director of Polus Capital, Steven Becker is the president and COO.
How MakerDAO Works
Before we get into the details, the one thing that you should know is that MakerDAO has 2 tokens: Makercoin (aka MKR) and Dai (aka DAI). Dai is the stablecoin that is used in this platform while MKR is the governance token of the whole ecosystem.
So, how exactly does one get their hands on Dai? Dai requires over collateralization of ether. When you interact with the MakerDAO system, you lock up your Ether in a “collateralized debt position” or CDP for short. CDP is a smart contract, and the entire system works because of it. Users simply lock up their Ether in CDPs in the form of Pooled Ether (PETH). The CDP then generates Dai for the users while calculating interest on the pooled ether over time. This interest is known as “Stability Fee”. If a user wants to withdraw their ETH from the CDP then they will have to payback the equivalent amount of Dai.
As of right now, Ether, and by extension, Pooled Ether (PETH) will be the only collateral type accepted on Maker. After the Maker Platform is upgraded to support multiple collateral types, PETH will be removed and replaced by ETH alongside the other new collateral types. Like we have said before, these CDPs are always over-collateralized. Ok, so how exactly do you interact with CDP?
Interacting with CDP
So you want to create your own CDP and generate Dai? Well, you need to follow a four-step process.
#1 Creating the CDP and Depositing Collateral
The user starts off by sending two transactions to Maker. The first transaction helps create the CDP, while the second transaction funds the CDP with the amount and the type of collateral that will be used to help generate Dai. At this point, the CDP is considered collateralized.
#2 Generating Dai from the Collateralized CDP
In order to generate the Dai, the CDP user sends a transaction to retrieve the amount of Dai they want to generate from in it. In exchange for that, the CDP accrues an equivalent amount of debt (stability fee), locking them out of access to the collateral until the outstanding debt is paid.
#3 Stability Fee and Paying the Debt
So, how do the users retrieve their collateral?
They will have to pay down the debt in the CDP and the stability fee that they have previously accrued over time. The Stability Fee can only be paid in MKR.
The CDP is considered debt free when the user sends the required amount of Dai and MKR to the CDP to pay down the debt and the stability fee.
#4 Withdrawing and CDP Closure
Now that the user has paid off the Debt and Stability Fee, the CDP user can freely retrieve all or some of their collateral back to their wallet by sending a transaction to Maker.
Let’s see an example of how this entire process will work.
Let’s assume that Ether is worth $100 and let’s assume that the collateralization ratio is 150%, meaning for $100 worth of ether you will get 66 Dai. Like we said, CDP is always over-collateralized.
The following flow diagram shows you how this process takes place.
What Are The Risk Parameters For CDPs?
There are multiple risk parameters that CDPs must work around in order to enforce how they can be used. Let’s go through some of these parameters:
Debt Ceiling: This is the maximum amount of debt that a single type of CDP can create. Once the ceiling has been reached by a CDP, it becomes impossible to create more unless existing CDPs are closed.
Liquidation Ratio: The ratio between collateral and debt is called Liquidation Ratio. Low Liquidation Ratio means low volatility and High Liquidation Ratio means high volatility.
Stability Fee: A stability fee is accrued over time once a CDP is made. This is basically an annual percentage yield and needs to be paid by the CDP user. This can only be paid by MKR and the MKR is immediately burnt after it has been paid off (to keep an overall supply of MKR under control).
Penalty Ratio: The penalty ratio comes into play if the liquidation mechanism is not deemed efficient enough. This is used to determine the max amount of Dai raised from a Liquidation Auction.
How does the Price of Dai Remain Stable?
Now that you know how to generate Dai from CDP, how do you know that your Dai will remain stable? What happens if the value of Dao fluctuates away from $1? There are two reasons why that might happen:
- The value of Ether goes down
- Dai trades for more or less than the target price
So what happens in both these cases?
#1 Value of Ether Goes Down
If the value of Ether goes down then the value of Dai, that it backs, will go down. So, how does Maker make sure that the value of Dai remains the same?
I events such as these, Maker liquidates the CDPs by auctioning off the ether locked up inside it before it becomes less than the amount of Dai getting backed by it.
Let’s take an example. Suppose the CDP indicates that the value of Ether has gone below a certain threshold, say 125%, then the CDP is liquidated and the ether is auctioned off for Dai until there is enough Dai to pay back the initial value that was obtained from that CDP.
This flow diagram will show you how the entire process will work:
#2 Dai is greater than or lesser than $1
This is a simple supply and demand equation. If the value of Dai goes over $1 then that means that there is a lot of demand for Dai and the supply isn’t enough to meet the demand. Conversely, if the value of Dai goes below $1 then that means that there is not enough demand for Dai so the supply needs to go down.
The spot where the two curves instersect is the sweet spot which is also called “equilibrium”.
Ok, so how does Maker control the supply and demand? They utilize the Target Rate Feedback Mechanism. So then, how does Target Rate Feedback Mechanism (TRFM) work? TRFM is a mechanism that adjusts the Target Rate in order to cause market forces to maintain the stability of the Dai price. During periods of instability, the Target Rate Feedback Mechanism kicks in and breaks the fixed peg of the Dai, without compromising on the denomination.
The Target Rate determines the change of the Target price over time. So, during normal times, when TRFM is not engaged, the target rate is fixed at 0%. However, when the TRFM is engaged, the Target Rate can determine the Target Price over time to either:
- Make it appealing enough to make users hold Dai.
- Make the users want to borrow more Dai.
According to the Dai whitepaper, the following happens upon TRFM activation to the Target Rate and Target Price, “change dynamically to balance the supply and demand of Dai by automatically adjusting user incentives for generating and holding Dai. The feedback mechanism pushes the market price of Dai towards the variable Target Price, dampening its volatility and providing real-time liquidity during demand shocks.“
Anyway, this is where we see two situations play out with regards to the price of Dai.
#1 When Dai < Target Price
If the price of Dai falls below the target the TRFM will act like this:
- The Target Rate will increase
- The target price increases at a higher rate
- The Dai generation via CDP will become more expensive
- Because of this increased target rate, it causes an increase in Dai demand
- The combination of reduced supply and increased demand causes a rise in Dai’s prices pushing it towards the Target Price.
#2 When Dai > Target Price
If the price of Dai goes above the target the TRFM will act like this:
- The Target Rate decreases.
- The Target Price decreases.
- Dai generation via CDP will become much cheaper.
- Because of the decreased rate, it causes a decrease in Dai demand.
- The increased supply and reduced demand pushes the value down towards Target Price.
As the MakerDAO whitepaper states, “This mechanism is a negative feedback loop: Deviation away from the Target Price in one direction increases the force in the opposite direction.”
How is the magnitude of the Target Rate change determined? The parameter is determined is called “Sensitivity Parameter”. So, who sets the sensitivity parameter? The MKR token holders. However, during times of crisis, the Target Price and Target Rate are determined by market dynamics.
The Last Resort
The last resort, when everything fails is Global Settlement. The idea is to shut everything down and unwind the MakerDAO platform. Also, they have to make sure that all the Dai holders and CDP users receive the net value of assets that they are entitled to.
The entire process is decentralized and only the MKR holders have the power to initiate the procedure and make sure that process isn’t exploited and used only during an extreme emergency. Examples of such emergencies are long term market irrationality, hacking, system upgrades etc.
The Global Settlement follows three steps, according to the Dai whitepaper:
Step 1: Activation of Global Settlement
If a majority of the global settlers, of the Maker Governance, feel that the system is open to a serious attack or if a global settlement is scheduled as part of a technical upgrade, they can activate the Global Settlement function.
Doing this will stop the
This stops CDP creation and manipulation and freezes the Price Feed at a fixed value that is then used to process proportional claims for all users.
Step 2: The Processing of the Global Settlement Claims
After Global Settlement has been activated, a period of time is needed to allow keepers to process the proportional claims of all Dai and CDP holders based on the fixed feed value. After this processing is done, all Dai holders and CDP holders will be able to claim a fixed amount of ETH with their Dai and CDPs.
Step 3: Dai and CDP holders claim the collateral with their Dai and CDPs.
Each Dai and CDP holder can call a claim function on the Maker Platform to exchange their Dai and CDPs directly for a fixed amount of ETH that corresponds to the calculated value of their assets, based on the target price of Dai.
E.g. If the Dai Target Price is 1 U.S. Dollar, The ETH/USD Price is 200 and a user holds 1000 Dai when Global Settlement is activated, after the processing period they will be able to claim exactly 5 ETH from the Maker Platform. There is no time limit for when the final claim can be made.
What is MKR?
Till now we have heard a lot of the MKR holders and MKR voters till now. So, it makes sense to learn some more about the second token in the MakerDAO ecosystem. Unlike Dai, MKR is not a stablecoin. Quite like the other “normal” coins, they have a volatile price because of their supply mechanics and the role that it plays in the platform. There is a total supply of 1 billion MKR tokens in the platform. MKR can be used as both a utility token and a governance token.
MKR’s Utility Role
MKR’s main utility role is to pay the stability fees that are accrued on the CDPs that have been used to generate Dai. These fees can be only paid by the MKR tokens and the tokens collected are promptly burnt and removed from the circulating supply.
The obvious implication is that the if the adoption and demand for Dai and CDPs increase, then the demand for MKR will increase as well (because they will be required to pay the fees). Also, the MKR burning will help decrease the overall supply of the tokens.
MKR’s Governance Role
The holders of the MKR tokens also have the capability to vote in the Maker platform via the MKR tokens. One of the main roles that they have, which is crucial to the success of the platform, is to vote on overall risk management.
The voting process in the platform is done through a continuous approval voting system wherein any MKR holder can vote for any number of proposals with the MKR that they hold. They also have the freedom to submit new proposals, or cast/withdraw their vote, any time they want to. Of these proposals, the one with the maximum votes from MKR holders becomes the top proposal and can be activated to implemented any changes in the MakerDAO platform.
Obviously, in an ideal case scenario, we want the MKR holders to be extremely competent and the CDPs to be always over-collateralized. However, this assumption doesn’t work here because we are working in a Byzantine environment where we are assuming that everyone is a malicious actor. For this reason, we need contingencies for some possible worst case scenarios.
Suppose there is a situation where parts of the collateral portfolio become under-collateralized. In that case, the MKR tokens trigger an “automatic recapitalization” through forced MKR dilution. So, what exactly does that do?
During automatic recapitalization, the MakerDAO system automatically creates new MKR tokens and sells them on the market to serve two important purposes:
- Firstly, it brings in some much needed liquidity.
- Secondly, it punishes the MKR holders and voters for bad governance.
MakerDAO Platform’s Risk Management
As we have mentioned before, the main focus of MKR governance is on Risk Management. Let’s look into it. MKR holders can vote on the following risk management factors:
- They can create a new CDP with a unique set of risk parameters.
- Modify the risk parameters of some existing CDP.
- Change the sensitivity of the Target Rate Feedback Mechanism (TRFM).
- Modify the Target Rate accordingly.
- Choose a set of trusted oracle nodes. We will get into what oracles are in the following section.
- Modify the price feed sensitivity.
- Choose the set of global settlers for a global settlement.
MakerDAO Ecosystem’s Three External Actors
While it is true the majority of the MakerDAO’s mechanism is automated, there are three external players in its ecosystem who play a major role.
- Global Settlers
Player #1: Keepers
These are independent actors who are incentivized by profit opportunities to contribute to decentralized systems. They have two purposes:
- To participate in the Debt Auctions and Collateral Auctions when CDPs are liquidated.
- Profit from Dai trading.
Player #2: Oracles
Oracles perform an extremely critical function in the Maker ecosystem. They provide real-time information about the market prices of assets to be used as collateral in CDPs. This information is extremely vital because it lets the platform know when to trigger liquidations.
Plus, the MakerDAO Platform needs info about the market price of Dai and its deviation from the Target Price in order to adjust the Target Rate if TRFM needs to be triggered. The MKR voters choose a set of trusted oracles to feed them real-time information.
Player #3: Global Settlers
Global Settlement is the last line of defense that MakerDAO has. Global Settlers are actors chosen by the MKR voters who have the authority to trigger Global Settlement in crisis situations. Also, this is the only role that these players play in this ecosystem, they have no other purpose to serve.
The Main Risks of The MakerDAO Platform
Obviously, no platform is perfect. The MakerDAO team, although extremely capable, has been very transparent about some of the problems that they may face while developing the platform.
- Since the Maker platform is a smart contract platform, fatalistic as it may sound, it is always open to potential attacks and hacks.
- If you really think about it, the MakerDAO platform is extremely complex. You have a stablecoin and a governance token. Plus, in order to use it, you have to go through a CDP. Now compare that with Tether which is much or simple to use.
- If the market acts irrationally for a long period of time then it can destroy the Maker system.
- Of course, the platform is still subject to basic error in coding by the developers. Even though they have a very experienced and enthusiastic team
- The most intriguing thing that can happen to Dai is a black swan event. Dai, right now at least, is pegged to Ethereum. If Ethereum goes through a severe crash and completely fails then it will obviously affect Dai as well.
Basis is a Hoboken, N.J.-based cryptocurrency startup at work on a stablecoin whose elastic supply will expand and contract accordingly to keep its value around $1 by using an algorithmic central bank. The company’s aim is to “develop a new token that people will actually use, instead of use to speculate.”
They are pegged to to $1 USD but is a non-collateralized stablecoin. This approach uses consensus to contract and expand supply of their coin.
It looks like more and more high-profile investors are getting intrigued by the project. They have raised a staggering $133 million in funding from Bain Capital Ventures, GV, longtime hedge fund manager Stan Druckenmiller, one-time Federal Reserve governor Kevin Warsh, Lightspeed Venture Partners, Foundation Capital, Andreessen Horowitz, WingVC, NFX Ventures, Valor Capital, Zhenfund, Ceyuan, Sky9 Capital, Digital Currency Group and others.
Brains Behind The Project
Nader Al-Naji is the Founder of Basis which is developing a stable cryptocurrency with an algorithmic central bank. Nader hails from Alexandria, Virginia and he graduated from Thomas Jefferson High School for Science and Technology in 2010. He then went on to attend Princeton University and was the member of the varsity rowing team and placed in the top two in two entrepreneurship competitions.
During his senior year of college i.e. 2012, Nader began mining Bitcoin, taking advantage of the free electricity which was present in the campus. From this tiny dorm room mining operation, he was able to accumulate 22 Bitcoins. He graduated summa cum laude in 2013, a year early, with a Bachelors in Computer Science and a minor in Applied and Computational Mathematics.
He was fascinated with the idea of stablecoins for a long time and once even wrote, “It’s also possible that nobody else will have the combination of motivation, vision, and expertise necessary to actually make and market the first actually legitimate price-stable coin. If you believe this is the case, then the best path forward might be to either just do it ourselves, or start trying to seed fund people to do it while also trying to get big-name VCs to go in with us. Honestly, I love this stuff so much that I wouldn’t be averse to just leading the effort to start one of these coins myself.”
The Quantity Theory of Money
Ok, so before we go any further, let’s understand what the quantity theory of money means. Imagine that the price of a commodity during a period of the economy is $100. The Quantity Theory of Money says that if you doubled the amount of money that everyone had in their bank accounts, then, in the long run, that same basket of goods would cost $200.
Why does that happen?
That’s because while the amount of money that everyone has doubled, the true value of the commodity remained the same. Because of this, people should be willing to part with twice as much money to get the same amount of value. The same thing works in reverse. If half of the people’s savings are yanked out of the economy, then, in the long run, the same commodity would cost only $50 instead of $100.
So, using this concept, how do you think the central bank acts while trying to calm down the inflation. High prices that are constantly rising mean that people are too willing to spend money. To restore prices, the banks will have to restrict people to have less money. Similarly, if the tables were to be turned, i.e. during periods of deflation, when people are unwilling to spend money, they need to restore prices by giving people more money.
This idea is the backbone of what central banks do to stabilize prices. These banks basically do two things:
- Expanding the overall money supply whenever the prices go down to bring it back up again
- Contracting the money supply whenever the price goes up to bring it back down again.
Expanding and contracting the money supply works because the Quantity Theory of Money states that long-run prices in an economy are proportional to the total supply of money in circulation. So, how can Basis use this same theory to keep the price stable?
So if you want to peg a currency like Basis such that 1 token always trades for 1 USD. This is how the system reacts by growing or shrinking the supply of tokens in proportion with how far the current exchange rate is from the desired peg.
- The first thing that needs to be calculated is to introduce the concept of aggregate demand. This is an indicator of how much demand people have for the coin. The equation works like this:demand = (coin price) * (number of coins in circulation)Since the market cap describes how much people total value the coin, this aggregate demand is also known as the market cap.
- Suppose the Basis coins are now trading for $1.10 a coin. This means that as of right now, the demand has risen to $1.10*X, where X is the total number of coins in circulation.
- So, how do you adjust the coin supply to restore the peg to $1, assuming that the demand stays the same? Suppose Y represents the desired number of coins in circulation:demand_before = $1.10 * X
demand_after = $1.00 * Y
demand_before = demand_after
- If you substitute the value of demand_before and demand_after then you can solve for Y knowing that you have the value of X. So, with the values that you have over here, we get:Y = X*1.1
So, in accordance with the Quantity Theory of Money, the Basis protocol can work in such a way that its price can be adjusted to $1 over the long-term despite fluctuations.
How Does The Basis Protocol Work?
It has been discovered that the Basis coin will maintain its peg in the long run if token supply is adjusted to match the token price. How does the Basis protocol measure the token price and how does it adjust the overall supply?
If you were to do a simple overview, then the Basis protocol is pretty similar to that of Bitcoin, but for these following features. ( NOTE: The following data has been taken from the Basis whitepaper.)
- The protocol defines a target asset to stabilize the coin against. The asset maybe USD, another fiat currency, or an index like the Consumer Price Index (CPI), or a basket of goods. When that is done, the protocol defines a target price for Basis in the pegged asset eg. $1for 1 Basis token.
- The blockchain monitors exchange rates to measure price. The blockchain sources a feed of the Basis-USD exchange rate via an Oracle system. This can be done in a decentralized way, as we’ll detail later.
- The blockchain expands and contracts the supply of Basis tokens in response to deviations of the exchange rate from the peg:a) If Basis is trading for more than $1, the blockchain creates and distributes new Basis. These Basis tokens are given by protocol-determined priority to holders of bond tokens and Base Shares, two separate classes of tokens that we’ll detail later.
b) If Basis is trading for less than $1, the blockchain creates and sells bond tokens in an open auction to take coins out of circulation. Bond tokens cost less than 1 Basis, and they have the potential to be redeemed for exactly 1 Basis when Basis is created to expand supply. This incentivizes speculators to participate in bond sales and thereby destroy Basis in exchange for the potential that bond tokens will pay out in the future.
As the whitepaper states, “The Basis protocol might be better understood by comparing it with the Fed. Like the Fed, the Basis blockchain monitors price levels and adjusts the money supply by executing open market operations, which in our case consists of creating Basis or bond tokens. Like for the Fed, these operations are predicted by the Quantity Theory of Money to produce long-run price levels at the desired peg.”
The Three-Token System of Basis
Basis is planning to use a three-token system to take care of the expansion and contraction of the supply of the tokens in the ecosystem. Let’s go through each of these tokens and see what they are going to do.
- Basis: These are the main stablecoins of the system. These are the ones that are pegged to the USD and is supposed to be used as a medium of exchange. In order to maintain the peg, the token supply will be accordingly expanded and contracted.
- Bond Tokens: These tokens are called bonds for short. Whenever the basis supply needs to go down, these bonds are auctioned off by the blockchain. Bonds are not pegged to anything, and each bond promises the holder exactly 1 Basis at some point in the future under certain conditions. These bonds are sold on open auction for < 1 Basis, so buyers will most probably be able to earn a competitive premium or “yield” for their bond purchase. The following conditions need to be met for the bond to be redeemed:a) The blockchain has determined that an expansion of the Basis supply is necessary and is creating and distributing Basis
b) The bond has not crossed its 5 year expiration period) All the bong tokens that were created prior this bond have been redeemed or expired.
- Share tokens: These tokens are called “shares” for short. These token have a fixed supply ever since the genesis block of the blockchain. They are not really pegged to anything and their value is derived from their dividend policy. When demand for Basis goes up and the blockchain creates new Basis to match demand, shareholders receive these newly-created Basis tokens in proportion so long as all outstanding bond tokens have been redeemed.
Expansion of The Token Supply
So how does the token supply expand?
Firstly, the blockchain creates an ordered sequence of bonds, called Bond Queue. The way it does this is by tallying outstanding bond tokens and ordering them according to when they were created, with the oldest one first. The blockchain also tallies all outstanding share tokens. The blockchain then creates N new Basis tokens and distributes them like this:
- Following the first-in-first-out (FIFO) order, the bondholders are paid first. If there are any outstanding bond tokens, the blockchain begins converting bonds into coins, one-for-one, according to their order in the Bond Queue. So, basically, if one needs to create 100 Basis tokens, they need to convert 100 of the oldest outstanding bonds into 100 new coins. So, what is the use of ofa FIFO queue? It basically incentivizes people to bonds sooner than later and get paid sooner.
- Shareholders are paid after bondholders and if there are no more outstanding bond tokens, the system distributes any remaining new coins to shareholders, pro rata, as a dividend. For example, if we need to create 1 million Basis, and there are 0 outstanding bonds and 10 million outstanding shares, then each share receives 0.1 Basis.
So, we have talked about this Bond Queue. What happens if this line goes out of control and the speculators who are at the end of the queue no longer see any value on in getting new bonds? The longer the Bond Queue grows, the longer it takes for new bonds at the end of the queue to get paid out. This causes the price of new bonds to drop since speculators start demanding a higher return for the extra time and risk that they take on. But if the price of new bonds drops to 0, the system cannot contract supply anymore, a price of 0 means that nobody wants to exchange their Basis for bond tokens.
To counter this, the bonds are given an expiration period to forcibly expire all bonds that have been in the Bond Queue for more than 5 years. This time period has been selected “after rigorous simulation showed that this produced a robust system with sufficiently high bond prices even in the face of wild price swings”
In summary, the expansion mechanism can also be understood through the following example, which has been taken directly from the Basis whitepaper:
- Suppose there are 500 bonds in the Bond Queue, 200 of which were created more than 5 years ago. Additionally, suppose there are 1,000 shares in circulation.
- Suppose the system needs to create 1,000 new coins.
- The system expires the 200 oldest bonds, leaving 300 bonds in the queue. If the system needed to create fewer than 300 coins, it would only redeem the oldest bonds. However, the system needs to create 1,000 coins, so it redeems all 300 bonds.
- The system still needs to create 700 more coins. The system distributes these 700 coins evenly across the 1,000 shares. Each share receives 700 / 1,000 = 0.7 coins. If you hold 100 shares for example, you would receive 70 coins during this expansion, which you can then sell for USD.
Contraction of The Token Supply
So, in order to destroy Basis tokens to contract the token supply, the Basis holders need to be properly incentivized to lock up their Basis in exchange for a future payoff. The way they incentivize this is, as we have covered earlier, by having the blockchain create and sell bond tokens. for less than 1 Basis, and in return you will get a future premium and payout, provided that the 5 year expiry period hasn’t passed.
In order to sell these bonds, the blockchain runs a continuous auction in which bidders specify a bid and bid size for new bond tokens. This means that auction participants specify exactly how much Basis token they want to pay for each bond and how bond tokens they want to buy at that price. So, for example, Alice can specify that she wants to purchase 100 bonds for 0.9 Basis per bond. When the blockchain does decide to contract the overall Basis token supply, it chooses the orders with the highest bids and converts the chosen holders’ coins into bonds until the required number of Basis tokens have been destroyed.
As an example (From the whitepaper):
- Suppose the system wants to sell 100 bonds.
- Suppose that there are three buy orders on the order book: One bid for 80 bonds at 0.8 Basis each, one bid for 80 bonds at 0.6 Basis each, and one bid for 80 bonds at 0.4 Basis each.
- The system will compute the clearing price, which is a single price at which all offered bonds would have been bought at. Here, the clearing price is 0.6 Basis.
- The system will fill the winning bids at the clearing price: The first user will receive 80 bonds in exchange for 80 * 0.6 = 48 coins, and the second user will receive 20 bonds in exchange for 20 * 0.6 = 12 coins.
So, what exactly does this protocol do?
It sets an artificial bar to the price of the bond tokens to make sure that it doesn’t borrow too heavily against the future in order to contract the overall supply. According to their whitepaper, they have currently set this floor at 0.10 Basis per bond. They have simulated bond prices to show that, under a very wide range of models of Basis demand, this floor is essentially never hit.
Robustness and Price Responsiveness
We have seen how the blockchain will expand and contract the supply of Basis tokens to main the peg. So, the two things that we need to consider when it comes to the validating this model:
- Robustness: Will the blockchain be able to contract the supply when required by selling bond tokens?
- Price Responsiveness: Does the blockchain respond quickly enough to price fluctuations, given that it operates on discrete time steps?
Another way of framing robustness is “under what scenarios will the price of new bond tokens hit the artificial floor”? In order to test this, they constructed multiple different models for bond price and multiple different models for Basis demand as measured by market cap. They then ran these models through different parameters in order to estimate the probability of bond price hitting the artificial floor under a wide variety of assumptions.
In order to make sure that these models have a degree of correctness, their approach to model market cap included the following:
- Modeling coin market cap as a geometric Brownian motion (GBM), a model commonly used in equity option pricing theory.
- Modeling coin market cap using block bootstrapping, a method for sampling dependent test statistics from non-stationary time series data.
The bond pricing is done in accordance with the following:
- Using a risk-neutral pricing
- To determine a bond price that doesn’t completely rely on GB< assumption, a time-tested Sharpe Ratio pricing method is used.
The team had to make sure that the Basis protocol doesn’t react to price drops or price increases in real time. The protocol takes quantizes its actions into discrete time steps, so that when there is a legitimate shock to the system, eg. when the price is too low or too high for an elongated period of time before the protocol responds. What assurance is there that the exchange rates will be bought back quickly to the peg.
The whitepaper says, “The critical insight is that as long as traders expect Basis price to correct in the long-term, they are incentivized to trade in the short-term to restore a peg. For example, suppose a speculator sees that Basis price is too low. As long as he believes that Basis price will correct because of a future protocol action, he is incentivized to buy coins now, in anticipation of the protocol’s actions, to capitalize on the current, temporary drop in prices. Similarly, if a speculator sees that Basis price is too high, then he might take a short position, which puts downward, peg-restoring pressure on Basis price. These incentives exist even in advance of any reaction from the protocol. Speculators taking long and short positions like this can be thought of as liquidity providers that buffer spikes in Basis demand, creating flexibility around when the protocol must respond. Thus, as long as there is sufficient liquidity, and as long as speculators trust the protocol to restore Basis supply before this liquidity is used up, we should expect only small deviations in coin price around any peg.”
Havven is a decentralized payment network where users transact directly in a price-stable cryptocurrency. Anyone who uses the stablecoin must pay fees to the participants who collateralize the network, compensating them for the risks of providing collateral and stability. These collateral providers help control the money supply, and fees are distributed in proportion with each individual’s stabilization performance.
Even though Havven is operating on the Ethereum mainnet, they are planning on launching on the EOSIO blockchain and as part of its launch, they will be launching 50% of the new HAV tokens on EOSIO to existing HAV holders on Ethereum.
The Havven Team
Havven is based out of Australia and launched a seed funding round in September 2017 to develop the concept of a self-contained stablecoin payment network. On February 28, 2018, they kicked off their public ICO and within a week, they met their goal of $30 million USD. Havven is led by a multidisciplinary team of 13 individuals and was founded by Kain Warwick, who previously co-founded blueshyft, one of the largest digital payment networks in Australia. The Director of Engineering at MongoDB, Justin Moses, is the CTO of the company.
Havven’s main aim is to disrupt the payment network space which is run by centralized giants such as PayPal, credit card networks, the SWIFT banking network etc. The problem with these powerful conglomerates controlling these areas is that it is in their power to block or reverse any transaction as and when they want. Also, since all the transactions are going through one centralized entity, it is more open to hacks and attacks.
Many though Bitcoin provided the ideal alternative for these payment solutions, however, as we have already discussed, the lack of stability is a major problem. Havven wants to step up in this department and they aim to become the ideal coin of choice for these transactions.
Havven’s Dual Token System
Havven implements a two-token system in its infrastructure:
This is the stablecoin whose supply floats according to the market conditions. Its price, as measured in fiat currency, should be always stable.
Havven is the other token in this ecosystem which provides collateral for the system and has a fixed upper cap. Its market capitalization reflects the system’s aggregate value. The ownership of these havvens empowers the user to issue nomin tokens in proportion to the dollar value of the havvens placed into escrow.
Now, what happens if a user wishes to release their escrowed havven tokens? They will first need to present the system with the number of nomin tokens they had previously issued. The fees that are generated in the network helps havven derive intrinsic value. The creation of these nomin tokens requires a big volume of havven tokens to be locked up in the system.
The ecosystem incentivizes the users to issue and destroy nomins tokens in accordance to changes in demand. However, ultimate the overall value of the havvens will reflect the required nomin supply. Using this kind of a backing allows the stablecoin to have full transparency over the total number of tokens issued against the available collateral.
Collateralization vs Stabilization
Havven incentivizes ts holders to fulfill two specific functions:
- Provide the system with collateral
- Participate in the stabilization of the nomin price
Over-collateralization helps with the confidence in the stability of the nomin because it helps increase the value of escrowed havvens and, by extension, keeps the value of the escrow more than the value of nomins in circulation.
As long as the ratio between total nomin value to total havven value remains optimal, there should be enough backing in the collateral pool to make sure that nomin tokens can be redeemed on face value.
Nomin issuers get rewarded by Havven. The rewards are collected from transaction fees and are distributed in proportion with how effectively each issuer acts to maintain the correct nomin supply. The Havven system takes note of the nomin price and responds by adjusting the targeted global supply accordingly. The individual nomin users are incentivized to move towards that supply and value.
Nomin Token Burning
So, how does one access the havvens that have been locked up in the system?
For this to happen, the system must destroy an equivalent amount of nomin tokens that were originally created. So, when the user indicates their intention to get back their havven tokens, the system should place a limit buy order on a decentralized exchange, up to a maximum price of $1. The system places this order on behalf of the user and, upon completion, the nomin tokens are promptly destroyed.
Carbon is a seigniorage shares style stablecoin that emerged early in 2018. According to their whitepaper, “Carbon presents a dynamic value transfer protocol for creating arbitrarily complex logic, which contextualizes value transfer while substantially reducing resolution costs (e.g. chargeback fees and refunds), increasing economic efficiency. We achieve these properties through an elastic supply engine that closely correlates Carbon to $1 using a decentralized oracle, a dual token model and optimal risk-to-reward incentives.”
Quite like Basis, they plan to use algorithmic mechanisms to increase and contract supply to counter the demand changes and keep the price stable. Carbon will be traded on Hedera Hashgraph. So, before we continue, it might make some sense to understand what hashgraph means first.
What is a Hashgraph?
Hashgraph is the consensus algorithm used by Swirlds. It was conceptualized by Swirlds co-founder Leemon Baird. This is how Swirlds describe themselves:
“Swirlds is a software platform designed to build fully-distributed applications that harness the power of the cloud without servers. Now you can develop applications with fairness in decision making, speed, trust, and reliability, at a fraction of the cost of traditional server-based platforms.”
It has been described as “blockchain on steroids”.
Hashgraph is said to have the following properties:
- Speed: It can compute 250,000+ transactions per second.
- Fair: It uses consensus time-stamping which makes the system fair.
- Secure: It is an asynchronous Byzantine Fault Tolerant system. Meaning it can still work even if some of its nodes aren’t participating properly.
Hashgraph uses two special features to achieve its fast, fair and secure transactions:
- Gossip about gossip.
- Virtual Voting.
Gossip About Gossip
Gossip about gossip or the gossip protocol is a very well-known concept in networking. Think of how gossip spreads in real life. Alice says something to Bob and then Bob says it to Charlie and Charlie says it to Dave and so on and so forth. Gossip about gossip roughly works on the same principle. Each “gossip” basically includes a piece of information attached to the hashes of the last two people talked to.
Every node in Hashgraph can spread signed information (called events) on newly-created transactions and transactions received from others to its randomly chosen neighbors.
The neighboring nodes then amalgamate these new events with the information obtained from other nodes into a new event and then send it forward to more neighbors who are randomly chosen. This goes on until all the nodes are aware of the information.
The way that each node determines whether a transaction is valid or not is by virtual voting. If a transaction has 2/3rd of the node in the network as a witness, then it is considered valid. Remember, hashgraph was designed to be Byzantine Fault Tolerant, hence this algorithm allows the system to work even if a third of the nodes turn Byzantine.
Blockchain Vs Hashgraph
The two biggest problems that the blockchain is facing are:
- Speed of transactions
- Fairness of transactions.
Let’s see how the hashgraph matches up against that
Speed of Transactions
Bitcoin right now manages 7 transactions per second, Ethereum fairs slightly better at 15 per second. Hashgraph claims to be doing 250.000+ transactions per second. So, what’s the catch?
Hashgraph currently operates on a permissioned, private-based network. What this means is that the number and identity of the nodes participating is known beforehand. This is why it is unfair to compare it to a blockchain which is public and non-permissioned, meaning there are no fixed number of nodes. As of writing, there is still no public and non-permissioned version of the Hashgraph available.
Fairness of Transactions
One of the most annoying problems of blockchain based currencies is the lack of fairness in transaction validation. Since the miners themselves manually put the transactions into their blocks, they will always choose transactions which favours them financially.
Hasghgraph mitigates this via consensus time-stamping.
If one transaction reaches 2/3rd consensus before the other transaction, then it is validated first. It is simple first-come-first-serve and keeps the network as fair as possible.
Carbon’s Two-Token Economy
Carbon has a dual-token system to fuel its economy. The two tokens used are:
- Carbon Credit
CUSD is the main stablecoin in the Carbon ecosystem. It is intended to be pegged to the US Dollar.
Carbon Credit is the free-floating coin and is sold for CUSD when the CUSD price moves below $1. The new carbon credits are issued via a Reverse Dutch Auction mechanism, with Credits priced and paid in CUSD. Payment for these carbon credits are done via CUSD and helps reduce the outstanding supply of CUSD, theoretically helping the price move back towards the $1 peg.
When the CUSD price moves around the price peg, it signals a strong demand for CUSD, and additional CUSD tokens are issued to Carbon Credit holders who are free to sell them into the marketplace, pushing the CUSD price back towards its peg. Carbon allows for the secondary trading of Carbon shares issued as part of the contraction of the money supply, potentially allowing a share bought at $0.90 to be resold at $0.98, rather than waiting for redemption which makes it pretty unique.
Achieving consensus on Carbon’s exchange rate with its US Dollar peg is done via decentralized Schelling Point oracle scheme. These exchange rates are established every 24 hours and the network nodes post collateral to submit their estimate of the Carbon-USD exchange rate.
Possible Use Cases for Carbon
The Carbon whitepaper identifies the following use cases:
Programmable Money: Carbon has been programmed to be both trustless and fully programmable through smart contracts. Carbon has pushed the horizons of what their money can be by giving context and a higher degree of information encoding to all the value transfers.
Trading Pair: There will always be demand for a stable trading pair in the crypto community. Carbon is planning to partner up with several crypto exchanges to use CUSD as a trading pair.
Global Payment Network: Being a stablecoin, Carbon has the potential to be a means of stable global payments, store of value, and unit of account. Carbon’s key characteristics are price stability, liquidity, and scalability. Carbon also allows arbitrarily complex logic to be encoded into transfers. The way this happens is by contextualizing payments and reducing resolution cost where one can trustlessly create payrolls, subscription services, event-triggered payments and much more using Carbon’s protocol. Payment disputes can easily be resolved through escrow contracts and programmable logic.
Fueling Future Decentralized Applications: One of the biggest problems with Ethereum and the current smart contract landscape is the high gas prices. Carbon can be used as a gas/payment for using decentralized applications. Carbon is in the process of securing partnerships with several dApps for adoption.
Hedge Against Fiat Inflation: Carbon’s CUSD stablecoin will serve as a hedge against fiat inflation. Their long-term vision is to create a stablecoin which is separate from national fiat currencies and is instead pegged to a basket of goods, ultimately serving as a hedge against the dollar itself.
Fundraising Economy: One way that Carbon will drive demand and give new crypto companies which have stability in funds by organizing efforts to onboard new cryptocurrency companies to accept Carbon stablecoins as a form of fundraising through token sales.
Lending Markets: Carbon’s vision is for lending markets to be built on top of Carbon’s base infrastructure layer, which will, in turn, enable global access to secure and price-stable loans. This will enable people to effectively and efficiently obtain capital with minimal friction.
Financial Products: Carbon wants to be the next generation of financial products that leverage distributed ledger technology. Their price-stable cryptocurrency will support a network of trustless, decentralized credit/debt markets, options, futures, and other derivative contracts.
The Aztec Model, Contraction, and Expansion
Carbon has a unique execution model called The Aztec Model. The Aztec Model works pretty differently from most elastic supply stablecoin models.. Under this model, users gain 100% of the upside in expansionary cycles assuming those users burned their tokens during contractionary cycles.
So what does this do?
This helps users to have a strong incentive to assist in Carbon’s price-stability mechanism. So, let’s look at how the mechanism works when it comes to both supply contraction and expansion.
When the tokens are trading from less than a dollar, Carbon Credits are auctioned off via a reverse dutch auction to market users who are willing to burn their stablecoins. This reduction in supply helps create an upward price pressure, appreciating the stablecoin price back up to $1. Whenever the oracle shows that the exchange rate is going below a dollar, the smart contract will initiate an auction for new carbon credits. The CUSD received will be burned, diminishing supply thus raising the price.
So, what happens when the coins are trading for more than a dollar?
In situations like these, the coins are distributed to Carbon Credit holders pro rata, creating downward price pressure and bringing the stablecoin price back down to $1.
This model and mechanism have several benefits. First and foremost, it is extremely clear with a very simplistic approach. It allows the Carbon Credits to be easy to price and it will translate to a higher degree of price stability.
Carbon Special Features
What are some of the special characteristics of the Carbon stablecoin? Well, let’s take a look”
Stable: Carbon will be closely correlated to the US Dollar and, eventually, CPI-based pegs aka “basket of goods”.
Programmable: It is smart contracts compatible and has the potential to become “intelligent money”. It aims to be a programmable, price-stable digital currency.
Lightning Fast: Carbon is based on Hedera Hashgraph so it can do 100,000 transactions per second, theoretically at least..
Trustless: As the Carbon website explains, you can “trust great code, not unknown third-parties”.
Borderless: You can send your Carbon tokens anywhere you want without any strings attached.
Team Behind Carbon
Carbon was created by Connor Lin, Gavin Mai, Miles Albert, and Samuel Trautwein.
Samuel Trautwein: Trautwein was on the founding CS team of Plenty, a Softbank-backed AI hydroponics company. He studied Computer Science with a specialization in AI at Stanford University.
Connor Lin: Lin worked at ConsenSys, Turing Capital and Riley, a Y-Combinator backed company. He studied Humanities and Psychology at Columbia University.
Gavin Mai: Mai worked on Uber’s Global Marketplace Forecasting team and SalesforceIQ’s Einstein Intelligence initiative. He also started the Hashgraph Bay Area meetup. He studied Symbolic Systems at Stanford University.
Miles Albert: Albert was on the early team of Hashgraph, a next-generation distributed ledger technology that overcomes many of blockchain’s limitations. He has evangelized smart contract protocols since Ethereum’s launch in 2015. Miles studied at the University of Southern California.
The company was founded in New York City in September 2017. The company is officially called Carbon-12 Labs, while their flagship product is the Carbon cryptocurrency.
The team comes from Stanford, USC, Columbia University, the Y Combinator accelerator program, Uber, Hedera Hashgraph, and other notable organizations.
Criticism of Stablecoins
The biggest detractor of stablecoins is Preston Byrne who has written a series of articles deriding the concept. He has individually taken apart various stablecoins like Basis, MakerDAO etc.
According to him, the concept of stablecoins “is so profoundly ill-conceived that I’d venture to say the “Stablecoin” is the closest thing the crypto world has for an answer to the Hitchiker’s Guide to the Galaxy’s Ravenous Bugblatter Beast from Traal, a creature known not only for being extremely vicious and hungry, but also for being denser than a neutron star. Which, for those of us not versed in stellar physics, is very dense indeed. In that series of books, the Traalbeast is regarded as the single dumbest creature in the entire universe, a failure of evolution so complete and irredeemable that it “believes if you can’t see it, it can’t see you.”
That’s quite a harsh criticism!
He believes that the idea of a stablecoin, a free-floating digital commodity devoid of intrinsic value, which attains market prices but instead works only by devouring new investment money at every available opportunity, is bound to be a failure.
The Basis coin team said that they plan to achieve price stability in the “first few years” of the project by raising a “stability fund… to keep the token stable.”
According to Byrne, their plan appears to be to use the ICO proceeds to buy their own product at or neat a dollar parity. This shows that this is just a simple self-trade instead of a well laid out algorithm. On top of that, basecoin claims that they have solved the problem of volatility via the issuance of a cryptocurrency which is pegged to a basket of goods while remaining decentralized. To compensate for the volatility, they said that they can algorithmically adjust the supply of the tokens in repose to these changes by “implementing a monetary policy similar to that executed by central banks around the world”.
Byrne counters this by saying that this is not central banks manage money. There is an ongoing proposal which works in a similar way, which will be enacted by banks in the future, however, there is nothing like this going on right now.
Byrne further concludes that while things are sailing smoothly, the system will work properly. However, when things do down, and it will, there will be insufficient new “bond collateral” entering the scheme to bring the price back up and “the only way you can achieve stability is by way of massive artificial buys on the part of insiders”. However, when this happens, the speculators will buy against the coin, which will eventually lead to a Soros attack.
The problem with MakerDAO is that because it is so massively overcollateralized in the underlying cryptocurrency, i.e. Ethereum, in the event of an Ethereum black swan event, the value of both Ethereum and Dai will both be wiped out.
He believes that the system of Dai is broken to its very core, and works only if the price of Ether goes up. The system uses overcollateralizing to protect the value of Dai. However, instead of doing just that, it is simply increasing the holder’s exposure to the price of the underlying Ether. So, if the value of Ether does get wiped out, the user will, in essence, lose $150 in their effort to create $100.
In this guide, we have brought you both the positive qualities and the various criticisms of Stablecoin. The point is to educate you on both the facets of the project to help you make your own decision. Stablecoins have long been called the “holy grail of crypto” which is going to, allegedly, help cryptos attain widespread mainstream adoption. We need to see how this pans out in the future. So, are they going to make or break the cryptospace?
Sound off in the comment section below!