Another Look at Stablecoins
When cryptocurrencies like Bitcoin were first hitting the digital world from their respective white papers, we were residing in a time of financial turmoil. With the financial crash of 2008/9 destroying (for many) the trust of the people in major banking institutions.
It’s in all of this tumult that cryptocurrencies professed to provide a new way: a decentralized, peer to peer alternative to the centralized monetary institution. But if we look on by a decade – is this where we are?
There’s no questioning that Bitcoin has proven to be the single most successful challenger to the mainstream financial systems that we’ve ever seen – has managed to transform into a know digital source of value, according to polls from 2018 within the United States. But what it has proven to be successful at is confined within the world of finance, and not as a confirmed medium of exchange.
Bitcoin proves to be a genuinely absorbing, and sometimes a highly profitable way for users to bid, invest and speculate on what “average opinion expects the average opinion to be,” according to the famed economist John Maynard Keynes. While there are those in the crypto space that will certainly take exception to the economists words, it is unfortunately true at this moment in time.
While we are seeing a lot more headway in making use of it as a currency, the likes of layer 2 solutions like the Lightning Network come to mind. It isn’t generally a medium of exchange for people, largely down to the fact that, for both users and businesses: it remains too speculative for both, and especially hard to turn a profit from, as we’ve seen from companies like Valve, Microsoft and Expedia which quickly implemented Bitcoin payment and subsequently withdrew it.
It’s position as a source of value and investment is one that it has taken to better. And for some, this makes it too awkward to use as a replacement for bank-notes, coins and card and smartphones. But this is far more a matter of time than function.
It is with these challenges in mind early on in the world of crypto that we saw the emergence of Stablecoins in the past five to six years. Much like Bitcoin and Ethereum, Stablecoins operate within its own blockchain, in contrast with these crypto assets, however, these coins have an intrinsic series of mechanics which allow for it to resist volatility, maintain a fixed price while being wholly stable for its users.
Users that own any number of Stablecoin are then able to convert these digital tokens into an associated amount of US Dollars, which are maintained at that value thanks to the bank of the issuer, which serves as a guarantor of that pairing’s value. Effectively, developers behind stablecoins have managed to develop a blockchain layer on top of a financial and digital system which already exists.
These solutions make for some pretty interesting ideas, but they are not exactly disruptive or unique – disruptive fintechs that are now known names like PayPal have been fighting to provide that kind of service for some time, what makes Stablecoins so special then?
This is what brings us over to one of these stablecoin iterations which is MakerDAO. This is the organization behind the DAI stablecoin, and what sets it apart from challenger companies in the financial space is that, much akin to Bitcoin, and very much in contrast with other kinds of stablecoins out there, MakerDAO has no connection at all with the conventional financial system – providing a decentralized stablecoin solution.
This gives DAI the best of both worlds – it’s a financial payments solution which stands divorced from the ‘mainstream’ financial institutions, while also having all of the iconoclasm of Bitcoin. In contrast to Bitcoin, it doesn’t suffer from the kind of market volatility that Bitcoin does. What this spells out for it is a far higher chance of being accepted as a medium of exchange on a digital, decentralized platform other than Bitcoin.
In general, this article is one dedicated to those that are more economically minded like a monetarist, as well as others who want to dig more into how stablecoins like MakerDAO function without getting much too specific about the technical details. Like any other kind of technical jargon out there, cryptocurrencies are among the more complicated and jargon has an unfortunate tendency for tossing out any otherwise interested parties with the bath-water.
The best kind of way to describe stablecoins is to compare it to a quantity that is quite familiar to all of us, this, of course is a bank.
MakerDAO’s stablecoin has as system which operates, in a lot of way, in similarity to an ordinary bank like Goldman Sachs, for example. This ‘bank’ works to generate stablecoins, or deposits, out of assets that are otherwise designated as unstable. These consist of asset ranges like personal financial promises, claims on profits, business futures among others.
Where does the deposit process begin? It starts with a single secured loan. X Party decides that they will pledge their house which has otherwise been given the appraisal of $1 million to the bank. This is followed by the bank creating $500,000 worth of digital currency (stablecoin) for party x. Party X then spends this within the economy, resulting in it being put into the hands of Party Y, who decides to invest this in ‘safer’ assets such as deposits already involved with the bank.
As a result of this, party x’s financially unstable asset has since been converted into a stable deposit for party y.
DAI tokens, when they’re created and distributed, operate in a very similar way. Party x decides to pledge 1 million USD worth of assets to the DAI system. In exchange for this, they receive $500,000 worth of DAI and, after they spend this amount, those coins go into circulation, where they end up with another user, who then decides that they want to hold onto this stable cryptocurrency.
While this is a good figurative example to use when trying to describe how DAI functions, there’s one difference that is made all the more glaring between any bank and DAI. For example, in order for the first party to get a hold of these stablecoin, they would need to pledge their assets as a kind of collateral, or another kind of real-world instrument, such as a financial inventory within a business, or some other kinds of equity shares.
This is not the case when we think about getting access to DAI. To get this stablecoin, this party only has the ability to pledge assets which currently exist within the blockchain. For why this is the case is because DAI operates on the Ethereum blockchain – which means that its digitally native token, Ether is the key pledgeable asset for loans within DAI.
So what is it that allows these DAI tokens to have the same kind of value as a dollar held by the federal reserve? In order to get to the bottom of this answer, it’s worth diving into why a bank dollar is always worth the same as one from the federal reserve.
For any major bank, they maintain a large-scale network of automated teller machines (ATMs) as well as a proverbial ‘army’ of tellers that are more than happy to redeem any of party y’s deposits on par with the corresponding paper currency. Considering that he knows that there’s an easy, accessible for them to cash in using a banking outlet thanks to this 1:1 ration. Meaning that whoever has these dollars would never need to take them to the open market.
In contrast to mainstream banks, DAI, in contrast, does not own or sustain a major network of ATMs around the world. As a result of this, there is generally no way to redeem cash from, or cash out of the DAI ecosystem, much unlike the flexible approach provided by other centralized stablecoins. Rather than proving to be a major flaw with DAI versus other coins, this is more of a commendation of its design.
The reason being because, if DAI were to provide the users with a cashing out mechanism, this would destroy the entire point behind having a wholly decentralized stablecoin solution. What MakerDAO is attempting to do is create a virtual dollar in every sense of the term, allowing users to have compete digital sovereignty in a way that they can’t with the market bills in their wallet.
As a result of this system, DAI has built a self-contained economy which doesn’t rely on any external dollar injections in order to continue to operate, which is an advantage when considering the financial domino effect which has taken place with banks during 1931 and 2008.
How Does the DAI’s Price Stay at $1?
In order to understand this too, it’s worth delving back into the examples used before. Say, for example, a bank announced that moving forward, deposits into its accounts would now be non-convertible. Meaning that users would be able to put money in, but they can’t take it out, thus silo-ing all assets that are held by the bank. So if a user can’t return their deposits on par with what the banks hold, does the value of that currency collapse? Or will this 1:1 ratio hold firm?
The simple answer to this would be that, to a larger extent, the existing exchange rate holds together. If this individual was under fiscal obligation to pay $500,000 back to the bank in this scenario as well. Even if this individual could no longer simply deposit his stablecoin into the bank directly in order to redeem them for dollars from the federal reserve, he can still do this through indirect methods. To do this, he would offer to sell them to another party in exchange for the currency he wants, the other party would then be obligated to return these deposits to the bank in order to address the loan repayment.
Taking this further, is we were to say that the second party now needs to pay that debt and has since decided to take the other one up on this offer. The price that the first would choose to pay for the second’s deposit funds depends on the amount of other buyers there are out there vying for the same thing. Depending on the kind of day, this may consist of any number of different borrowers looking to purchase bank deposits in order to resolve any outstanding debt that they have. If, for example, they’re all eager to get their debts sorted, then the buyer may have to offer anywhere from $1.05 to $1.07 for the deposits that they already have.
The complete absence of any ATMs or human tellers in order to make his whole situation easier means that there is no reliable way at all in order to ensure 1:1 conversion for currency, leading to the emergence of these kinds of odd exchange rates, which can fluctuate depending on where and when they’re taking place as well.
This one individual wouldn’t be the only one selling off deposits that they have with the bank. It may be the case that there are a broader range of those holding deposits that are looking to sell their deposits on any given day, with a fluctuating range of buyers, often being in dwindling numbers. As a result, this one buyer may be able to haggle down the seller to accept less than $1 for each dollar they hold in deposit.
It is because of this issue of [hypothetical] convertibility that the price of deposits within an existing bank relative to those same assets held by the Federal Reserve would depend on short term circumstances between both depositors and buyers within that bank’s market. If there was a sudden spiked demand by buyers in order to get their debts settled one day, and this was offset by a dwindling number of sellers, then this would cause the value of that money to surge above the $1 threshold.
Conversely, if a large number of users wanted to sell their dollars on another day with very few debtors interested in buying, then the value would fall below $1.
This soft peg that we have been discussing is the kind of way that DAI operates. And depending on when you see charts of its performance over a given day or week, you’ll see these fluctuations in frequency whenever supply and demand ratios change.
This flexibility in terms of the soft peg is not essentially a bug in the way that DAI works. Instead, it serves as a unique feature of this self contained economic model, and it is a similar kind of behavior we would see from a bank if a they were to adopt this non conversion policy.
There are limits to the analogy being used, however, as there are some limits to just how far this dollar can move away from its central point, which is a base value of $1. If the volume of deposits within the bank fall too low, for example: if it dropped to 90 cents, then borrowers within the ecosystem would sense a good deal to capitalize on. They would then move to buy any cheap deposit funds that they could get their hands on. These same borrowers would then cancel their existing loans, allowing any assets they wanted to offer to be unencumbered, all before moving over to another bank in order to take out a loan in order to pursue these cheap deposits.
The end result of this whole process of re-opening loans while closing older ones will result in a 10 percent increase in profits. This will then have a knock on effect to the banks pace of cancelling debt, reducing the existing supply of dollar deposits, bringing the price back up.
This same mechanic of equalization takes place whenever the prices get too high over time as well, for example: when the dollar value jumps above $1.10, leading borrowers to be further encouraged to take out mortgages on their homes with the associated bank. Why this makes sense is because, if a borrower decided to secure collateral against their home from this bank versus any other: they can secure 10 percent more for what they offered as collateral – why would they go anywhere else?
Consequently, this surge in the amount of newly secured loans from the bank increased the volume of dollar deposits within the ecosystem, driving the currencies premium downwards towards $1.
As well as being equipped with these kinds of automated counter-measures which can act to force deposit prices down towards the $1 mark, this same bank can make use of monetary policies from any particular changes in the interest rate, allowing the existing exchange rate between the dollars within this bank and the federal reserve’s dollar pool to reach parity.
Here is another example – if there was a sudden glut in the amount of depositors within the bank’s ecosystem who want to get rid of their deposits of dollars: the results of this glut and an underlying desire to sell would temporarily push the value of these dollars downwards to 90c. What would change this is an increasing interest rate on loans that are already in circulation, the bank can make it more problematic for users to pay back their debts and adhere to the associated interest payments.
In order to address this disparity, borrowers will then start on buying up more of these deposits in order to offset their financial burden. This buying will act as a counterbalancing measure relative to the glut of depositors looking to sell, resulting in the price of dollars will steadily climb back up to the $1 mark again.
This hypothetical bank can then choose to set a new monetary policy using the current rate that it provides to its existing depositors. For example, there is a long line of debtors looking to repurchase and, in the process, cancel their debts to the bank, driving up the price of deposits overall to approximately $1.05.
In the process of reducing the interest rate that it provides to its depositors, this bank can then reduce the kind of material incentive that depositors have in holding these deposits. This will go on to cause a broader desire from depositors to sell, causing the overall purchasing power of these deposits to slide back down to $1.
Just how this kind of stablecoin provides a way of ensuring stability is through its manipulation of a rate referred to as the ‘Stability fee’ to make it sit at a level that is more consistent with MakerDAO’s DAI ideal value of $1. This same stability fee is the same rate that any borrowers within the DAI ecosystem must pay. Along with this already existing fee, MakerDAO is also in the process of introducing a new rate known as the ‘DAI Savings Rate.’ This same rate offers holders of DAI with a reward in a similar way that depositors with a bank are paid interest on their assets.
This sounds like a pretty effective system, but does MakerDAO’s monetary policies within DAI work as well as they seem? In recent memory, we have seen the price of DAI fall to a rough 3 to 4 percent discount relative to the dollar. As a result of this, MakerDAO increased its stability fee.
JP Koning (@JP_koning) states,
“DAI’s stability fee was increased to 16.5% yesterday. As far as I can tell, it hasn’t pulled DAI any closer to $.”
JP Koning continues:
“But the stability fee increases do seem to be reducing the supply of DAI, which is down by almost 10 million since April 10: This should eventually nudge the price back up to $1. Milton Friedman’s long & variable lags?”
In doing this, DAI managed to get dragged back towards the $1 margin.
This is a good demonstration of how these stability fees can help to regulate the price point of DAI to ensure it has parity with the USD.
During periods of financial stress, can this same system ensure this kind of stability over time?
Each deposit into the bank is paired up with a lender who will have to, at some point, repurchase these same deposits. For example, if one user along with a few other debtors suddenly go bust and, as a result, cannot pay back their outstanding loans. This results in the creation of a number of ‘orphaned’ deposits, which is bad news for the peg as a whole. There simply will not be enough debtors on the ecosystem in order to successfully repurchase the deposits owned by other depositors. As a result of this problem, the price of these deposits will fall far below 1 dollar.
While this would represent a glaring hole in the infrastructure, this bank has a tool in order to prevent this sort of issue from happening. If one party provided collateral in order to secure this loan. If this one user is no longer able to pay for this loan, the bank can then claim this collateral, whatever that asset may be. The bank could then seize it and sell it in order to repurchase deposits. These formerly orphaned deposits would then be withdrawn, consequently causing the $1 exchange rate to drift upwards again.
This is exactly the same kind of mechanic that happens with DAI. As opposed to seizing the physical assets of the debtor, however, MakerDAO would take control of any crypto-based collateral that they had provided initially.
One of the other mechanics in play that allows for this same figurative bank to keep its non-convertible deposits as close to parity as possible is that the bank can always reduce its own operations and subsequently decide to close up shop wholesale. If it were to do this, all of the debtors on the ecosystem would then need to settle their debts outstanding, effectively meaning they would need to buy up any bank deposits and cancel what is due to the depositors. Those debtors that can’t pay what they own will have their collateral seized and sold to offset. These proceed would then be used to pay outstanding depositors for each of their deposits.
So long as this bank has managed to conduct proper appraisal of the value of associated collateral that has since been deposited, then it will be able to give everyone what they’re due. The kind of associated proximity of any wind down, even the slight prospect that something like this would occur would be more than enough to encourage a push back upwards towards the $1 mark too.
MakerDAO is very similar to this example with its own equivalent system that is referred to as global settlement, which takes place when the DAI system is shut down, meaning that all DAI holders at that time would be given a payout equal to $1, with debtors within this system getting whatever there is outstanding.
Even with these kinds of functions in place for stablecoins like MakerDAO, there is still a lot of outstanding skepticism towards using them. Individuals such as Preston Byrne is one of them, who is especially convinced that stable coins are an inherently doomed solution, with some of them already being subject to collapse.
Will digital stablecoin solutions like DAI prove successful in overthrowing the current incumbents, as some are inclined to believe?
Very much in contrast to convertible bank deposits, nonconvertible banking deposits do not make for an effective or marketable product. Thanks to the previously mentioned convertibility solution, regular deposits prove to be fungible in characteristic, not only with other banks across the world, but with Federal Reserve dollars to. To be fungible, after all, means to be completely interchangeable with other tokens of its kind as well. No matter if they come from JP Morgan Chase, Goldman Sachs, Bank of America or somewhere else.
Interoperability, or as it is sometimes known as – Harmonization – can be a highly useful solution for users. This provides an exceptional degree of flexibility for the user – if someone wanted to go to a store and buy goods with whichever kind of dollar they had to hand, neither party would need to concern themselves with the kind of dollar that was or was not being used.
This is not so much the case with DAI, or any other kind of non convertible assets. Where they completely lack any direct 1:1 convertibility with Federal Reserve dollars, for example, the price of ‘soft peg’ dollar will never quite be on par with their centralized counterparts. Effectively, if you’re trying to go to a restaurant in the USA, that would be like going into that restaurant and attempting to pay in Euros.
Effectively, the purchase can go ahead, but it adds so much extra friction to the whole endeavor that it just makes it all the more awkward and time consuming to accomplish. You need to figure out the existing exchange rate between the two currencies ensure that that exchange can take place and then complete it. This is like a purchase with DAI, of course it has a great degree of stability associated with it, but it simply is not fungible with the kind of asset that it is supposed to represent.
This same kind of financial awkwardness takes place when you try and take out loan in this same kind of way, if you wanted to invest in a specific business, raise capital for a house, etc. Businesses and / or individuals can earn their income and obtain sustainable salaries in Federal Reserve dollars, for examples. But, if they were to receive loans and need to pay interest on DAI, they would ultimately owe money in a foreign currency.
So what about the issue of decentralization? Does this kind of system provide DAI with some kind of advantage versus other dollars?
So, in contrast with non convertible bank deposits, which are provided by a centralized financial body, DAI Tokens are wholly decentralized in nature. What does this mean exactly? It means that the entity which allows for the maintaining of the economic system, doesn’t essentially exist within a physical location. The only place in which it wholly resides is within the Ethereum network, which is operated by a large pool of validators from all across the world.
While authorities can easily put pressure on centralized financial bodies – the same simply cannot be said of MakerDAO, which is made up of decentralized nodes, meaning there is no way to control or put the ‘screws’ to it.
Centralized banks depend on a massive staff population in order to keep the system running day to day. MakerDAO by contrast almost completely automates these solutions through the use of smart contracts – automated segments of code which are completely immutable. The broad governance of this system takes place across the internet, with the shareholders within DAO voting and passing resolutions like adjustments to interest rates. These same shareholders can maintain their anonymity too, meaning that no pressure can really be effectively exerted against them.
Decentralization like this allows for dissent against centralized entities and subversive institutions like MakerDAO to come into fruition. A mainstream bank is placed under a an extensive list of regulatory guidelines, financial obligations and laws as to how much capital they can hold at any given time, identification practices for customers, along with a wide range of others.
Authorities can’t easily do the same thing for MakerDAO and its anonymous list of shareholders and it can’t be subject to punishments of any kind, meaning that MakerDAO can really side-step financial sanctions and punishments from costly regulations. These kinds of elements mean that a lot more of the costs can be brought over to its customers with the likes of lower interest rates than is seen from mainstream banks.
Without a doubt, there is definitely a clientele out there to capitalize on a decentralized economy like MakerDAO’s DAI. But while there are some major benefits in participating in a decentralized organization – freedom from regulatory policies, resistance to censorship. These are more than enough for some to overcome the friction attached with DAI being a non-fungible kind of currency.
It is worth contemplating just how much MakerDAO can be regarded as a decentralized entity. If, for example, DAI became a go to currency for users in Iran and Russia as a way of getting past international sanctions imposed on the countries – would the United States Treasury have some way to prevent this from happening through the use of back doors?
Those involved with MakerDAO as core developers are popularly known public individuals and, as shareholders of the company as well. So, if the United States wanted to arrest them in violation of US sanctions, would they obey the US diktat, or battle against the US or write out Iran / Russia?
If this is the case, then DAI is not exactly that much of a subversive entity, and more akin to something like PayPal or Citibank.
- Source: First Appeared Here
- Published Time: 2019-06-03 07:15:35
The views and opinions expressed in the article Another Look at the Good, Bad and Ugly of Fiat Tokens do not reflect that of 48coins, nor of its originally published source. Article does not constitute financial advice. Kindly proceed with caution and always do your own research.
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