Shade Protocol — A Community Series: Stable Coins

Article #5

author: VJ

Everything you Need to Know about Stablecoins (and what makes SILK different)

Why are you in crypto? For most people, the answer comes down to a couple of ideas. You likely have a deep appreciation of the principles decentralized finance stands for. And secondly, let’s be honest, we’re here for the volatility.

If you hold crypto at the end of 2021, statistically speaking, you are an early adopter. The risk and potential reward are exciting. But, as the world re-imagines its economy in the next decade, we need more than that volatile digital asset gem that might do 100x.

We need stability if crypto is going to earn adoption and scale.

And, no surprise, stability is the goal of stablecoins. When the market turns bearish, you can watch the total value in stables trend up. Investors aim to remove themselves from volatility. And then, when the green days are back again, money moves out of stables and back to where the risk and reward is.

That’s the general essence of stablecoins in crypto today. But what if we told you that your favorite stablecoin isn’t as stable as you think? Well… yes… unfortunately that’s what we have to tell you now… and it’s true for a couple of reasons.

  1. A stablecoin tied to a single currency carries the volatility of that monetary system (e.g. inflation)
  2. Regulation is coming to stablecoins

Risk in Stablecoins

A stablecoin tied to a single currency carries the volatility of that monetary system. For example, if you hold a US dollar in your hand, that dollar has 99% less buying power than it did a hundred years ago. When you create more of something, its scarcity and value decrease. And since 40% of all USD in existence was printed in the last year, there are very real economic repercussions tied to that monetary decision.

Here’s the difficult truth history would suggest: the US dollar is not sustaining its value as we would hope. So if you hold a stablecoin that is pegged to the US dollar, any real or perceived volatility attached to the US monetary policy is now infused into your crypto portfolio.

Regulation of Stablecoins

Sovereign governments are no longer ignoring crypto. That’s not an option. What they are trying to do, in various ways, is bring regulation. In some cases, this is necessary and healthy.

In September of 2019, there was approximately $5B of value in stablecoins. As we close the books on 2021, that figure is roughly $100B. If in 5–7 years, the market has a trillion dollars of stablecoins that are tied to the USD, it makes sense that the US government would have something to say about that.

Those conversations have already begun. Tether was fined $41 million by the US Commodities Futures Trading Commission. Outside of Tether, the key sentiment of the US government seems to be, “Mr. Stablecoin, you aren’t in trouble. We are just concerned… ”

The Secretary of Treasury and the President’s Working Group on Financial Markets published a 26-page report on Stablecoins. There were three primary concerns expressed:

  1. To address risks to stablecoin users and guard against stablecoin runs, legislation should require stablecoin issuers to be insured depository institutions, which are subject to appropriate supervision and regulation, at the depository institution and the holding company level.
  2. To address concerns about payment system risk, in addition to the requirements for stablecoin issuers, legislation should require custodial wallet providers to be subject to appropriate federal oversight. Congress should also provide the federal supervisor of a stablecoin issuer with the authority to require any entity that performs activities that are critical to the functioning of the stablecoin arrangement to meet appropriate risk-management standards.
  3. To address additional concerns about systemic risk and concentration of economic power, legislation should require stablecoin issuers to comply with activities restrictions that limit affiliation with commercial entities. Supervisors should have the authority to implement standards to promote interoperability among stablecoins. In addition, Congress may wish to consider other standards for custodial wallet providers, such as limits on affiliation with commercial entities or on the use of users’ transaction data.

While we don’t know exactly how stablecoin regulation will express itself in the future, we can see its inevitability.

The Current State of Stablecoins

Some stables are reserve-backed (Tether and USDC). That means that, theoretically, fiat collateral has been locked up somewhere in order for that stablecoin to come into existence. Tether’s $41 million fine was for, at best, obscuring, but possibly lying about the size of their reserves.

Other stablecoins, like USDTerra or DAI, are algorithmic and non-collateralized. That means the smart contracts of a particular protocol are defining the parameters for the coin. A big part of that is balancing supply and demand dynamics through the system’s particular dynamics so that value remains stable or “pegged”.

These stablecoins each bring value to users in their own way. But there is still a big need to imagine and push on the limits of stablecoins as they exist today. Between the surprising volatility of single-currency-backed stablecoins and the unknown impact of oncoming regulation, Shade Protocol sees an opportunity to re-invent the approach to stable, digital money.

What Do We Want from Stablecoins?

Imagine something that ticked all these boxes:

  • A verifiable, accepted store of value
  • A user interface where holders can interact with the value and make decisions
  • Accepted as a unit of settling accounts
  • Recognized as a way of valuing/quantifying debt (acceptable as a standard deferred payment)
  • Has a network where payments/value chain can flow freely (in TradFi: credit card networks and banks, in DeFi and PriFi: decentralized, private payment gateways)
  • Open-source, decentralized protocol governing the issuance, redemption, and stabilization of the coin

Can you imagine if a stablecoin met all those criteria? Well, that’s the dream behind Silk.

Silk is an algorithmic stablecoin pegged to a basket of assets and currencies.

This weighted index positions Silk to ‘shock absorb’ massive amounts of global volatility while maintaining stable value.

Let’s play with a wild hare scenario… suppose that the US dollar inflates 14% in one year. That means any USD pegged stablecoins you hold functionally lost 14% of their value over the year even though they are still priced at $1.00.

Conversely, Silk addresses those two big problems mentioned earlier…

  1. Silk mitigates the risk associated with most stablecoins by pegging to a weighted basket of about twenty assets and currencies. So the volatility of any single country’s economy will leave Silk unscathed relative to other stables.
  2. Silk wisely sidesteps the regulatory scrutiny of 1:1 fiat derivative stablecoins by being pegged to a global index of value instead of a single currency.

Not only does Silk address the pain points other stables struggle with, in doing so we’ve created something pretty special. Silk is positioned to become the most stable asset on the planet. And that stability is more than a factor of the weighted basket. Even better, there are massive market incentives for users to help Silk maintain its peg. But we’ll leave that explanation for another piece. Until then, we’ll just keep our heads down building… well… you know… our own little part in the future of money.

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