The Future of Currency — Stablecoins, Scaling, or Other Solutions?

Try asking people: what is the future of currency? Certainly, the responses will vary significantly. Many would say Bitcoin, or some fork of it, will become mainstream currency.

I will argue that the future of currency systems will be highly decentralized and secure, highly scalable, have zero transaction fees, and will provide near-instant settlement. And anything else will be obsolete.

I may have agreed back in 2012–2013 with the opinion that bitcoin would be mainstream currency someday, when it seemed like simpler times. The scaling issues with Bitcoin weren’t fully present or known at that time, mainly because there wasn’t enough people on the network to show its weaknesses, or just general lack of knowledge.

Back then, the whole movement was to create the world’s future currency that uses cryptographic proofs, and somewhere along the lines, the space has moved away from this. The narrative has changed from digital currency to digital gold, assets, utility tokens, and other types of tokens, not designed to be a universal currency. I get it, the space is way bigger than just currency, but the attention was shifted to all of these other use-cases before the first one was perfected. Some may say that the open-source nature of these blockchains will allow it to be perfected over time, while others believe there is a limit to what can be added without building a new foundation. Most people, it seems, have already given up on bitcoin for anything other than a store of value.

Regardless of what the future is for bitcoin, the overall distributed ledger tech has likely advanced enough to bring us a true digital currency that will be used for years to come. Will it involve improvements to existing tech like Bitcoin, a new blockchain, or a new type of distributed ledger or payment system altogether?

The battle is on to give practical digital currency to the world, and create a medium of exchange/unit of account currency system that is better than fiat. When referencing currency, these are the two properties that are implied.

There are many different approaches to how this will be achieved. A good currency will have a relatively stable purchasing power. Otherwise, it would not be practical. If the currency were to fluctuate wildly within a short period of time, then it would not be practical for anyone to buy and sell goods or services using this form of money, or measure other assets or services with it.

One popular approach that is discussed frequently is the notion of a ‘stablecoin’.

Stablecoins

Anyone following the cryptocurrency news cycle over the past 8–12 months would know that there is a lot of discussion going around about so-called ‘stablecoins’. Stablecoins, the rhetoric goes, will allow traders and institutions to be able to more easily interact with the ecosystem, with the ability to get in and out of the market more fluidly, without having to convert back into fiat each time, and will ultimately carry much less friction. Stablecoins also have the ability to interact with smart contracts.

The other attempted use-case for a stablecoin is to be used as a preferred currency. The fact is, current cryptocurrencies, like Bitcoin, are far too volatile and premature to be used like this at the moment. A crypto that is made to be stable could allow it to be adopted as a currency without needing to go through the process that money generally goes through before finally acting as a unit of account. The process is:

This is the process many think Bitcoin will go through, where we are arguably somewhere between the 2nd and 3rd phase, and are just patiently waiting for the day to come where extreme volatility fades. This would occur when bitcoin obtains a market cap and daily volume high enough where big buying or selling pressure is negligent, because there will almost always be enough counterparties to take orders without the price generally being affected too drastically in any direction, such as with FX markets today.

The problem with most of these stablecoins thus far is that they only really solve the first issue, and not the latter. While something like Tether, or the new Gemini dollar, allows for reduced friction, with an easier ability to transact between cryptos, while getting the stability benefits of the USD, it still doesn’t necessarily fix anything long-term. Since it is tied to the USD, it comes with all the risks inherent in the USD, as well as other risks. The stability (or lack thereof) of the USD comes largely from the Fed and its monetary policy, which has its own set of inherent problems and risks, and is the reason why we look to cryptocurrencies as a new form of money to begin with. Adding another layer on top of that and calling it a stablecoin doesn’t really make it any better.

Of course, there are stablecoins that do not attempt to play this dangerous game of fiat-backing, and either try to back itself with some other asset(s), or even operate freely-floating.

The question is, can these stablecoins, or the premise of them, fulfill the needs of a currency? Are stablecoins efficient and practical? This may seem like an easy yes or no answer, but the answer lies much deeper.

What makes a currency practical and efficient? The ability to transact with it easily, and at a low cost are key attributes to efficiency and practicality. What also adds to practicality is stability. If the currency had major fluctuations in purchasing power, it wouldn’t be very practical.

“But, wait a minute…” — you’re thinking. Isn’t stability implied? Well, according to the name it is. But is this reality?

How Do We Make It Stable?

Stability is ultimately relative. The question should be how is it stable, or how does it attempt to be?

Stability in the U.S. dollar, for instance, is obtained through monetary policy, by which the Fed attempts to control the supply in a way that will keep the purchasing power of the dollar relatively stable, and in balance with other factors in the overall economy.

Stablecoins that attempt to piggyback off of this stability come with more risk than holding USD because of the way they attempt to make this synthetic tie to the underlying. Some rely on some mechanism that will attempt to incent the market to keep the price at 1:1 with the underlying, such as through arbitrage mechanisms. Even if these mechanisms are sound, they still make some assumptions about the market, such as that it will act rationally.

Markets, it turns out, are sometimes not very rational. This is why we have seen stablecoins that are supposed to be tied to the USD, like Tether or True USD, lose their 1:1 tie, and by a large margin in some cases. This is speaking purely to the demand side, and doesn’t take into account issues of centralization that might have caused negligent supply manipulation.

While these problems may exist to some degree for any fixed-rate currency, the way most of these stablecoins are setup currently do not mimic the best practices that a large government fixed-rate fiat currency has in place, and their performance has shown this.

There are also stablecoins that are freely floating, and not tied to another asset or currency, so they may attempt to do their own form of monetary policy, such as in a decentralized and/or autonomous fashion. Some are being built on the premise that stability can be programmed by adding mechanisms that work to keep the price within a certain range based on factors such as demand, and may not be backed by any underlying currency or asset(s). Some could use human elements that utilize some group of people to make decisions, instead of a programmed mechanism. Some might do both in parallel.

Regardless of what mechanisms are in place to attempt to gain stability, there are ultimately two general types of currency, elastic or inelastic.

Elastic VS. Inelastic Currency

What does it mean for a currency to be elastic? A currency that is elastic can have its supply increased or decreased, and the changes may be based on certain economic conditions. Bitcoin is inelastic in that its properties are predetermined and set, and the supply does not change based on external factors. It will only ever be disinflationary or deflationary, the total maximum supply cannot be changed without a fork.

An elastic currency like the USD has nothing that is predetermined or set in stone, and the Fed ultimately gets to decide what should happen at any given time to the supply. However, an elastic currency could have this elasticity based on predetermined factors, and the supply would be dynamically based on whatever underlying mechanisms govern the changes. For example, smart contracts may be implemented to programmatically govern the supply.

There are many economists who agree that elasticity in a currency is needed, and this is rooted in traditional economic theory. The argument is that an economy is always changing, and there exists certain cycles of demand for currency (referred to as the business cycle), and this requires that the supply either contracts or expands based on how much currency is demanded relative to differing economic conditions.

In the case of modern economies, a currency is elastic so that certain economic factors can be mitigated or manipulated, as to create the best outcome for the overall economy within each instance. For example, if there is a recession, or if the economy is getting too hot, the Fed may try to either increase or decrease the supply of currency in order to manipulate other economic variables. If we did not have these controls, it can be argued that negative economic forces could be amplified. Of course, there are arguments against this methodology.

Having a purely deflationary currency, some economists have theorized, could lead to a ‘black hole’-like effect, where as currency becomes worth more due to decaying supply, and stable or increasing demand, more people will demand currency. In an inflationary currency model, the inflation inherently disincentivizes people to hold currency because its value will be lost over time. In order to preserve wealth, people will move their wealth elsewhere, such as by investing in businesses. Without this incentive to spend money, it could have dire consequences on the overall economy.

It is rarely a good thing when people are hoarding currency. If everyone was incentivized to ‘HODL’, then where would crucial investments into businesses, infrastructure, and other asset classes come from? The black hole effect is meant to portray the vicious cycle of increasing demand for a deflationary currency creating the price of the currency to increase, which leads to more demand and hoarding, instead of spending.

This is just a theory which carries its own set of assumptions, and other economic factors or market behavior will ultimately determine and potentially counterbalance this cycle. But, since we have not really had a purely deflationary currency, at least not in modern times, there is really no telling, aside from estimations based on economic theory. There is really very little empirical evidence available to predict with near certainty one way or the other. Although, many economists do agree that a purely deflationary environment would be bad. If this is true, then Bitcoin may not be a good choice for a global currency itself. However, there may be a way around this purely deflationary paradigm while still being able to use Bitcoin as the basis for value, rather than using it directly.

Some have theorized that Bitcoin will become the reserve currency for banks and act as “high level money”. Banks will lend bank notes, or their own cash, redeemable for Bitcoin. This could be done through methods of fractional reserve banking or not, and would ultimately allow Bitcoin to be settled much more cost effectively, and faster than settling every transaction on-chain. In this paradigm, the banks are still being trusted. Although, people would always have the option to send a transaction on-chain, so at least there is a choice. I would argue that there will ultimately be a currency that is able to be settled directly on-ledger that will be just as comparable, if not better, than a bank’s service.

Overall, there seems to be a great amount of opposition to the idea of inelastic currency. It can be argued that inelastic money was used for many years before, but almost any currency that ever tried this has failed (ie. the gold standard). There are many arguments as to why it has failed.

Gold Standard and Economic Schools of Thought

One widely made case is that with traditional commodity-based standards, it makes the boom-bust cycle much more severe in an economy. One of the reasons the Fed created a fiat currency and got away from the gold standard was to try to get the U.S. out of the Great Depression. Monetary policy, according to some economists, can help smooth that volatility in the business cycle. However, if that monetary policy is done incorrectly, it could have the opposite effect on the market, and essentially could make a downturn in the economy much more severe. There are very differing opinions on this subject. It mainly depends on what economic school of thought a person bases their opinion on.

For example, if you follow the Keynesian economic school of thought, then you would believe that monetary controls are an optimal and necessary way to try to lessen the effects of negative economic events, or even prevent them. However, the Austrian school of thought would argue that by trying to interfere with naturally occurring market cycles, they are actually making it worse in the long-run. They believe more in free markets and letting the market run its course undisturbed.

There are many other schools of thought as well, and many contradict each other, with each having their own set of empirical evidence to support the theories.

This is why it can be so difficult to answer a seemingly simple question such as “how should currency work?” There are so many theories with different bits of evidence backing them up (or lack of evidence), that it makes it difficult to determine what will be the best solution. However, this is the great aspect of decentralized cryptocurrencies. There need not be one method that is forced upon the market like in the traditional fiat system. Instead, the market can determine what best solution is itself.

Currency Competition

The idea of competition in business is almost universally agreed as a beneficial thing for innovation and growth. Why should this not be the same for currency? Yes, we sort of have this already, but not really…

While many different fiat currencies exist, they are mostly alike, and actually are mainly all pegged to another currency like the USD or EUR. Countries do tend to compete in what some call ‘currency wars’, and as the name implies, it is not the good kind of competition that leads to innovation and growth. Instead, this is when countries attempt to manipulate the value of their currency to affect other countries and their respective currencies, and may be done inadvertently as well. This kind of competition generally doesn’t produce a net benefit for society or the economy as a whole.

We don’t really have any idea what exactly will happen if you challenge this paradigm, although a global currency that cannot be manipulated by any single entity via monetary policy would at least put everyone on an equal playing field. It might actually even do a lot of good, and would mitigate the currency risk of countries and companies participating in international trade.

We can speculate that currency competition in this kind of global, free-market paradigm will be a net benefit for all parties because all participants will be incentivized to improve a currency system that they all have an equal stake in. This global free market is enabled, and in some aspects forced upon by these decentralized networks that are permissionless and very immune to most forms of censorship and manipulation.

Answering the elasticity question may ultimately need to be left for the market to decide. Maybe the answer is both inelastic and elastic currencies existing in a healthy competition with each other.

Competition will also weed out other problems with wannabe currencies today, such as fees and settlement time. This is an aspect of Bitcoin that may hold it back from ever having a chance at becoming a currency, and is the reason why much of the Bitcoin camp now refers to it as digital gold.

Fees Are Too Damn High!

Bitcoin fees, as we are all are likely aware of, are too damn high! Actually, it can be argued that cryptocurrency that uses Proof-of-Work models like Bitcoin’s will always have fees that are too high to be used as a practical currency when all transactions are settled on-chain. Yes, I am speaking about you too, Bitcoin Cash (or whatever new fork there is this week).

Perhaps these types of cryptocurrencies could make it as a digital store of value or collectible though, who knows. At that point, however, it’s largely just a popularity contest.

The reason Bitcoin cannot be a good currency is because it is not a practical and efficient medium of exchange; the costs of transacting are high. While Bitcoin or other cryptocurrencies may have relatively lower cost transactions in some respects — such as when sending cross-border payments and remittances — sending $20 to my neighbor for cutting my lawn shouldn’t incur a fee. I can use something like Venmo and send fiat dollars to him for zero fees, and instantly. Is Venmo comparable to Bitcoin in terms of it being a permissionless, trustless form of payment? No. But that’s not my point.

Cryptocurrencies like Bitcoin will have to compete with both traditional payment networks and future, decentralized payment networks if it stands a chance at beating fee-less competitors in the long-run. Second layer options are there, but they generally don’t retain the important traits that the underlying layer has, such as the elimination of counterparty risk. Also, state channels still can come with a relatively large cost, such as when the time comes to close the channel and settle on-chain. I find it hard to believe that there won’t be decentralized, trustless, permissionless, etc. payment networks in the future that will be fee-less.

Granted, when I say fee-less, I do not mean that those fees wouldn’t be in another form. It would be hard, if not impossible, to get rid of fees altogether. In the type of model I describe, fees would come in the form of inflation, as with the USD. The point of eliminating transactional fees is mainly for convenience, as well as to defer up-front costs which could add up if money is being sent back and forth at a high frequency. Imagine having to pay a 1% fee every time you send your friend some money. It wouldn’t be very practical. One could argue that merchants get charged a fee for accepting payments using credit card processors, but that is credit-based, which is always going to have a cost associated with it.

Some may make the argument that these first layer payment networks already exist that can be sent without transaction fees, and can be settled nearly instantly. Nano, Iota, and other non-blockchain based crypto’s come to mind since the tech they use makes it more viable to eliminate transaction fees compared to using a blockchain, but there is criticism with how decentralized or secure they are currently. Let’s just say that those platforms are perfect in this regard. What does this mean for Bitcoin and all other blockchains?

Decentralized, Zero Transaction Fees, Fast Settlement

Ideally, currency will have zero, or near-zero friction. The costs of any transaction would effectively be zero, and they would settle almost instantly, all while being able to scale to fit global demand. I think this is certainly possible, but not in the current environment, at least not without all of the attributes and security that lies in the Bitcoin blockchain. Proof-of-Work as a consensus mechanism has proved itself to be very secure against threats, and allows for a fairly good degree of decentralization, allowing it to be very durable and robust. Other cryptocurrencies, blockchain-based or not, such as PoS consensus-based coins, have yet to prove themselves to this degree.

However, without nit-picking all of the tech, let’s just agree that, if it were possible to have all of the benefits of Bitcoin merged with the fee-less and fast settlement properties of Nano, that it may make for something that could be fit to be used as a true currency.

One emerging cryptocurrency that is trying to do just that is called Meros. It uses both a PoW blockchain and a DAG in parallel. A Directed Acyclic Graph (DAG) is the type of structure in cryptocurrencies like Nano, and allows for far more scalability than what blockchains are limited to. In this way, Meros is able to capture the best of both worlds — the decentralization and security of PoW, merged with the instant transaction appending and fee-less transaction capability that utilizing a DAG offers.

This is not to say that things will never change with Bitcoin or other Altcoins. Scalability and efficiency may be achieved through a second-layer solution, as long as it doesn’t compromise the security and trustlessness of the transactions. Technology like Plasma, or sidechains, and State Channels look promising.

It is possible that there will be multiple different types of currencies on top of different tech solutions, and each one will serve a role in promoting overall global economic stability and fill their own respective markets.

I think the one thing that can be almost guaranteed is that the future of currency, or at least the way in which we use it, will come with zero or near-zero fees for transactions, and will be settled nearly instantly. As soon as one currency or payment platform is able to do this effectively, then all others that don’t have these properties, and that don’t offer some other type of value, will become obsolete. The path of least resistance will be taken.

Final Thoughts

Given the hypothesis that there has to be fees in some shape or form in any currency scheme, is it better to defer these fees in the form of inflation, or should these fees be up-front, and then potentially be reduced or eliminated completely by a second layer solution like state channels that defers the settlement off-chain?

Do we need a stablecoin in regards to today’s definition of what that is?

Is it enough to see if something like Bitcoin can reach a high enough market cap that it grows steadily less volatile, and maybe is updated to scale more efficiently to the point where it becomes a practical currency?

Do we need elasticity built into the currency from the onset?

Will second layer approaches fix current scalability issues?

Could crypto/asset backed currencies be a viable long-term solution?

There are many questions that need to be answered, and will likely be answered only through experimentation and competition. What we can say is that the cryptocurrencies of today have a long way to go before they become mainstream currency.

What are your thoughts? Shoot them in the comments section below.