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Decentralizing stability: An examination of crypto supply models and stablecoins
An in-depth look into the stablecoin space, its challenges and evolution
Of its defining characteristics, perhaps a currency's most important are its total supply and rate of issuance. Different supply and issuance models encourage different behaviors from a currency's users. While absolute scarcity might prompt hoarding, an oversupply can be catastrophic for an economy, as the purchasing power of currency dwindles quickly.
In this OKEx Insights article, we examine how supply and issuance models impact a currency's utility and, ultimately, price. Alongside comparing Bitcoin's finite and ETH's unlimited supply models with fiat monetary policies, we'll be discussing rising demand for stablecoins and an emerging class of digital currencies seeking to emulate fiat's stability using algorithms alone.
These algorithmically stabilized currencies have introduced concepts like elastic supply, rebase and debase, and have started getting more recognition of late. On paper at least, they represent promising efforts to create digital currencies that are simultaneously stable in purchasing power and completely decentralized. Relying on unproven theoretical assumptions, however, as we discuss further, these solutions are far from ideal.
Bitcoin's case for hard-coded supply caps
Most currencies today have a potentially unlimited supply. In the fiat world, central banks hold a monopoly over their creation. The stated mandate of the United States Federal Reserve, for example, is to achieve currency stability and maintain maximum employment.
The tools available to achieve this include the ability to expand the money supply in response to changes in demand for U.S. dollars. Increases in the monetary base in excess of demand result in inflation, which lowers the value of all units of currency in the economy. Inflation incentivizes spending, leading to economic growth while making it expensive to save. Some argue that inflation is necessary to stimulate an economy. Meanwhile, others call it a covert tax on citizens' wealth.
Bitcoin's anonymous creator, Satoshi Nakamoto, appears to fall into the latter group. They designed Bitcoin in stark contrast to the fiat system, as it has a hard cap of 21 million coins and no central authority can increase its issuance. Both the total supply and the rate at which new coins enter circulation are set in stone thanks to its system of reducing block rewards, also known as halving events.
Clues suggesting an anti-central bank motive pop up throughout Nakamoto's posts. Perhaps the most explicit is the message included in the first Bitcoin block ever to be mined. Taken from the front page of British newspaper The Times, it reads:
"Chancellor on Brink of Second Bailout for Banks."
Nakamoto was also among the first to draw parallels between Bitcoin and gold. The two assets are both scarce, meaning their supply cannot be diluted at the whim of some central entity. This narrative has picked up steam in recent years. At first, it was chiefly espoused by Bitcoiners, but then, last year, more traditional financial institutions began to note the similarities.
It's telling that this sentiment shift occurred during a year in which central banks around the world created more new units of currency than at any other point in history. Those holding large cash reserves were forced to take the issue of its increasing dilution seriously. Thus, we saw a new breed of institutional and corporate investors publicly buying BTC, often citing the asset as a hedge against a weakening dollar.
That being said, the fact that Bitcoin's supply is hard-coded is partly why it also struggles to garner mainstream adoption as a medium of transfer for daily usage.
Ethereum: An experiment in unlimited supply
Although many cryptocurrencies followed Nakamoto's lead in implementing a hard supply cap, some do have potentially unlimited issuance. Ethereum is one such example. However, the motive behind the creation of new ETH is different from that of fiat currency.
Like Bitcoin, Ethereum's security model relies on incentivized validation of transactions. Rewards motivate honest participation in both networks, strengthening their overall security. These rewards come in the form of BTC or ETH that is minted with each new block of transactions, as well as from the fees that transactors pay to use the network.
The two networks take a different approach when it comes to long-term security, however. When the last BTC is mined, Bitcoin's coinbase block rewards — new coins minted with each new block — will stop. At that point, transaction fees alone should incentivize honest miner participation. By contrast, Ethereum will continue to reward transaction validators with newly minted Ethereum.
Despite ETH and fiat currencies both having a potentially unlimited supply, demand for ETH does not influence its creation. Instead, inflation is a product of the network's security model, and it's something that developers and users are keen to keep in check.
Not only has Ethereum co-founder Vitalik Buterin mulled a hard cap on ETH's total supply, but a proposed future upgrade could involve burning a portion of the miner fees and removing units from circulation. Alongside the potential to reduce fees across the network, there have been proposed updates such as EIP-1559 that suggest giving Ethereum a somewhat harder monetary policy with reduced inflation — something very popular among ETH investors.
The search for stability and "stablecoins"
While the monetary policies of Bitcoin and Ethereum might make them attractive speculative investments — or even stores of value — their current utility as a unit of account is questionable. When a currency's supply is not responsive to changes in demand, said changes result in dramatic price swings. This not only makes things hard to price, but it also requires a merchant accepting BTC or ETH to take on some volatility risk.
For use outside of speculation, trading or long-term holding, Bitcoin's volatility is undesirable. Users of a currency want to be confident that the money they have today can be exchanged for roughly the same value of goods and services tomorrow. Therefore, stablecoins — i.e., tokens designed to be used as mediums of exchange representing a single unit of currency, most commonly the U.S. dollar — have seen increasing adoption for many use cases less suited to BTC.
Stablecoins attempt to provide the transactability benefits of a digital currency while remaining free from the volatility that hinders BTC's retail adoption. The growth of the leading stablecoin, Tether (USDT), from a market cap of less than $5 billion last year to around $23.5 billion today, demonstrates just how important price stability is to many cryptocurrency users.
Stablecoins, as they currently exist, all have a technically unlimited total supply. How they are issued and the mechanisms used to maintain stability place them into one of two broad categories:
- Elastic supply
Fiat-collateralized stablecoins function as a form of digital IOUs. An entity (e.g., a bank or smart contract) holds units of currency or other assets and issues stablecoins in proportion to such assets.
Tether is by far the largest example of a fiat-collateralized stablecoin. Although a controversial topic itself, the company presumably holds $1 for every 1 USDT in existence. Since every USDT is backed by a dollar, the currency's purchasing power remains consistent. Other fiat-collateralized stablecoins, such as USDC and TrueUSD, also follow this model.
When backed one-to-one, fiat-collateralization provides the greatest stability of any current stablecoin system. However, there are drawbacks to fiat-collateralization. Firstly, users must trust that the issuer does indeed hold the reserves it says it does. This hardly sits well with the transparent, trust-minimized vision of cryptocurrency.
Additionally, since fiat-collateralized stablecoins rely on banks to hold funds, their issuers are subject to regulatory pressures. U.S. lawmakers are currently attempting to pass legislation that would, among other things, require stablecoin issuers to obtain a federal banking charter. Those against the recently proposed STABLE Act reason that such a change would stifle innovation in the stablecoin sector. Pressure from law enforcement has also previously resulted in both Tether and Centre blacklisting Ethereum addresses that were holding the respective stablecoins of each company (i.e., USDT and USDC).
The aforementioned shortcomings of fiat-collateralized stablecoins gave rise to the crypto-collateralized model. The most prevalent example is MakerDAO's DAI token. Instead of dollars in a bank account, smart contracts hold ETH and other cryptocurrencies as collateral, and the protocol lends out DAI tokens at a rate that intends for each token to trade close to $1. This type of mechanism is also known as a soft-peg.
In some ways, crypto-collateralized stablecoins represent an improvement upon their fiat-collateralized counterparts, like USDT. For example, users can verify the total collateral backing DAI tokens via the Ethereum blockchain, significantly reducing the inherent level of trust typically demanded by fiat-collateralized stablecoins. However, as discussed above, most crypto assets suffer from extreme price volatility, making them ill-suited as a form of collateral.
To get around the volatility issue, crypto-collateralized stablecoins must be overcollateralized. By backing them with assets greater in value than those issued, these stablecoins are protected from sudden swings in the prices of the collateral assets. This allows decentralized stablecoin projects to achieve a price stable enough that they become useful in various financial contexts. However, 150% collateralization or more represents a highly inefficient use of capital, while still not entirely removing the threat of forced liquidation during crypto market swings.
Algorithms offer a "no collateral" approach with elastic supply
Stablecoins are undoubtedly useful. USDT has long provided traders with a stable asset to exit into during periods of heightened cryptocurrency volatility. With the explosion of interest in decentralized finance last summer, use cases for stablecoins only increased. Lending, borrowing, trading and providing liquidity using a stablecoin negates some risk for users.
However, as we've discussed, existing implementations of stablecoins are not perfect. The likes of USDT and other centrally collateralized projects represent a counterparty risk not at all aligned with the ethos of the wider cryptocurrency industry. Meanwhile, cryptocurrency collateralization models make for inefficient capital use, at best, and can, at worst, result in brutal liquidations during periods of heightened volatility.
However, given that prices move in accordance with both supply and demand, stability should theoretically be possible if changes in a currency's supply are responsive to changes in its demand. If a 10% supply increase coincides with a 10% demand increase, there should be no price increase. That is loosely the premise behind a category of cryptocurrencies that has been gaining increasing attention lately.
Known as algorithmic stablecoins, or elastic supply coins, these projects attempt to trade at a specified target price by increasing or decreasing the circulating supply of currency in response to demand. If the price is below the target (often, but not always, $1), then the supply of stablecoins contracts, increasing the price of each unit. Conversely, when demand increases and the price is above the target, new coins are minted to dilute the supply and bring the value of each unit down.
The concept of an elastic supply token is hardly new. In fact, two different proposals for algorithmically adjusted supply stablecoin systems were put forward as early as 2014.
Naming his solution after the anti-central bank economist and political theorist Friedrich Hayek, Ferdinando M. Ametrano, in his essay "Hayek Money: The Cryptocurrency Price Stability Solution," describes a system in which users themselves benefit from the creation of new units of currency, while also financing contractions of supply when demand falls. The value of a single unit of a currency using such a system should theoretically remain constant, yet wallet balances would grow and shrink in accordance with changes to the total market capitalization.
In "A Note on Cryptocurrency Stabilisation: Seigniorage Shares," Robert Sams puts forward a similar model for an elastic supply coin. In this model, like Hayek Money, the money supply would grow and shrink in accordance with demand. However, Sams reasons that increasing and decreasing wallet balances pro-rata simply transfers volatility in price to volatility in wallet balances. While the purchasing power of a single unit of Hayek Money should remain constant, that of any given wallet would expand and contract in tandem with the total size of the market.
"Price stability is not only about stabilising the unit-of-account, but also stabilising money's store-of-value. Hayek money is designed to address the former, not the latter."
Instead, he favors a system in which only users who care to would need to concern themselves with the currency's underlying stability mechanism. The Seigniorage Shares model relies on a second token that allows the holder a share of any future supply expansion.
Those opting to support such a stablecoin system do so by taking units of the currency out of circulation when the price is below its target. In return, they receive share tokens that they can exchange for the stablecoin minted during a supply expansion event. With the number of coins received outnumbering those burned, potential profits incentivize users to influence the protocol's monetary policy themselves.
Renewed interest in algorithmic, elastic supply stablecoins
As noted by both Sams and Ametrano in 2014, theorizing about elastic supply coin models was inspired by both the clear need for a viable decentralized stablecoin as well as the shortcomings of existing collateralized models. More recently, however, a potentially hostile regulatory environment seems to be hastening development.
Even before the proposed STABLE Act in the U.S., efforts to create stablecoins presented potential regulatory issues. Those behind the original Basis stablecoin were forced to disband the project in December 2018. Citing a potential conflict between themselves and U.S. securities regulators, the team refunded investors and shelved the early Seigniorage Shares-inspired project.
With the STABLE Act now threatening stablecoin issuers and a thriving DeFi space providing compelling use cases for consistently priced cryptocurrencies, many algorithmic stablecoins following both the pro-rata rebase and Seigniorage Shares models have emerged in recent months. The superior censorship resistance of such projects compared with that of centralized efforts makes their development a particularly worthy pursuit when faced with aggressive regulators. It's understandable, given the uncertain regulatory environment, that developers behind projects like Based Money, DEBASE, Basis Cash and Dynamic Set Dollar prefer the cover of anonymity, however.
Algorithmic stablecoins: On paper vs. in practice
Those following the cryptocurrency industry closely might recognize the premise behind both Ametrano's Hayek Money and Sams's Seigniorage Shares. The former is almost identically reflected in the design of the rebase currency Ampleforth, which itself has been borrowed by projects such as YAM Finance, DEBASE, Base Protocol and others.
Those systems, drawing inspiration from Ametrano, undergo a process known as a rebase at a set interval. An oracle delivers the asset's price on external exchanges to the protocol. When the price is above the target, users' wallet balances holding the rebase token grow. If the price is a long way above the target, most protocols don't immediately release the total supply required to bring it all the way down. To avoid price overcorrections, many use some supply smoothing mechanisms to stagger release.
Conversely, when demand for the token shrinks, so too does the money supply. Again, the percentage difference between the current and target price determines by how much the protocol reduces wallet balances. When the price is close to the target price, the network does not need to adjust the supply. By distributing and removing tokens directly to and from wallets, whatever percentage share of the entire market capitalization users held prior to the rebase remains the same following it.
Despite having a clearly stated price target, Ampleforth prefers to distance itself from the term stablecoin. Since each user benefits from the network's growth with increased token balances, the team describes its token, Ample (AMPL), as having the potential to become a diversifying asset and serve as an attractive hedge against other markets, cryptocurrencies included.
Indeed, research into Ampleforth by Gauntlet noted low market capitalization correlation between AMPL and other major digital currencies. This lends support to the notion that rebase currencies could eventually represent an innovative and largely uncorrelated asset class of their own.
Another interesting application of supply elasticity following the Hayek Money model is Base Protocol. Expansion and contraction of the token supply are supposed to keep the protocol's token, BASE, priced at one-trillionth of the total cryptocurrency market capitalization. Like AMPL holders, those invested in BASE receive supply expansions and finance contractions pro-rata. If it's able to maintain its peg long-term, BASE would offer a way for speculators to bet on future growth of cryptocurrency as a whole.
Meanwhile, Sams's Seigniorage Shares has been implemented with various tweaks in projects like Basis Cash, Empty Set Dollar, Dollar Protocol and several others. The multi-token system separates the stablecoin itself from its stability mechanism. Users not wanting to contribute to price stabilization can just transact ESD, DSD, BASIS, etc. as they would any stablecoin.
Those users inclined to take on risk for potential rewards can partake in the stabilization of the currency. This usually involves burning units of the stablecoin in exchange for a bond token. In the event of a later supply expansion, bond tokens can be exchanged for the new units of the currency at a profit.
Despite the concept making sense theoretically, many algorithmic stablecoin projects seem to struggle to stick to their target in reality. The current market leader in Seigniorage Shares-style tokens is Empty Set Dollar (ESD), which has a total market capitalization of more than $324 million.
Launched in September 2020, ESD traded as high as $2.29 and as low as $0.44 within the space of a single week. While it might be premature to write the project off entirely, it's also quite the stretch to call such price moves stable, at this point.
Other examples seem to fare better in terms of stability. Despite incredibly erratic prices at launch, an effort to revive the original Basis protocol, called Basis Cash (BAC), has traded close to its $1 target for much of its own short existence. However, price alone doesn't reveal the full picture.
With any elastic supply coin, the target is easier to maintain when the market capitalization is rising. Confidence in a given protocol runs high, as those supporting it make profits from market growth. It's when the market capitalization contracts that faith in the project is put to the test. As seen below, Basis Cash has yet to experience a prolonged contractionary period.
Once the price falls below the target, elastic supply protocols rely on users taking on debt to bring it back to the target. This, therefore, requires that users believe the price will eventually trade above the target again, allowing them to profit from the bonds they receive when burning the token supply. If faith is lost in a protocol, there will be few willing to exchange tokens for bonds, no matter how lucrative the profits could be.
Software engineer and managing partner at Dragonfly Capital, Haseeb Qureshi, highlighted this flaw in an essay titled "Stablecoins: Designing a Price-Stable Cryptocurrency":
"Seigniorage Shares can absorb some amount of downward pressure for a time, but if the selling pressure is sustained for long enough, traders will lose confidence that shares will eventually pay out. This will further push down the price and trigger a death spiral."
BankUnderground's Ben Dyson drew similar conclusions prior to the latest wave of algorithmic stablecoins hitting the market. Dyson looks at the monetary policy behind the original Basis in his article "Can 'Stablecoins' be Stable?" Ultimately, he states that the algorithm alone cannot guarantee that bond buyers will step forward to bring the price back up:
"Whilst algorithmic stablecoins like Basis manage to eliminate the need for trust in a third party, they instead end up being heavily dependent on investor belief and confidence."
Equally critical of the Seigniorage Shares system is Ampleforth's founder, Evan Kuo. Dismissing projects like Basis Cash as "zombie ideas," he warned those excited by such systems to "temper expectations":
"Stablecoins that rely on debt marketplaces (ie: bonds) to regulate supply will always rely on lenders of last resort (ie: bailouts)."
The Ampleforth team elaborated to OKEx Insights:
"Seigniorage tokens can 'break,' due to their reliance typically on a 'lender of last resort,' similar to traditional financial actors. This represents the opposite of decentralization. On top of that, given these are relatively newer and smaller DeFi projects, they do not have the backing of a lender of last resort as proven as a government (like the U.S.) or central bank (like the Fed). This means they are also inferior in the 'safety' provided by such a 'safety net.'"
Despite flaws, stablecoins are here to stay
The limited supply of Bitcoin, coupled with its unprecedented security, serves it well for use as a hard monetary asset. However, price volatility makes it a very poor unit of account. There may come a time that Bitcoin's market capitalization is so vast that volatility reduces to an acceptable level so as to price things in BTC, yet this is certainly not the case today.
Given this volatility, stablecoins are an increasingly vital part of the cryptocurrency industry. Traders exit positions into them, DeFi yield farmers use them to manage risk, and a growing list of merchants accept them. To accommodate changes in demand, stablecoin supplies grow or shrink and are technically unlimited. Some systems rely on a central issuer and others use algorithms. Different approaches result in tradeoffs that users must weigh themselves.
In addition to being potential targets for regulators, those holding collateral in centralized ventures, such as USDT, are exposed to counterparty risk. They can also be blacklisted, as both Tether and Centre did last year at the request of law enforcement agencies. Despite their flaws, however, centralized solutions remain both the most stable and the most popular.
Stablecoins collateralized by crypto assets or using algorithmic supply adjustments cannot be censored in such a way. Yet, they're themselves subject to the standard protocol risk that's always a factor in decentralized finance, along with their own unique flaws.
Thanks to their collateralization, projects like DAI are generally more stable than elastic supply coins. However, extreme price volatility can induce liquidations. Meanwhile, overcollateralization requirements intended to mitigate liquidation risk makes DAI an inefficient use of capital.
Elastic supply tokens represent the most risk. Completely uncollateralized, they rely on game theory and often elaborate incentive structures to target a price. If market sentiment turns against an elastic supply token, sellers may outnumber buyers when the protocol requires an increase in demand to return to the peg.
However, all things considered, we're still in the very early days of an unprecedented period of monetary experimentation. Ideas that were never previously implementable can now be tested with real capital in play. Bitcoin's invention has resulted in opportunities to create entirely new financial systems and, although far from perfect today, decentralized stablecoins of some description will surely be part of its eventual design.
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