The Problem With Stablecoins

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With their pegs to maintain price stability, stablecoins are expected to carry the torch of bitcoin’s vision of becoming a medium for daily transactions. But two recent developments in the stablecoin ecosystem illustrate the difficulties in achieving that goal with profits for investors.

Tether’s Reserves in the News Again

The first one involves Tether, a stablecoin which has already become embroiled in controversy earlier regarding its fiat reserves. Previously, Tether claimed that each of its coins was backed by an equivalent US dollar or Euro as collateral. The fiat currency backing, especially by a currency as stable as the US dollar, meant accessible liquidity for investors and bolstered their confidence in the coin.

In a curious development this week, Tether expanded that list of assets it uses for price stability. News reports stated that Tether had updated wording on its website to include “other assets” and “receivables from loans made by Tether to third parties, which may include affiliated entities” as additional sources of reserves. Kasper Rasmussen, marketing director at Tether parent company iFinex, told online publication CCN that the change was made several weeks ago. As of this writing, the site’s Transparency page, which lists reserves, only displays their quantities in USD and Eur.

In the past, Tether has been criticized for refusing to provide comprehensive proof of its collateral or submitting itself to an audit. Prominent banks have severed relationships with the coin as its relationship with Hong Kong-based cryptocurrency exchange Bitfinex has come under a cloud. Both entities, which share senior management, were also subpoenaed by the SEC in 2017. Last year, Bloomberg claimed to have seen bank statements proving that Tether had sufficient reserves. But critics remained unconvinced. This latest move could again set alarm bells ringing for some regarding the stablecoin’s capitalization in case of a crash.

Some analysts have conjectured that the change in composition of assets is an attempt at generating additional profits. Stablecoins trade at parity with a basket of tradeable goods. While the parity ensures price stability, it makes such coins unattractive to investors who profit off volatile price swings in cryptocurrency markets. Investment in other assets is an astute strategy to diversify revenue. Presumably the loans to affiliated parties within the cryptocurrency ecosystem are part of the same plan.  

MakerDAO DAI’s Price Problems   

Related to the above development are MakerDAO’s attempts to generate more funds by increasing its stability fees. MakerDAO is the organization behind the Dai stablecoin – a crypto-collateralized token that is backed by cryptocurrencies on Ethereum’s blockchain instead of fiat currencies like the US dollar. The Dai token trades at parity against the US dollar.

Collateralizing stablecoins directly with crypto presents a stability problem. Cryptocurrencies are a volatile asset whose value fluctuates constantly. To solve the problem, MakerDAO uses another token – known as Maker (MKR) – to insulate DAI from price swings. The MKR token is traded on the Maker smart contract platform on Ethereum’s blockchain and represents a multiple of the underlying cryptocurrencies used as collateral for DAI.

In simple words, this means that one Dai may be backed by as many as 500 ethers. Not surprisingly, the use of MKR token has inflated overall costs and MakerDAO charges a stability fee for transactions from users during trades.

But the instability in Dai’s price (it has lost its peg with the US dollar multiple times recently) has forced MakerDAO developers to hike stability fees three times in the past. Now developers at the stablecoin are considering a fourth hike to cover costs, according to a Coindesk report. When the stablecoin last hiked fees, Rune Christensen – its co-founder, wrote that the increase “brings the cost of financing in line with the short-term financing cost in USD.”

There are two ways to analyze this development. Continuous increases in stability fees could hamper adoption for Dai because users have other, cheaper stablecoin options in cryptocurrency markets right now. Adoption is the most important metric to measure a stablecoin’s success because it could transform the stablecoin’s use case from being an investment to a medium for daily transaction.   

But the opposite scenario – in which stability fees decline to zero – could mean an end for MakerDAO. A piece in The Block, an online publication, discusses such a situation. The author states that Dai might be forced to reduce its overall fee to zero to spur user adoption against better-capitalized competition, such as Goldman Sachs-backed Circle’s USDC. The strategy could prove to be counter-productive for Dai’s capital reserves as well as for investors in the stablecoin because loss of stability fee revenue will have a negative effect on MakerDAO’s balance sheet.