Stablecoins Explained

What are stablecoins?

In most parts of the world, there is no such thing as a stable form of money. Especially in cases of hyperinflation, as it currently is the case in Venezuela, we can really experience the importance of a stable currency. Even fiat currencies such as the US Dollar and the Euro are subject to fluctuating exchange rates, diminishing purchasing power, and inflation. However, these fluctuations are usually so small that we can still use these government-issued currencies on a day-to-day basis.

These fluctuations are amplified in the realm of cryptocurrencies which are subject to massive volatility, making them both attractive to speculators and impractical for mainstream use. An ideal cryptocurrency is stable in its purchasing power or is at most slightly inflationary as to incentivize the owners to spend their coins rather than holding on to them. This ideal cryptocurrency is also known as a “stablecoin”. In their most simplistic form, stablecoins are simply cryptocurrencies with stable prices measured in fiat currency.

“A stablecoin is a cryptocurrency that is often pegged to another stable asset, like gold or the U.S. dollar. It’s a currency that is global, but is not tied to a central bank and has low volatility. This allows for practical usage of using cryptocurrency like paying for things every single day.” Sherman Lee

A perfectly engineered stablecoin is the key to achieve all three essential properties of a currency.

Why are stablecoins important?

For any currency, stability is crucial to trade goods and services without the risk of either the buyer- or seller-side losing value as a result of the price volatility. For cryptocurrencies specifically, price volatility prevents mainstream adoption of applications built on top of the cryptocurrency protocols.

“Any application which requires a low threshold of volatility to be viable on a blockchain, consumer loans for example, simply cannot be denominated in a currency which fluctuates 10–20 percent in a day, like Bitcoin and Ether.” Gregory DiPrisco from MarkerDAO

For example, it is hard to design a decentralized insurance solution, derivatives or prediction markets if the underlying cryptocurrency changes significantly over short periods of time. The adoption of stablecoins will therefore be a catalyst to the new decentralized internet becoming mainstream.

                                                                                                 60-Day BTC/USD Volatility

The chart above shows the volatility of the bitcoin price, measured as the average of daily deviations during the last 60 days. The volatility has been decreasing over the past years to a low of only 1% daily deviation by the end of 2016, but has since increased again above 7% which makes bitcoin almost unusable as a day-to-day currency. For comparison, the daily volatility of gold is around 1.2% and the exchange rate between major fiat currency has a daily volatility of about 0.5–1.0%.

Volatility fuels the use of a cryptocurrency as a speculative asset. However, if something is speculated on to increase in value, it will not be used for day-to-day transactions. For example, rarely anybody would buy a Pizza with bitcoin today if they believe that they are giving up a multiplication of value over just a few months. On the flipside, if the price of a cryptocurrency decreases significantly over a period of time, owners are incentivized to spend their coins all at once for goods and services, effectively creating a “hot stone” that gets thrown around with high velocity in the market. Therefore volatility is to be prevented to retain the medium of exchange and store of value properties of a currency. Also, defining prices of goods and services gets more difficult as prices fluctuate, making the currency unsuitable as a unit of account.

How can a stablecoin be achieved?

A recent Medium article discussed the three major types of stablecoins. These strategies are summed up below.

                                                       Three Stablecoin Strategies (source)

Fiat-collateralized stablecoins are the most straightforward way to create a stable currency. A certain amount of fiat currency is deposited as a collateral and coins are issued 1:1 against this fiat money. Although this method is simple and robust, it requires a central party (custodian) which guarantees the issuance and redeemability of the stablecoin. Regular audits are needed to ensure that the stablecoin is indeed fully collateralized. Naturally, other pegs such as gold, silver or oil are also possible.

Crypto-collateralized stablecoins work quite similar to their fiat-counterparts, with the exception that the collateral is not an asset in the “real-world” but rather another cryptocurrency. To account for the price-volatility of the underlying crypto-collateral, these stablecoins are often over-collateralized. This means that one needs to deposit, for example, $200 worth of ETH to receive $100 worth in stablecoins in return. In this case, even if the price of the underlying asset depreciates by 20%, the stablecoin can still keep its price stable as there are still $160 worth in ETH collateral backing the value of the stablecoin. However, in case of a black swan event, where the underlying asset becomes completely worthless, the stablecoin would collapse too. In this case the loss-exposure would even be amplified for the stablecoin owners because of the over-collateralization. This is also why some experts are strongly discouraging this approach.

Non-collateralized stablecoins are not actually “backed” by anything other than the expectation that they will retain a certain value. One often-mentioned solution to non-collateralized stablecoins is the seigniorage shares approach. This concept builds on smart contracts that algorithmically expand and contract the supply of the price-stable currency much like a central bank does with fiat currencies, but in a decentralized manner.

What stablecoins do exist today?

There are several projects working on bootstrapping a stablecoin and each one has their advantages and disadvantages. Let’s explore some of the more popular stablecoins in more detail.

Tether is a stablecoin with a 1-to-1 peg against the USD, whereas the conversion rate is 1 Tether USDT equals $1 USD. For every Tether USDT in circulation, $1 USD is added to a centrally managed savings account as a collateral. However, some people doubt that Tether is actually fully collateralized.

Pro: Simple concept | Con: Centralized, questionable activity

MakerDAO is a decentralized autonomous organization that is pegged against the U.S. dollar, but is completely backed by ETH. Each “Dai” is worth $1 USD. Stability is maintained through an autonomous system of smart contracts.

Pro: Completely fiat-less | Con: Highly complex

Basecoin also pegs their price to $1 USD but is a non-collateralized stablecoin. This approach uses consensus to contract and expand supply of their coin.

Pro: No collateral needed | Con: Faith in protocol required

TrueUSD is building a USD-backed stablecoin that is 100 percent collateralized. Much like USD Tether but legally protected and transparently audited. TrueCoin has developed a legal framework for collateralized cryptocurrencies in collaboration with Cooley and Arnold & Porter, and has a growing network of fiduciary, compliance and banking partners.

Pro: Focus on privacy | Con: Centralized

Other projects include:

Stablecoin criticism

Critics of stablecoins suspect that stablecoins, in particular crypto-collateralized stablecoins, are inevitably doomed to fail, because even over-collateralized stablecoins would not survive a black swan event. Also real-world currency pegs, such as the Saudi Arabian Riyal which is pegged against the US Dollar, often get too expensive to uphold in the long-term.

Others doubt that pegging a cryptocurrency to a fiat currency such as the US Dollar is the right fundamental problem to solve in the first place. First, because the US Dollar is not stable after all, loosing purchasing power through inflation and volatility in exchange rates. Second, a fully USD-pegged cryptocurrency would just end up being yet another USD derivative, potentially making it subject to national legal tender law. According to this reasoning, an actual stablecoin should not be stable towards a fiat currency but rather remain stable in its purchasing power.

An outlook on stablecoins

Only time will tell whether we will ever see a mainstream stablecoin. Smart contracts could help keep a stablecoin’s value constant and make it an effective unit of account. The outstanding problem, however, is that no team has been able to develop a universally accepted stablecoin that does not compromise features of either privacy, security or decentralization.

A successful implementation of a stablecoin could potentially be a major catalyst for fundamental long-term innovation in the crypto-ecosystem. Lack of price stability prevents cryptocurrencies from displacing most forms of fiat money and enabling decentralized applications, stablecoins can provide the solution. A broadly established fiat-free currency that’s price stable will likely challenge the legitimacy of weak government-issued currencies around the world.


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