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.

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, is the most prominent example. Then there is Havven, which has received funding from BlockTower Capital and AlphaBlock investments. The main attraction of stablecoins to venture capitalists is that a stablecoin blockchain actually consists of multiple tokens, whose value fluctuates based on economics and trading in markets.

Depending on the assets backing them, there are three 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. However, the concentration of assets into a single fiat currency centralizes the system.

Multi-asset backed collateral coins have emerged as decentralized stablecoin alternatives. They are backed by multiple assets, from fiat currencies to other cryptocurrencies to precious metals, such as gold and silver. Through their association with equity tokens, such as ethereum’s ether or even gold, multi-asset collateral coins can be construed as an investment into the underlying token or asset.

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,” he said. 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 the system from crashes.

The value of the third type of stablecoin known as seignorage coins is determined by 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.

The Design Problem For Stablecoins

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.