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I recently spoke with MakerDAO CEO Rune Christensen. MakerDAO is the company behind not one, but two, top 2oo-cryptocurrencies by market cap. One of these is Dai, sitting at #107 with a modest market capitalization of $46 million, and the second is Maker (MKR), which currently sits at #29 with a market capitalization of $272 million. At its peak, MKR had a market capitalization of over $1 billion.
The market performance of either of these coins individually would be impressive. The fact that the coins exist together and one governs the other makes it even more impressive. Dai is a stablecoin, intended to behave in a similar fashion to Tether (e.g., pin the value of the coin to a fiat asset, in the case of both Tether and Dai this is the US Dollar). The similarities between Tether and Dai, however, pretty much end there.
What is a Stable Coin?
Very early on in the days of cryptocurrencies, it became evident that bitcoin was going to become a speculative investment, at least until it achieved global adoption. The coin’s limited supply, low volume, and boom and bust cycles made it untenable for use as everyday money.
Enter the stablecoin. These coins can potentially offer all the benefits of blockchain technology: an immutable ledger, smart contracts, decentralization and more without any of the volatility that comes with more traditional cryptocurrencies like bitcoin and ethereum.
The Three Types of Stablecoins
There are three types of stable coins:
The basics: Each unit of this type of coin is backed by a unit of fiat currency. For instance, in the case of Tether every unit of Tether is backed by a US dollar. I can even go to Tether’s website and redeem my Tether for US Dollars.
[Editor’s note: Tether does not operate in all jurisdictions and is not currently accepting any registrations through its main website portal.]
The good: These coins are incredibly easy for consumers to understand. While they are sometimes subject to volatility, especially in cases where the integrity of the currency is being questioned, in theory, the fact that you can always redeem one token for one fiat unit should stabilize the price.
The bad: While we touched on this briefly in our interview, what follows below is a much longer explanation of how fiat currency went from being a reserve currency to it’s current, inflated state.
A Brief History of USD Inflation
The easiest way to explain this type of currency to explain might be the US dollar prior to Richard Nixon’s presidency. At that time, anyone could walk into any bank in America, hand the bank $1 and get 1.67 grams of gold at nine-tenths fine. This was the law and the result of the Gold Standard Act passed at the turn of the 20th century. Then, one day 47 years ago, Richard Nixon decided to take the United States off the “gold standard.” Why it happened and what happened next are key to understanding the issues behind a reserve currency.
The gold standard worked great throughout the first and second world wars. In 1944 with the war coming to an end, representatives from 44 nations met to develop a new monetary system. The system, named “Bretton Woods” after the name of the town in New Hampshire where this meeting would take place, had the goal of devising a monetary system that would “ensure exchange rate stability, prevent competitive devaluations, and ensure economic growth.” The system centered around the US Dollar and required that all international accounts be settled in USD. These dollars could be converted to gold at an exchange rate of $35 per ounce.
The system worked extremely well in the postwar years. Virtually every other economic powerhouse in the world had been destroyed by the war leaving the United States with an unprecedented monopoly on manufacturing and trade. Additionally, the country owned over half the world’s gold, and other countries rapidly consumed American goods. They had no choice, their manufacturing capacity, natural resources, and to some extent their labor forces had been devastated by the war.
What happened next was easy to anticipate: Germany and Japan rebuilt. Both countries had been formidable industrial powerhouses before the war and regained their status in only a few years. The U.S. had issues of its own to contend with: the Vietnam war and aggressive spending had caused huge amounts of inflation and it’s percentage of economic output had dropped by nearly 10%. The system was heavily criticized internationally, with one American economist explaining: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one.”
Nonetheless, the system teetered along until the overvaluation became too blatant for foreign leaders to ignore anymore. The U.S. central bank held only $13.2 billion in gold compared to $14 billion in other central banks. Only about 20% of that was redeemable by other countries. French president de Gaulle announced his intention to exchange all of his country’s dollars for gold. This is when the dominoes started to fall: West Germany left the Bretton Woods system and other countries watched as their currency increased almost 8% compared to USD. The overwhelming economic response was panic. Switzerland and France exchanged paper dollars for hundreds of millions of dollars worth of gold.
Rather than leave Bretton Woods, Nixon decided to suspend the convertibility of gold. On national TV in 1971, Richard Nixon announced that the U.S. would leave the gold standard. He then imposed a 10% import tariff and froze wages and prices for the next 3 months to prevent any immediate inflation. He proceeded to comfort the American people by saying “in America, your dollar will be worth just as much tomorrow as it is today.” This, as we now know, was not the case. Over the next 50 years, expansionist monetary policy increased government spending, and the continued recovery and subsequent boom experienced by countries formerly struggling to pick up the pieces of their economies following World War 2 recovered. All of this rendered the dollar at 19% of what it was worth when Nixon made his announcement.
All this brings me to my original point: the problem with reserve currencies. Yes, it may be true that when you by your Tether today you can exchange it for a physical dollar. But it might not always be that way. Tether has thus far refused to undergo a full audit of its books (as promised), and its price has experienced volatility more than once. It even faced criticism from Bloomberg for its trading patterns on certain exchanges.
The basics: Instead of using a fiat to back the currency, crypto is used, typically in an over-collateralized fashion (that is the ratio of the stable coin to crypto is greater than 1:1). The system is then managed by smart contracts that buy and sell the underlying assets to keep the currency at $1.
The good: Transparency is the biggest here. Since all transactions happen on-chain, everyone can inspect the underlying assets.
The bad: Cryptocurrencies are incredibly volatile. Volatility in the underlying asset means in order to maintain a price peg, you need to be extremely over-collateralized.
The basics: Smart contracts are used to maintain the price level by regulating the supply of currency. As the price of the coin goes up, more currency is created to bring the price down. As the price decreases, currency is bought. If the reserve of money runs out, rights to the future issuance of coins are sold to raise funds. In some cases, the system governed through the use of a decentralized autonomous organization (DAO) where users can vote on monetary policy. Users can also lock up coins (to reduce the circulating supply) and earn interest.
The good: The best part of these types of currencies is that they are independent of any other currency. The value of the collateral can’t come spiraling down because there is no collateral.
The bad: There is no collateral. If the price of the coin takes a big enough hit and enough people sell at once the coin won’t be able to recover since it will have no money to buy back coins.
Going back to our U.S. example, this is why Nixon issued an executive order fixing prices: to avoid this kind of runaway inflation. This kind of inflation is not theoretical either: Nubits, a cryptocurrency founded in 2014, was able to maintain the $1.00 price peg for over a year but is now trading at $0.20.
As you might have gathered from the complexity of the coins above, stablecoins have a variety of use cases the biggest one being providing a non-speculative way for consumers to spend money on the blockchain. Near the end of the bull run of 2017, I wrote an article about a site that let you bet on the Super Bowl with ethereum. One of the responses I got essentially said: “there’s no way I’d risk even a Wei [the smallest unit of ethereum or 0.000000000000000001 ETH] because it’s going to keep going up”. The same kind of FOMO induced HODLing is on display every year when we celebrate Bitcoin Pizza Day and gawk at the $179,000,000 pizza. The reality is, most people don’t want to spend bitcoin or ethereum (yet), it’s just too volatile.
Beyond consumer benefits, stablecoins have other benefits. For example, “decentralized cross-border lending” is achievable through other currencies. The problem is financial planning becomes almost impossible when some currencies have 60-80% intraday volatility. For large adoption of digital currencies (as opposed to digital assets) in the financial services industry, stability is necessary.
Everything above applies to most stablecoins, including Tether (despite the risks outlined above). MakerDA)’s unique approach gives it a huge leg up over Tether in the creation of new currencies though. Currently, MakerDAO’s MKR token is used for the governance of Dai, their currency pegged at $1. But Maker’s unique approach means they can peg the price of a new coin to anything. They can create 10 new cryptocurrencies tomorrow pegged to the top 10 global reserve currencies, or pegged to something completely different.
Herein lies the most compelling use case, and something Rune and I discussed as an eventuality for MakerDAO: it could actually track the Consumer Price Index (CPI). CPI ” is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services” and as such is not subject to hyperinflation (the kind of economic effect that creates “worthless” hundred trillion dollar bills in Zimbabwe and barrels of money in post-World War 1 Berlin)or hyperdeflation (of which, the best example is bitcoin itself. This op-ed does a good job of explaining the psychological and economic effects hyperdeflation). A MakerDAO currency has the potential to become the first currency in the world immune to hyperinflation and hyperdeflation.
Disclaimer: The views expressed in the article are solely that of the author and do not represent those of, nor should they be attributed to CCN.
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Crypto News & ICO Reviews
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