How to make a “stablecoin” stable?

After a meteoric 1,300%+ run in 2017, bitcoin and other altcoins are widely considered speculative assets. But for many prophetic crypto use cases, that type of volatility is counterproductive — that’s why many believe 2018 will be the year of the stablecoin. This piece covers the space of asset and algorithmic backed coins, with a deep dive into Basis, which recently raised $133mm from the likes of A16z and Google Ventures.

What is money?

There are three primary functions of money:

1. Store of value
2. Unit of account
3. Medium of exchange

Bitcoin’s white paper begins with the flaws of e-commerce in 2009, setting out to create “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”.

The original vision was to create new money with new rules, but which still served all three functions. The immense volatility over the past years has weakened bitcoin’s utility as a stable store of value and has made it hard to imagine using bitcoin as a medium of exchange. Imagine trying to buy a slice of pizza with a currency that can effectively double or halve the cost in any week.

These limitations span beyond commerce — they impact the ability to build crypto-based debt and income products, as well as delayed smart contracts around prediction markets, and more**.**

“The opportunity for stablecoins is, intrinsically, the largest possible TAM. This vision is larger than that of Bitcoin itself. A fiat-free currency that’s price stable will challenge the legitimacy of weak governments around the world.”

— Multicoin Capital

As crypto attempts to push beyond early adopters into the installation / deployment phases, investors have converged on the need for a stablecoin first and foremost.

Leading stablecoin contenders

A stablecoin is a type of cryptocurrency that maintains a fixed value relative to an underlying asset or basket. The primary goal is to preserve the benefits of electronic, distributed coins like bitcoin while serving as a store of constant value and reliable medium of commerce exchange.

Asset-backed

At $2.2bn market cap, Tether is by far the market leader in the space. Tether is built atop the Bitcoin blockchain and each USDT corresponds at a 1:1 reserve ratio to USD stored in their bank. Thus, the market cap is supposed to be fully asset-backed, giving the currency value through traditional means of legitimacy (NAV). While it has been largely successful from an adoption standpoint, Tether remains shrouded in scandal around unknown bank accounts and potentially fraudulent reserve accounting. As such, the market is furiously investing in alternatives across the board.

Other asset-backed projects include: SAGA, Monerium, Maker Dai, TrueUSD.

Algorithmic

Of course, any asset-backed coin is fundamentally centralized around either a bank or a company that has opened those bank accounts, which is at odds with the decentralized mission of crypto. Thus, many believe the long-term solution must be algorithmic, whereby the stablecoin derives value from monetary supply and related scarcity.

There are other benefits of an algorithmic solution — the peg can span many currencies (like the SDR) or something abstract like CPI. Seigniorage refers to a subset of algorithmic solutions that include parallel classes of bond and equity shareholders. These classes create an ecosystem of advocates around the stablecoin and can serve as a monetization base for the token, creating a reserve to buoy the stablecoin in down-cycles.

Algorithmic projects include: Basis, Fragments, Kowala, Carbon.

Basis

Basis recently made headlines for raising $133mm from the likes of A16z, Bain Capital Ventures, GV and Polychain Capital. It’s viewed as the leader in the algorithmic stablecoin space, and all eyes will be on the token’s formal launch later this year.

There are three main components to Basis’s protocol:

• Basis tokens: These are the stablecoins, pegged to USD initially, to be transitioned to a basket of goods / currencies over time. Basis supply will expand and contract to keep the price pegged.
• Bond tokens: Each bond represents 1 Basis token and is issued when Basis drops below the peg. Vice versa, these bonds are first to be repaid when Basis trades above the peg.
• Share tokens: Shares have a fixed supply and operate most like cryptoassets. They derive value from market forces (including this initial offering) and then accrue value every time new Basis tokens are issued, akin to dividends.

Contraction: When Basis tokens are trading below the peg, the protocol issues bonds much like the US Treasury. These bonds are sold on an open auction at a discount, offering buyers an attractive yield in exchange for 1 future Basis. Basis tokens from current holders, exchanges or the reserve can be exchanged at cents on the dollar for the guarantee of a full dollar at a later date. Thus, bonds remove tokens from circulation, decreasing supply and stabilizing token price. The bonds have a max term of 5 years, but the protocol can prepay at any point, in FIFO order. Alternatively, if bonds hit their 5 year maturity, they expire without payment.

Expansion: When Basis tokens are trading above the peg, the protocol must expand the monetary supply. The first line of defense is any outstanding bonds, which the protocol will repay to release the corresponding Basis tokens. Next, shareholders receive new Basis tokens pro-rata, so their shares gain value proportional to the amount the Basis network grows.

Since the shareholders have a stake in Basis growth, they are likely to step in as the lender of last resort. They are also likely to become advocates for the overall protocol, which is valuable in a highly competitive space.

Still, there are a few obvious challenges to this framework, which mostly center around the market’s perception of Basis:

• Basis bonds function as the lender of last resort, yet they are also subject to odd terms such as fluid repayment and potential expiry without repayment. As such, if the market loses faith in Basis, or the queue of bonds becomes so long that new lenders believe they may not be paid, these bonds could more easily fall out of favor.
• Trust: despite the USD’s departure from the gold standard decades ago, people don’t constantly question the assumptions that underpin its value. In this scenario, that will happen constantly. Thus, it can be difficult to ever really achieve the peg at the onset, and then difficult to pull in other parts of the ecosystem (traditional e-commerce sites, banks, etc) that are necessary for scaled adoption.

What it all means

All of this investment and financial engineering boils down to one core motivation — creating a less volatile, decentralized digital asset. That asset unlocks crypto use cases across the board — meaning the success of a stablecoin is likely directly linked to the broader adoption of crypto.

On the investing front, a stablecoin would reduce trading friction and allow investors to manage their risk without fully converting back and forth to fiat — each time triggering taxable events and requiring KYC / bank integrations. That stablecoin could also underlie margin trading.

As a means of exchange, the opportunities are even more vast. E-commerce, debt, remittance and income projects all rely on a less volatile means of exchanging wealth for goods and services. Similarly, delayed outcomes from smart contracts around insurance and prediction markets can only function in a world where you’ve locked in value — otherwise imagine betting 1 BTC in December 2016 (~$700) that expired one year later. Suddenly, you’re paying out $19,000 in December 2017 — 2600% more than you intended (and 2600% in your counterpart’s favor!).

Finally, on the sovereign side, a stablecoin is an even stronger proxy for fiat, meaning consumers can choose to move their money and thus their tax revenue elsewhere. We’ve already begun to see this shift in areas experiencing erratic monetary policy like Zimbabwe at the end of Mugabe’s term, where a surge in demand pushed bitcoin to twice the price in local markets. Similarly, many of bitcoin’s earliest adopters hailed from Argentina, where they struggled to send money home past capital controls. This introduces a level of competition and accountability into the system, as people across the world can opt for a global currency instead of their local regime’s.

So, are we done here?

Most of these projects either just launched or are raising for a launch later this year, so there’s a lot that remains to be seen. Will the market follow investors’ cue and accept an algorithmic solution like Basis? Or will skeptics succeed in a Soros-like test of the currency’s resilience, leaving only asset-backed solutions? And within asset-backed options, can a crypto-backed token like Maker Dai weather violent crypto cycles and correlation?

My best guess: stablecoins start (fiat) asset-backed, and transition to an algorithmic solution slowly as market trust solidifies — mirroring the dollar’s move away from a gold standard.

Currently, the best example of that is SAGA. That said, this space is ripe for iterations and the final winners may not be the initial winners, as new tokens can pull from past learnings and emerge stronger. That cycle will continue until enough utility platforms emerge, such that the winning stablecoin(s) integrate with the winning providers of debt, prediction markets, etc.