This article is a re-post from the original published in Money On Chain's Medium.
In my last article, Argentina’s volatility inspires a Bitcoin collateralized stablecoin I talked about how volatility is extremely harmful for a currency. We concluded that stability is needed to make money execute its functions. Here I want to discuss stablecoins, their possible collaterals, the pros and cons of those solutions and then focus on the Bitcoin collateralized stablecoin.
Stablecoins have emerged in response to the high volatility of cryptocurrencies such as bitcoin, Ethereum and others in order to allow these currencies to fulfill the three functions of money: medium of exchange, unit of account, store of value. Only when these 3 characteristics are met, cryptocurrencies will work properly and efficiently. The ongoing extreme shifts in the price of these currencies make Stable Coins very popular these days.
As the name suggests Stable Coins, are coins that bring stability to the cryptocurrency system. More specific Stable Coins guarantee price stability. The mechanism behind these coins requires that the issuer holds collateral and manages the supply through trade incentives.
The collaterals, which can either be assets or money, serve as a guarantee for the coin to be stable. We can distinguish between three possible types of collaterals for a Stable Coin: Fiat-, crypto-, or non-collateralized.
If a cryptocurrency is Fiat-collateralized the coin issuer will need to hold Fiat money (USD, YEN, EUR, etc.) and can then start emitting coins against this money. The most common exchange rate will be 1:1 and the Fiat money used normally are US dollars. Fiat collaterals are the most popular form for collaterals and bear the advantage of having a simple business model. The dependence on a central party to function as a custodian to store the Fiat money and the necessity for regular audits to ensure the full collateralization should be mentioned as disadvantages.
Instead of using Fiat we can use another cryptocurrency as collateral, in this case, the currency will be crypto-collateralized. The deposit will hence not be in USD, but in cryptocurrency such as Bitcoin, etc. Due to the fact that cryptocurrencies are more volatile than Fiat money, the issuer of the Stable Coin will have to over-collateralize his coins to compensate for the high volatility. Crypto-collaterals hence are said to be more capital-intensive than Fiat collaterals. Furthermore, they are more complex and exposed to Black Swan events. The positive aspects of crypto-collaterals are the decentralization, transparency, the speed of the blockchain to liquidate the Stable Coins, and the possibility to create leverage.
Last but not least there are non-collateralized Stable Coins. The concept behind these coins is that the expectation serves as the collateral. The belief that my Stable Coin will retain a certain value is the backup to this system. The Seignorage Shares represent this concept.
As pointed out Fiat collaterals are the most popular form of collaterals, nevertheless, there are good reasons for using cryptocurrencies as collateral. These benefits result from the crypto-ecosystem and are: decentralization, transparency, transaction speed of the blockchain, and leverage.
Interestingly Bitcoin — despite being the biggest player — has not been explored as collateral. Why so? One of the main reasons is that the technology to make smart contracts with bitcoin as the collateral wasn’t available. Thanks to RSK Labs things have recently changed and the technology to realize such projects is now available.
Money On Chain will use this new technology in order to launch a bitcoin-collateralized stablecoin. At Money On Chain we believe that various reasons make Bitcoin a perfect collateral.
First, bitcoin is the most liquid cryptocurrency, has the largest capitalization and the biggest user base (network effect). Furthermore, bitcoin is the oldest cryptocurrency with brilliant minds leading the development team and the largest cryptographic mining power in the world, which makes it the safest payment system.
The 2 main reasons though are bitcoin’s decentralization and clear monetary policy. The decentralization provides a unique and little-understood feature which is the resistance to the change of the rules. In the Bitcoin ecosystem, there is no entity with sufficient power to change the rules, since the consensus of miners, users, developers, and companies will be needed.
The monetary policy is immutable, has a pre-established limit of 21 million bitcoins and a decreasing emission rate. Discussing a change in Bitcoin monetary policy is unthinkable and allows an anticipation of the future. The limit of 21 million bitcoins ensures a shortage of the asset turning it into deflationary currency since for different reasons some bitcoins are lost forever, therefore, reducing the supply.
All described characteristics make Bitcoin the best collateral for a Stable Coin. Details about our Stable Coin can be found on www.moneyonchain.com
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Written by Olivier Perruchoud, team member of MoneyOnChain.