Asian fintechs are at the forefront of a new move in the youthful world of stable coins to use collateral to create reliably valued tokens.
The most famous “stable coin”, a tradable digital token that faithfully tracks the value of a fiat currency or real asset, is Tether, which uses a verifiable pool of capital to maintain a price of US$ per token. Circle, a fintech backed by Goldman Sachs, is another so-called proponent of “off-chain collateral”. Other companies such as HelloGold seek to do the same vis-à-vis the price of gold.
An emerging set of players, including MakerDAO in Shanghai and Havven in Sydney, thinks this isn’t the way to go. They are now releasing stable coins that rely on collateral “on-chain” instead.
“What’s the main problem with crypto-currencies?” wondered Pan Chao, economist at MakerDAO. “People don’t use it as a currency because it’s too volatile, and businesses can’t risk taking income in bitcoin.”
Stable coins, if they are proven to work, will serve as an important bridge between the fiat world and crypto finance. They could even underpin a new payments system that bypasses credit-card companies, suggests one crypto investor in Hong Kong; a stable coin becomes a vehicle for lending and other financial services.
So the stakes are high: getting stable coins right, which means attracting massive adoption and acceptance for a token to serve as both a store of value and a gateway to other tokens, could prove one of the most important battles in crypto economics.
On the chain
The drawback to relying on pools of underlying capital is twofold. First, it requires a centralized authority to maintain the pool and make markets, which creates a point of vulnerability. Critics say the point to the crypto world is decentralization, so developers are looking for other ways to handle this. The second problem is obvious: verifying the underlying capital; Tether resisted showing its books before finally adopting a more transparent approach. Even so, if stable coins are to meet their potential by scaling, the ability to amass sufficient volumes of the underlier is going to be questioned.
So now blockchain companies are introducing coins that rely on mathematical treatment of user collateral, which is a step toward decentralization and also reduces the need to maintain a pool of capital equal to the value of outstanding tokens.
(There is a third school of stable coin enthusiasts, including Basis and Carbon Fragments, seeking to go 100 percent decentralized and bin collateral altogether in favor of algorithms that serve the same function. Too early to tell if this works in the real world.)
MakerDAO is the first to release a stable coin built on the Ethereum blockchain. Its model is complicated. It relies on two coins, one a governance token (MakerDAO) and the other the coin traded among users (Dai).
It accepts ether as collateral in order to create Dai coins, which are pegged at $1 (the company’s original idea was to peg it to Special Drawing Rights, the IMF’s unit of accounts). This is done by locking users’ ether via smart contracts into swaps of Dai at 66% the value of the ether collateral. Then Dai can be traded at crypto exchanges for other types of tokens. The MakerDAO coin is used to make markets in order to maintain the value of Dai to ether.
The benefit here is that users can take a plentiful, relatively liquid but volatile asset, ether, and turn it into something that tracks the dollar. Users sacrifice a certain amount of ether for the privilege of stability, which should beget liquidity. The structure is akin to making a deposit in ether and borrowing it back in the form of Dai.
But if the price of ether should crash, MakerDAO might not be able to arbitrage enough to maintain Dai/dollar parity. Indeed, the ratio has decoupled a few times in times of stress, a reminder that there is no legal authority or sovereign backstopping these coins. Maybe in a panic situation the market would find a new equilibrium, but unwinds in illiquid situations are dangerous.
And the system also faces challenges if the news is all good: to scale Dai would require constantly attracting more ether.
The company is looking to add other types of collateral so it’s not dependent upon ether. “If a stable coin is to be widely accepted, some derivatives will be needed,” Pan said. MakerDAO has a fund that invests in startups working on such solutions.
There are alternative ways to create “on-chain” collateral. Havven charges transaction fees for use of its stable coin, Nomin, which has launched in beta form in June. Its first iteration tracks the U.S. dollar, with other currency pairs including the Australian dollar in the works.
Right now the first use cases are in things like video games, enabling game companies to sell items – a magic sword or whatever – as tokens while pricing them in a player’s local currency. But the logic applies to financial services too.
Whereas MakerDAO does not charge a transaction fee, in a bid to attract users and acceptance, Havven reckons such a fee is a better path to sustainability.
“The challenge is to be able to scale the network,” said Kain Warwick, the company’s founder. The company is not trying to position Nomin as a consumer-facing coin: “We see ourselves as an infrastructure project.”
Users that pay the transaction fee benefit from the network’s stability. Even if the price of Nomin crashes, along with the value of users’ collateral, the company still generates those fees – which ensures the stability of the entire project.
So will users gravitate to MakerDAO, or Havven – or some other project? Is there a path to mass adoption? So far no one has an answer. The math, the model, the customer experience, access to crypto exchanges, different collateral types, faith in the company – all of these will count. These are brand new and have yet to weather meaningful market downturns. Investors may not understand the technical details of a given coin, which could get ugly if people see their collateral spiraling down a black hole.
One analyst says most users today are early adopters that are interested in these projects, rather than actually using their stable coins to do something else valuable in cryptoland.
And then there’s the regulators: no one knows what they think of stable coins, although companies like MakerDAO have been eager to position their coins as utility coins, in order to avoid complying with securities laws in the U.S. and elsewhere.
“The hardest part of this is adoption and gaining transaction volumes,” Warwick said. “Ideally, though, this is a better payments rail.”