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Abstract

Stablecoins make the promise that they will combine the best of both worlds. First, since stable-coins are part of the cryptocurrency world, all benefits from digital money also apply to them. Sec-ond, coming with the intention to keep the value of a stablecoin stable as known with fiat curren-cies, they do not have the high volatility of commonly known cryptocurrencies. The following paper first examines the influence of stablecoins on the financial sector through a detailed analysis of the risks and challenges posed by initiatives of various scales. Second, it classifies stablecoins, based on their stabilization mechanism, into four different groups, namely: (i) Tokenized funds, (ii) Off-Chain collateralized, (iii) On-Chain collateralized and (iv) Algorithmic. Third, with the differentiation of privately and state-issued stablecoins, the paper describes the possible classification of issuers. The paper recognizes the advantages of stablecoins for underbanked people and people with an unstable domestic currency but, at the same time, mentions the significant challenges. Legislators are faced with the main challenge of creating cross-border regulations in a highly sensitive market without hindering innovation.
Stablecoins Classification of stablecoins and their impact on the
financial sector
Christian Bolliger1
1University of Applied Sciences and Arts Northwestern Switzerland, Olten, Switzerland
christian.bolliger@students.fhnw.ch
Abstract: Stablecoins make the promise that they will combine the best of both worlds. First, since stablecoins are part
of the cryptocurrency world, all benefits from digital money also apply to them. Second, coming with the
intention to keep the value of a stablecoin stable as known with fiat currencies, they do not have the high
volatility of commonly known cryptocurrencies. The following paper first examines the influence of stable-
coins on the financial sector through a detailed analysis of the risks and challenges posed by initiatives of
various scales. Second, it classifies stablecoins, based on their stabilization mechanism, into four different
groups, namely: (i) Tokenized funds, (ii) Off-Chain collateralized, (iii) On-Chain collateralized and (iv)
Algorithmic. Third, with the differentiation of privately and state-issued stablecoins, the paper describes the
possible classification of issuers. The paper recognizes the advantages of stablecoins for underbanked people
and people with an unstable domestic currency but, at the same time, mentions the significant challenges.
Legislators are faced with the main challenge of creating cross-border regulations in a highly sensitive market
without hindering innovation.
1. INTRODUCTION
Stablecoin is another topic from the world of
cryptocurrencies with increasing popularity. At least
since the announcement of project “libra” from
Facebook, everyone has been talking about the
principle behind the technology. Stablecoins can
create new opportunities in the financial world and
are a possible solution for some existing financial
problems. Nevertheless, as is normal with new
technologies, new challenges and risks are arising too.
The following paper is about the principle behind
stablecoins with a focus on the challenges and risks
which the new technology creates. First, a short
introduction about the blockchain technology is made,
providing an essential mindset to understand the
technical core of all initiatives. Second, the benefits,
as well as the main challenges and risks of stablecoin
initiatives, will be discussed. The challenges are
analyzed from different angles regarding the scale of
the stablecoin. Third, the four possible stabilization
mechanisms behind stablecoins are listed, and a real
example for each type is named. With the last chapter,
the classification by issuer from the perspective of a
central bank, stablecoins are exposed form the
perspective of a central financial actor.
2. BLOCKCHAIN
Blockchain is one of the fastest developing
technologies in the last few years. The new and
innovative concept is used by an increasing number
of different sectors and is partly described as being
revolutionary as the internet. The technology is
increasingly being used for applications that have a
significant impact on our daily lives, especially in the
financial sector (Kakavand, Kost De Sevres &
Chilton, 2017).
This chapter is divided into four parts. First, the
technology behind blockchain is explained, and
second, the innovative principle of blockchain
technology is discussed. After the theoretical part, the
chapter will list two possible applications of the
technology in the financial sector. First, the use as a
crypto coin in the form of Ethereum, second the use
as a token in the form of ICO and STO.
2.1 Technology
Blockchain technology has the ability to change
the traditional understanding in business from a
centralized, trusted organization to a decentralized
system of trustable nodes. Since the publication of the
whitepaper of Satoshi Nakamoto, the inventor of
bitcoin and with thus the blockchain technology,
blockchain has developed very quickly. In the past
eleven years, there were about five different versions
of blockchain, each of them focusing on adding
another solution to one of the big demanded problems
of our economy (Prasad & Rohokale, 2020). The
blockchain technology follows the principle of
distributed ledger technology (DLT), which means
that a user can store and retrieve data in a shared
database without a central instance taking over the
validation (Kakavand, Kost De Sevres & Chilton,
2017).
The most known version of the blockchain, as it
came with Bitcoin, is the first one. Although the
details of the technology are complex cryptographic
functions, the main principle behind the blockchain
technology can be described in a simple way (Prasad
& Rohokale, 2020).
Blockchain is a data structure that stores data in
the form of transactions in blocks. Every block is
linked to another block, forming a chain as a
structure. A block is built out of two parts, named
header and transaction data (Prasad & Rohokale,
2020). The blocks are linked together by a hash based
on their header. This means, that every following
block stores the hash of the header of his previous
block, except the first block, the genesis block, which
cannot store a hash from a previous block because
there is none (Kondova & Simonella, 2019).
Since the blocks are chained together by their
hashes, a transaction of a block cannot be changed
without automatically changing its hash. The change
of the hash leads to the fact that the following block
is referencing a false hash, why the reference must be
updated. This chain reaction would lead to a
recalculation of all following blocks, which is
practically not possible. Although the problem of a
double-entry still exists (Nakamoto, 2008).
According to Nakamoto (2008), the solution for
the double-entry problem is found in a timestamp
server with a proof-of-Work system. Every hash of a
block will be marked with a timestamp. This means
that «The timestamp proves that the data must have
existed at the time, obviously, in order to get into the
hash. Each timestamp includes the previous
timestamp in its hash, forming a chain, with each
additional timestamp reinforcing the ones before it.»
(Nakamoto, 2008, p. 2).
A new block is created in six steps. Each node is
collecting new transactions in a block. After the block
is full, the node tries to find a difficult proof-of-Work
for its block and broadcasts the block to all other
nodes, once the node finished its proof-of-Work. The
other nodes check the provided block and its
transaction on their accuracy. Once the other nodes
have accepted the new block, they start to work on the
next block, based on the hash of the just accepted
block. As long as the CPU power of bad participants
is outnumbered, the honest chain will have the fastest-
growing making the chain securer with each new
block (Nakamoto, 2008).
2.2 Innovation
The innovation behind blockchain technology can
be separated into two parts. First, the
disintermediation and with that, the decentralization.
The blockchain technology has the possibility to
revolutionize a whole industry by making the main
actors powerless, because of the structure as a chain
and the proof-of-Work principle. Second, blockchain
is unforgeable. Based on the hashing system and the
fact, that the honest chain will grow fastest,
blockchain is a very secure technology. Further on, it
is tough to fake the whole chain, because of the
decentralized structure (Prasad & Rohokale, 2020)
2.3 Use of blockchain: Ethereum
Ethereum is a programmable blockchain,
providing the using of smart contracts and writing of
decentralized applications with a built-in
programming language. The native cryptocurrency of
Ethereum is called Ether (ETH), with similar
characteristics and functionalities as bitcoin
(Ethereum, 2019).
2.3.1 Smart contracts
«A smart contract is a set of promises, specified
in digital form, including protocols within which the
parties perform on these promises.» (Szabo, 1996).
According to Szabo, the fixed implementation of
Smart Contracts in all possible hardware and software
should make breaking the contract costly to
unaffordable. (Szabo, 1996). The principle of smart
contracts can be used with the blockchain technology,
as the contract can react to events like a transaction
with executing the tasks defined in the contract.
Technically speaking, smart contracts are not
contracts in the traditional sense, but rather the
execution of code. Due to the distributed ledger
technology, smart contracts are installed on all
actively participating nodes, ensuring transparent and
tamper proof execution of the code (Lewrick & Di
Giorgi, 2018).
2.4 Use of blockchain: ICO and STO
Initial coin offering (ICO) is another possible use
of blockchain technology. With an ICO, mostly small
companies try to find investors for their solutions.
Based on a white paper, the company sales a fixed
number of digital tokens in exchange for
cryptocurrencies or fiat currencies. As an ICO works
with the blockchain technology, the buyer and seller
get in direct contact. The investor usually has the
options either to use the tokens in the new built
ecosystem, or he can trade the tokens on a crypto
trading platform (Kondova & Simonella, 2019).
Security Token Offerings (STO) is a more
regulated way of ICOs. With an ICO, the investor is
usually investing to a promise like a claim to a
service. There is no guarantee that the promises of the
issuer will be kept, following that the invested money
can be lost. The FINMA classifies STOs as asset
tokens meaning that they promise future rights for the
investor, like having the right to vote or to take
dividends. Asset tokens can be compared with
traditional securities like shares, and they fall under
respective securities regulations (Kondova &
Simonella, 2019).
According to Kondova & Simonella (2019), ICO
and STO are new possibilities to invest in a fast way
with low entry costs and low funding costs for the
issuer. ICO allows the issuer to sell utility and
payment tokens while STO can be used to create
security tokens for the investors. Since STO is more
regulated than ICO, there is a high chance that this
technology will gain more popularity in the next
years.
3. STABLECOINS
Stablecoins are another form of cryptocurrency.
Since Bitcoin and other cryptocurrencies have very
high volatility, they do not fit some of the base
functions of money, for example, the using as a mean
of payment or a store of value. With stablecoins that
can be described as digital tokens, which are relying
on a set of stabilization tools (for example fiat
currencies), the problem of the high volatility should
be solved. Besides the use as a value storage,
stablecoins can have a very high potential for
international transactions (Bullmann, Klemm &
Pinna, 2019).
Generally, from a user perspective, stablecoin
initiatives can be separated into two different groups.
The first group can be used by anyone, called retail or
general-purpose. The second group can only be used
by a limited group of actors, mainly financial
institutions called wholesale (G7 Working Group on
Stablecoins, 2019).
Another possible classification comes with the
scale of the initiative. In addition to stablecoins
initiatives run by individuals or small companies with
a relatively small user group, initiatives with a global
scale are imaginable too. Existing platforms with a
significant global customer base can create stablecoin
initiatives that can scale rapidly due to the existing
users combined with the existing infrastructure and an
easy to use interface (G7 Working Group on
Stablecoins, 2019).
The following chapters describe the benefits as
well as the challenges of all different groups of
stablecoins.
3.1 Benefits
Stablecoin initiatives can offer three main
advantages. First, stablecoins can revolutionize cross
border payments. With the technology of stablecoins,
international payments can be processed quick,
cheap, and, due to the technique of the distributed
ledger, transparent and traceable. Second, stablecoin
initiatives have the potential to reach people who are
currently unbanked or underserved with financial
services. Considering that this target group counts
approximately 1.7 billion people, the impact of the
initiative should not be underestimated. Third, global
stablecoin initiatives can bring advantages to citizens
of countries with an unstable currency. Stablecoins
can evolve to a primary mean of payment, similar to
the process of the well-known dollarization. This
process, in turn, can lead to new challenges, described
in the following paragraph. The benefits of stablecoin
initiatives are clearly visible, but, especially on a
global scale, the challenges and risks are numerous
and should not be underestimated (G7 Working
Group on Stablecoins, 2019).
3.2 Challenges and risks
Despite the visible benefits, stablecoins come
with a package of challenges and risks. The potential
impact of stablecoin spread around a wide area, inter
alia the monetary policy, financial stability, money
laundering, terrorist financing, and monetary
sovereignty coming with currency substitution.
Further on, the challenges depend on the scale of the
stablecoin project. As some challenges and risks
concern all scales, others relate mainly to initiatives
that reach a global scale. It is important that no
(especially global) stablecoin project should begin
their operation before all challenges are identified and
adequately addressed (G7 Working Group on
Stablecoins, 2019).
The designers of new stablecoin initiatives face a
wide range of existing laws, regulations, and various
jurisdictions, addressing some of the challenges
named above. Notwithstanding, some risks are not
covered by the existing regulatory, supervisory, or
oversight frameworks. Ministers and Governors of
the G7 agreed that «possible stablecoin initiatives and
their operators must meet the highest standards and
be subject to prudent supervision and oversight, and
that possible regulatory gaps should, as a matter of
priority, be assessed and addressed.» (G7 Working
Group on Stablecoins, 2019, p. 2)
3.2.1 Challenges and risks regardless of scale
One of the most significant challenges is legal
certainty. Currently, most stablecoin projects move at
least partially in a legal no man’s land. Existing
frameworks and regulations may address some of the
challenges and risks coming with the new technology,
but a large part is not clearly covered by laws. In order
to ensure smooth functionality, a stablecoin must be
based on clear legal terms. It is essential that the users
have the assurance that the initiative is as stable as
promised. Three points, in particular, make this
difficult. First, nearly every stablecoin project is
individual, starting with the stabilization mechanism
up to the faces behind the issuers. For the jurisdiction,
it is crucial to make an unambiguous legal
characterization of the project. The legal base can
differ, based on the legal characterization. Second,
one can expect that most of the initiatives will act in
a cross-jurisdictional context. For each project must
be cleared, which jurisdiction’s laws apply to which
individual element and a potential conflict of law,
evolved by different treatments in different
jurisdictions, must be minimized. Third, the
technology sector is developing faster than the
financial law sector. The legislators must ensure that
the gap between the technology and the law does not
widen over the years (G7 Working Group on
Stablecoins, 2019).
Next to the legal certainty, a sound and efficient
governance is another fundamental requirement for a
successful stablecoin initiative. The structure and
responsibility of all participating providers must be
clearly defined and communicated to the ecosystem
participants. As the financial system is a closely
networked, good governance on a single initiative can
support stability on the whole system. Stablecoin
initiatives that include third-party providers (for
example, caused by their stabilization mechanism)
must ensure that they know and control the risks
coming with these connections. The distributed
ledger technology creates another pool of challenges,
regarding the distribution of responsibility and
accountability on the individual members (G7
Working Group on Stablecoins, 2019).
Coming with the characteristics of
cryptocurrencies and the distributed ledger
technology, stablecoin initiatives are vulnerable to
illegal financing activities like money laundering and
terrorist financing. The issuers of stablecoin projects
should comply with the international standards for
AML/CFT, provided by the Financial Action Task
Force (FATF). In June 2019, the FATF has updated
its recommendations to clarify that the AML/CFT
standards apply to financial activities involving
virtual assets, too (G7 Working Group on
Stablecoins, 2019).
As written before, regulatory and policy
frameworks must evolve with new opportunities,
provided by technologies like stablecoin.
Notwithstanding, it is essential that the regulations
remain technology-neutral and do not prevent
innovation while trying to guarantee a secure and
robust system. Payment systems have an important
influence on financial systems and entire economies.
It is, therefore, of crucial importance that payment
systems always function securely and efficiently.
This is exacerbated by the fact that problems in
payment systems can have a significant impact,
including the triggering of far-reaching financial
shocks. As stablecoin initiatives have the potential to
reach the state of a generally accepted means of
payments, they must adhere to the same requirements
as traditional payment systems (G7 Working Group
on Stablecoins, 2019).
Stablecoins are facing some challenges during the
ongoing operation too. As the initiatives are in a
digital form, cybersecurity should be a core aspect of
all issuers. Distributed ledgers provide some
advantages against traditional centralized systems,
but other risks are coming with the technology, for
example, by an undermining of the system. The
initiatives should use well known best practices like
ISO or NIST to reduce the risk of a successful cyber-
attack to a minimum (G7 Working Group on
Stablecoins, 2019).
The value of a currency is always related to the
trust the users have to it. To win trust, stablecoins
must ensure market integrity in order to protect their
investors, consumers, and competitors. Depending on
the stabilization mechanism, a stablecoin initiative
can give a different level of opportunity for price
manipulation. It is indispensable that the users have
the security that the issuer of the stablecoins can and
will redeem their tokens to the reference value as
requested. Further on, it must be clear that no
untruthful information about the project is
disseminated, which could cause mispricing and
market dysfunctions (G7 Working Group on
Stablecoins, 2019).
Coming with a stronger consciousness for data
protection, stablecoin issuers must expect strict data
protection measures to be applied. As with regulation
and frameworks, data policies are often complicated
to apply over different countries. The G20 has
identified this problem and is working on
improvements in global standards for data protection.
Regardless, stablecoin initiatives must clearly list
how they use the personal data of the participants in
their ecosystem and how this data is shared inside the
network and with externals. Next to the using of the
data by the network participants, the technology
behind the project may face some challenges on data
protection. A good example is the «right to be
forgotten», which is a big challenge on a distributed
ledger system. Besides the risk of cyber-attacks, other
operational risks can also arise during daily operation.
There must be a clear structure about what happens if
unauthorized payments are made. Once again, a
trade-off between the advantages of the new
technology and ensuring the availability of the
payment systems must be made. Having, for example,
multiple synchronized ledgers may prevent
unauthorized payments, but at the same moment,
multiple ledgers restrict the scalability (G7 Working
Group on Stablecoins, 2019).
Considering that stablecoin is a widely unknown
nascent technology, it is essential to ensure that all
participants are well informed about the material risks
and their obligations. Stablecoin projects often have a
high complexity, which makes it hard for users to
understand the potential risks. Especially retail
initiatives can have a wide area of different
consumers and investors, who must all receive clear,
complete, and understandable information about the
nature of the initiative (G7 Working Group on
Stablecoins, 2019).
Like other cryptocurrencies, stablecoins face two
types of challenges for tax administration. First, as
written before, the legal status of stablecoins is not
completely clear. The uncertainty leads to insecurity
in how transactions, made with stablecoins, must be
classified on the tax settlement. The second challenge
is that stablecoins can be used to avoid taxes. As the
individual user is unidentifiable on the distributed
ledger, the tax authorities may have some struggles to
prove tax fraud (G7 Working Group on Stablecoins,
2019).
3.2.2 Challenges and risks for global
stablecoins
Global stablecoins, which are based on a large and
potentially cross-border customer base, may scale
very fast and achieve a substantial footprint.
Considering the fact that a global stablecoin is very
likely to become systematically relevant and will act
beyond national borders, it is very likely that the risks
and impacts will increase. In addition to risks already
listed, a global initiative will face some extended
challenges (G7 Working Group on Stablecoins,
2019).
Innovation and competition are some of the most
important foundations of our economy. Innovation
can lead to a better user experience and creates the
ability for underserved populations to access new
financial services. Notwithstanding, regulators
should always guarantee a market without cartels,
abuses of dominance, or monopolism. Coming with
global stablecoins, a new challenge will face the
market regulators. Global stablecoins have the
potential to achieve market dominance due to
network effects. Considering the fact that the digital
economy is borderless, individual regulators must
work together to ensure fair competition in financial
markets, even with potential dominating global
stablecoins (G7 Working Group on Stablecoins,
2019).
As it comes to financial markets, all participants
are exposed to risks which can affect the financial
stability. Global stablecoins are in a unique position
as they can either increase fragilities in one domestic
financial sector as well as spread domestic shocks
with cross-border transmissions, affecting the real
economy in multiple countries. Stablecoin initiatives
are a complex system with many individual parts. It
is essential to look at both the system and the
individual components at the same time (G7 Working
Group on Stablecoins, 2019).
A stablecoin initiative is just as stable as its
collateralization. This means that not just a loss of
trust in the initiative can negatively affect the
economy, but also any effects on the underlying
collateral. A fall in the value of the collateral reduces
compulsory the value of the stablecoin, potentially
resulting in a massive attempted to redeem the global
stablecoins. The effects resulting from this scenario
are similar to a traditional bank run. Since a
stablecoin initiative is a complex interaction of
individual components, it is crucial knowing the
interdependencies between the components.
Fragilities in single components may reinforce each
other, especially if the obligation and responsibilities
are unclear (G7 Working Group on Stablecoins,
2019).
Global stablecoins can have adverse effects on
fragilities in the financial system as a whole. First, the
traditional business model of banks is in danger. With
a growing number of users holding stablecoin
permanently as a storage of value, banks may have to
face a decreasing number of bank deposits. As a
result, banks may be forced to increase their
dependence on more costly and volatile sources.
Second, easy access to global stablecoins may result
in a higher number of bank runs. Third, with a global
stablecoin becoming a big player in the financial
market, traditional financial services providers like
banks may have a decrease in their profitability. This
leads banks directly to take on more risks or reduce
the granting of credits. It is conceivable that, in
certain countries, a stablecoin initiative is more stable
than domestic currency. In times of a high domestic
financial instability, citizens may switch to a global
stablecoin instead of retaining in their local currency.
The effects of such a capital flow out of the country
can be compared to sudden dollarization. In contrast
to the traditional dollarization are the transactions on
a stablecoin initiative much faster, preventing the
authorities to react and stop the disruptive process
(G7 Working Group on Stablecoins, 2019).
The impact of risks to the real economy depends
on the using of the stablecoin. If the initiative is
mainly used as a means of payment, a disruption
would have immediate impacts on the real economy.
The reach of the disruption effect depends on the fact,
how far the substitution of other payment systems is
processed. If the stablecoin is mainly used as a store
of value, a drop in the value of its underlying
collateral decreases the wealth of the owner. This can
lead to further effects on the economy, as the owner
is likely to spend less money (G7 Working Group on
Stablecoins, 2019).
The impact on the monetary policy can be
massive. Once again, it depends on the using of the
stablecoin. The most substantial effect will occur
when the coins are used a store of value, as it reduces
the influence of the interest policy of the central bank.
As long as the stablecoin have the domestic currency
as a reference value, the impacts on interest rates will
not be very noticeable, because the policy will affect
the collateralization and with that the stablecoins in a
direct way. Though in countries with an unstable
domestic currency, the effect will be much higher. It
is very likely that in such countries, the citizens use
stablecoins where the own domestic value is not a part
of the underlying collateral which means, that the
domestic interest rates will not affect the stablecoin
(G7 Working Group on Stablecoins, 2019).
Further on, if stablecoins are mainly used for
cross border payments, the dependency on foreign
assets will rise, and the domestic interest rates will
face amplified responsiveness to foreign interest
rates. The impacts of international trade are not
necessarily noticeable as long as the trade continues
to use conventional currencies (G7 Working Group
on Stablecoins, 2019).
3.3 Stabilization mechanisms
According to the European Central Bank,
stablecoins can be classified on three different
criteria. First, the extent of the decentralization. As
Nakamoto (2008) writes, the cryptocurrencies
underlying technology blockchain creates a
transaction system without any underlying central
trust unit. Depending on the application of
technology, a stablecoin can be more or less
decentralized. Second, the existence or absence of an
issuer who is responsible for the investments. Since
most cryptocurrencies are entirely or nearly
completely decentralized, every user is responsible
for his investments. Third, the type of their
collateralization. The collateralization and with that,
the stabilization mechanism of the stablecoin, can be
identified as essential to define the core of the
stablecoin (Bullmann, Klemm & Pinna, 2019).
Since the stabilization mechanism is of
paramount importance that the tokens can maintain a
stable value, the following chapter will take a more
in-depth look at the four currently known
mechanisms.
3.3.1 Tokenized funds (FIAT-Collateralized)
Tokenized funds or FIAT-collateralized, are the
most common type of stablecoins. They have the
simplest structure of stablecoins, which can be easily
understood and are therefore very suitable for
beginners in the world of cryptocurrencies (CB
Insights, 2018).
Tokenized funds are backed 1:1 to their reference
currency, which is a fiat currency like USD, EUR, or
CHF. This means that every unit in the stablecoin
currency has to be backed by the issuer or a custodian
appointed by the issuer. The consequence of this
structure is that the value of a tokenized fund keeps
stable as long as the reference currency has no
extreme exchange rate fluctuations. Further on,
stablecoins based with tokenized funds as
stabilization mechanism are not a new type of assets.
They are more likely considered as the representation
of existing currency units in a distributed ledger.
Usually, the issuer is obligated to guarantee that all
backing funds are redeemable (Bullmann, Klemm &
Pinna, 2019).
The Issuance of tokenized funds starts typically
with a bank transfer from the user to the bank account
of the issuer of the stablecoin. At the moment, where
the issuer receives the receipt for the funds, the smart
contract creates the stablecoins and allocates the new
tokens to the user, who has transferred the funds. The
transfer of the stablecoins follows mostly the usual
pattern of a transaction on a distributed ledger. The
transaction takes place between two parties, while the
whole (active) network is evaluating the transaction
and validates the transfer. The redeem is similar to the
issuance but in the opposite sequence. Once the issuer
has received the tokens to redeem, the smart contract
withdraws («burns») the tokens and transfers the
backing funds to the user (Bullmann, Klemm &
Pinna, 2019).
An existing stablecoin with tokenized funds is
Tether. Tether distributes two different stablecoins,
USDT, which is backed by the US dollar and EURT,
which is backed by the euro (Bullmann, Klemm &
Pinna, 2019). Tether is the dominating stablecoin
available at the free market at the moment and the
fourth largest market participant in terms of market
cap (Coinmarketcap, 2019).
3.3.2 Off-Chain collateralized (Commodity-
Collateralized)
Off-Chain collateralized stablecoins have many
similarities to tokenized funds. The most crucial
difference is that the stablecoins are backed by units
of one or more assets (Bullmann, Klemm & Pinna,
2019). According to CB Insights (2018), commodity-
collateralized stablecoins are often backed by
interchangeable assets, like precious metals. Other
commodities, like oil or real estate, are possible too.
Off-Chain collateralized stablecoins have the
unique characteristic that their reference value
fluctuates over time. Consequently, the value of the
assets backing up stablecoins must include a certain
margin to ensure that every unit of the stablecoin is
backed at least on a 1:1 ratio. The result of this
structure is that stablecoins are generally over-
collateralized. Another specialty of Off-Chain
collateralized stablecoins is that the backing
commodity does not exist in digital form. Therefore,
the issuer is responsible for providing some services,
necessary for an electronic representation of the asset.
The issuer must ensure that the commodity is stored
securely and that he can deliver the commodity when
requested by the users. For these two services, a
custodian is generally necessary (Bullmann, Klemm
& Pinna, 2019).
The issuance of Off-Chain collateralized
stablecoins follows the same principle as tokenized
funds. As it is mostly not possible or too expensive to
transfer the physical assets to the issuer, the investors
have, most of the time, the possibility to send either a
fund of fiat currency or crypto-assets to the issuer,
which he will transform into Off-Chain collaterals.
Once the Off-chain collaterals are received, new
stablecoins are issued. The redeeming can be
separated into two different types. First, redeem can
be voluntary. On a voluntary redemption, the process
follows the issuance in opposite steps. Second,
compulsory redemption. A compulsory redemption is
necessary, if the value of the underlying collateral
drops below a specified ratio, compared to the value
of the stablecoin. This ratio is at least a 1:1. As this
happens, the user is asked to replenish the amount of
collateral, necessary to keep the value of the
Stablecoin stable. If the user is not reacting, his
collaterals will be sold, and with the received funds,
stablecoins with the same value as the one of the users
will be purchased from the market. As soon as this
Stablecoins are received, the user’s stablecoins will
be burned. Any possible revenue from this process
will be transferred to the user, mostly with a penalty
fee deducted (Bullmann, Klemm & Pinna, 2019).
An off-chain collateralized stablecoin from
Switzerland is SwissRealCoin (SRC). The
collateralization of SRC is in the form of Swiss real
estate (CB Insights, 2018). Currently, the launch of
the token is on hold, despite an enormous market
interest (SwissRealCoin, 2019).
3.3.3 On-Chain collateralized (Crypto-
Collateralized)
On-Chain collateralized stablecoins are backed
by other cryptocurrencies. Therefore, this type of
stablecoins shares a lot with traditional
cryptocurrencies. On-Chain collateralized stablecoins
are entirely based on a distributed ledger, providing a
high amount of decentralization and a high liquidity.
As his complement, the Off-Chain collateralized
stablecoin, this type is often over-collateralized to
prevent fluctuations in his currency of reference (CB
Insights, 2018).
Since there is no centralized issuer, the user has to
send on-chain collateral to the smart contract of the
system to get some stablecoins issued. The smart
contract then creates the stablecoins and sends them
to the user. From the moment the user has received
the stablecoins, he stays responsible for ensuring the
necessary value of the collateralized tokens. The
transfer of On-Chain collateralized stablecoins is
based on the principle of the blockchain technology,
with no central control unit but a verification of the
transactions from every active user on the distributed
ledger. As with Off-chain collateralized stablecoins,
Crypto-collateralized tokens have two possible types
of redemption. First, the voluntary, which follows the
issuance process in opposite steps. Second,
compulsory. The compulsory process is a
complicated process since there is no centralized trust
unit. The first step, the smart contract has to do, is to
buy the same amount of stablecoins as the ones that
are undercollateralized. This can either be achieved
by using revenues generated during the operation
(fees on transactions) or through the sale of future
revenues. Once there are enough stablecoins
repurchased, the smart contract burns the newly
preserved coins. He can now relink the
undercollateralized stablecoins to the collateral of the
just burned, new stablecoins. The undercollateralized
stablecoins have now sufficient underlying collateral.
Further on, the old collateral of the
undercollateralized coins can now be used, to rebuy
the rights of the just burned stablecoins. If anything
of the initial collateral is left, the user may get it back,
less a penalty fee for the under-collateralization
(Bullmann, Klemm & Pinna, 2019).
An example of an on-chain collateralized
stablecoin is Dai. Dai is backed by Ether and tries to
keep a 1:1 ratio to US dollar (Bullmann, Klemm &
Pinna, 2019).
3.3.4 Algorithmic (Non-Collateralized)
Algorithmic or non-collateralized stablecoins are
currently mainly a theoretical possibility. The idea
behind algorithmics stablecoins is that they are not
fully backed by their currency of reference. Instead,
algorithmic stablecoins try to keep their price stability
by adjusting the supply of stablecoins on the market
(Bullmann, Klemm & Pinna, 2019). Using the laws
of market supply and demand, algorithmic
stablecoins create new stablecoins as the demand
increases and buy up circulating stablecoins if the
coin is traded too low (CB Insights, 2018). To control
the number of coins in circulation, either on-chain
assets created during the ongoing operation with fees
on transactions or sales for future revenues can be
used. Algorithmic stablecoins are, therefore, mainly
based on secondary stabilization mechanisms
(Bullmann, Klemm & Pinna, 2019).
Since Algorithmic stablecoins are not backed up
by any form of assets, they have a very high level of
decentralization. On the other side, with the absence
of a collateral to liquidate the stablecoin back, the
users bear the risk that they will lose their investments
in the event of a crash (CB Insights, 2018).
The Issuance of algorithmic stablecoins is simple.
Usually, the coins are distributed for on-chain assets.
The smart contract will use these assets as reserves
for future investments, regarding keep a stable value
of the coin. Another possibility is, with the benefits of
network effects in mind, a free «air-drop», meaning a
free provision of stablecoins for new users.
Considering that algorithmic stablecoins are not
redeemable against any assets, the redemption
process is obsolete. For keeping the value of the coin
stable, the algorithm can use a contraction in case of
excess supply. The process is very similar to the
compulsory redemption with on-chain collateralized
stablecoins. The smart contract can either sell rights
for future revenues for stablecoins, or he can use the
reserves, which have been accumulated over the
ongoing operation, to withdraw stablecoins from the
circulation. While the algorithm can use the reserves
to buy the circulating stablecoins, it should never use
the assets created by the issuance. The using of the
assets, which would be a reverse of the issuance
process, would decrease the value of the coins, which
leads to a non-stable coin (Bullmann, Klemm &
Pinna, 2019).
NuBits is an excellent example of an algorithmic
stablecoin. After a first loss of trust in June 2016, the
value of NuBits has recovered. The second loss of
trust in March 2018 was too much as the value is still
at EUR 0.05, with 1:1 ratio to the euro as reference
target (Bullmann, Klemm & Pinna, 2019).
3.3.5 Secondary stability mechanisms
Besides the primary stabilization mechanisms
discussed up to now, some stablecoins have
additional secondary stability mechanisms to keep
their value stable (Bullmann, Klemm & Pinna, 2019).
In the following paragraphs, a few of the secondary
mechanisms will be covered.
One of the most popular secondary stability
mechanisms can be found in the principle of fees.
Fees that are created during the daily using of
issuance, transfer, and redemption of the stablecoin
can be held as reserves by the initiative. Using the
reserves to buy stablecoins on the market to keep
parity to the currency in reference is well known,
especially in case of a compulsory redemption.
Another form of fees are penalty fees, a lot of
stablecoin initiatives are imposing if the promised
minimum level of collateralization is not being hold.
Further on, some initiatives allow more a price band
than a fixed price for their coins, allowing a certain
fluctuance for the initiative (Bullmann, Klemm &
Pinna, 2019).
Talking about the principle of central bank digital
currencies (CBDC), redemption limits is a big topic.
To prevent bank runs, the issuer can set some limits
on the redemption of the coins. Very similar is the
staking of stablecoins. Staking of stablecoins allows
the issuer to temporary freeze active holdings of
stablecoins and with that to restrict the temporary
overflow (Bullmann, Klemm & Pinna, 2019).
Re-adjusted peg is another secondary stability
mechanism that can be used to keep the parity to the
currency in reference. Whereas most of the other
mechanisms are trying to change something on the
stablecoin itself, re-adjusted peg changes the value in
the reference currency in the extreme case, that the
initiative threatens to fail. If the initiative clearly fails,
the option of implementing a kill switch is another
secondary stability mechanism. The kill switch stops
the initiative on a pre-defined point and freezes
everything. The goal behind it is to prevent the users
from selling all their coins in the event of an
unexpected price drop of the coin (Bullmann, Klemm
& Pinna, 2019).
As a lot of the secondary stability mechanisms
can complement each other, the scenario of hybrid
stablecoins is a reality. Important to notice is that the
primary stability mechanism cannot be combined on
tokenized funds (FIAT-Collateralized) and
algorithmic initiatives. As soon as a tokenized fund is
backed up by anything else than funds, the initiative
would become collateralized (off-chain or on-chain).
Further on, the core characteristic of an algorithmic
stablecoin is, that it keeps its stability because the user
believes in it and its value (same as with a modern
FIAT currency today). Providing redeemability to,
for example, a reference currency would change the
character of the initiative in its core. Talking about the
fact that not all stablecoins can have a hybrid solution,
it is possible that they change their characteristics
through their activity, which is called morphing
stablecoins (Bullmann, Klemm & Pinna, 2019).
3.4 Classification by issuer from the
perspective of a central bank
According to the Swiss National Bank, stablecoin
initiatives can be separated by the issuer. First,
privately issued stablecoins, like Libra. Second, state-
issued stablecoins (Jordan, 2019). The following two
chapters each describes one of the possible types.
3.4.1 Privately issued
The perspective of a central bank on privately
issued stablecoins does not differ from the points
discussed so far. The SNB identifies the risks behind
privately issued stablecoins, especially if they are
based on one or more foreign currencies. As long as
the initiative would be collateralized only by the
domestic currency, the effects in Switzerland will not
be significantly noticeable. The main challenge is
indeed the regulation of the stablecoin and especially
of the issuer. Regarding Thomas Jordan, president of
the Swiss National Bank, each initiative must be
examined individually regulated according to its
functionality (Jordan, 2019).
3.4.2 State-issued CBDC
Central Bank Digital Currencies can be in form of
state-issued stablecoins (Senner, R., & Sornette, D,
2018). Like the G7, the Swiss National Bank
separates state-issued stablecoins into two types.
First, publicly available tokens called retail (G7
Working Group on Stablecoins, 2019). Publicly
available stablecoins face most of the challenges and
risks described in chapter 3.2. The SNB particularly
emphasizes the threat to financial stability that may
arise from possible bank runs and other uncertainties.
Another critical impact on retail stablecoins is that the
central bank would change its position in the market.
The central bank will change from a bank of banks to
a commercial bank (Jordan, 2019).
The second possible type is a restricted
availability to specific financial actors. As described
in chapter 3, the G7 group calls this classification
wholesale (G7 Working Group on Stablecoins, 2019).
According to Jordan (2019), wholesale stablecoin can
offer significant advantages in the area of increasing
efficiency, especially in the area of trading securities.
With the using of «security tokens», which can be
traded against a domestic collateralized stablecoin, a
nearly real-time owner change is thinkable. The SNB
is currently testing the introduction of a digital e-
Frank together with SIX. This is to be used in a
protected exchange based on blockchain technology
(Fischer, 2019).
4. CONCLUSION
The principle behind Stablecoin is a promising
technology with countless application possibilities
and the chance to revolutionize a widely established
system. Initiatives both initiated privately and
publicly can bring numerous advantages to our
finance system, especially for underbanked people or
people with an unstable domestic currency. With the
ongoing globalization, a stablecoin of global scale has
the potential to improve the daily commodity flows at
its core.
Notwithstanding, the challenges and risks a
stablecoin is facing are immense. First and foremost,
legislators must ensure that innovation is not
hampered despite regulation. At the same time,
despite all technical progress, they must ensure that
the financial system is a highly sensitive entity that
can react massively to possible instabilities. As the
technology is generally available and low entry costs
are associated, many new projects will be launched in
the near future. The legislators are faced with the
significant challenge of keeping up with
developments and drawing appropriate regulations.
Since the traditional international borders have no
significance for stablecoins, the challenges are all the
greater. International collaboration is a must on
facing the current and upcoming challenges.
The four different stabilization mechanism allows
a wide range of applications. The central banks will
mainly be interested in tokenized funds as this
mechanism allows them to create a digital domestic
currency. Investors will take a closer look at off-chain
and on-chain collateralized stablecoins as they can be
very interesting for long-term and profitable
investments. Further on, off-chain collateralized
initiatives create new possibilities of investment for
small investors. The big unknown is the algorithmic
stablecoin. The technology is too young and too little
researched to make meaningful predictions.
Central banks need to research in the area of
stablecoins and take a pioneering role. A domestic
stablecoin could give completely new possibility for
their monetary politics but not without any side
effects. In addition to a precise analysis of the impact,
the roles and responsibilities of the various financial
actors must also be precisely defined.
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... Excluding existing forms of currency, it focuses on the ability of this instrument to mitigate the high volatility inherent to cryptocurrencies and, as a result, the potential for use in international transactions. The increase in the number and volume of the latter is associated with three circumstances: their relative speed and low-cost, the possibility of reaching the target audience with no or limited access to banking services, and the benefits for businesses and citizens of countries with unstable currencies (Bolliger 2019). These characteristics essentially describe the functional components of the instrument, highlighting the contours of the basic conditions, area of origin and nature of factors for its use for settlements and investment purposes. ...
... These characteristics essentially describe the functional components of the instrument, highlighting the contours of the basic conditions, area of origin and nature of factors for its use for settlements and investment purposes. In terms of the ability to implement the latter in relation to stablecoins, it is important to keep in mind that they have been proven to be an elegant solution for developing the entire ecosystem of cryptocurrency trading while minimizing dependence on traditional banking services (Bolliger 2019). ...
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Currencies, money and digital tokens
  • T Jordan
Jordan, T. (2019). Currencies, money and digital tokens. Retrieved from https://www.snb.ch/en/mmr/speeches/id/ref_20190905_tjn
Live aus dem Krypto-Valley
  • M Lewrick
  • C Di Giorgi
Lewrick, M. & Di Giorgi, C. (2018). Live aus dem Krypto-Valley. München, Verlag Franz Vahlen GmbH.
Smart Contracts: Building Blocks for Digital Markets
  • N Szabo
Szabo, N. (1996). Smart Contracts: Building Blocks for Digital Markets. Retrieved from http://www.fon.hum.uva.nl/rob/Courses/InformationIn Speech/CDROM/Literature/LOTwinterschool2006/sza bo.best.vwh.net/smart_contracts_2.html CB Insights. (2018, November 15). What are Stablecoins?. Retrieved from https://www.cbinsights.com/research/report/what-arestablecoins/ What is Ethereum?. (2019, December 12). Retrieved from https://ethereum.org/beginners/
What are Stablecoins
CB Insights. (2018, November 15). What are Stablecoins?. Retrieved from https://www.cbinsights.com/research/report/what-are-stablecoins/