The Rise of the Stablecoin
Stablecoins have often been referred to as, “the holy grail of cryptocurrency.” Maybe it is because they promise to bring stability to an extremely volatile market, or because they are a potential proof-of-concept which could change digital assets forever. Whatever the case may be, the race to develop stablecoins is heating up.
The idea behind stablecoins is simple: create a digital asset which never fluctuates in price and can be used as a method of payment and store of value across the globe. The importance of a trustworthy stablecoin in the industry currently is obvious when compared to cryptocurrency as a whole.
This was pointed out by Origin Protocol co-founder Josh Fraser.
I don’t know whether the price of that crypto is going to go up or down, but it’s almost certainly not going to be the same as it is today. That introduces the problem [for] either the buyer or seller…as part of that transaction.
To date, cryptocurrencies have been much too volatile to use as currency in its truest sense. The benefits of relative stability in a digital asset are immense and could provide a missing piece in the growing digital economy.
Properties of a Stablecoin
In order to be seen as a stablecoin, a digital asset must pass several tests to ensure it is able to not only maintain its price, but be a usable currency in any situation. A cryptocurrency can only be a stablecoin if it is:
- Store of value
- Medium of exchange and mean of payments
- Have own blockchain
In case of tokens they could be a stablecoin, only if they fits to next features:
- Store of value
- Medium of exchange
- Built-in price stabilization measures
It’s not enough for a stablecoin to maintain one or a few of these properties, it must fulfill each of these requirements in order to have a chance of becoming a currency.
A currency is fungible if it is easy exchangeable or substituted for other units of the same currency. One 5 euro note is worth the exact same as another 5 euro note, making it a fungible form of currency. This is property which applies for all forms of working currency.
Having a currency be divisible makes it easy to conduct smaller transactions. Precious metals such as gold and silver are not very divisible, which is one of the reasons they are rarely used in transacting.
Because they are digital forms of money, cryptocurrencies are easily divisible into fractions as small as 18 decimal places. This makes it simple to sub-divide assets and make micropayments.
Store of Value
This is a big one for stablecoins as their cryptocurrency counterparts are proving to be terrible as a store of value, and unlikely to be an asset which retains its value over time.
As the price of cryptocurrencies, such as Bitcoin, fluctuate heavily, users quickly transfer value out of these cryptocurrencies in search of a safer, more stable asset. This flow of capital out of cryptocurrencies make them only a go-between on transactions, and not a place where value is stored for the long-term. Stablecoins seek to be the store of value the cryptocurrency industry needs and give users the confidence to store significant value in these digital assets.
Medium of Exchange and a Means of Payment
The kicker here for stablecoins is the lack of real-world adoption of cryptocurrencies to pay for goods and services. A stablecoin must be viewed as a legitimate and easy way to exchange value for goods and services on a regular basis, as method of payment in any situation. Until a stablecoin is viewed as a medium of exchange and a means of payment, it provides little use.
Because fiat currency has been viewed as the ultimate medium of exchange over the past hundred years, it will take time to convince the general public that a stablecoin can provide the same medium of exchange value coupled with the other stablecoin features which make it a better form of money.
Price Stabilization Measures
For a stablecoin to hold its price at any given time, it must have built-in measures to maintain stability in any market condition. These stabilization techniques can be make-or-break for any stablecoin and represent the methodology in which a coin accomplishes its goal of keeping its price level. Without methods to stabilize price, stablecoins wouldn’t exist.
Have Its Own Blockchain
In order for a stablecoin to maintain its stability it must operate on its own blockchain. Often times a stablecoin blockchain will operate in conjunction with another blockchain for increased security and validation. A stablecoin built with another blockchain is at the mercy of that chain and will never have true autonomy. Regardless of how it is designed, any cryptocurrency with the hopes of maintaining price stability must have its own blockchain in order to operate as a stablecoin.
How Are Coins Stabilized?
The function of maintaining a stable price can be achieved in a variety of ways. Stablecoins can be collateralized in three ways:
Each of these methods has its benefits and drawbacks, which bring into question the best methodology for designing a stablecoin.
The idea in theory is simple. Peg one unit of cryptocurrency to one unit of any fiat currency. This should result in the exact amount of cryptocurrency being backed by a reserve of fiat currency. Coins are created when users make a purchase, and coins are destroyed when they liquidate any capital back into fiat currency. Fiat collateralization is a subset of asset-backed cryptocurrencies.
Creating a stablecoin which is pegged to fiat currency requires significant third-party trust that a custodian will perform the actions of creating and destroying the digital currency based on market actions. This also requires regular financial audits to ensure there is an adequate amount of reserve fiat to cover the floating cryptocurrency.
Instead of reverting back to fiat currency or other assets to collateralize a stablecoin, there are some which have chosen to back their stablecoin via cryptocurrency. A crypto-collateralized stablecoin can be easily verified via smart contracts which hold collateral in a transparent manner.
However, because they are collateralized by cryptocurrency these types of stablecoins represent more of a price volatility risk, as a crash in crypto prices could create instability in crypto-collateralized coins.
The most complicated category of stablecoins, non-collateralized coins, utilize a combination of mathematics and economic principles to maintain price stability. The most common method of non-collateralized cryptocurrency is using seigniorage shares.
Seigniorage shares is based on mathematics and algorithms to control money supply in a cryptocurrency. The methodology, first coined in a 2014 paper by tech CEO Robert Sams, operates via algorithms which purchases and sells a stablecoin based on certain market conditions in an attempt to maintain market equilibrium.
Non-collateralized stablecoins have yet to be fully developed and released into the mainstream market. Therefore, these come with a significant amount of unknown risk for those involved. There are many industry experts who believe the idea of creating a central banking system based solely on mathematics is a dangerous idea.
Will They Work?
Stablecoins feel like a utopian idea, one which is promised but never fulfilled. Whether a stablecoin is backed by fiat currency or an algorithmic control of money supply, there remains significant skepticism of their validity. These range from questions of use, to that of outright fraud.
Tether (USDT), the stablecoin pegged to the US Dollar, has come under fire for questions of its reserves to back-up its market peg. Many believe Tether doesn’t hold enough US Dollar reserves as it claims to support its cryptocurrency floating on the market, turning it into a fractional reserve system. For this reason, the price of USDT has been seen floating up and down, at times losing its peg to the US Dollar.
Stablecoins which are not collateralized are viewed by most economists as nothing more than a false promise. University of California, Berkeley Economics Professor Barry Eichengreen doesn’t take too fondly to the stablecoin promise.
The problems with the latest wave of cryptocurrencies will be familiar to anyone who has encountered even a single study of speculative attacks on pegged exchange rates, or to anyone who has had a coffee with an emerging-market central banker.
There has yet to be a stablecoin which has proven its price stability in addition to the other properties needed to become a widely used currency. This has led to significant questioning of the entire stablecoin market and if it can truly perform the functions it claims.
Stablecoins on the Market
The demand for a solid, unmovable stablecoin is higher than ever. This has created a sub-genre of cryptocurrencies which are flooding the market, hoping to prove themselves as the solution to the stablecoin dilemma.
Tether has significant problems maintaining its peg to the US Dollar, making room for new market entrants backed by fiat currency. The Gemini Dollar is the first regulated stablecoin, monitored by the New York State Department of Financial Services. This stablecoin can be used on the Ethereum network and are backed at a 1:1 ratio with US Dollars as monitored by a verified financial third-party.
Gemini hopes its stablecoin will create a better way to exchange value globally. Gemini co-founder Cameron Winklevoss noted, “While cryptocurrencies operate 24/7/365 (similar to email), fiat currencies only operate during specific “business hours” (like snail mail) — a fundamental mismatch. As a next step in our mission, we must improve the linkage between these worlds by giving fiat currency the same desirable technological qualities of cryptocurrencies.”
The MakerDao Dai stablecoin is designed to maintain a stable value across the globe at all times. The Dai is said to be pegged to the US Dollar, but is done in a much different way than other fiat-backed cryptocurrencies.
Dai allows users to obtain crypto-collateralized loans in exchange for Dai tokens. The cost of borrowing Dai becomes more expensive when the price is lower than its target, and the cost of creating more Dai reduces when the price is above its target. This creates an economic model which veers towards stability as the token supply increases and decreases. If the underlying collateral of Dai-backed loans falls too far, liquidation of underlying assets will be triggered to prevent a falling price.
Labeled as an “algorithmic central bank,” Basis is a non-collateralized cryptocurrency on a mission to revolutionize the entire stablecoin industry.
Basis is pegged to the US Dollar, but stabilizes its currency not by using collateral, but instead by controlling its money supply. When demand for Basis is rising, more currency will be created on the blockchain. Alternatively, when demand is falling, currency is repurchased by the blockchain and supply is controlled. This is meant to mimic a government-controlled central bank which is instead governed by mathematical and algorithmic laws.
Basis is led by a team of experts in algorithmic trading, quantitative finance, and machine learning which have designed its central bank-like structure.
While many major cryptocurrencies promote themselves as currencies, they don’t maintain the price stability necessary to be used as such. The ongoing development of stablecoins is where the rubber hits the road, and where true adoption of cryptocurrencies as new forms of digital payment will be realized.
Balaji Srinivasan, the Chief Technology Officer at Coinbase hammered the point home.
Stablecoins bring some of the early potential of crypto into view, and they make possible payments that are very small, very fast, very large, very international, very transparent and very automated.