News of Bitcoin and Ethereum is everywhere these days. The two cryptocurrencies have had returns over the past year that make a big-time hedge fund manager look like he’s running a lemonade stand in front of his parents house.
Since last year, Bitcoin is up (at the time of this writing) 390.55 percent and Ethereum’s currency, Ether, is up a mind-blowing 1,896.13 percent.
New money is pouring into the cryptocurrency space, with one investment fund announcing a raise of $400 million dollars. Though talk of the inevitable Tulip mania and Internet 1.0 bubble burst abounds (and has for years), it does not feel a burst is likely anytime soon. (Note: not investment advice.) And that is actually kind of a problem.
If you go back to the Bitcoin whitepaper (everyone should read it, it’s fairly consumable), the title is very clear about its intent: “A Peer-to-Peer Electronic Cash System.”
Bitcoin, Ether and a host of other currencies are faced with hourly and daily price volatility (in relation to the US dollar). It is not uncommon to see drops of $50-$100 in Bitcoin and $30-$50 in Ether in a day, even if the overall trend line is up. On multiple occasions, we have seen drops of 10 and 20 percent in one day.
What this means in practice (and I know from firsthand experience) is that the earrings I bought for my wife with Bitcoin that cost $13 at the time of purchase were worth $16 a few hours later and today are the equivalent of $28. My wife is worth it, of course, but such volatility can wreak havoc on people. Even more so on companies, which desire stability for financial planning purposes.
The Bitcoin believer’s mantra of “HODL” or “Hold On For Dear Life” is precisely the opposite of what you want in a system designed to encourage people to treat digital currency like cash.
The need for crypto-stability
True believers in blockchain and decentralization recognize that these new technologies and monetary systems will never achieve mass mainstream adoption with these kinds of violent swings.
Ethereum’s creator, Vitalik Buterin, identified this challenge back in November, 2014 in his post “The Search for a Stable Cryptocurrency.” It’s a very long and complex read (as are many of his writings), but he ends it with a fairly prescient prediction:
“There would then be multiple separate classes of cryptoassets: stable assets for trading, speculative assets for investment, and Bitcoin itself may well serve as a unique Schelling point for a universal fallback asset, similar to the current and historical functioning of gold.”
The groundwork for this environment is being laid right now, as the number of new crypto-tokens continues to grow into the thousands. The second part, however, the “universal fallback asset” has not materialized fully. The SchellingCoin is the search for the stability.
Many of the advanced financial instruments that Wall Street uses and that are familiar to many of us through the 2008 housing crisis and the book/movie The Big Short have achieved some degree of notoriety. Still, we don’t want to throw the baby out with the proverbial bathwater.
Vitalik further wrote that “One of the main applications of Ethereum that people have been interested in is financial contracts and derivatives … [and] the underlying concept in fact has a number of legitimate uses, some of which actually help people protect themselves against the volatility of financial markets.”
A new crop of startups is emerging to do just that with “smart contracts.”
Smart contracts: The foundation of stability
In simplified terms, the smart contract takes the “if/then” statements that form the basis of legal and business rules and puts them into computer code. Then, with the security of the blockchain behind it, the contract is executed automatically without any human interference or risk of tampering.
Ethereum was built to support smart contracts in a way that Bitcoin was not (though a recent release by Rootstock is seeking to make it easier to run smart contracts on the Bitcoin blockchain). This fact explains why almost every new crypto-token being issued today happens in the ERC20 format, which is designed specifically for the Ethereum blockchain. It may also be a core driver of the huge Ethereum price run-up.
By relying on smart contracts, in theory, we have the ability to remove centralized systems (like banks), which introduce risk and lack transparency, and lower fees significantly. Venture capitalist and thought leader Vinay Gupta highlights that smart contracts can reduce “the 7 percent margins taken by all manner of middlemen to a more realistic 0.07 percent margin.”
If you can reduce the cost of executing contracts by 99 percent AND do it with increased confidence that the assets are not going to be highly volatile, that would be fairly appealing to an extremely large number of people.
The goal of each of these smart-contract-driven projects is to bring some degree of financial stability to the crypto-asset market.
Maker, MKR, and SAI: Stability through programmatic collateral
The first effort I’ve come across of a crypto-native solution to volatility came from an organization called MakerDAO. In its original white paper, it introduced a very complex concept known as a DAI, that would derive its value (and stability) from a simple centralized collateral custodian model.
However, in a sign of how quickly things change in this industry, MakerDAO has already abandoned that pursuit because, in the company’s own words, “an individual custodian takes on some level of risk, and no one enthusiastically stepped up to take this risk on.”
But don’t confuse the company’s change in focus as a lack of intellectual rigor. On the contrary, there is some heavy thinking in its latest effort, known as a SAI (or Simple DAI). A SAI is designed to be the stable coin that people need to make long-term investments. It is backed by collateral (at this time, only Ether, aka ETH) through a mechanism known as a collaterized debt position (CDP). The total number of SAI available is limited by a debt ceiling, and SAIs are created and destroyed (through the power of smart contracts) as…