How Do Investors Profit From Stablecoins?

Even as a swirl of doubts engulf the utility of Tether, the numbers of stablecoins to prop up cryptocurrency markets has multiplied dramatically this year. The stablecoins list includes the likes of Basecoin, MakerDAO, and Havven, all of which have received funding from marquee names in the venture capital industry. The Winklevoss brothers, who are pioneers in cryptocurrency markets, also recently launched the Gemini dollar, a stablecoin for their crypto trading exchange.

As their name denotes, stablecoins are intended to bring stability to volatile cryptocurrency markets. Currently, their primary function is to serve as an entry point to cryptocurrency markets and as a conversion mechanism for retail investors interested in cryptocurrency trading. Investors convert their fiat currencies, such as the US dollar, into a stablecoin, which trades at parity with the fiat currency. Subsequently, the stablecoin can be converted into other cryptocurrencies. In the future, crypto enthusiasts believe that they will evolve to fulfill functions of money, such as becoming a medium of transaction, unit of account, and store of value.

What Are the Types of Stablecoins?

Depending on the assets backing them, there can be four types of stablecoin projects.

Fiat-backed collateral coins are backed by fiat currency. Tether, which claims to have an equivalent amount of USD as the number of its coins in circulation, is an example of this kind of coin. Critics of Tether say the concentration of its coins into a single fiat currency centralizes the system.

Asset-backed collateral coins have emerged as decentralized stablecoin alternatives. They are backed by tangible assets, such as precious metals. Gold, whose price swings run counter to international markets, is the most popular instrument for backing such stablecoins.

Some stablecoins are backed by multiple assets. For example, the Tiberius coin is backed by a combination of seven precious metals used in tech products. The stablecoin’s founders believe that the stablecoin’s price will rise with an increase in usage of its constituent precious metals.

The third type of stablecoin is backed by crypto-collateral. In other words, the coin is backed by reserves of other cryptocurrencies. Given the volatility and wild price swings of the crypto market, it is obviously not a good idea to maintain a 1:1 peg with another cryptocurrency because a steep decline in prices could easily break that peg. Therefore, crypto-collateralized stablecoins are currently testing different ratios to ensure that the peg remains intact.

MakerDAO is an example of this type of approach. Dai, MakeDAO’s stablecoin, is backed by Collateralized Debt Positions (CDP) in Ethereum’s Ether. Users wishing to generate Dai will have to deposit ether in smart contracts to generate a specified number of Dai tokens. In the future, MakerDAO plans to make multiple collateral coins available in the system.

“The crucial difference between something like this and Tether is that even if one of the places where collateral is deposited turns out to be insolvent, there are so many other points in the system that, on their own, overcollateralize…It (the system) can mitigate even large crashes in one asset,” the founder of MakerDAO said in a podcast. As an example, he said DAI has a 3:1 ratio currently for ether, meaning that there are three Ether for a single dollar invested in the system to help protect it from crashes.

The final type of stablecoin is an algorithmic stablecoin. The value of this type of stablecoin, also known as seignorage coins, is determined by the market forces of supply and demand. Basecoin is an example of this type of coin. In addition to Basecoin, there are two other tokens in its system. A bond token is associated with Basebonds, which are issued to contract supply in the system. Each bond token can be redeemed by one Basecoin when the blockchain creates new coins. Share tokens are used in lieu of bond tokens to pay out dividends. “…shareholders receive these newly-created Basis (Basecoin’s earlier name) pro rata so long as all outstanding bond tokens have been redeemed,” the cryptocurrency’s whitepaper states.

How Do Investors Benefit From Stablecoins?

At first glance, investing in stablecoins might not make sense given their parity with fiat currencies. According to some, their value may also steadily decline with time. However, a steady stream of private money in the form of venture capital has made its way into the stablecoin ecosystem in recent times.

Basecoin, which received backing from Andreesen-Horowitz, was the most prominent example. Then there is Havven, which has received funding from BlockTower Capital and AlphaBlock investments.

There are a couple of reasons why investors might be interested in them.

First, stablecoins offer the earnings potential of a fixed-income instrument, which doles out a stream of income at regular intervals. Stablecoins earn income from charging transaction fees to users for converting their coins to fiat and vice versa.

They also earn interest from the collateral backing them. For example, Facebook’s low-volatility coin Libra will invest in an array of conservative instruments, such as government bonds and currencies, using its reserve fund stash. These investments will earn periodic interest. According to some estimates, yearly interest income for founding members of the LIbra Association could be as high as $600 million.

Christensen from MakerDAO makes the case that crypto-collateralized stablecoins offer investors the chance to invest in other coins without exposing themselves to the downside risk of volatility. In effect, the stablecoin cushion will ensure that they do not suffer due to the crash in price for a single coin but will receive the upside of an appreciation in its price. MakeDAO also charges stability fees from investors in order to maintain its peg.

Christensen may have jumped the gun in making those assertions. Recent problems at MakerDAO are illustrative of the problems of this approach. DAI, the native cryptocurrency of the MakerDAO chain, lost its peg to the US dollar during the crypto bear market and had to increase its stability fee charges to overcome the shortfall in its reserves.

The Stablecoin Design Problem

The design of the current crop of stablecoins is not without its flaws. Barry Eichengreen, an economist at UC Berkeley, highlighted a couple in a post on The Guardian.

The first type of stablecoin is centralized, he says, because it concentrates assets into a single holding. The multi-asset collateralized system may be prone to bank runs, a situation in which an exodus of investors turns into a stampede. Here’s how the situation would work: one set of reserves used to collateralize the stablecoin may be used to make up for the shortfall in another reserve’s value or numbers. But the total quantity of reserves is finite. According to Eichengreen, this could set up the entire system for the possibility of a bank run in which investors scramble to get out of the cryptocurrency before it crashes.

For stablecoins backed by bonds, Eichengreen casts doubt on growth of the Basecoin network. This is because the price of bonds issued by the platform depends on the platform’s growth. “If the outcome becomes less certain, the price of the bonds will fall. More bonds will then have to be issued to prevent a given fall in the value of the coin, making it even harder to meet interest obligations,” he writes. Such a situation is frequently witnessed in the bond market, where bonds issued by countries whose economies are troubled trade at a significant discount. Eichengreen writes that Basecoin might lose its peg entirely, if there are absolutely no buyers for its bonds even at low prices.

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