A Comprehensive Guide to Stablecoins: Finance of the Future
There are many schools of thoughts that explain market behavior and sentiment with regards to information up gradation. A lot of schools of thoughts that were once accurate, seem not to be so true right now.
But there’s one that has stood the test of time, the Efficient Market Hypothesis. It also happens to be highly disputed.
Basically, the hypothesis states that markets are always ‘efficient’ in the sense that the numbers of the market represent the quantification of all publically available information.
For example, share sell-offs preceding a dividend accounts for the potential increase in the value in the share-price itself; before said dividend, where the share-price is the addition of share price and the dividend to be received.
Already, you might have noticed several drawbacks to this. So have a lot of people. A major one is the fact that it might not necessarily be true that all information is available to all people during all the time. More importantly, rationality among investors, which is a major assumption for the hypothesis, is not always the case in real world.
Still, it has remained popular in the general conscience and has guided both individuals and institutions alike to address volatility in a much more concise, quantifiable manner. It has also guided governments too look at the variables affecting volatility within the supply-chain of said information.
Volatility is as ruthless as it is necessary for trading actions. Volatility is a major reason why blockchain backed cryptocurrencies received the size of market cap that they did. It’s the reason why the adoption of blockchain solutions and blockchain services was exponential to the extent that within the first decade of the technology being popular, there are already applications building on top of it. Things like NFT development services were built on blockchain technology. Volatility is key here.
However, one of the reasons why fiat-currencies worked for so long was because they were not only an efficient, divisible medium of exchange, they were backed by an institution like a monarchy, oligarchy or governments. There were stable. For a while there, it’s one of the issues that plagued cryptocurrencies.
What are Stablecoins?
Stablecoins are coins that are pegged to another currency, commodity or algorithm which it derives its value from. Think of it as a derivative, in the same sense that fiat currency is a derivative of USD which is a derivative of gold.
However, stablecoins offer a bit more flexibility than those. See, no matter how nice your friendly, neighborhood government is, you can’t really go to a central bank and ask for the amount of gold that your promissory note promises to be backed by. I don’t know why either.
You can sort of do that with stablecoins. In fact, being ‘pegged’ to another currency means that if you should choose to do that, via the institution or secondary market, it will always be at a fixed rate. That ratio would be seldom affected by market fluctuations, and even if they do, there is a clear incentive for arbitrage for market participants that would bring it closer to the ratio.
The promise, much like your regular promissory note, is not only to be backed by an asset, but also to be able to exchange with an asset. This provides stability, if you will. Why?
Take BTC. In March 2020, when we entered the pandemic, BTC was around $4K. By the same time next year, it was around $32K. That’s roughly 800% YoY increase. Roughly. 800%.
The next year, same time, after touching $69K mark, it was around $40K. At the time of writing this article, it’s around $19.6K. You get the idea why.
The thing is, if any part of Efficient Market Hypothesis is true (and it is!), then new information is the primary source of movement in prices. The problem with currencies that are wide and global is that factors affecting it are also wide and global. This means violent movements on chart, which is good for trading; but not really a valid variable when the application is being a dependable currency. Stable coins intend to solve that.
How do Stablecoins work?
The idea here is along with normal functionalities of a conventional market, like buy, sell or stop, the additional functionality of stability is built into the asset itself.
For instance, Tether’s UST is backed by US dollar in the ratio 1:1. This means for every unit of USDT that is in circulation, there is one USD in reserve with Tether. Ideally, but more on that later. Tether, ideally, should manage this collateral with the help of a government custodian who regularly audit the reserve, and effective smart contract development, which would maintain said reserve.
This, however, is one way it is done. Stablecoins can be backed by anything, there are even stablecoins coming into the space that are going to be backed by consumer price indexes and countries’ market indexes. Usually, they’re created in one of three ways.
1. Fiat-Collaterized Stablecoins:
Like the name suggests, fiat-collaterised stablecoins are backed with a fiat currency reserve, or a basket of reserves. It can also be backed by other reserves, for example precious metals like gold or commodities like crude oil. In practice, however, it’s usually USD or USD equivalent. Examples include Tether’s UST and True USD (TUSD)
2. Crypto-Collaterised Stablecoins: While the name is pretty self-explanatory, stablecoins backed by crypocurrencies do face a bit of an insurance problem. Cryptocurrencies are highly volatile, which means the movements on either side have larger deviations, and when you have a ‘stable’coin, these deviations have to be accounted for. As a result, crypto-backed stablecoins have to be over-collaterised. Sometimes, that collaterisation rate even goes as high as 200%; for every stablecoin issued, there are 2 cryptocurrency coins in reserve. This results in massive opportunity costs due to a forced-hold of funds, which is why firms usually prefer a combination of crypto and fiat. Notable examples include MakerDAO’s DAI and EOSDT token.
3. Algorithmic Stablecoins: They are sort of like banks, in that, they do not hold reserves, but they function with smart contract creation which regulate and maintain the supply of the currency. The aforementioned index-backed stablecoins are also examples of algorithmic stablecoins. However, stable coins don’t always work out.
Terra is basically a blockchain for dApp development services, however most of their decentralized applications are limited to infra applications, on which people trade. Terra has two stablecoins, UST and Luna.
In order to create UST, you have to first burn Luna. For example, if Luna was worth $20, it would result in creation of 20 UST, and the Luna token in question would be destroyed; which makes sense from a stability point of view. The dollar value of that burned Luna would be used to back UST, which could further be used for operations like lending.
To incentivize users to create UST, Terra offers a 19.6% yield for staking i.e. 19.6% keeping your money with them. About 70% of the funds deposited with them were under this scheme.
The idea was that if UST falls below the $1 mark in the market, arbitragers could just buy it and exchange it for Luna, until the price rose back to $1. If situation was on the other end of the spectrum, you could just burn Luna to get UST for a dollar, unstaking that to make a profit.
However, there was a catch, only about $100 million worth of Luna could be burned a day, which sounds like a lot, but really isn’t. On May 7, over $2 Billion worth of UST was unstaked and hundreds of millions immediately sold.
These sells put a deflationary pressure on UST, pushing the price down to 90 cents. When traders couldn’t unstake, they started selling, so much, that the price for UST dropped below 20 cents. Luna’s fate was even worse, at 1 cent.
Like a cherry on top, this was followed by New York’s attorney general accused Tether of lying of how much it had in reserves. Whether it was true or not, it was real enough that deflationary pressure all but consolidated.
There are reports, which point to this being a consolidated attack from crypto’s fiat counterparts. Whether that’s true is yet to be discovered. However, this does not mean stablecoins are a failed venture, because every time cryptocurrencies become too volatile, traders flock to stablecoins. It might be an unperfected technology, as of yet, but that does not mean it’s not a valid solution.