Decentralized finance is the next wave of applications on scaleable cryptocurrencies, for which Bitcoin Cash is preparing.

Examples of existing DeFi components include stablecoins, and tokenized assets.

One perspective is that DeFi distracts from the main purpose of cryptocurrencies as a medium of exchange.

Bitcoin entrepreneur Vin Armani has been proposing a different idea – “Bitcoin [broadly defined] is not money.”

Because of Bitcoin’s ability to make assets like property titles and even fiat currencies digitally native – tokenization – Vin proposes that Bitcoin is essentially a value transfer network.

While some tokenized assets present security risks for Bitcoin Cash through economic abstraction, use of certain types of tokenized assets will magnify the increase in BCH’s price as they are created – thus incentivizing greater security by increasing the network hash rate.

“Backed” stablecoins

Tether was the first generation of stablecoins – cryptocurrencies which stay at or near a $1.00 value, despite major volatility in the prices of the networks on which they’re hosted.

As the first of its kind, Tether was justified in its rudimentary attempt to do this using a trusted third party.

However, Bitcoin was created to eliminate the need for trusted third parties – instead using math, game theory, and economic incentives to guarantee secure value transfer.

The next generations of stablecoins must incorporate these principles to become similarly trustless.

Algorithmic (collateralized) stablecoins

Dai is a recent stablecoin, built on the Ethereum blockchain. For the visually inclined, here’s a one-minute video explanation.

Dai maintains a 1:1 peg with the USD through a decentralized autonomous organization (or DAO).

While Dai is a novel concept, it bears many parallels with the US Federal Reserve. MakerDAO issues DAI in exchange for the ETH – Ethereum’s native asset – from borrowers.

Like the Federal Reserve Board, MakerDAO lenders vote to set interest rates, which in turn affects the price of the DAI token.

Interest rates can be raised to dissuade potential borrowers, which would decrease the value of the DAI token, or vice versa to increase it.

When borrowers return DAI, they receive their ETH back, minus the interest – called a stability fee.

This works because DAI is overcollateralized by ETH. Should the price of ETH fall sharply in a short time frame, in theory, the MakerDAO could vote to decrease interest rates.

Liquidation of collateral is also possible, but hasn’t been necessary to maintain Dai’s 1-to-1 USD peg.

Traditional backed assets present a security threat to the base layer

In Tether’s case, a theoretically infinite amount could be issued on any chain, without a corresponding change in the price of that chain’s base asset.

For example, one trillion Tether (USDT) issued on the Ethereum chain would not directly affect the price of ETH.

The transfer of tokenized assets is only as secure as the blockchain on which they’re issued.

Security, in turn, comes from the fees paid to miners to maintain the network by honestly recording transactions.

Without enough security, miners could defraud the network, making a payment, then reversing it after receiving the other side of the presumed exchange of goods or services – a double spend.

For this reason, backed stablecoins present a double-spending hazard if the value they transfer exceeds the cost of a double-spend.

The security of a network which prevents this – measured by the hash rate of that network on a proof-of-work chain like Bitcoin or Ethereum – follows the price of the chain’s native asset.

Value capture dynamics of stablecoins

Stablecoins like Tether, which don’t necessarily increase the price of the underlying blockchain’s native asset are subject to double-spending as the value they transfer increases, but the value of the native asset remains unchanged.

By contrast, Dai and other algorithmic stablecoins increase the price of the underlying asset through collateralization.

Dai does this in two ways:

First, the price increases when the collateral asset, ETH is purchased. Then, subsequent lockup of funds decreases circulating supply of coins, increasing the value of those outstanding.

This phenomenon is magnified in Dai’s case because positions are overcollateralized – there is a greater lockup of ETH than the value is issued in Dai.

According to the equation of exchange, the price floor of the base currency will increase.

Again, the higher price of a blockchain’s base asset attracts miners, which provide security; hash follows price.

In this way, collateralized stablecoins offset risk of double-spending otherwise encouraged by backed assets.

This hazardous phenomenon is known as economic abstraction.

Conclusion

Stablecoins will be required to build more useful, user-friendly financial applications on Bitcoin Cash.

Algorithmic stablecoins are preferable to backed stablecoins because they offset the risk of double spends by increasing the price of the base asset – a benefit in itself.

All this while maintaining censorship resistance, since assets remain on chain; with algorithmic stablecoins, trusted third parties are not required to exchange assets.

This is a major step toward more powerful financial applications on Bitcoin Cash – the only real frontrunner with an on-chain scaling plan that is open to these.