The stablecoin cryptocurrency system is grounded in a unique philosophy of what constitutes the best institutional arrangement for generating trust in money. The stablecoin philosophy minimizes the roles of both central and commercial banks. In contrast to fiat currency, and CBDC’s, trust in a stablecoin system shifts to the administrator(s) of the stablecoin and the technological infrastructure upon which the currency is issued and payments are processed. The legal and economic implications of implementing a stablecoin system depends on the technological design of both the money and payments infrastructure underlying the system. The following aims to provide the reader with a comprehensive understanding of how stablecoins work.
Today, most stablecoins are cryptocurrencies collateralized to the value of an underlying asset, or basket of assets. The underlying assets, and the manner in which they are managed by the administrator(s), characterize the stablecoin and contribute to an end-users ability to trust the resulting currency and payment system. There are three general categories of stablecoins: those backed by off-chain collateral, those backed by on-chain collateral, and algorithmic stablecoins.
The most common form of stablecoin is backed by collateral held “off-chain” (i.e. not on the blockchain). This off-chain collateral can be a single fiat currency like USD (ex. Tether), a basket of fiat currencies (ex. Libra), or other assets like precious metals (ex. Digix Gold). Stablecoins backed by off-chain collateral operate like a form of e-money, which leverage blockchain technology as a means of payment and store of value. The stablecoin itself is a digital representation of the funds that collateralize it, and every unit represents a claim on the issuer over the funds it receives from users. The issuer ensures the funds are redeemable according to the terms of service communicated to users, either on the basis of bilateral contracts or via rules that are publicly auditable by the users themselves. While the issuer assumes the responsibility of redeeming stablecoins for fiat or other assets in centralized stablecoin projects, most decentralized stablecoin projects require users to sell their stablecoins back to the stablecoin ecosystem itself to redeem their original cryptocurrency or fiat currency. This process of stablecoin redemption relies on third party intermediaries or network participants to play a specific ‘stablecoin redemption’ role.
Stablecoins backed by on-chain collateral are cryptocurrencies that remain in blockchain records at all times and depend on the state of the blockchain for their validity (ex. Maker Dai). Unlike stablecoins backed by off-chain collateral, stablecoins backed by on-chain collateral do not need to rely on third parties to safeguard collateral and control issuance. Depending on the project, general users of on-chain stablecoins may have the ability to participate in the rule-setting and governance of the on-chain stablecoin network; the rules of the network dictate when and how stablecoins are issued and redeemed. Participation in management is often optional for users, and characteristic of the decentralized governance enabled by blockchain-based projects.
Algorithmic stablecoins are not fully backed by either on-chain or off-chain assets; they are stabilized by using the reserves in on-chain assets that the network has accumulated over time (e.g. transaction fees), or selling rights on future revenues. Algorithms control stablecoin supply by relying on supply and demand information from trading platforms and market data providers. The smart contract at the core of an algorithmic stablecoin initiative includes rules on how the issuance and redemption of stablecoin units will be used to match demand while maintaining parity with the currency of reference. These non-collateralized stablecoins attempt to mimic the role of reserve banks by maintaining necessary supply of tokens in accordance with economic circumstances.
A commonality between all stablecoin types is the payment flow. A transfer of stablecoins begins with someone creating a transaction, which in the case of stablecoins, involves entering the amount you want to send and receive into a smart contract populated by the intended recipient’s public key address. When a transaction is issued, the transaction request is broadcast to all the computers in the network (these computers are referred to as nodes). The ‘miner’ nodes work to validate the transaction by solving complex algorithms designed to verify a transaction’s legitimacy before appending it to the blockchain. The mining process begins with miners bundling pending transactions to create a new block. Each block has a header that contains the timestamp of the block, which includes a cryptographic hash of the block’s items. Along with the new block’s cryptographic hash, the header also includes a reference to the previous block’s hash, which creates a chain of verified transactions (the ‘block’ ‘chain’). Transactions are considered secure because data recorded on each block is agreed upon by a majority of the network participants in accordance with the rules of the stablecoin initiative.
The primary differences between stablecoins is the degree in which a centralized identity retains control over money supply (i.e. who controls issuance and redemption), and the basis of trust in the stablecoin itself (i.e. the underlying assets and technology). The following section provides a case study of three stablecoins to demonstrate key differences. These case studies do not include an example of algorithmic stablecoins because this form is the least popular, and the only algorithmic project in circulation has not recovered since its fall in March of 2018. The case studies are of two stablecoins collateralized by off-chain assets: Tether and Libra, and one stablecoin collateralized by on-chain assets: Maker Dai. These projects have been chosen because of their popularity and relative likelihood for mainstream adoption.
- Blockdata, “Stablecoins: An Overview of the Current State of Stablecoins”, online: https://download.blockdata.tech/. at 6. ↩
- It is important to note that many of the entities responsible for the creation of stablecoins proclaim that they are not intended to replace fiat currency. However, for the purposes of this report, we explore the nature of stablecoins and whether they could serve a global currency and payment function. ↩
- Electronic money is currency that is stored in banking computer systems, it is backed by fiat currency, which distinguishes it from cryptocurrency. Examples of companies that enable e-money transactions are PayPal and Square. See: Andrew Bloomenthal, “Electronic Money” (2019) Investopedia, online: https://www.investopedia.com/. ↩
- For simplicity the term blockchain is used consistently in this paper. However, it is important to note that blockchain is only one form of distributed ledger technology (DLT), and there may be various implementations of DLT that facilitate payments. ↩
- Dirk Bullman et al, “In Search for Stability in Crypto-Assets: Are Stablecoins the Solution?” (2019) European Central Bank n. 230, online: https://www.ecb.europa.eu/ at 27. [Bullman et al, 2019]↩
- A smart contract is a computerized self-executing protocol that enforces the execution of a predefined contract in a real-time manner. Nick Szabo, “The Idea of Smart Contracts”, (1994), online: http://www.fon.hum.uva.nl/ ↩
- Stan Sater, “Blockchain and the European Union’s General Data Protection Regulation: A Chance to Harmonize International Data Flows”, online: (2017) SSRN https://papers.ssrn.com/ at 19. ↩
- Nakomoto, Satoshi. Bitcoin: A Peer-To-Peer Electronic Cash System, 2 (2008), online: http://bitcoin.org/bitcoin.pdf at 1.↩
- Ibid. A hash function takes an input (or 'message') and returns a fixed-size alphanumeric string that serves as the digital fingerprint of that input. It is a pseudonymization technique in cryptography used in storing and sharing information for efficiency.↩