Author is the head of MakerDAO China
“There are three types of stable coins: legal currency mortgage, digital asset mortgage and unsecured algorithm.” This classification has become a popular perspective for analyzing stable currencies.
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Classification according to the type of collateral is simple and easy to understand, but there are limitations and deviations.
This paper provides a stable currency classification perspective based on stability mechanism. From the perspective of stability mechanism, stable coins can be roughly divided into two types: cloned currency vs. pegged currency.
Clone coins, as the name suggests, are the direct "cut and paste" of French currency. To issue tokens of equal face value by storing the same amount of the subject currency or assets, free circulation based on the blockchain. The biggest use of this stable currency is to give users who cannot access the legal currency account or trade specific assets the same exposure.
The essence of cloning stable currency is a strict fixed exchange rate system, requiring the issuer to perform the traditional currency board system :
- The issuer maintains a stable and unrestricted stable currency and standard asset acceptance at any time.
- The issuer must maintain a reserve of more than 100%
- No assets other than the corresponding legal currency are included in the balance sheet
- If there are other assets on the balance sheet, they need to be frozen and not traded.
- The issuer only earns interest by absorbing deposit interest
- The issuer does not have any monetary policy space
No monetary policy is the best policy for cloning coins. In order to prevent speculation and run-off, the way in which the coin is stabilized is to strictly reserve 100% of the underlying assets and to ensure convertibility. When the user deposits the underlying asset, a 1:1 token is issued. When a user redeems an asset, the corresponding 1:1 token is withdrawn from circulation. The issuer is not allowed to have discretion, or super-operational space.
In this model, compliance is the biggest premise and advantage. USDC and Paxos' PAX USD and its recently launched PAX Gold (gold coin) are at the "top of the pyramid" and are eligible for custody and US Federal Deposit Insurance. In contrast, TUSD, Digix Gold and the US dollar stable currency launched by several exchanges in China need to rely on other trust company partners and commercial insurance.
Example of USDC:
In contrast, the USDT is an exception. Although USDT is often classified as one of the other currency-stabilized currencies, it does not follow the rules of the currency board system:
- Tether does not guarantee real-time acceptance
- USDT has only 74% of the reserve
- Other assets such as Bitcoin are included on Tether’s balance sheet
- Tether participates in trading bitcoin and lending reserves
- Tether affects the money market through over-issue (credit creation)
From this perspective, the USDT does not belong to the fixed stable currency category, but the anchor currency. Discretion gives the USDT a flexible liquidity, but at the same time it also has a huge tail risk.
Anchoring coins maintains the equilibrium of stable currencies relative to the anchored currency through intrinsic monetary policies, such as loan-facilitating interest rates, “central bank” bills, etc. Anchoring coins does not mean that 1:1 is always perfect and stable, allowing for short-term fluctuations.
There are two ways to implement anchor coins: the chain asset mortgage model and the mint coin model. The difference between the two is mainly whether there are mortgage assets and redemption mechanisms.
The representative of the chain asset collateral model is MakerDAO's Dai, the mechanism is similar to the open Repurchase Agreement, or understood as an automated, distributed managed pawn shop on the blockchain. The benefit of this model is that it does not rely on traditional banks and custodians, is missionless, and preserves the independence of currency reserves, issuance, and policy adjustments.
A user holding a qualifying collateral can pledge the corresponding asset and issue a debt that is less than the net asset value (Dai). When the assets need to be retrieved, the debts and interest are repaid, the collateral is unlocked, and the corresponding part of Dai is withdrawn from circulation.
Other collateral may be added to the issuer's balance sheet and an over-guarantee must be maintained.
Due to over-collateralization, the chain-based asset-backed model stabilizes the currency to ensure that users redeem assets at a fixed value of 1:1 under potentially adverse conditions, such as the global settlement of the Dai system. The redeemability of global liquidation is the basic support of Dai's stability mechanism.
The issuer has the tools to influence the price of the stable currency through the loan facilitation rate. When the price of a stable currency is always higher than one dollar, it means that demand is greater than supply. It can lower the loan interest rate and encourage the generation of stable coins. When the price of the stable currency is always lower than one dollar, it means that the supply is greater than the demand, and there are too many stable coins in the market. The loan interest rate can be raised to slow down the generation of stable coins, and the person who borrows the stable currency can purchase the stable currency from the market to repay the debt and withdraw from the market.
In addition, MKR is also introduced into the Dai system for deposit insurance. Capital adequacy in the case of insolvency, not to be repeated here.
Let's take a look at the coinage model. The coinage model stable currency is often associated with the algorithmic stable currency. However, the concept of algorithmic stable currency tends to blur monetary policy and reserve assets. The algorithm is just a monetary policy based entirely on established rules.
The Coinage Model Stabilization Coin introduced two financial instruments, Stabilizing Coins and “Bonds”. When the price of the stable currency is less than $1, the system will issue bonds that can be purchased in stable currency, and the bond will receive more stable coins in the future. By withdrawing the supply of stable currency in the market, the price is pushed back to around $1. When the price of the stable currency is higher than US$1, the system will issue more stable coins to the holders of the bonds, increase the supply of stable coins in the market, and flatten the price to about US$1.
The stable currency and “bond” combination of the coinage model is essentially a tradable equity instrument rather than a financial liability. In other words, the issuer does not guarantee that the stable currency can redeem a fixed value asset or currency 1:1. Correspondingly, the stable currency issued by the issuer to the “bond” holders is essentially a futures without reserve assets and does not have the economic essence of cash flow. Any unsecured, non-redeemable algorithmic stable currency will inevitably collapse and de-anchor due to speculation or run. Further reading: "Algorithm Stabilizing Coins" is a false proposition .
Both cloning coins and anchor coins are classified as stable coins, but they are completely different in terms of foundation, goals and monetary policy. The cloning coin is the shadow of the French currency. To achieve currency stability, it must strictly follow the 100% reserve and rely on the compliance and supervision of traditional finance, and does not have any independent monetary policy space. The anchor currency is an interest in the “naive stage” of the cryptocurrency world and retains an independent monetary policy and “encrypted sovereignty”. Both require reserve assets and a certain degree of redeemability.
 The currency board system is a form of fixed exchange rate. It means that the government expressly stipulates in the form of legislation that the local currency and a certain foreign currency can be exchanged at a fixed rate without restrictions, and the monetary authorities are required to ensure this. The exchange rate system for the realization of the exchange obligation.