How the stabilization system works (backing methods for stablecoins)
In order for stablecoins to maintain their stability a system or a method needs to be applied. By that we mean that if there is no demand for the payment asset then the issuer will repurchase it from the backed collateral provided by the system at a pre-fixed price. If there is no such system or it is used incorrectly, then the price will be determined by speculations of the whales, which leads to extreme volatility even in the short term. The system must ensure that the issuer is able to repurchase the total amount of coin issuance at a pre-fixed exchange rate even in the short term. The rate of issuance by the blockchain accountant device and the system that ensures that the price is stable requires substantial economic knowledge.
The successful stablecoin projects are more like a fintech start up company than a fully decentralized system.
The primary reason for this is that individual interests do not prioritise the interest of the community. Hence, without an adequate system in place the value of stablecoins can be very volatile.
In the case of independent projects, there are currently 5 types of solutions for exchange rate stability.
- Fiat-backed: The most convenient solution is that every coin purchased it is backed by an actual US Dollar or Euro on a bank account. This FIAT backing can only be used to repurchase previously issued coins. In this the involvement of a third party (bank, escrow) is inevitable.
- Crypto backed: When a stable cryptocurrency is collateralised by other liquid cryptocurrencies or a cryptocurrency portfolio it can be a great solution to strengthen decentralisation. The biggest drawback is that the collateral is very volatile. Hence it requires the system to implement multiple safeguards. Meaning that 1 USD worth of issued coins should be backed by at least 2 USD worth of cryptocurrencies, that can only be used to repurchase previously issued coins. This can be solved by using smart contracts or escrow handlers.
- Other asset backed: In this case the issued payment assets are not backed by other payment assets. Instead, they are backed by securities, stocks, government bonds or even gold. This is a great method to ensure stability but we must be borne in mind that these assets are not as liquid. The portfolio to be hedged must be continuously evaluated for market capitalisation and coin issuance is only possible with that value in mind.
- Community and/or algorithmic backed: Complete decentralisation can be achieved if the community is responsible for coin issuance and coin price based on a previously agreed system or algorithm. Corion Foundation made a Smart Contract based attempt earlier to achieve a stable price payment asset using this method. There is a risk that users of short-term interest and speculative behaviour will act against the interests of the community, thus exacerbating stability
- Hybrid: It can significantly reduce risks if a stablecoin is backed by a “hybrid” method. This means that the hedge is made up of multiple items as stated above. This gives the system room for manoeuvring and provides extended security. As the payment asset becomes more and more adopted it allows the system to extend the portfolio with less liquid assets such as real estate funds or hedge funds.
Each of these solutions can be found on the market in order to achieve stability.
Easy adoption and usage is absolutely key in the mainstream adoption of stable price payment assets. Decentralisation means that the system can operate without the involvement of a third party although it significantly complicates usability. So with current levels of technology we believe that the general adoption of decentralised stablecoins are highly unlikely.
Easy usage is followed by security, cost and speed.
There are newer and better solutions emerging everyday to support the ease of use (eg new exchanges, merchant gateways, swap, e-wallets, private key storage, platforms).