For all the pundits predicting that decentralized financial assets like cryptocurrency will be the “future of money,” there’s been one consistent hurdle to that idealistic future: stability.
In the traditional fiat world, designating an asset as currency typically requires it meet 3 basic requirements: a form of exchange, a unit of account, and a store of value. When applying the same framework to today’s crypto world, it becomes evident that while very functional as a form of exchange, volatility is a key driver in crypto's shortfalls on the others.
And without a cryptocurrency that can achieve those elements, as well as the trust of its users, we’re unlikely to see crypto used as a day-to-day transactional currency with mass adoption any time soon. While even the most adopted coins like Bitcoin and Ether have been revolutionary in their contributions to crypto longevity, their price volatility has led to both merchant weariness and speculative investing.
When paying for goods and services, a currency’s stability is crucial in making sure that neither buyers nor sellers lose value in the process due to price volatility. From a trading perspective, having a truly stable crypto asset to keep your funds safe from price swings but fluid for re-investing is important to furthering adoption of crypto assets as an (even speculative) investment vehicle.
Enter Stablecoins: cryptocurrencies that apply a framework to achieve stability of value, or put simply, price stable cryptocurrencies.
Stable in value with theoretically no price volatility, this new class of crypto assets has the potential to serve as the backbone of financial applications on the blockchain, and lead to further adoption for both crypto trading & eventually use as a day-to-day transactional currency beyond fiat.
With such high stakes, it’s no surprise that several (and few very well-funded) stablecoin projects have been attracting a lot of media attention lately. We mention some of them below, but with interest in this new class of assets rising so quickly, we wanted to give our readers a breakdown of the different approaches being taken.
Although we’ll no doubt see more iterations as projects vie for the stablecoin crown, most approaches to date fall under one of these three categories:
The fiat collateral system is the simplest and most straight forward approach. A certain amount of fiat currency is deposited as collateral and stablecoins are issued 1:1 against it, making the fiat currency the trust system backing the value of the stablecoin. This is a more centralized approach to stablecoins wherein a central entity holds money as collateral and issues a token that represents the money held by the entity.
Tether is one of the first and most popular examples of this strategy. Their USDT token is pegged to the US dollar at a 1:1 ratio and regular audits ensure that it is indeed fully collateralized. However recent audits indicate they may not have all the USDT in circulation collateralized – which is particularly concerning considering they recently climbed into the top 10 in terms of overall market cap across all crypto assets.
Critics say that while a fiat-pegged stable coin could withstand some of the most volatile crypto market conditions, it falls short simply with its dependency on a fiat currency’s price – which itself is centralized and vulnerable to inflation and forex volatility.
The crypto-collateralized stablecoin is backed by another cryptocurrency vs. fiat, offering a much more decentralized approach with the totality of transactions occurring on the blockchain. However considering the price volatility of most cryptocurrencies, this approach requires over-collateralizing the stablecoin with massive amounts of committed capital for any chance of success.
Essentially, a larger quantity of one cryptocurrency is used to issue lesser units of a stablecoin - giving room for inflation or price drops while keeping its value stable with the excesses accounted for. For example, $100 USD worth of LTC would be reserved to then issue 50 $1 USD valued crypto-collateralized stablecoins. In this case if LTC’s price dropped 20%, the 50 $1 USD stablecoins would still be collateralized by the $80 USD worth of LTC and hold their value.
Beyond jut the initial upfront capital, critics call out the ‘black swan’ event, where the underlying cryptocurrency becomes worthless, in turn causing the stablecoin to also collapse. In this worst case scenario, the loss would be amplified further for the stablecoin owners because of the over-collateralization. Several projects are tackling these challenges, with one of the most popular to date being MakerDao’s Dai stablecoin, collateralized by Ethereum. Another we’ll likely see activity from soon with a unique approach to crypto-collateralization is Reserve, which recently made headlines with investments from Coinbase and seasoned Silicon Valley investor Peter Theil among others.
In this system, no collateral is needed in order to regulate the value of the stablecoin. Instead, smart contracts algorithmically expand and contract the supply of the stablecoin, much like a central bank - only automatic and decentralized. For example, if a particular stablecoin’s value was pegged to $1 USD, the supply would automatically increase if the price rose above $1, and supply would decrease if the price fell below $1. This mechanism creates upward and downward pressure on the price when necessary to ensure its consistent purchasing power.
The leading example of this approach is Basis, marketed as a “price stable cryptocurrency with an algorithmic central bank.” Launched in 2017 and backed by the likes of Andreessen Horowitz, Bain Capital, and DCG, Basis implements a system similar to that of a central bank, making use of base coins, base bonds, and base shares.
If Basis or others are able to deliver on this non-collateralized vision, these stablecoin assets may have the best chance of long term success. Critics are quick to point out however that they depend on investors trusting the future growth of the coin by buying the equivalent of seigniorage shares, which can lead to massive losses in value if confidence falls.
Stablecoins are very promising for the mass adoption of crypto at large and will likely even play a role in the market’s short and mid-term price outlooks. And if they can achieve true decentralized price stability, stablecoins would issue the first real and large scale challenges to the legitimacy of centralized, government-issued, inflation-susceptible fiat currencies around the world.