Stablecoins and the Stability Misnomer
In the beginning, there was Bitcoin. Purists will tell you otherwise, but there’s no denying that for most, it’s the first cryptocurrency that comes to mind when one thinks of the word. Since Bitcoin, multiple iterations of cryptocurrencies have emerged, each promising to fulfil a need greater and more urgent than the last. And since Bitcoin, the world has seen the rise of a euphoric bubble of mainstream attention and accompanying price action, as well as the later bursting of said bubble.
Which leads us to today.
It may be because the current bear market has shown us the negative impacts of volatility, but people seem to be seeking an alternative digital asset that presents all the boons of distributed ledger technology with none of the banes. And the answer, many believe, lies in the stablecoin.
Understanding the Stablecoin
As its name suggests, a stablecoin is a cryptocurrency that is, well, stable. At least with regards to price action.
Increasingly viewed by traditional businesses as a gateway to entering the cryptocurrency space with the least amount of relative risk in terms of price volatility, stablecoins have garnered the attention of big industry names. Two prominent examples of such organisations are Facebook and JP Morgan.
Facebook’s cryptocurrency initiative has especially generated much dialogue as the social media giant purportedly wants to issue a stablecoin which can be used for fund transfers through Whatsapp globally. While the technical details have not been revealed as of yet, what we do know is that it is intended to be a cryptocurrency pegged to the US dollar or a basket of fiat currencies.
JP Morgan
JP Morgan’s cryptocurrency initiative is built around a stablecoin called JPM Coin. The cryptocurrency will help the bank instantly settle transactions for the clients using its wholesale payments service. JPM Coin is expected to replace wire transfers which currently use the age-old SWIFT protocol.
In addition, the stablecoin will also provide instant settlement for securities and, more interestingly, replace US Dollars held by businesses using the company’s treasury services.
The above are just examples of private stablecoins, but when it comes to mass adoption, we need to talk about stablecoins that can be used as a replacement for traditional currency. These are your fiat-backed stablecoins that are designed for retail trading and will most commonly be used on exchanges.
Stablecoins are currently the fastest growing sector of the cryptocurrency market.
The Most Popular Public Stablecoin: Tether (USDT)
Tether is the most widely-used cryptocurrency in the globe with more than $2 billion in market capitalisation. The stablecoin is also ranked among the top 10 cryptocurrencies in the world by market cap. USDT is leveraged by a lot of traders to protect profits and hedge risks.
Recently, the daily transaction volumes of USDT hit an all-time high. USDT saw 38,150 transactions on March 31st, representing a new milestone for the stablecoin. At the time of writing, its 24-hour volume was above $12 billion, more than even Bitcoin.
Apart from fiat-backed stablecoins like USDT, there are other asset-backed stablecoins which function in a similar fashion to fiat-based stablecoins. A good example is Digix, where one token is backed by one gram of gold. Venezuela’s infamous Petro is also an example of an asset-backed stablecoin where the cryptocurrency is pegged to the barrels of crude oil. It is important to note that both Digix and Petro are backed by reliable commodities like gold and crude oil respectively.
So What’s the Catch?
Thus far, we’ve covered what stablecoins are and how they are intended to be used. But we’ve yet to address the elephant in the room — the fact many stablecoins, USDT included, are issued by entities which are unregulated, unaudited, and operationally opaque.
USDT and Proof-of-Solvency
Despite its market dominance, USDT has been surrounded by many controversies since its inception. Analysts have raised doubts about USDT’s claim that it’s fully backed by equivalent fiat reserves. Tether has an unclear relationship with BitFinex — an exchange that has been accused of using USDT to artificially prop up the price of Bitcoin. While Tether did publish a report last year about its cryptocurrency being backed by US dollars, it was neither a third-party report nor a full-scale audit.
Just last month, Tether made changes to its terms of service which seemed to confirm the industry’s worst suspicions. The new terms imply that USDT is backed by other assets including loans given to third parties, which bring the soundness of its reserves into question. Tether is essentially operating as an unregulated fractional reserve bank. The company has never truly provided a proof of solvency and many have said that the business model used by Tether is extremely risky.
With its new terms and conditions which say that USDT may be backed by other assets, there may be a case where it is pegging one volatile asset with another one, which makes it unstable.
While Tether promises that USDT will remain stable, diversifying its reserves with ‘other assets’ without a stabilising mechanism in place makes it seem like a ticking time bomb.
The final nail in the coffin of bad press surrounding the solvency of USDT may perhaps be the recent announcement that “the New York State Attorney General (NYSAG) is suing Bitfinex, the cryptocurrency exchange, and affiliated firm Tether, the company behind the stablecoin of the same name” (The Block).
The lawsuit centres around the claim that “several New York and US-based traders transact on the firm’s platform.” One of the firms mentioned in the article is Panama-based payment processor Crypto Capital.
According to the lawsuit, Bitfinex also commingled client funds through Crypto Capital, meaning the firm mixed funds held on behalf of their clients with its own capital.
It is important to note here that while USDT may be right in the thick of a much-needed investigation, it doesn’t mean that it should be written off immediately as a potential stablecoin that can be trusted and used by the mainstream.
Tether’s current murky state may just be the result of constantly evolving best practices surrounding the regulation of such currencies. These fears, uncertainties, and doubts may very well clear up as soon as there is more transparency in the way USDT is issued, regulated, and distributed.
So Where Do We Go From Here?
Stablecoins, like cryptocurrency and blockchain in general, are a disruptive technology, which means that there will be hiccups along the way as they mature. This also applies to regulation and compliance.
It’s no secret that banks do not maintain a strict 1:1 balance on funds held in the bank vis-à-vis funds reflected in savings accounts. They engage in fractional reserve banking, where only a portion of bank deposits are backed by actual cash. Research shows that this is normal, and is even expected of a bank in order for them to remain solvent and profitable.
Applying this to stablecoins, it means it’s not a matter of 1:1 fiat-backing, but of transparency and structure.
Perhaps, as stablecoins mature, they will begin to operate more like federal currencies.
There have been some attempts in this direction. USD Coin (USDC), the stablecoin released by Circle, has been consistently releasing third-party audit reports which verify that its stablecoin is backed 1:1 by US dollars. This is why platforms such the Gibraltar Blockchain Exchange (GBX) and Securitize have opted for USDC over other stablecoins like USDT to base their transactions on. TrueUSD has also been very transparent in its approach and its audits have also shown full US dollar backing.
It is likely that many central banks around the globe will start issuing regulated stablecoins which are either 1:1 backed by fiat currencies or managed similarly to fiat currencies. This may introduce centralised risks typically associated with fiat currencies, but it does offer the average investor familiarity while operating in a digital ecosystem.
In a truly digital world, stablecoins could potentially replace the fiat currency system.
What Are Our Alternatives Now?
It may take a while for stablecoins to achieve the level of regulation and structure that will make the average user comfortable enough. So for those who want a stablecoin that’s functional and trustworthy now, what are our options?
Enter the decentralised stablecoin. Built on the foundation of blockchain technology, it is truly trustless without the associated volatility.
The most famous decentralised stablecoin out there is DAI by MakerDAO. DAI is pegged to the US dollar, but there are multiple mechanisms in place which ensure decentralisation and transparency. One of these mechanisms is the Collateralised Debt Position (CDP).
Users can essentially collateralise ETH through smart contracts and borrow loans in DAI without the need for a third party. The DAI can then be used for multiple purposes such as trading, payments or holding value. This gives users clarity on what they owe and also protects their initial assets. The assets held within the CDP can be recovered only when the user returns the DAI plus the interest accrued on it.
Maker is able to maintain DAI as a stablecoin thanks to another mechanism called the Target Rate Feedback Mechanism (TRFM). The TRFM is an automated mechanism which adjusts the price of DAI close to $1 during a market swing. For instance, if the target price of DAI is below $1, then TRFM increases to push the price of DAI up again.
This also makes the generation of DAI through CDPs more expensive and increases demand for DAI. This increased demand makes more users buy DAI and push it back to the original price. You can check out this article for a detailed understanding of DAI and its mechanics.
The great thing is that this decentralised stablecoin exists today and runs on the Ethereum platform. However, the CDP mechanism is not without its fair share of troubles. DAI has constantly been trading below $1 this year and has had trouble maintaining a true USD peg. The Maker team has been looking at making loans more expensive and hiking interest rates to correct this anomaly. Users have been borrowing DAI in an increasingly bullish market and keeping their CDPs open to long Ethereum and increase profits.
Closing Thoughts
As the research has demonstrated, both centralised and decentralised stablecoins bring to the table their own unique set of boons and banes. This is unavoidable due to the emergent nature of the underlying distributed ledger technology as well as the platforms and applications upon which they are built. Factor in the historically slow speed at which regulations concerning financial products adapt, and many crypto-enthusiasts may find themselves in a bit of a conundrum as to which stablecoin they should choose.
The answer, to me, has already presented itself: we should choose all of them. As with any other form of asset management, diversity is key, and this applies also to stablecoins.
Crypto exchanges such as GBX have already made this easier than ever before. The regulated and insured digital asset exchange offers trading not only of centralised stablecoins such as USDC, TUSD, GUSD, and PAX but also of decentralised stablecoins like DAI, with the intention of adding more in future. And for the traditionalists out there, fret not, for they also offer fiat trading including USD, EUR, and GBP pairs.
At the end of the day, while stablecoins in their current state may not yet be the perfect solution to volatility in the cryptocurrency markets, the future is bright, and I’m hopeful that the underlying infrastructure and regulations surrounding the stablecoin will positively mature towards widespread adoption.
*This article was first published on Hackernoon.
