Crypto world was dominated by the news headlines of JP Morgan introducing their intention to launch the stablecoin named “JPM Coin” a few months ago.
The report by Blockchain.com says that the stablecoins are coming up to the market with unprecedented speed.
With stablecoins quickly becoming an important building block of the crypto-ecosystem, it is crucial to understand how will they have an impact on the next generation of digital securities.
Security tokens also emerged as an approach to introduce legal implications to the crypto world and build trust among investors. Now, the question is if the stablecoin is also a type of security token. If no, how they both are different from each other.
This article is intended to understanding the difference between two popular terms, “stablecoins” and “security tokens.”
Let’s first understand what is stablecoin.
What are Stablecoins?
A Stablecoin is a cryptocurrency pegged to any stable asset, for example, fiat currencies, gold or other precious metals. Most of the times, stablecoins are linked to a decentralized autonomous organization who controls pricing and issuance.
They are designed to stabilize the value of a crypto token, reducing its volatility. By associating with another asset, for example, USD, the value of stablecoin remains constant with respect to that particular asset.
Stablecoins were introduced as a result of the high volatility rate of cryptocurrencies. It was difficult for users to use cryptocurrency as a medium of exchange as they cannot afford to pay for a coin that can lose half of its value another day.
Once it is clear what are stablecoins, let’s understand what is a security token and how it is different from the stablecoin.
What are Security Tokens?
A security token is a crypto token that can obtain its value from a tradable and external asset or is supported by an asset with security like features.
Securities are considered as tradable financial assets, for example, debentures, options, bonds, warrants and shares. A token should be subject to federal security regulations in order to classify as a security token.
StableCoins vs Security Tokens
The relationship between security tokens and stablecoins is far beyond just enabling the payment foundation for digital securities. The linkage between both can be considered bidirectional; stablecoins allow new types of security tokens which can be combined to form new types of stablecoins using the underlying programming model.
In traditional financial markets, it is quite complicated to create new forms of fiat currencies backed by any asset, but that limitation does not exist in the crypto space. Non-collateralized or crypto-collateralized stablecoins can come up from security tokens.
Combining stablecoins and security tokens can unleash various key scenarios in crypto markets in the coming years.
Let’s understand some of the following scenarios that explain how stablecoins are related to security tokens.
Scenario1: Fiat Collateralized
A company holds assets or vault in a bank and issues tokens representing a claim on the assets backing them. They build stablecoins equivalent to the number of supporting assets. The digital token derives its value from another asset with a defined value.
TrustToken’s TrueUSD is one of the stablecoins, fully collateralized by USD held in a trust company’s escrow account. The company has publicly audited smart contracts that mint TrueUSD when USD qualifies the escrow account and burns it when US dollars are redeemed to ensure a 1:1 parity between USD in the escrow accounts and TrueUSD in circulation.
Moreover, TrustToken has planned to extend its model to precious metals like Gold and Diamond, other fiat currencies such as Yen or Euro and baskets of assets like real estate and stocks.
Non-currency extensions can be classified as a security token. For example, Eidoo, Switzerland-based startup, has added an ERC-20 compatible token, Ekon which is redeemable for one gram of 99.9 percent fine gold that is stored in vaults and audited within every 90 days.
Ekon derives its value from the value of gold and therefore, could be considered a security token.
Fees for selling and buying Ekon on the exchange will make a revenue for Eidoo in the form of its token, EDO. This approach classifies EDO as a security token.
Looking at the cases mentioned above, a stablecoin designed via scenario 1 can be defined as a security token.
Scenario 2: Uncollateralized (Seigniorage Shares)
Many crypto projects are nowadays adopting the Seigniorage shares model to do what the Federal Reserve does. When the Federal Reserve (FED) purchases issued securities from large securities dealers or banks, the money supply is increased. On the hand, the money supply gets decreased if FED sells security.
Similarly, the initial allocation of stablecoin is created and pegged to a specific asset. The supply automatically gets changed with an increase or decrease in the total demand for stablecoins.
The commonly used method to expand or contract the supply of stablecoins is the “bonds and shares” approach. It was first introduced by Basis that raised $133 million for their stablecoin project before its launch.
The challenge is to create a system for examining if you need to increase or decrease the money supply in a decentralized way. To overcome this issue, the system supplies bonds with a par value of $1 sold at some discount to incentivize holders to remove the circulation of stablecoins.
This process takes place when the stablecoin’s price goes below the targeted range. In case the demand goes up in the future, the system has to increase the “money supply.” Firstly, the bondholders are paid in the order they were purchased. Once all the bondholders are paid, the system pays the one who has shares.
The contraction is not finite in this mechanism because each bond issuance includes a promise of an increase in total supply in the future. The bond queue increases when the new bonds are issued. As a result, the price of the bond decreases and stablecoins removed from circulation also decreases.
The above mechanism seems to have more features like that of security. The process of issuing bonds and shares, the way they are priced, dividends payments stream and evaluation, types of risks involved and the bondholder and shareholder expectations are security related features.
Scenario 3: Crypto-collateralized
In this scenario, a stablecoin is supported by decentralized crypto assets. For example, Dai uses the same mechanism.
Unlike TrueUSD and Tether, Dai is backed by Ethers held as collateral in the Ethereum-based smart contract. Collaterals are held in a smart contract where it can be accessed by paying the stablecoin debt or sold by the contract code if collateral goes below a specific threshold.
The issue with this type of scenario is that the collateral supporting the stablecoin could be volatile. Since it is backed by crypto assets, it can lose their value quickly. That is why the projects that are based on this mechanism are overcollateralized to deal with the sharp price movements.
In Scenario 3, though the collateral is done via a crypto asset, the value of a collateralized asset can represent the fiat value of the stablecoin. The coins are collateralized with cryptocurrency assets and the value can be determined from those assets. Pegging to fiat can be done by the value of the collateralized crypto asset.
Stablecoin holders can have a claim on a digital asset and stablecoins derives its value from that specific asset. Therefore, this scenario can also fall under the security token definition.
From the analysis mentioned above, it seems that all scenarios for creating stablecoins can have security like features and can fall under the category of a security token.
At LeewayHertz, we have a team of stablecoin development experts who can create a stablecoin backed by any asset, including crypto assets, real assets or precious metals.