Credit vs Collateral

Collateralized stablecoins currently dominate the market. Since Tether launched in 2014, there have been hundreds of collateralized stablecoins launched by nearly as many different issuers. The fundamental value proposition of collateralized stablecoins is simple: perfect stability compared with some index of value (usually the US Dollar).

But collateralized stablecoins come with baggage: the vast majority of those on the market today are issued by centralized custodians of off-chain value because there is simply not enough on-chain value to use as collateral to issue enough stablecoins to meet demand. These centralized issuers of stablecoins have the unilateral ability to censor holders of the asset. The unfortunate reality is that so much of the value on-chain today is dependent (e.g., for liquidity, TVL, collateral for loans) on stablecoins collateralized by off-chain value which is custodied by centralized parties that the integrity – the censorship resistance, credible neutrality and permissionlessness – of the chains themselves are compromised.

Credit offers the most compelling alternative to collateral to create a network-native, scalable and leviathan-free medium of exchange and unit of account.

The major downside of credit compared with collateral is that it cannot support a perfect peg. But, in addition to being crypto-value aligned – on-chain credit can be trustless, permissionless and censorship resistant – a properly architected credit-based stablecoin can outcompete collateralized ones based solely on its economic advantages.

Collateral Over Credit? The Hard Peg

Collateralized stablecoins track the value of the index they are pegged to almost perfectly because there is always – except for the rare (but incredibly important) instances in which the issuer is unable to or refuses to honor redemptions for the underlying collateral – the ability to redeem the stablecoin for its peg value worth of collateral.

In the case of credit-based stablecoins, there is no such redemption mechanism. Therefore, in juxtaposition with collateralized stablecoins, credit-based stablecoins maintain a soft peg – one in which there is some volatility relative to the value target index. In the instance of downside volatility, the credit-based system attempts to borrow excess supply from the market on credit (i.e., the promise of interest in the case of future supply growth) to reduce supply and return the stablecoin's price to its value target.

Because one of the primary drivers of utility for a medium of exchange and unit of account is low volatility, collateralized stablecoins have a major advantage over credit-based ones.

Credit Over Collateral: Carry Costs

The other major driver of the utility of a medium of exchange and unit of account besides low volatility is carry costs for (a) holding the asset, and (b) borrowing the asset. Holders want to earn a competitive interest rate on the money they hold, and borrowers want to be able to borrow money at the lowest interest rate possible. Credit-based stablecoins dominate collateralized ones with respect to carry.

While modern collateralized stablecoins, particularly USD denominated ones, are largely backed by US Treasuries, thereby offering non-zero positive carry to holders of the asset, the single digit yields offered by this model are generally outpaced by the inflation of their indices, leading holders to lose value over time. The yield accrued from holding collateralized stablecoins pales in comparison to the potential yield accrued from holding a credit-based stablecoin whose newly minted supply – a response to excess demand pushing the stablecoin price above its value target – is passed onto holders. Particularly until the credit-based stablecoin's supply reaches hundreds of billions or trillions, high double digit percent positive carry or low triple digit percent positive carry are possible.

Historically, the carry cost paid to borrow an asset must always exceed the opportunity cost of not holding the asset, including the positive carry, if it exists (as otherwise no one would be incentivized to lend it out). A collateralized stablecoin will always be subject to this dynamic. However, a properly architected lending infrastructure surrounding an on-chain credit-based stablecoin has the potential to combine high positive carry for holding and low carry costs for borrowing by having the protocol itself lend out value. Such architecture, although not yet implemented in practice, will create the optimal money: a low volatility yield-bearing medium of exchange and cheaply borrowed unit of account.

When it comes to both types of carry costs, credit-based stablecoins are dramatically better than collateralized stablecoins.

The Fundamental Tradeoff: Volatility for Carry Costs

The tradeoff between collateralized and credit-based stablecoins is clear: perfect stability and less competitive carry, or some volatility and far better carry.

Collateralized stablecoins have very little room to improve on carry costs or alignment to crypto values due to their requirement to remain fully collateralized at all times. While their volatility is typically near 0 with respect to peg maintenance, the positive carry of holding the asset is often outpaced by the inflation of its pegged value. While the costs to borrow are often low, they could be lower. The low supply of on-chain value usable as collateral means collateralized stablecoins will require centralization for the foreseeable future.

Credit-based stablecoins, on the other hand, while still in their experimental phase, can combine much better carry costs with freedom from centralization. It is only a matter of time before the volatility minimization mechanisms and lending architecture are strong enough to create sufficient utility and unlock the power of credit to free Ethereum and other crypto-networks from the existential threat of centralized stablecoins.

The fundamental thesis behind Pinto is that an autonomous algorithm, well-designed, can sufficiently (1) demonstrate and use its creditworthiness (and various endogenous incentive mechanisms) to dampen the volatility of the credit-based currency it issues and (2) distribute yield to holders of the currency, that the utility of the currency can outcompete centralized stablecoins.

*Note, this entire document refers to exogenously collateralized stablecoins, but for simplicity uses the more colloquial term collateralized stablecoins. Read more about stablecoin classification here.