STABLE TOKENS, RISKS AND PROMISES OF THE BLOCKCHAIN FINTECH – Part I

While academic researchers are increasingly engaged in trying to make sense of the new challenges presented by blockchain technologies, papers on stablecoins are still relatively few. Let us take a closer look at an example of the latter, a joint effort of six European scholars entitled Monetary Stabilization in Cryptocurrencies – Design Approaches and Open Questions.

The paper not only gives an interesting perspective on stablecoins, but also includes X8Currency in the sample of 24 stable token projects, some already trading on exchanges, others in preparation. The criteria for inclusion were that the token runs on permissionless blockchain, is intended for general use as currency and has a whitepaper available. It is interesting that at the time (February 2019) only 24* projects (of which 15 are fully implemented) met the criteria when one considers that 235 stable tokens projects have been announced since 2014.

The reader is reminded that many stable token projects have failed since their announcement, so the picture they offer is just a snapshot of the current projects. The authors believe that the definition of a stable token that is based solely on a peg to some fiat currency or an asset is too narrow. We agree this is much justified and approve of their working definition that declares stable tokens as cryptocurrencies with mechanisms that mitigate the fluctuations of their purchasing power.

 

PRICE STABILIZATION TECHNIQUES ON BLOCKCHAIN

The authors make a generalizing statement that all stabilization methods are based on the supply and demand model. Consequently, the difference between stable tokens must be the difference between how they respond to changes in supply and demand. As we will discuss later, this definition already excludes X8Currency and X8Dollar, but let us first look at the classification they provide.

Tokenized collateral is a stabilization technique whereby tokens are created by users’ deposits and destroyed when deposits are redeemed. If the token’s market price rises due to excess demand, an opportunity for arbitrage prompts the creation of new tokens. Conversely, a price lower than the underlying collateral creates an incentive for arbitrage by destroying the tokens, which brings down the supply.

Some tokens are directly collateralized with a 1:1 peg to a fiat currency (The most known example of this type of stable token is Tether). Others are collateralized by a proxy, which can be another asset or another cryptocurrency. In this way the 1:1 peg is targeted in a roundabout way. This brings about elevated risk since the state of the crypto market affects both, the stable token and its collateral.

An example of such backing was the token BitUSD collateralized by another token, BitShares. The approach of proxy collateralization often relies on two risk mitigating measures: over-collateralization and margin calls. While over-collateralization covers the gap acts as a buffer, margin calls are triggered if the price of the token drops below a predetermined threshold. In this case the token creator deposits additional collateral or, alternatively, the collateral if offered on the open market in exchange for the stable token with the aim of decreasing its supply.

Some stable token projects (ex. Nubits, Stableunit and Minex Coin) use locking or parking fees that function like interest rate on deposits in traditional finance. With this approach the supply is controlled by offering users an interest, or stabilization fee, when they lock their stable token for a certain period of time and thus remove it from circulation.

Another way to maintain the peg are direct currency interventions where the token creator or a third party counters market swings by buying and selling tokens in exchange for the currency to which they are pegged. The authors in this case do not provide an example, but many crypto sceptics believe this to be a common practice for maintaining stability of stable tokens.

Similar to direct currency interventions are Open market operations. This process mimics the central banks’ interplay between fiat currencies and sovereign bonds. Some projects (Fragments, Carbon) advocate a closed system where special self-issued tokens are created to be exchanged for stable tokens which are then burnt to reduce the supply.

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* The projects included in the research: Augmint, Aurora, Basecoin, BitShares, Carbon, Celo, Centre, Digix, Fragments, Globcoin, Karbo, Kowala, Maker, Minex coin, Nubits, Stableunit, Stably, Stasis, Stronghold, Synthetix, Tether, Trusttoken, USC and X8Currency.

Image source: Adobe Stock
David Prezelj
David Prezelj

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