Achieving a stable value cryptocurrency has long been the goal of many projects that aim to take crypto a step beyond just a medium of exchange and into the realm of a store of value. If I put $1000 into Bitcoin today, I can’t be guaranteed what it will be worth tomorrow which puts off businesses and everyday users that want to use crypto beyond just a speculative investment as a method to accept payments or pay salaries.
There are three common methods for achieving a stable value cryptocurrency. They fall into the categories of fiat-collateralised, crypto-collateralised and non-collateralised. Lets look at them individually.
The simplest method of constructing a stable value is to issue one coin per one dollar received. This method is the most foolproof currently as you can be sure that any volatility in the market won’t disrupt your liquidity as you always have enough fiat to back the coins you have issued.
The fundamental issue with this method is that it is centralised and requires a large amount of trust in the company that is holding the fiat. It is not a long term solution and is counter-intuitive to exactly what crypto is trying to solve. It’s also an expensive, regulated solution that needs frequent audits to ensure that the amount issued is in line with how much fiat is received and coins aren’t being falsely issued.
The same concept as above, but instead of backing your stablecoin with fiat, you back it with another crypto like Ethereum or Bitcoin. This solves the centralisation issue but falls victim to itself in that the crypto you are backing against has an unstable value. The resolution is to add more collateral than is needed which is inefficient and doesn’t solve the underlying issue as a big enough price drop could exceed the amount of collateral and force you to liquidate.
A non-collateralised coin functions like a central bank by controlling the money supply of coins in order to move the price towards $1. This is a step in the right direction but still falls short. If the current price is $1.50, more coins are created and sold into the market to lower the price. If the current price drops to $0.50, coins can’t simply be burned so the central entity has to buy up coins in the market until the price hits $1. This is completely subject to how much reserve the central entity has. They cant buy up coins forever and if they run out of buying power the whole thing will unfold. Attempts to circumvent this by selling contracts to users to temporarily fund shortfalls and pay them back once the price goes up (ponzi?) may work in the short term however the end result is the same in that a big enough price drop will leave the whole thing in ruins.
So then, the mechanism to power the ideal stable value cryptocurrency has not yet been implemented. We have ideas that are usable but questionably sustainable.
The ideal stablecoin should be secure in a crash, decentralised and collateral-efficient. None of the existing options meet all 3 criteria.
Meeting the criteria
A coin that could be burned at the current market price to record the current fiat value, could later be retrieved by minting new coins in the amount that matches the new market price at the time of retrieval. Such an idea is so simple but simultaneously solves all 3 of the criteria.
The underlying coin is decentralised and the collateral efficiency is at a maximum (burning $100 worth gives you $100 worth). It’s also secure in a crash as no matter the price, the method of minting and burning works without discrimination.
The caveat to this method working is that the underlying coin must have cryptographic measures implemented to ensure complete privacy of transactions, both senders/receivers and amounts, which in turn provides complete anonymity of the total money supply at any given time.
Lets look at an example:
If we have 200 coins and the current value is $1 USD then we can burn these coins to record a value of $200 USD. The burning of coins lowers the total supply and is a forgoing of the $200 worth of coins today, in order to preserve it for a later date.
If the price of the coin then moves to $2 USD and you want to retrieve your coins, you will be returned 100 coins (100 * $2 = $200 USD as per original value).
If the opposite occurs and the price halves to $0.50 then 400 coins will be minted and sent to you.
At first, minting new coins may make you think the value of the coin would decrease as the total money supply has increased. In practice, this operates a little different.
This ’mint and burn’ method draws on the quantity theory of money described in monetary economics in order to avoid inflation and changes in currency valuation based on the movements in the total supply.
The theory states that MV = PT where:
M = Money supply
V = Velocity of money
P = Average price level
T = Volume of transactions
An increase in the money supply should, with a constant velocity and volume of transactions (assumptions of the economic model), cause an increase in the price level (inflation). The problem with this is that the money supply of of this coin will always be unknown. The ’mint and burn’ lets the money supply fluctuate freely. Velocity of money is also cryptographically unfeasible to determine as the blockchain does not reveal the amount transferred nor the wallet addresses they are transferred to.
For this reason, the currency is unable to be valued based on total supply.
This concept is called Offshore Storage and is the basis of Haven Protocol.