Talking Stablecoin #3 — Understanding how Stablecoins work
Previously at Talking Stablecoin #2, we’ve learned about the importance and mission of Stablecoin in Crypto world. It has become an important innovation in the cryptocurrency world, solving the issue of volatility and facilitating the integration of digital assets into the traditional financial system.
In Vietnam, DONG is striving to enhance the efficiency and security of OTC trading by providing a trustless platform for instant swapping of stablecoins and a seamless conversion to fiat currency.
Now we continue with this blog series, learn further on how to create a stablecoin, and the way stablecoins work.
How to create a Stablecoin?
You need to consider the undermentioned steps to create a stablecoin.
1. Identify the type of stablecoin to be developed
As mentioned above, there are two significant categories of stablecoins, i.e., collateralized and non-collateralized stablecoins. Therefore, it is difficult to say one kind of stablecoin is superior to another type. If you aim to bring long-term stability, then you should prefer algorithmic stablecoins. But if the goal is short-term stability where the underlying asset is reliable, you should opt for collateralized stablecoins. To identify the type of stablecoins you require, ask yourself the following questions:
- How much liquidity do I need from my stablecoins?
- What kind of decentralization/independence do I seek?
- How many audits can I afford to increase trust and reduce risks in my stablecoins?
- How simple or complex do I want the whole architecture to be?
Once you get the answer to the questions mentioned above, it will be easy for you to decide the type of stablecoin you want to build.
2. Identify the blockchain platform and technologies required to build a stablecoin
Once you narrow down the type of stablecoin you want to develop, it is time to select the platform to create your stablecoin. Initially, Ethereum was the only platform for building stablecoins, but it is no longer the case.
The majority of stablecoins were running on Ethereum before 2018, but now, we are witnessing new entrants into the blockchain market. Other new platforms coming up to build stablecoins include Tron, EOS, and more. In 2019, we saw a huge number of EOS stablecoin projects such as Carbon (CUSD), Tether, EUSD, and EOSDT launched on EOS. People preferred building stablecoins on EOS as compared to Ethereum because of the following benefits of EOS:
- Greater interoperability
- High scalability and transaction bandwidth
With the pros and cons of all the available platforms, you can make an informed decision on the platform you want to work on. Once you select the platform and technologies you want to use for developing stablecoins, you need to move to the next step, where you should consider the maintenance of liquidity.
3. Think about the maintenance of liquidity
If the liquidity is lost, the entire concept of building a stablecoin might go in vain. We recommend the following steps to ensure good liquidity:
- Evaluating inflation and value: It is essential to integrate an automated monitoring system to offer daily currency rates and index rates from the Consumer Price Index and Personal Consumption Expenditures.
- Transaction Fees: Revenues from transaction fees should be split, with some parts going to the stablecoin partner while the remaining going into the liquidity reserve to improve the liquidity.
- Protecting from high supply: Users who want to redeem or sell their stablecoins should be able to do so at current face value minus transaction fees. It removes any incentive for sellers to market their stablecoins at discounted rates on secondary markets.
4. Create a smart contract
Smart contract development is another crucial step in stablecoin development which is another key factor in crypto-business success. Smart contracts ensure security through digital agreements. To ensure stablecoin reliability and authenticity on a decentralized platform, you need to decide which protocols you will use when you get smart contract development services. Developers create, test, and launch smart contracts on the test network with virtual wallets.
5. Create visual and technical designs for the system
Now, it is time to go ahead and design your required token. Designing a stablecoin means understanding the flow of transactions of a stablecoin and how the entire system will work. Also, in this step, you may need a system design that will help your users interact with your token. For instance, you may require a website or a mobile app to enable interaction with a stablecoin. Therefore, this step requires designing screens for web/mobile apps. Our stablecoin experts also provide technical designs for a stablecoin that represents the entire workflow of a stablecoin.
6. Development, integration of a blockchain platform and launching to mainnet
Once the designs are ready, the next step is to develop the system. In the development stage, you write smart contracts required to interact with a stablecoin and launch nodes on the blockchain platform that you are using. When features of the stablecoin are developed and connected to the blockchain backend, the next step is to launch it on the test net. If you are developing a stablecoin using the Ethereum platform, you will find various test nets to use. Ask different groups of people to check the quality of your developed product on the test net and provide feedback for improvement. Fix issues that might have arisen during the testing phase. Once all the issues are fixed, you can launch the stablecoin on the mainnet.
Let’s understand the process of creating a stablecoin in a detailed way with the help of an example.
How stablecoins work?
All stablecoins try to mimic the price of another asset, but not all of them do it in the same way. This means that some stablecoins may be riskier than others and more prone to price fluctuations when they claim to provide safety.
1. Fiat-backed stablecoin
Fiat-backed stablecoins are cryptocurrencies that are backed by a reserve of fiat currency, such as USD, EUR, or JPY. These stablecoins are usually issued and managed by a centralized entity, such as a company or a financial institution.
The process of creating and managing fiat-backed stablecoins typically involves the following steps:
- The issuer creates a reserve of fiat currency equal to the amount of stablecoins they plan to issue. For example, if the issuer wants to create 1 million stablecoins backed by USD, they would need to hold $1 million in reserve.
- Once the reserve is established, the issuer mints the corresponding amount of stablecoins and makes them available for purchase on cryptocurrency exchanges or directly from the issuer.
- When a user purchases stablecoins, they transfer fiat currency to the issuer, who holds it in reserve. In exchange, the user receives the corresponding amount of stablecoins. For example, if a user purchases 100 USD-backed stablecoins, they would transfer $100 to the issuer and receive 100 stablecoins in return.
- The issuer keeps track of the reserve and ensures that it always matches the amount of stablecoins in circulation. If the supply of stablecoins increases or decreases, the issuer can adjust the reserve accordingly.
- When a user wants to redeem their stablecoins for fiat currency, they send the stablecoins back to the issuer, who then transfers the equivalent amount of fiat currency back to the user’s bank account.
Fiat-backed stablecoins are designed to provide users with a stable store of value that is pegged to a fiat currency. The reserve of fiat currency backing the stablecoins is intended to provide confidence to users that they can redeem their stablecoins for the equivalent amount of fiat currency at any time.
2. Crypto-backed stablecoins
Crypto-backed stablecoins, also known as collateralized stablecoins, work by using cryptocurrency as collateral to back the stablecoin. The amount of collateral required to back the stablecoin is typically higher than the value of the stablecoin to ensure its stability.
When a user wants to create a crypto-backed stablecoin, they deposit their cryptocurrency as collateral into a smart contract. The smart contract then mints new stablecoins, which can be used by the user or traded on a cryptocurrency exchange.
If the value of the collateral falls below a certain threshold, the smart contract will automatically sell a portion of the collateral to maintain the stability of the stablecoin. This process is known as “liquidation” and is designed to prevent the stablecoin from becoming undercollateralized.
The main advantage of crypto-backed stablecoins is that they do not rely on a centralized entity to manage the collateral or issue new tokens. This makes them more decentralized than fiat-backed stablecoins and less vulnerable to regulatory scrutiny.
Examples of crypto-backed stablecoins include MakerDAO’s Dai, which is backed by Ethereum, and BitShares’ BitUSD, which is backed by BitShares.
3. Algorithmic stablecoins
Algorithmic stablecoins are digital assets that rely on smart contracts to regulate their stability. Unlike other stablecoins that are backed by assets such as fiat currency, cryptocurrency, or commodities, algorithmic stablecoins use a set of rules programmed into smart contracts to maintain a stable value.
The algorithmic stablecoin works by adjusting its supply in response to market demand. When the market demand for the stablecoin increases, the smart contract will automatically increase the supply of the stablecoin, and vice versa. This is achieved through a system of incentives and penalties that encourage holders of the stablecoin to either mint new tokens or burn existing tokens.
For example, when the price of the algorithmic stablecoin rises above its target price, the smart contract will create new tokens and distribute them to holders of the stablecoin, incentivizing them to sell the tokens and bring the price back down. Similarly, when the price of the stablecoin falls below its target price, the smart contract will penalize holders of the stablecoin by burning their tokens, reducing the supply of the stablecoin and increasing its price.
One of the benefits of algorithmic stablecoins is that they are not subject to the same regulatory and custody issues as other stablecoins. However, they are also subject to higher levels of volatility and are more susceptible to market manipulation due to their reliance on smart contract rules.
How MMC’s DONG works?
To keep the balance, whenever a user deposits VND into the My Money Credit platform, the VND is automatically sent to The Reserve, and a corresponding amount of DONG is minted and returned to the user’s My Money Credit account. Conversely, when a user sells DONG for VND, the VND is transferred from The Reserve to their bank account and the sold DONG is then burned.
To further enhance the reliability and transparency of The Reserve, DONG will implement Chainlink’s Proof of Reserves technology. An accounting firm will gather The Reserve data and serve it on-chain via Chainlink’s decentralized oracle network. This enables DONG’s smart contract to authenticate that the issuance of new tokens does not surpass the total VND held in reserve.
DONG’s minting/burning mechanism and the integration of Chainlink’s Proof of Reserves allow for direct, secure, transparent, and almost instantaneous VND to DONG conversion (and vice versa) at a 1:1 ratio.
DONG is designed to be deployed on multiple blockchain networks, including Ethereum, Arbitrum, Polygon, and Tron. Once DONG is in your My Money Credit account, you can withdraw it to your personal digital wallet in any of the aforementioned blockchains.
While minting new DONG on My Money Credit does not incur any fee, redeeming DONG tokens to a bank account incurs a fee of 1 MMC regardless of the amount being redeemed.
Conclusion
Stablecoins have emerged as a popular alternative to traditional cryptocurrencies due to their ability to maintain a stable value. Creating a stablecoin involves the use of various mechanisms such as collateralization, algorithmic stabilization, or a combination of both. The success of stablecoins largely depends on the ability of their underlying mechanisms to maintain the peg to the target asset. As stablecoins continue to gain traction in the cryptocurrency market, it will be interesting to see how they evolve and whether they will become an essential part of the financial ecosystem.
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