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The Anatomy of Stablecoins: Why is it easier to ride a bicycle

The world economy is going through quite an interesting and important period right now. The trust limit to fiat currencies is almost over — Central banks are not able to handle the inflation, authorities misuse their issuing rights, while the taxpayers are tired of paying for the inflation. This is why there is plenty of enthusiasts in the world who are looking for a more rational structure of the financial system.

You can find more details about the reasons of inflation and methods of fighting it in another article of Reserveum Group: Why do cheeseburgers become even more and more expensive?”

The new era in the world of finances started in 2009 with Satoshi Nakamoto who created Bitcoin, the world’s first cryptocurrency with an open protocol, and software for its functioning. The idea was caught on by millions of users; thanks to their trust, many are now viewing BTC as an alternative to fiat money.

But when it came to implementing digital currencies into the real economy, the crypto community faced a Gordian knot: there are not so many businesses that can acknowledge Bitcoin as a payment method; such functions of money as storing and price measure were actually impossible for cryptocurrencies. It is impossible to store your savings or measure the value of goods in a currency that can change in price by 20% within a day. Such high volatility also eliminates the possibility of paying salaries in Bitcoins, as well as giving out loans, creating derivatives, and many other financial processes.

This is why it was only logical when people started working on stable cryptocurrencies — stablecoins, — tokens that are tied down to stable assets. Developers released several types of such coins:

· Tied down to a fiat currency;

· Tied down to other cryptocurrencies;

· Not tied to other assets (algorithmic stablecoins).

Tying stablecoins to fiat money

Actually, there is nothing new about this idea, the history has many episodes when one currency was tied to the rate of another currency. We also know that it never ended well for the submissive currency tied to another one. Just recall the crash of the British pound in 1992, the Mexican peso in 1994, or the Russian ruble in 1998. All these examples teach us that the currency tied down to another currency is always at great risk.­­

Well, the US dollar can also be called stable by only a stretch of the imagination. The American national currency is not backed up by anything and is printed unstoppably. The ever-growing inflation is paid for by consumers in the USA and the countries dependant on dollars.

There also is an opinion that inflation is a process created by the world elites for smooth transformation of the population’s savings into the government’s profit that is received in a form of seigniorage (profit from printing new currency units).

You can find more about the reasons behind inflation and the methods of fighting it in another article by Reserveum Group: Seigniorage: how to make billions on money emissions”.

It is obvious that all problems of the US dollar will also run in family for the stablecoins based on USD. So a stablecoin that is backed by the US dollar will just become a replicate of USD with the same list of issues.

We can find a more reliable provision and create a stablecoin that reminds more of the Dow Jones industrial index. The new token would be tied to all the companies of the USA, which is much safer than just USD.

But stablecoins have to have a centre where they would control the issuing and the circulation. Also, the money that is directly tied to industry breaks the principles of the market economy and makes it closer to the command type of economy because, in this model, industry volumes have to be controlled artificially as well.

One of the bright examples of fiat-backed stablecoins is Tether issued by a private company Tether Ltd. This is a centralised digital currency that requires regular audit. It is still uncertain how transparent this asset is, since the issuer has still not proved that the token is fully backed with USD.

According to Reserveum Group, this type of digital currency has no future in the digital payments market and can only be used as an intermediate unit — for example, for creating a financial supply for a completely different decentralized algorithmic cryptocurrency.

Stablecoins backed with cryptocurrencies

If we want to eliminate centralized currencies we can try tying a stablecoin to another cryptocurrency. But there is one problem: cryptocurrencies are highly volatile.

There is a solution — extra supply. For instance, if 100 one-dollar tokens are issued with a supply for 200 USD, for instance, in Ethereum. Then, even if Ethereum drops in price by 25%, the total supply will amount to 150 USD, which still allows it to keep the stablecoin price at the level of 1 USD per coin.

The disadvantage of such a system is that when the supply currency rate decreases to a certain level, blockchain spontaneously liquidates stablecoins. And if a stablecoin is oversupplied, it becomes too capital intensive, which contradicts the very idea of a convenient currency.

Despite all the obvious advantages of stablecoins tied to cryptocurrencies — decentralization, liquidity, and transparency, their flaws are too big to see them as an option of a stable currency. These are the risk of automated liquidation, the dependence on the “health” of the supply currency, the ineffective capital use for supporting tokens, and hard implementation.

Unbacked stablecoins

With all this said, it seems pretty impossible to create unbacked stablecoins, but let’s not rush to conclusions. We can come back to the same US Dollar that still has a dominant position among other currencies, even though it is not backed by anything.

People discussed money with no supply even back in the XX century, but then it was just theory. The problem of such currency’s stability was open for a long time until in 2014 someone offered a concept of Seigniorage Shares. In this theory, Central Bank releases a smart contract with a mechanism of emission and supporting a steady stablecoin rate by controlling its supply.

If such stablecoin is released at a price of 1 USD, but later grows in price to 2 USD due to low supply rate, the smart contract will issue and sell new tokens, thus raising the supply until the price returns to the required level. That also helps earn on seigniorage which can be later used to raise the token price if its market price falls below 1 USD.

In case the seigniorage savings are not enough to buy back the low-priced stablecoin, Seigniorage Shares offers to issue shares. This way, the issuer can attract extra funds and stabilize the rate. Later, these stocks can take part in the distribution of the seigniorage.

As you may have guessed yourself, this system has serious flaws. First of all, it really reminds a pyramid, since it is built on selling a cheap token promising it will grow in price later. While all the profit for the participants is derived from new investors coming to the project. Secondly, new coin issuing and new shares launch cannot be endless. Like with any bubble, this system has its strength limit and bears high risks for all of its users. If the system stops growing, it cannot support its currency. Also, long-term support of extra supply for sale can eventually turn into a situation when investors don’t want to wait for their dividends anymore and quit the asset in packs.

Algorithmic stablecoins backed by cryptocurrencies

By the end of 2021, there are no significant coins of this type yet. However, Reserveum Group believes that this type of asset is the future.

The main idea for creating this type of currency is based on three presumptions:

1) The emission volume of an algorithmic stablecoin should be regulated by the market participants. So any digital asset owner can perform either creating or destroying such a token.

2) Every new stablecoin should be backed up by an equivalent amount of any digital currency at the rate from the moment of its creation. There is no need in extra reserves.

3) The amount of reserve needed to create one stablecoin should only grow over time. The growth rate should be regulated with the help of a formal algorithm created in a form of an open code (smart contract).

4) The growth rate should be defined by an algorithm that would depend on the market situation and correlate with the external inflation. Which means that this algorithm would imply having feedback.

A block scheme is a smart contract, feedback, change in the speed of reserve norm growth

In other words, Reserveum Group believes that it is easier and much more useful not to create a stablecoin that does not mirror the dollar price, but make a stablecoin with the issuing price, which means, the market price will grow monotonously. And the growth speed of this hypothetical token at first would be quite high, but as the supply amount grows, the speed would reduce until it does not correlate with the external inflation rate.

To illustrate it, we can compare it to this. It is easier to ride a bicycle than just balancing a motionless bicycle.

Learn more about the protocol Reserveum.

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