Stable Coins: A Requirement for Growing a Blockchain Economy?

UDC Story — Insights from UDC 2018

‘A boy asked his father, a Bitcoin investor, for 1 Bitcoin as a gift for his birthday. The father reacted like this: “What? 15,554 dollars? 14,354 dollars is a lot of money! Why would you need 16,782 dollars?”’

That’s a joke Terra CEO Daniel Shin showed on the screen during his speech at UDC 2018. “How much value has cryptocurrencies added to our daily lives?” Shin asked, before providing answers for why it hasn’t. The first was the volatility of cryptocurrency prices, illustrated in the joke. Considering the daily fluctuation, there’s some question as to whether it can be referred to as a ‘currency’ at all.

The other issue he brought up was the misconception that users will automatically flock to whatever service developers release. From his point of view, earlier DApps failed to become killer content because their usage was limited. Shin believes that blockchain projects need to piggyback on already popular services to become successful.

◇ Solving the fluctuation issue

Shin’s ideal cryptocurrency, stable coins, resolves both of the issues mentioned above. The first issue, price volatility is obviously not an issue. Recently, there have been reports companies including IBM, financial startup Stronghold, and another startup Circle, backed by Goldman Sachs, are all preparing their own stable coin. Stable coins are cryptocurrencies that literally have stable values. If the price fluctuation issue is resolved, existing financial services can be efficiently integrated with cryptocurrencies. Fees will be cheaper and international wire transfers can happen in real-time. Stable coins will take on the role of a bridge between the real world and blockchain technology.

Stable coins can be largely divided up into 3 categories: Fiat-collateralized stable coins, crypto-collateralized stable coins, and non-collateralized stable coins.

Fiat-collateralized stable coins refer to cases when a specific company or agency deposits currency such as dollars, pounds, KRW, etc. into their account as collateral and issue tokens for that amount. Generally, tokens are issued with a 1:1 exchange ratio to 1 dollar (USD).

The usage method is simple as you just need to get the stable coin exchanged to legal tender by the operating agency. The operating agency always exchanges the cryptocurrency to legal tender at the designated exchange rate. Both the buyer and seller can minimize loss from price fluctuations if the transaction is made using stable coins. Even if the price of the stable coin fluctuates wildly, the universal value (USD 1) is recognized through the operating agency.

The problem is the operating agency as it needs to handle multiple tasks including token issuance, exchange services, and deposit management. The credibility of the operating agency must be guaranteed. The value of a stable coin will vanish if the operating agency secretly siphons legal tender deposits or changes policies at whim, refusing exchanges at the designated exchange rate.

Tether (UDST) and TrueUSD (TUSD) are probably the most well-known ones. Tether’s market capitalization is over USD 2 billion, and it plays a key role as a currency in exchanges around the world. However, non-transparent operations and excessive early supply have led to controversy regarding whether they actually have enough deposits (USD) to cover the Tether issued.

Crypto-collateralized stable coins use the value of cryptocurrency as collateral. The price of the stable coin is also steadily maintained based on a legal tender (USD). The reason the price is stable is due to the existence of the collateral. It is operated by lending consumers coins whose value are stabilized using cryptocurrencies such as Ethereum as collateral.

The stable coin user deposits cryptocurrencies like Ethereum as collateral to the account. Then stable coins are issued based on the value of the collateral, and the user receives it as a loan. The account is settled when the stable coin user returns the same amount of stable coin within the loan period and gets back the collateral. All processes are handled automatically using smart contracts.

Two systems are necessary to maintain this collateral-loan structure: over-collateralization and forced liquidation. The former means that the value of the collateral currency must be higher than the actually loaned stable coin. That way, stable coin consumers will want to pay back their loans.

Cryptocurrency prices may plummet, making the value of the collateral become smaller than the value of the loaned stable coin. In that case, there is no reason for consumers to settle their loans and collect their collateral. Stable coins matching the loaned amount are purchased and settled using the collateral deposited by the user through smart contracts, liquidating the consumer’s loan account.

This is what happened with the ‘MakerDAO’ case in 2017. With Ethereum as the collateral currency, MakerDAO self-issued two coins: Maker and Dai. Between them, the Dai token played the ‘stable coin’ role. The issued and incinerated amount was adjusted according to the exchange rate, achieving price stabilization. On top of that, the passageways (like TRFM and Global Settlement) for maker token holders to intervene in decision making were left open for additional stability maintenance.

◇ Terra, stabilizing the price through an algorithm without collateral

Finally, there are the non-collateralized stable coins. These are price-stable cryptocurrencies in which the price of the coins are maintained only by adjusting the circulation volume of the coins via an algorithm or system. The algorithm or system adjusts according to changes in the exchange rate with the pegged asset, or in other words, the coin price. What causes a coin’s price to fluctuate is the rise or fall in demand. The price for cryptocurrencies with set supply volumes can fluctuate widely depending on the demand, whereas the target price can be maintained for non-collateralized stable coins by adjusting the circulation of the coin according to the degree of demand. Theoretically (based on the quantity theory of money), it can be assumed that the currency value can be steadily maintained if the supply of the currency is accurately adjusted to match the precisely measured demand.

Terra, devised by Shin, is a non-collateralized stable coin. The price of Terra rises if the demand increases. When demand for Terra increases, a protocol also increases the amount of Terra issued. As the supply increases, the increased price shifts its way back down. The amount of Terra issued must decrease if the demand decreases. That can be accomplished by buying and incinerating enough Terra on the market (according to an algorithm) to get the price back to normal.

The important part is when a price drop occurs. If the price increases due to an increase in demand, issue more Terra and problem solved. If the price drops due to a decrease in demand, you need to buy Terra back from the market, and this is where the token Luna comes into play. Whenever Terra is used for payment, a small payment fee is paid to Luna. This means that Luna will continue to receive transaction fees, and the value generated will be used to buy and burn Terra when the price drops. The payback to the Luna network occurs when the price of Terra has increased.

Luna’s value is formed from the fees generated whenever a Terra payment occurs. In other words, Luna will not have much value when there is little to no Terra payments made during the early stages of the platform. Luna’s value is preserved in the early stages through investments made by companies such as Dunamu, Binance, and Hashed. Shin’s goal is to grow the Terra payment network and reduce the ratio of cash value that Luna holds.

Terra and other non-collateralized stable coins are attractive because of the system adjusting the circulated currency volume and the lack of collateral. However, there is the risk of the stable coin’s value plummeting once people lose faith in the future growth potential and stop using it.

◇ Terra will go where the consumers are

From a price stability viewpoint, there doesn’t seem to be much difference between legal tender and stable coins. Shin considers ‘programmable currency’ and ‘token economy’ to be the two key differences.

First, unlike legal tender, various DApps can be developed on top of stable coins, which are digital currencies that can be programmed. Further innovation can be generated through stable coins by placing products such as loans, finance, money transfers, and insurance on top of it. “DApps built on digital currencies will serve the role of creating value, similar to how the smartphone obtained value through various apps,” stated Shin.

With Terra, a token economy can be designed where proper rewards are provided to participants who contribute to the ecosystem as it grows. It’s not possible for the public to know or control where legal tender issued by the government is invested. With Terra, everything is reinvested to help grow the ecosystem, with loyal users that contributed to the growth receiving various discount benefits. The As more users join Terra and its economy continues to grow, that will also result in more benefits for the users.

It’s a lofty goal, and there are some questions. The most serious issue for cryptocurrencies is commercialization. More people need to actually use it for true commercialization to occur. Although the blockchain ecosystem has seen a number of services and platform coins, most platforms are created without a real strategy to attract users. Many seem to expect users to flock to their side just because their platform technology is better. This is rather delusionary.

“During the last 20 years, the most successful payment services have been Alipay and PayPal. Alipay and PayPal grew by piggybacking on major e-commerce platforms, Taobao and eBay, respectively. Terra is taking the same approach. The yearly total transaction volume for our partner companies is KRW 28 trillion, with 40 million users. The approach is not to just create a platform and wait for users, but to bring cryptocurrency to existing users.”

That is Shin’s attitude, and it’s noticeably different from leaders of other blockchain projects. Blockchain technology and cryptocurrency must seep into places where users already are. Terra has signed MOUs with sites including Ticket Monster, Baedal Minjok, and Yanolja. On these sites, you will be able to use Terra to make convenient payments, no different from traditional payment services like PAYCO or PayNow.

Shin explained that “You can consider Terra to be sort of Alipay on the blockchain.” Alipay started out as a payment service, but it then attracted customers to sign up for other financial products by offering high interest rates. Using those funds, they started credit and investment services and ultimately became a global financial powerhouse known as Ant Financial. Ant Financial is valued higher than history and tradition-rich Goldman Sachs.

Shin concluded, “We’re starting with Terra Pay, but we want to create an ecosystem where more financial DApps can thrive. We hope even those who view cryptocurrency in a negative light can experience its value through Terra.”

※ Referenced speeches (The speeches can be viewed in their entirety on the UDC 2018 YouTube page)

- “Role of Stable Coin in Growing the Real GDP of Blockchain Economy” by Terra CEO Daniel Shin

*This post is a translated excerpt from Proof of Report UDC 2018 written by Ran Ko, CCO of Join:D, a blockchain media affiliated with JoongAng Daily.