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Spend enough time investing in (or reading about) the cryptocurrency world, and it’s easy to become a bit jaded about the wild, unpredictable price swings that seem to come with the territory. But it doesn’t necessarily have to be this way, say some blockchain developers. The trick, they argue, is to peg the price of a crypto-token to that of a fiat currency like the US dollar.

“Blasphemy! Heresy!” come the cries from the crypto-originalists, the hard core in the community who hopped on board this careening bandwagon in the conviction that cryptocurrencies were invented to replace fiat money, not coexist with it. And there is plenty of legitimate criticism to be leveled at “stablecoins.” Some say the concept as a whole simply isn’t viable. Nevertheless, of late it has drawn plenty of interest—and venture capital. So let’s investigate.

This piece first appeared in our twice-weekly newsletter, Chain Letter, which covers the world of blockchain and cryptocurrencies. Sign up hereit’s free!

The schemes: The idea of a stablecoin is in fact several years old, and dollar-pegged tokens(for example, Tether and TrueUSD) are already available on some cryptocurrency exchanges. But the recent mania around initial coin offerings has seeded a new crop, giving rise to different approaches to building a stablecoin. These fall into three broad categories:

  • Back up the tokens with cash in a bank account. This is how Tether, the most popular dollar-pegged coin, works. That’s what they say, at least—the company hasn’t shown the public any proof that the more than 2.5 billion “USDT” tokens in circulation are all actually backed by dollars. Perhaps the well-funded startup Circle, which last month announced plans to develop a stablecoin fully backed by dollar reserves, will be more transparent. Either way, users of a system like this must trust a third party with their money.
  • Back up the tokens with other cryptocurrencies. Instead of using fiat money as collateral, why not use cryptocurrency? That eliminates the need to trust a third party, since it can be done on a blockchain. But it also introduces another source of volatility—so you risk getting a stablecoin that’s not very stable. One way to fix that is by “over-collateralizing”: users must first deposit a larger amount—$150 worth of ether, say, in return for $100 worth of a stablecoin. Ultimately, though, if the collateral currency crashes in price—always a threat in crypto-land—the pegged token would go with it.
  • Create an “algorithmic central bank.” This entails using software to increase and decrease the supply of the stable token to maintain its peg. The best example is a forthcoming project called Basis, which raised $133 million in April from several big-name Silicon Valley VC firms. Basis’s white paper (PDF) describes a system that relies on buying and selling additional tokens besides the stablecoin (which, for now at least, is also called a “basis”). If its price drops below $1, the blockchain will sell “bond tokens” to users for stablecoins worth less than a dollar and remove them from the system. The bond tokens are guaranteed to yield payouts of a full dollar once the stablecoin’s price returns to its peg.

Failing econ 101: Perhaps the most vocal critic of stablecoins is Preston Byrne, a founder and former COO of the early blockchain startup Monax. Byrne, who has written extensively about the topic, said in an e-mail to MIT Technology Review that developers of stablecoins fail to account for basic economic principles by assuming that they will always be able to “incentivize users of their systems to purchase their coins at an arbitrary price.” This “ignores that in all market-based exchange, price is determined by a meeting of the minds of a buyer and seller, not by an algorithm,” Byrne says. “All that is required for these systems to fail is for people not to buy the product.

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