A Brief History of Uncollateralized Stablecoins & the Future

Stablecoins which are not backed by any assets or fiat are classified as uncollateralized stablecoins. The stablecoin projects which adopt this model to create a stablecoin, generally attempt to do what the Federal Reserve does, though in a decentralized and algorithmic way. 

Devising such a mechanism in a decentralized and tamper-proof way is challenging to say the least. Once a stablecoin is created, its value is pegged to a certain asset and the supply automatically changes in response to an increase or a decrease in the total demand of stablecoins to maintain the value spread and keep the value as close to the initial allocation as possible. In case of increase in demand, expanding the money supply is quite easy – print more money whereas in case of decrease in demand, contracting is a bit trickier since someone has to lose money, but who?

In the “bonds and shares” method, if the price of the stablecoin falls below the target range, the system issues bonds with a par value of $1 (or the initial value of the stablecoin) that are sold at discount to incentivize holders, purchase the bonds with the stablecoins, to remove stablecoins from circulation and thus reducing the supply of stablecoins. If in the future,  the demand increases – the system needs to increase the supply. The bondholders are paid out first in the same order they had purchased. Once all bondholders have been paid, the system pays those who own shares. Shares and bonds in the system represent a claim on future value of the stablecoin when demand increases – a dangling promise which may or may not be fulfilled.  Since the stablecoin value contraction is not finite,it might cause a spiral in the price of bonds as new bonds are issued, the bonds queue increases and the likelihood of them being paid decreases. As a consequence, bond price decreases and the number of stablecoins removed from circulation decreases with it, which results in a need to issue more bonds.

In another mechanism, the voting system tried to stabilize the uncollateralized stablecoin but it was against the very definition of a stablecoin as the voting system could be gamed. Another mechanism observed to create uncollateralized stablecoin was the block rewards method, dependent on math and code; it was unsuccessful as well and the project had to be halted.

No major success stories have been observed so far in the non-collateralized stablecoin vertical – Basis, NuBits, Havven stablecoin, Carbon stablecoin, Kowala are a few of the projects which tried creating non-collateralized stablecoins. But none of them have been successful so far due to various reasons. The peg for NuBit broke in 2016, a peg break is the worst case scenario for any stablecoin and even more so if it is uncollateralized as the market confidence wavers off pretty quickly. Carbon and Havven, stablecoins built on EOS, faced a similar fate as they could not gain market traction. Basis stablecoin blamed its failure on regulatory concerns which would have classified it as a security – which again is a major hurdle to overcome to gain market confidence. 

With no asset backing uncollateralized stablecoins, the vulnerability involved is quite high and as soon as the community loses confidence, the value of the coin tanks. It’s not the lack of funding nor the hesitancy to follow regulations nor the lack of willingness to experiment to find an apt mechanism to design a suitable stablecoin but the insurance on investment that plays a major role in building  community confidence. With stablecoins deemed as the bridge for investors to enter the crypto market, the high vulnerability may drive them away from crypto altogether – which could be detrimental. 

Thus, for now fiat collateralized stablecoins are leading the field but over time with more advances in mechanisms, risk averseness of the users and favorable global regulations, I am optimistic that we may soon have a highly available and trustworthy uncollateralized stablecoin which will open a doorway to a much larger user base to the crypto world.