Why Cryptocurrencies Need Stable Coins
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Have you ever heard that joke about the Zimbabwean mother that goes out to buy bread? No, well, it goes something like this:
A mother wakes up one day in Harare, Zimbabwe, and goes to the bakery to buy bread. Due to Zimbabwe’s crippling skyrocketing inflation she takes a shopping cart and fills it to the brim with bank notes, for that’s exactly how much bread cost, yesterday afternoon. However, when she gets to the bakery the price of bread has once again gone up by 5% and so, she is short on money. She parks her cart full of bills in front of the bakery and goes back home for the remaining cash. When she gets back, however (albeit none surprisingly) she has been a victim of theft. Ill-intended actors have stolen her shopping cart, but left all the bills behind.
There is one single important image to take from this poorly-elaborated story. The shopping cart represented a more stable store of value than the Zimbabwean dollar. Now you care about cryptos and believe you are witnessing the biggest financial revolution in generations, but perhaps haven’t taken the time to address the issue of price stability and how it hinders mainstream application of blockchain tech.
For cryptocurrencies to be considered currencies, in the traditional sense, they should fulfil three essential functions: being a medium of exchange, a unit of account, and a store of value.
Cryptocurrencies are very good as a medium of exchange, cheap, trustworthy, quick, but are poor as means of storing value. That is due to their price volatility. While the crypto world continues to be dominated by highly unpredictable currencies, their use for long-term financial activities, like loans, credit notes, and any sort of investment is extremely limited. Hence the need for or dream of the stable coin.
What are stable coins?
The definition of stable coin, as the name so obviously indicates, are cryptocurrencies that retain a constant value, in contrast to most tokens, which see price gains and losses of over 10% on a regular day. They are considered the single most important untaken step towards the practical widespread use of cryptos for everyday financial transactions, from paying for coffee to buying a new car.
Their relevance however, is pegged to long-term predictability. For companies to issue long-term loans to individuals, provide health insurance or make long-term investments, which are the basis of modern day economic systems, they need to be able to predict return on investment and be sure they will not face unsustainable price highs or derailing price losses.
Until we can have a strong stable coin in the crypto universe, cryptos will always be a target of speculation and keep away a myriad of risk averse individuals and businesses.
What models of stable coins are there?
So far, three different models of stable coin have been tried, with challenges and advantages inherent to each of them:
Stable coin collateralised by fiat
The simplest and most functional form of stable coin in existence today is achieved by fiat collateralisation. There is to say that a company will issue as many tokens as the amount of fiat currency it has in a bank account on a one to one ratio. This system is resistant to crashes and volatility as its value is dependent on the value of the real-world currency it is pegged to, that is, as long as you believe the company issuing the tokens is not overstepping its boundaries.
Well known examples of this sort of stable coin are Tether and TrueUSD, which are backed by US dollars. For each of these tokens in circulation there is one US dollar in the companies coffers. The problem with this system is that the issuer controls the system and the holder must believe that the issuer not only actually holds the collateral in full, but that it will be willing to trade it back, doubts that surround Tether and other such organisations to this day.
Stable coin collateralised by crypto
Now, cryptos collateralised by other cryptos are a bit trickier, because if you back a stable crypto with, let’s say Monero, the stable coin will be subject to Monero’s volatility. That will not do. In order to reduce the level of volatility, a coin can be over-collateralised. This means that for each USD$100 of the stable coin, the issuing company will deposit USD$200 worth of Monero. A protocol can be established that if Monero ever goes below the initial established value of the stable coin, in this case USD$100, that coin can be automatically liquidated into Monero, but that leaves the investor once again exposed to volatility.
This system offers are considerable gains in decentralisation and trust, since the collateralisation and liquidation are inscribed into an automated smart contract, but it is hardly a full proof solution against volatility and it implies considerable investment to over collateralise the coin. The most well known such coin today is the DAI, which is collateralised by Ether.
Non-collateralised stable coin
Finally we have the most ambitious and complex model of them all, the stable coin that is not collateralised by anything. The idea here is to model a smart contract as a central bank issuing coin. If the demand for the coin is high and the price starts to rise, the smart contract can issue more coin and sell in the market pressuring the price of the coin down. If the demand is low, the smart contract can buy the coins in the market and burn them to reduce supply and bring the price back up.
The earnings of creating and selling new coin in the open market are expected to offset the cost of buying back coin for burning in order to raise the price. The idea is very appealing as it could really represent a challenge to the current fiat system. There are a few drawbacks though.
If the market pressure goes down continuously, the contract might run out of funds to continue to buy coins in the open market, which would leave the coin again open to volatility or even complete crash. Like in the case of Basecoin, a non-collateralised stable coin, the contract can sell bonds to coin holders which pay a dividend on top of the principal price in order to continue to buy coins and push the price up. However, the issuing of the bons is dependant on the holder’s belief in the future of the currency.
In this way, the system is dependent on a continued economic and system growth, which, while common amongst most world fiat currencies, is not a given. Further, the currency’s ability to resist these downward market pressures would be difficult to analyse, and it would demand a considerable amount of initial capital to deploy until it reached the desired balance. However, non-collateralised stable coins would be a sort of holy grail for cryptos. They would be fully independent from fiat and even other currencies, and above all, independent of any political system or currency policy imposed by central banks.
Stable coins 2018: what to expect
It is difficult to say when these or other projects will find solutions for the challenges that the widespread dissemination of stable coins still faces. It is certain that a number of projects are trying hard to come up with answers. Others in the crypto world believe the pursuit of stable coins is a fool’s run, an impossible task, or even an undesirable one at that.
Certainly, we will see many more projects emerge in this sector throughout the year. In a time of downward pressures in the market stable coins start to sound like a better idea than when Bitcoin was skyrocketing. Nubits, for instance, another coin pegged to the dollar, saw its market capitalisation skyrocket in January. After it had been mostly ignored by investors since its inception in 2014, its market capitalisation went from under USD$1 million to over USD$14 million in 5 days. Articles in the media heralded it as the real threat to fiat currencies, and then, in mid-march, its USD$1 stable coin started to stumble and lost over 60% of its value in three weeks. It now trades at USD$0.31. This and other examples tell us that the road my still be a bumpy one in the quest for the truly stable coin. However, at the speed that the crypto world changes it is fair to assume that sooner or later an innovative solution will make an effectively stable, trustless, and sustainable coin a reality.
Originally published at www.coinvision.co.
