How to make a “stablecoin” stable? – Hacker Noon

Basis

Basis recently made headlines for raising $133mm from the likes of A16z, Bain Capital Ventures, GV and Polychain Capital. It’s viewed as the leader in the algorithmic stablecoin space, and all eyes will be on the token’s formal launch later this year.

There are three main components to Basis’s protocol:

  • Basis tokens: These are the stablecoins, pegged to USD initially, to be transitioned to a basket of goods / currencies over time. Basis supply will expand and contract to keep the price pegged.
  • Bond tokens: Each bond represents 1 Basis token and is issued when Basis drops below the peg. Vice versa, these bonds are first to be repaid when Basis trades above the peg.
  • Share tokens: Shares have a fixed supply and operate most like cryptoassets. They derive value from market forces (including this initial offering) and then accrue value every time new Basis tokens are issued, akin to dividends.

Contraction: When Basis tokens are trading below the peg, the protocol issues bonds much like the US Treasury. These bonds are sold on an open auction at a discount, offering buyers an attractive yield in exchange for 1 future Basis. Basis tokens from current holders, exchanges or the reserve can be exchanged at cents on the dollar for the guarantee of a full dollar at a later date. Thus, bonds remove tokens from circulation, decreasing supply and stabilizing token price. The bonds have a max term of 5 years, but the protocol can prepay at any point, in FIFO order. Alternatively, if bonds hit their 5 year maturity, they expire without payment.

Expansion: When Basis tokens are trading above the peg, the protocol must expand the monetary supply. The first line of defense is any outstanding bonds, which the protocol will repay to release the corresponding Basis tokens. Next, shareholders receive new Basis tokens pro-rata, so their shares gain value proportional to the amount the Basis network grows.

Since the shareholders have a stake in Basis growth, they are likely to step in as the lender of last resort. They are also likely to become advocates for the overall protocol, which is valuable in a highly competitive space.

Still, there are a few obvious challenges to this framework, which mostly center around the market’s perception of Basis:

  • Basis bonds function as the lender of last resort, yet they are also subject to odd terms such as fluid repayment and potential expiry without repayment. As such, if the market loses faith in Basis, or the queue of bonds becomes so long that new lenders believe they may not be paid, these bonds could more easily fall out of favor.
  • Trust: despite the USD’s departure from the gold standard decades ago, people don’t constantly question the assumptions that underpin its value. In this scenario, that will happen constantly. Thus, it can be difficult to ever really achieve the peg at the onset, and then difficult to pull in other parts of the ecosystem (traditional e-commerce sites, banks, etc) that are necessary for scaled adoption.

What it all means

All of this investment and financial engineering boils down to one core motivation — creating a less volatile, decentralized digital asset. That asset unlocks crypto use cases across the board — meaning the success of a stablecoin is likely directly linked to the broader adoption of crypto.

On the investing front, a stablecoin would reduce trading friction and allow investors to manage their risk without fully converting back and forth to fiat — each time triggering taxable events and requiring KYC / bank integrations. That stablecoin could also underlie margin trading.

As a means of exchange, the opportunities are even more vast. E-commerce, debt, remittance and income projects all rely on a less volatile means of exchanging wealth for goods and services. Similarly, delayed outcomes from smart contracts around insurance and prediction markets can only function in a world where you’ve locked in value — otherwise imagine betting 1 BTC in December 2016 (~$700) that expired one year later. Suddenly, you’re paying out $19,000 in December 2017 — 2600% more than you intended (and 2600% in your counterpart’s favor!).

Finally, on the sovereign side, a stablecoin is an even stronger proxy for fiat, meaning consumers can choose to move their money and thus their tax revenue elsewhere. We’ve already begun to see this shift in areas experiencing erratic monetary policy like Zimbabwe at the end of Mugabe’s term, where a surge in demand pushed bitcoin to twice the price in local markets. Similarly, many of bitcoin’s earliest adopters hailed from Argentina, where they struggled to send money home past capital controls. This introduces a level of competition and accountability into the system, as people across the world can opt for a global currency instead of their local regime’s.

So, are we done here?

Most of these projects either just launched or are raising for a launch later this year, so there’s a lot that remains to be seen. Will the market follow investors’ cue and accept an algorithmic solution like Basis? Or will skeptics succeed in a Soros-like test of the currency’s resilience, leaving only asset-backed solutions? And within asset-backed options, can a crypto-backed token like Maker Dai weather violent crypto cycles and correlation?

My best guess: stablecoins start (fiat) asset-backed, and transition to an algorithmic solution slowly as market trust solidifies — mirroring the dollar’s move away from a gold standard.

Currently, the best example of that is SAGA. That said, this space is ripe for iterations and the final winners may not be the initial winners, as new tokens can pull from past learnings and emerge stronger. That cycle will continue until enough utility platforms emerge, such that the winning stablecoin(s) integrate with the winning providers of debt, prediction markets, etc.

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