An Introduction to Stablecoins

Stablecoins are cryptocurrencies that are usually backed by another asset, in most cases, a fiat currency like the US dollar, a commodity like gold or silver, another cryptocurrency, or in the case of a seigniorage share stablecoin, economic policies. Most stablecoins can fall into one of three categories, fiat backed, asset-backed, or seigniorage shared. What differentiates stablecoins from most cryptocurrencies is that stablecoins typically experience less volatility than cryptocurrencies. There was a point in time when Bitcoin was increasing by nearly $1,000 every day — in juxtaposition to that; Bitcoin is down by about 65% from its all-time high — to say the least, the cryptocurrency market can be extremely volatile. However, because stablecoins are often backed by fiat currencies, assets, or economic policies that do not experience as much volatility as a cryptocurrency, stablecoins can make for reliable investment vehicles in an investors portfolio and can fulfill the three essential features of money — something that cryptocurrencies struggle with.

Before a unit that is exchanged can be considered money, it needs to have three essential features.

On the other hand, stablecoins do fulfill the three essential features of money, unlike their volatile counterparts, a stablecoin can be a reliable store of value — especially stablecoins that are backed by fiat currencies. But not only can stablecoins be classified as money by definition, owning a stablecoin gives its holder the benefits of both cryptocurrency — like decentralization, cryptographic security, and an immutable ledger — as well as the three features of money mentioned above; some might even argue that stablecoins are better than money and most cryptocurrencies for that reason. Because stablecoins run on blockchain-based platforms, the holder of a stablecoin can take the power of a financial institution/intermediary into their own hands. On a blockchain, users can transact peer-to-peer, reducing transaction costs and time lags; this makes blockchain-based currencies a perfect tool to execute cross-border transactions. For example if Alice wants to transfer $200,000 to a Bob who lives overseas, going through the traditional financial system would require Alice to pay a transaction fee, and will most likely require her to fill out some paperwork; this process causes there to be several days of delay between the time Alice sends the transaction and the time Bob receives the money. However, if Alice were to send Bob $200,000 over a blockchain network, it would be as easy as entering Bob’s wallet address, entering the amount Alice wishes to send Bob into any electronic device that connects to a blockchain network, and then clicking send. Through a blockchain-based system, Bob should have his $200,000 within the same hour opposed to waiting several days for his money to arrive.

Blockchain-based currencies like stablecoins also offer a more secure way for individuals to transfer value; a blockchain is cryptographically secured, and for the data that enters a blockchain to be fraudulently manipulated, an attacker would need an unfeasible amount of computing power to launch a 51% attack or an unfathomable amount of wealth to attack a Proof-of-Stake system.

Anyone looking to benefit from the advantages of a blockchain technology — transparency, security, immutability — without losing the guarantees like trust and stability that are provided by fiat currencies might want to look into stable cryptocurrencies. Stablecoins can be powerful investment vehicles that can be used to hedge investments, make payments, pay salaries or rents, or act as on-chain collateral that can easily be accessed. Let’s take a look at the three main types of stablecoins and blockchain projects that fall into each categorization.

Stablecoins Backed by Fiat

But still, some fiat-backed stablecoins — like Tether — make investors wary. As mentioned above, Tether has never been formally audited. It is possible that fiat-backed stablecoin companies like Tether do not actually have the amount of wealth they say they do in their reserves. If this was the case, and every user within the fiat-backed stablecoin community tried to withdraw their funds, then the stablecoin company would not have enough money to pay all the users the amount they are entitled to. The fact that fiat-backed stablecoins like Tether require a centralized broker and the success or failure of the token relies on the honesty of the issuer makes fiat-backed tokens something to be cautious of. There is often little to no transparency into the company that controls the fiat-backed stablecoin which makes it hard to trust the claims these companies make regarding token liquidity — in reality, there is no guarantee that they have the funds they say they have or that you will be able to redeem your tokens. Not only that, but most fiat-backed stablecoins are difficult to convert back to fiat currency — not all stablecoins have a direct withdraw process that allows you to convert from stablecoin to fiat, in some cases, you have to convert from stablecoin to Bitcoin or Ether, to USD — and that’s not efficient at all. What the fiat-backed stablecoin market needs is regular audits to ensure full transparency, and verification that their token volume is legitimately backed, however, that is currently missing from the fiat-backed stablecoin market; this inevitably increases the risk associated with these types of investments.

Fiat-backed Stablecoin Pros:

Fiat-backed Stablecoin Cons:

Stablecoins Backed by Physical Collateral

If you owned 56 DGX tokens — or in other words, the value of two ounces of gold, then from August 5th to August 6th your level of wealth would have dropped by $19.54 — not nearly as bad as a drop in the price of cryptocurrency can be, but still a factor you must keep in mind when investing in asset-backed stablecoins.

Cryptocurrency-backed Stablecoins

Let’s look at an example:

David deposits $1,000 worth of Bitcoin and then issues 500 $1 stablecoins against it. Thus, the stablecoin is 200% collateralized. If the price of Bitcoin drops by 20%, then our 500 stablecoins will still be collateralized by $800 of BTC. Therefore, David will still have some safety margin left. The stablecoin owner can liquidate (sell) stablecoins and give $500 worth of BTC to the owner of the stablecoins, and the remaining $300 that is in BTC can go back to original depositor.

Although this may sound appealing to some, there are quite a few downsides that come with investing in cryptocurrency-backed stablecoins. If the underlying cryptocurrency crashes enough, your stablecoins are usually liquidated to that underlying cryptocurrency. And a cryptocurrency-backed stablecoin leaves you susceptible to the price swings of the underlying crypto.

Cryptocurrency-backed Stablecoin Pros:

Cryptocurrency-backed Stablecoin Cons:

Seigniorage Share Stablecoins

“Coins are the object of stabilisation, and ∆i of coin is distributed to the holders of shares. When coin supply needs to increase, coinbase is distributed to shareholders in exchange for a certain percentage of shares, which are destroyed (coin supply increases, share supply decreases). When coin supply needs to decrease, sharebase is distributed to coin holders in exchange for a certain percentage of coin, which are destroyed (coin supply decreases, share supply increases). The mechanism of these shares-for-coin and coin for-shares swaps is a voluntary one, a decentralised auction the rules of which are written into the protocol.”

Let’s take a look at the following example so we can understand the concept better:

And now for our example. Let’s say the target value of a seigniorage-share is $1 per token. If the token is trading at a premium of $1.50, then the price is too high. According to supply-demand rules, supply needs to go up to decrease the price. Thus, a smart-contract will mint new coins and release them to the open market proportionally, until the price becomes $1.

Now, what if the token is trading at a discount of $0.80? This price is too low. Supply would have to go down and for the price to increase. For supply to go down, smart-contracts need to buy tokens from the market to decrease supply.

Some might wonder, “what if the smart-contract doesn’t have any funds left or the funds left in the contract are not enough to buy up enough tokens?” In that case, the system can entitle people to a future seigniorage; this means that the next time a smart-contract issues coins, releasing them to the market and making a profit, people who are entitled to future seigniorage will receive part of those profits.

By utilizing the above algorithm, a blockchain system will work to stabilize the price of the token back to $1.

On the bright side, no collateral is required to drive a seigniorage stablecoin economy, and these systems are the most decentralized of the three stablecoins discussed because they are not tied to another cryptocurrency or fiat. However, for these systems to remain sustainable, continual growth is required.

Seigniorage Share Stablecoin Pros:

Seigniorage Share Stablecoin Cons:

The Best of Both Worlds

Stablecoins have the three essential features of money, and reap the benefits of a blockchain-based system at the same time; for this reason, stablecoins have the potential to disrupt the fiat economy by acting as a viable substitute to transfer wealth and make transactions. In places that are experiencing hyperinflation like Venezuela, stablecoins can offer a more efficient means of money than the Venezuelan bolívar which is currently worth 0.0000048 USD per bolívar. Although stablecoins do have the ability to fluctuate in value, the fluctuations in a stablecoin are not nearly as devastating as the fluctuation in the value of the bolívar over the years.

Investors may find stablecoins appealing because they are less volatile than most cryptocurrencies, hence it can be used as a hedging instrument. By investing in a stablecoin on a crypto exchange, it is easy to transfer wealth out of the stablecoin into another cryptocurrency if you believe the market is about to heat up, or transfer your wealth from a cryptocurrency into a fiat-backed stablecoin if you think the market is about to decline. Because stablecoins have features of both traditional money and cryptocurrency, stablecoins have the potential to give their users a lot of utility when it comes to transacting, storing wealth, providing a collateral, making investments and many more. But of course, whenever there is an opportunity, there are side effects and risk! That is why it’s important to always do your due diligence before investing in any market!

Disclosure:

This article is an informational document and does not constitute an investment recommendation, investment advice, an offer to sell or a solicitation to purchase any assets or any entity organized, controlled, or managed by WhitePark Capital LLC (“WhitePark”) or any of its affiliates and therefore may not be relied upon in connection with any offer or sale of securities or other assets. Any offer or solicitation may only be made pursuant to a confidential private offering memorandum (or similar document) which will only be provided to qualified offerees and should be reviewed carefully by any such offerees prior to investing.

The views expressed in this letter are the subjective views of WhitePark personnel, based on information which is believed to be reliable and has been obtained from sources believed to be reliable, but no representation or warranty is made, expressed or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of the information and opinions. The information contained in this letter is current as of the date indicated at the front of the letter. WhitePark does not undertake to update the information contained herein.

This document is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. WhitePark and its principals have made investments in some of the instruments discussed in this communication and may in the future make additional investments, including taking both long and short positions, in connection with such instruments without further notice.

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