Why Stablecoins Will Not Be Able To Maintain the Peg

An inevitable collapse

Stablecoins are pegged to another currency. Usually, this is the dollar. In the crypto market, we currently have $100 Billion in stablecoins, close to reaching 10% of the entire industry market cap.

All pegged exchange rate arrangements are subject to predicaments that cast doubt on the ability of the policymakers to maintain the peg.

- Harris Dellas (professor at University of Bern) — Source (2002)

Throughout history, there have been many attempts at pegging a national currency to another one. The peg is usually fixed to the dollar, and quite often, the result was a catastrophic failure.

National fiat currencies like the Argentinean Pese, Thai Bhat, the Lebanese Pound, and many more were all fixed (pegged) to the dollar and completely failed unable to maintain the peg, and the currency crashes. Inflation usually adjusts higher as the first response of Central Banks after the fail of the peg is to increase the money supply.

Floating and Fixed Cryptocurrencies

Stablecoins in the cryptocurrency industry is a similar concept to the fiat currencies pegged to the USD.

Just as with the foreign exchange market (Forex), cryptocurrencies are also divided into two different types according to their exchange rate.

Floating Cryptocurrencies

Floating cryptocurrencies (non-stable ones) are aiming to achieve higher adoption levels since the network effect provides increased value to the system. This value in each blockchain project is displayed in the price of the underlying cryptocurrency.

Threats:

The price of cryptocurrencies is subject to regulations and acceptance by governments. Negative regulations like a blanket ban (India in 2018) or restrictions in trade (China 2017) results in the reduction of users, thus demand reduction.

The fixed supply of some of the top cryptocurrencies (BTC, BCH, LTC) helps to withstand lower demand levels and recover later. Other cryptocurrencies with low inflation in supply (Ethereum) can also find support and not completely collapse.

However, demand is equally crucial to supply, and the network effect is what pushes the prices of cryptocurrencies to higher levels. Together with limited supply, it creates massive waves of volatility.

A huge reason I am against the Stock to Flow model is that it doesn’t consider demand and doesn’t contain the network effect. This is also the reason I dismiss BTC as an investment, as the BTC asset lacks utility, and the network effect of other decentralized blockchain networks provides better odds and risk/reward ratio for the long run.

Fixed cryptocurrencies (Stablecoins)

Stablecoins are pegged to a fiat currency, usually the dollar. They are also divided into two different categories:

Corporate Stablecoins (USDT, USDC, Libra)
Decentralized stablecoins (DAI)

Libra was facebook’s attempt of creating a regulated parallel currency, pegged to a basket of currencies. In late 2020 it changed the name to Diem and pushed for regulators to accept it, however, it already looks like a dead project.

There was no way the US government and the FED would ever accept a private entity launching a competitor to the USD, especially at a time when cryptocurrencies were already considered a threat.

Centralized currencies created by private companies require consent and recognition by governments to proceed. They face existential issues in case they fail to convince the regulative financial authorities. USDT, USDC, and other stablecoins are centralized and under the control of a parent company.

In this sense, it is way worse for a stable coin since it can cease to exist if the US government decides so. It is no different from the issuance and eventual shut down by the US government of “ Liberty Reserve” or “E-Gold”. Being centralized equals being subject to regulators along with possible charges for financial irregularities and fraud for the operators.

Moreover, stablecoins are subject to maintaining their fixed rate. This can be challenging during a market downtrend. Stablecoins are mostly used for trading in exchanges. They helped exchanges reduce the required huge bank deposits and provided more liquidity in the market.

Maintaining the peg will also require having an equal valuation in assets as collateral. This requires complete transparency from the parent companies that issue these stablecoins, something that the top stablecoin, USDT, has been avoiding for years.

DAI

DAI is a decentralized smart contract running on the Ethereum network and has an interesting system of collaterals. It is a system created by MakerDAO with the concept aiming to reduce risk from high volatility. Investors collateralize assets accepted by MakerDAO (mostly ETH) and give back DAI in return.

It is a system I am still researching and try to thoroughly understand the potential ramifications it could produce. However, it is based on very volatile reserve assets (Ethereum and ERC20 tokens), and for the time being, there is no real economic application. There are thoughts by MakerDAO to include some types of real-life assets as collateral, something that will bridge the gap between the traditional economy and DeFi. It is also decentralized and censorship-resistant, making it probably the best option out of all stablecoins so far.

Conclusion

There are fiat currencies pegged to the dollar that face no problems since they are backed by booming economies. China has had a peg to the dollar for decades, and only last decade it decided to slowly adjust the exchange rate. The Yuan (or Renminbi) is considered to be suppressed in valuation versus the USD. This was in order to increase China’s exportations and GDP growth.

Before Bitcoin, all previous attempts of creating a digital currency failed mostly because of their centralized features. One admin was able to block transactions and shut down the whole network. Most of the stablecoins currently are centralized and can be censored.

The P2P transactions network and the blockchain allowed Bitcoin to overcome any government censoring and provided access to a modern payments network that empowered the individual and removed the state and banks from the transactions equation.

The unauthorized issuance of new money in any form is prohibited by financial regulations all over the world. Stablecoins are centralized entities inside the fully globalized cryptocurrency industry.

Tether issued USDT in 2016, creating this new category in the market, stablecoins, and they have been increasing their market dominance since then. I’ve explained my thoughts and position on Tether’s USDT in this article: Tether ($USDT): An Accident Waiting To Happen.

Stablecoins are pegged another currency usually fiat. Most are pegged to the dollar, and history has taught us the financial regulative bodies do not enjoy competition to the national fiat.

Besides the current centralized state of stable crypto assets, a second drawback is the underlying assets required to back these stablecoins. Reserves should be equal to the total marketcap of the stablecoin however, often, we see them lacking transparency and the parent companies being unable to provide adequate proof.

Also, volatile assets used as reserves could create an additional danger. In case reserves are in extremely volatile assets, then the peg of 1:1 with the USD is probably very difficult to maintain for a long period of time.

As with all pegged national fiat currencies, eventually, the exchange rate will have to change, since economies are rapidly changing and experiencing boom and bust cycles. The burn of tokens held in supply by the parent company is going to look similar to the Thailand government trying to sustain the peg to the USD and reduce depreciation by purchasing Bhat.

Lead Image from: Vulcanpost

References:

Wikipedia: Liberty Reserve
Wikipedia: Network Effect
Investopedia: Top Exchange Rates
Investopedia: Pegged vs Floating Currencies
JSTOR: The Collapse of Exchange Rate Pegs

Originally published at https://read.cash.

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Why Stablecoins Will Not Be Able To Maintain the Peg

An inevitable collapse

Floating and Fixed Cryptocurrencies

Floating Cryptocurrencies

Threats:

Fixed cryptocurrencies (Stablecoins)

DAI

Conclusion

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