Stablecoins blog post series – part 2: challenges and possible solutions

In our first article in the series "Stablecoins" we looked at the background to the topic and showed why and by whom stablecoins are currently used and what advantages they offer. In the second part, we will look at some problems and possible solutions of the existing stablecoins.

Problems of existing approaches
Existing stablecoins face several problems, which we will address below.

High transaction costs
If a stablecoins transaction is to be carried out on the Ethereum blockchain, for example, the transaction fees depend on the current network load and the time the sender has to have the transaction confirmed. The costs can range from a few cents to several euros. Moreover, in addition to the actual stablecoins, the blockchain currency Ether is also needed to pay the transaction fees. In the case of Ethereum there is currently also the fact that the scalability is not yet given after the change of the consensus mechanism from proof-of-work to proof-of-stake. This will be addressed in future updates. Therefore, only a few transactions per second can currently be processed by the Ethereum blockchain.

Availability of centralised blockchains
Centralised blockchains such as the Binance Smart Chain (operated by the crypto exchange Binance) advertise low transaction fees. One disadvantage here is the necessary trust of users in the exchange Binance, which operates the blockchain. In the past, it happened more than once that the operator had to stop its own blockchain in times of crisis to fix problems. Basically, when a blockchain is stopped, users can no longer carry out any transactions and thus no longer have their assets at their disposal, which is equivalent to freezing the bank account or the entire payments.

Type of issuance of new coins
As already described in the first article, a distinction is made between algorithmic (decentralised) and collateralised (centralised) stablecoins. However, both methods have disadvantages in addition to the advantages mentioned.

The value collateral of central stablecoins is usually realised manually, i.e. the company issuing the stablecoin centrally controls the type and scope of the collateral.

The reserves of decentralised stablecoins are usually controlled algorithmically.

  • If the price falls due to selling pressure, the reserves are automatically increased (minting).
  • If the price rises due to high demand, the reserves are automatically lowered (burning).

Most algorithmic stablecoins are linked to cryptocurrencies whose supply is centrally controlled.

In the crypto scene, 'supply' refers to the number of coins issued on the market. Various cryptocurrencies provide for a limited number of coins for the supply (e.g. 21 million bitcoins for the currency Bitcoin). Stablecoins, on the other hand, do not have such a limit due to their different economic approach. If the exchange rate of a currency is to remain constant, the money supply must be flexible (e.g. Tether). If the money supply is fixed, the exchange rate of the currency will fluctuate (e.g. Bitcoin).

This type of collateral was the undoing of the TerraUSD stablecoin in May 2022. As selling pressure on the TerraUSD stablecoin increased, the cryptocurrency TerraLuna, which was deposited as collateral, had to be generated in large quantities to support the stablecoin's price. In the general crisis situation in May 2022, the additional minting of new coins put increasing pressure on the price of the reserve currency TerraLuna. This created a downward spiral that led to the complete loss of value of TerraUSD and TerraLuna.

This example shows very well the essential weakness of algorithmic stablecoins. If many users want to exit stablecoin at the same time, the downward spiral will be further exacerbated as additional reserve currency units are created in large quantities, leading to a total loss of value.

New possibilities with Taro

Stablecoins based on the Bitcoin Lightning Network are a new idea. This is where Taro comes in. Taro (Taproot Asset Representation Overlay) is a protocol that can be used to create stablecoins on the Bitcoin network, in addition to other assets, and send them through the Lightning Network.

Taro assets are created in the Bitcoin blockchain in the form of hashed meta data. Since there is no limit to the amount of data that can be represented by a hash, one transaction on the blockchain can represent millions of transactions. Taro Nodes can recognise these assets represented by a hash. Besides Taro, there is also the RGB protocol, which pursues a similar goal.

As a result, stablecoins benefit not only from the low transaction fees in the Bitcoin Lightning Network (fractions of a cent) but also from the network effects of the Bitcoin network as the most widespread cryptocurrency and its uptime of 99.98 %. The Bitcoin network simultaneously ensures that Taro assets cannot be spent twice. Users would thus be able to carry out stablecoin transactions at a low cost and benefit from the value stability of the USD. Cross-border payments without KYC and financial institution are possible. People can access their money 24 hours a day without stopping the network.

The problem of the collateral for stablecoins remains. Both algorithmic and collateralised approaches have some problems, as discussed above.

The last part of our series will deal with the regulatory aspects for stablecoins. We invite you to also have a look at it.

Authors: Philipp Uhinck, Benjamin Schreck


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