Intro to MakerDAO: Understanding Stablecoins (Part 1)
Cryptocurrencies are revolutionary in every sense of the word. However, despite all its good qualities, there is one thing that has consistently stopped them from mainstream adoption. In fact, this one thing is so deeply interwoven with the crypto-culture, that it has almost become a joke.
Intro to MakerDAO: Understanding Stablecoins
Let us give you a hint:
Does that ring a bell?
Well.. how about this:
Still doesn’t ring a bell?
We are talking about volatility. That, in many ways, is the biggest barrier that cryptocurrencies are facing right now.
When you keep that statement in mind, you will understand why Stablecoins are so important.
If you were to define them, Stablecoins are:
digital tokens which are intended to provide measurable stability and security. In layman’s term, their value remains constant and stable.
Stablecoins have been called many things from “the holy grail of cryptocurrencies” to the “foundational component of the next-generation economy.” They have been embroiled in controversy and they have been dissected and studied by some of the smartest minds in the cryptospace.
For your reading convenience, we are going to be splitting up this guide into two parts. In the first part, we are going to acquaint ourselves with stable coins and why they are necessary.
In the second part, we are going to do a deep dive on the most promising stablecoin out there, MakerDAO.
The Importance of Stable Currencies
Stability of currencies is such an important aspect. In fact, let’s see a real-world example of how instability and over-inflation can cause havoc to the economy.
Back in the 80’s, the Zimbabwean dollar had strong growth and measured up pretty well against the US dollar. However, all that was about to change. From 1991-1996, the Zimbabwean Zanu-PF government of President Robert Mugabe embarked on an Economic Structural Adjustment Programme (ESAP) that had serious negative effects on Zimbabwe’s economy. Over that 5 year period, Zimbabwe went through extreme hyperinflation. In fact, in November 2008, the hyperinflation rate went up to 79,600,000,000% per month, which resulted in $1 USD becoming equivalent to the staggering sum of Z$2,621,984,228!
Image Credit: Wikipedia.
In fact, the government ran out of paper to print money, which left a lot of soldiers without any pay. They were even forced to print a trillion-dollar note!
Now, what happened because of this hyperinflation?
- The banking sector collapsed.
- The farmers were unable to get any loans from the bank and as a result, for a 10-year period from 1999-2009, there was a sharp drop in food production.
- Unemployment rose to 80%.
- Life expectancy also dropped.
Zimbabwe was eventually forced to give up their currency for the USD.
Making The Case For Stablecoins
A good currency should fulfill the following three roles:
- Medium of exchange.
- Unit of account.
- Store of value.
While cryptos do a great job as a medium of exchange, it is as a unit of account and store of value where it falters miserably. The reason? It is just not stable enough. If you own something that is extremely volatile, will you trust it as a store of value?
Would you want to safely invest your hard-earned money in an asset which may be worth half of its present valuation in 24 hours?
In fact, let’s do some more research on this.
What are the problems that we face because of the volatility of cryptocurrencies and what are the main advantages of stablecoins?
- While traders take advantage of this volatility to make their profits, the reality is that they could easily lose all their money by taking their eyes off the screen. Most of these crypto-crypto exchanges don’t support fiat funds, which is why it is necessary to have a stablecoin where traders can keep their profits untouched.
- Cryptocurrencies are not ideal for time-based contracts. If someone were to bet 1 BTC on an event occurring in a year’s time, then they are exposing themselves to two major risks. Firstly, the event may not occur at all, and secondly, the value of BTC may drop down in that time. This volatility makes it extremely difficult to do a proper risk assessment.
- Finally, in order to have widespread mainstream adoption, stablecoins maybe the best form of the currency to take up that role.
So, where does the stability comes from? For that, we need to understand the idea of “pegs”.
The concept of pegs or fixed exchange rates lies at the very heart of stablecoins. According to Wikipedia:
“A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.”
So, why do we do it?
A peg is used to keep the value of a currency stable by directly fixing its value in a predetermined ratio to a different more stable or more internationally prevalent currency (or currencies).
This method is extremely useful for small economies, economies which borrow primarily in foreign currency, and in which external trade forms a large part of their GDP.
So how do they do it?
In order to maintain a peg, the country needs to first accumulate large reserves of foreign currency. As Richard Chen says in his article:
“This is because if the country needs to appreciate its own currency to maintain the peg, then it can buy its own currency on the market using its reserves of foreign currency. The country can also raise interest rates and contract the money supply to attract foreign demand for its currency, thereby causing appreciation.”
Similarly, if a country needs to depreciate its own currency to maintain the peg, then it can sell its own currency on the market, lower interest rates, and expand the money supply.”
Pegs Through the Ages
#1 The Classic Gold Standard
From 1880 to 1914 the classic gold standard was followed by most of the countries. The very first use of a gold standard was in the UK in 1821. In this standard, the external value of all currencies is denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset.
During this time period, 1 USD was denominated as 0.048 troy oz. of pure gold.
#2 The Brenton Woods System
Following the second world war, various countries came to the realization that a new system was required. They knew that that gold standard was far too rigid, and they also knew that main reason behind the second world war was the economic imbalance during the inter-war period.
To prevent a third world war, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference.
After the second world war, the US had the majority of the world’s gold reserves, so it was decided that the other countries will peg their currencies to the USD, while the USD remains pegged to gold. Now, this does sound good in theory, however, it didn’t really workout.
Due to various reasons, the dollar got devalued and over the course of 25 years, other countries exchanged their USD foreign reserves for gold, slowly draining Fort Knox of gold. This led Nixon to terminate convertibility of USD to gold, and the USD has remained a free-floating fiat currency ever since.
Maintaining Pegs – The Four Questions
There are still some Pegs out there, however, most of nations and banks have moved away from them. Time and again, we have seen economic and financial disasters that have happened because of rigid pegs. The Soros attack of 1992 is a classic example (more on that later).
Ok, so we have seen that stablecoins can’t exist without pegs and we have just mentioned that pegs are fast becoming outdated in the international economy. Does that mean that all stablecoin pegs will fail?
Turns out that that’s not true.
Any peg can be maintained, provided it is within a certain bandwidth of market behavior. In other words, “within at least some market conditions, it’s possible to maintain a peg.”
For a peg to maintain itself, it must ask 4 questions (taken from this article):
- Can the peg withstand a good amount of volatility?
- Is it expensive to maintain?
- How easy is it to analyze the band of behavior from which it can recover?
- How transparently can traders observe the true market conditions?
The final two questions are critical before that’s where the Schelling point game theory comes in.
What is the Schelling (Focal) Point?
The great economist Thomas Schelling conducted an experiment with a group of students asking them a simple question: “Tomorrow you have to meet a stranger in NYC. Where and when do you meet them?” He found out that the most common answer was, “Noon at the Grand Central Terminus.” This happened because the Grand Central Terminus, for New Yorkers is a natural focal point, the focal point is also known as a “Schelling point”.
So, to define a Schelling point: It is a solution that people will tend to use in the absence of communication because it feels special, relevant or natural to them.
Let’s demonstrate this concept with a game.
Suppose there are two prisoners kept in two different rooms and they are given a random series of numbers. Then they are told to guess the number that they other prisoner will guess, without any communication between the two. If they guess the wrong number, then they will be killed (just to up the ante).
The numbers that they are given are:
7816239, 676716313, 100000000 and 871823719.
Which number do you think they will choose?
Because it is different and special when compared with the rest of the numbers and that is why it is Schelling point. Throughout our history, human beings have unknowingly subconsciously converged in various places such as bars, churches, community centers etc. because in a society those places are common Schelling points.
A very famous example of the Schelling point in action is a game that we hope you have never played in your life called “The Chicken Game.” This is how it works, two people ride towards each other on a bike. If they collide head-on, they die. However, the first person who swerves away from the incoming rider is a “chicken”.
So, in this game, there are 2 scenarios which can end in a crash:
Image Courtesy: Mind Your Decisions blog
Case 1: Both riders head towards one another.
Case 2: One rider swerves left and the other swerves right.
Thomas Schelling gave the solution to this using the concept of focal points. He said, that the best solution to this game is to not look at the other rider in the eye (i.e. cut off communication with the other rider) but focus on one’s own instincts. Since, in the United States, people drive on the right side of the road, if we let our instincts take over, we will automatically steer the bike towards the right side, because that’s where our Schelling point lies.
So how does Schelling point help us in understanding the strength of the peg? As Haseeb Qureshi puts it in his Hackernoon article:
“If market participants cannot identify when a peg is objectively weak, it becomes easy to spread false news or incite a market panic, which can trigger further selling — basically, a death spiral. A transparent peg is more robust to manipulation or sentiment swings.”
The Three Kinds of Stablecoins
Image Credit: Medium
There are three kinds of stablecoins:
- Fiat Collateralized.
- Crypto Collateralized.
#1 Fiat Collateralized
Fiat-collateralization is probably the most simplistic and straightforward execution of stablecoins. The way it works is pretty simple. A certain amount of fiat is locked up as collateral and coins are issued 1:1 against it. Instead of fiat currency, gold, silver, oil etc. can also be kept as collateral.
Tether is probably the best example of this and it also happens to be the most widely used stable coin. We will talk about Tether and its problems a bit more in the second part.
#2 Crypto Collateralized
Crypto-collateralized stablecoins are actually pretty similar to fiat-collateralized coins…with one major distinction. Instead of using fiat as a peg, they use another cryptocurrency.
However, we all know that cryptocurrencies are unstable, unlike fiat currency (comparatively), so how does this system work?
The answer to that question is “over-collateralization.” So, if you want $100 worth of stablecoins then you will need to deposit $200 worth of ether. It is not a straightforward 1:1 ratio.
Dai is an example of this kind of stablecoin. In the next part, we will explore them in detail.
Finally, we have the non-collateralized stablecoins. These are the coins who are not backed by anything. If you think about it, a privately issued, non-collateralized, price-stable currency could pose a radical challenge to the dominance of fiat currencies.
But, how does one execute this?
Back in 2014, Robert Sams came up with the concept of Seignorage Shares and it is based on a very simple idea. Create a smart contract which would act as a central bank with only one policy, issue a currency which will always trade at $1.
So what happens if the coin is trading at $2?
Since the price is high, the smart contract will automatically create more coins to increase the supply and dilute the price. The extra profit that would be left over in the smart contract, as a result, is called seignorage.
Now let’s look at the other scenario.
What if your coin is trading at $0.50? How does the smart contract reduce the supply? The contract simply buys up coins in the open market to reduce the supply.
This method has come under criticism because of its resemblance to a pyramid scheme.
Anyway, we now know the three form of stablecoins. In the next part, we are going to looking into MakerDAO in detail.
However, before we do that, let’s look into a possible vulnerability that stable coins may face.
The Unholy Trinity – Possible Vulnerability?
To conclude the first part of the article, let’s checkout a concept in international economics which can lead to some rather “interesting” consequences with stablecoins. The name of this concept is the “Unholy Trinity” and we are going to thank Richard Chen and his article “The Macroeconomics of Stablecoins” for introducing us to this.
The unholy trinity aka the impossible trilemma states that it is impossible to have all three at the same time:
- A fixed foreign exchange rate (peg).
- Free capital movement (absence of capital controls)
- Sovereign monetary policy.
Image Courtesy: Medium.
We already know what “peg” means let’s look into the other two.
Free capital flow (i.e. no capital controls): This basically means that citizens will have the freedom to diversify their holdings by investing abroad. Conversely, this also allows foreign investors to bring their expertise into the country.
Sovereign monetary policy: This means that the central bank can increase the money supply to reduce interest rates when the economy is down and they can reduce the money supply and raise interest rates when the economy is up.
So, when you bring it all together, the unholy trinity states that central banks can only execute two out of the three mentioned properties. Trying to execute all the three at the same time may lead to some truly catastrophic results, such as the 1997 Asian financial crisis.
In the 90’s, East Asian countries had their currency pegged to the USD, they were making their own independent monetary policy, and had free capital flow. This meant that their citizens could not only invest anywhere they wanted, foreign investors were also encouraged and incentivized to invest a lot of money in these countries.
While the trade conditions were favorable, the investments made by these foreign investors reaped enormous amounts of profit and contributed to an overheated economy. However, when the trade balance reversed, the investors quickly pulled their money out which resulted in one of the worst financial catastrophes in history.
In fact, the damage done economically was equivalent to a full-scale war. Thailand, in particular, ran out of USD reserves and were forced to let their currencies float and devalue.
This means that we now have three options left. According to the diagram given above, the options are labeled: A, B, and C.
The Three Options
Option A: Free Capital and Fixed Exchange
In this option, the banks are letting go off the option of enacting their own monetary policy.
This kind of system is especially prevalent in the Eurozone. All the countries in the zone are bound by one currency i.e. Euro. Plus, there is free capital flow in and out of all the member nations.
However, the member nations cannot enact their own independent monetary policy. This means that it is extremely tough for a member nation to take care of an overheated or depressed economy. In fact, this is exactly what happened in Greece. This option may make you feel like that there is a one-size-fits-all solution when there really isn’t.
Option B: Free Capital and Sovereign Policy
In this option, the investors will have the freedom to invest wherever they want and the central bank of the country has the power to enact their own monetary policies, however, there is no fixed peg.
The US uses a system like this. They have their own monetary policy and has a free flow of capital. However, the exchange rate is floating and is determined by the market.
Option C: Fixed Exchange and Sovereign Policy
Finally, we have option C. In this case, you can have a fixed peg and the central bank can issue their monetary policy, however, there is no free capital.
China is an example of a country that uses their own monetary policy while maintaining an exchange rate. However, they control the amount of capital flowing inside and outside the country.
Which option works best for Stablecoins?
Since stablecoins already have a fixed peg, option B is automatically out of the contention.
Let’s examine Option A and C:
Option C says that one cannot have free capital. However, that defeats the very purpose of decentralization. In a decentralized ecosystem, one cannot have any third party to control the flow of funds. This is why Option C is out.
That leaves us with Option A. But, this, however, leaves Stablecoins open to a Soros attack. So, what is this Soros attack?
In 1992, George Soros, a Hungarian-American investor made over a billion dollars. However, in the process, he broke the Bank of England. This is what happened as per Wikipedia:
“Soros had been building a huge short position in pounds sterling for months leading up to September 1992. Soros had recognized the unfavorable position of the United Kingdom in the European Exchange Rate Mechanism. For Soros, the rate at which the United Kingdom was brought into the European Exchange Rate Mechanism was too high, their inflation was also much too high (triple the German rate), and British interest rates were hurting their asset prices.”
What Soros did is often called the “Greatest financial bet of the 20th Century.”
The Bank of England realized that raising interest rates during a recession would be political suicide which is why they broke the peg and let the Pound float with the German Deutsche Mark.
Now the question is, what happens if something stablecoins face is a Soros attack?
If a stablecoin were to become the currency of the future, then it makes sense that there will be wrong periods of recession. Since stablecoins can’t control the monetary policy, if someone attempts a Soros attack during a recession, the Stablecoin’s smart contract would immediately contract the money supply to counterattack, which will make the recession even worse.
As Richard Chen concludes,
“Thus, stablecoins are subject to the impossible trilemma and, in achieving their stability, make a conscious choice to give up monetary policy. This is politically popular in the short-term, but without the ability to use monetary policy to alleviate an overheated or depressed economy, it would be difficult for stablecoins to become a world currency in the long-term.”
So, now that you know what a stablecoin is, in the next article you will learn the following:
- Tether’s Flaws.
- MakerDAO analysis.
Look forward to it!
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