The Cryptoeconomics Of Stablecoins
The cryptocurrency market is highly volatile due to speculation and uncertainty. The price action is prone to swings that move the market in an upward trend one minute and then back to a downward trend moments later. Speculation drives the volatility, which leads to so much uncertainty with prices. Differences in prices cause slippages, which can lead to massive losses when prices go down. This is the risk when it comes to cryptocurrency in general.
To hedge against volatility, stablecoins were developed. These digital assets are a type of cryptocurrency that offsets the volatility in prices. Stablecoins can be pegged to reserve assets like fiat currency (e.g. US Dollar), real world assets like commodities (e.g. Gold) and even other cryptocurrency (e.g. Bitcoin).
It can be pegged in a 1:1 ratio, which means the value of the stablecoin is being backed by an asset. The asset, in this case, is also the collateral type that is backing the stablecoin.
1 USDT = 1 USD
If you have 1,000,000 USDT, that means the value you own is worth the equivalent of 1,000,000 USD.
This gives stablecoins various purposes in the cryptocurrency space, which we shall evaluate.
The US Treasury Department has some nice things to say about stablecoins:
“stablecoins that are well-designed and subject to appropriate oversight have the potential to support beneficial payments options.”
While that sounds like an encouraging statement, we must not forget that cryptocurrency like stablecoins are not under the regulatory framework of traditional financial institutions. While they do see its benefits, there is also the call for regulation.
Types Of Stablecoins
The most common type of stablecoin is backed by fiat currency. Since fiat currency is issued by a central bank for their respective government, it is considered an off-chain asset. This means that the asset is not recorded on a blockchain. A stablecoin pegs to fiat currency, but it is recorded as an on-chain asset (blockchain).
Tether (USDT) is one of the most popular fiat-backed stablecoins that is supported by many digital exchanges. The token was developed by Tether Unlimited as a cryptocurrency that maintains a peg with USD. This stablecoin has been around since 2014, making it the oldest on the blockchain. USDT gets its value from from the total USD held in reserves to the total USDT in circulation. This maintains a value of 1 USDT to 1 USD.
Another popular fiat-backed stablecoin is the USD Coin (USDC). This was created by a consortium headed by payment processor Circle and US-based digital exchange Coinbase. The USDC token launched on September 26, 2018. One of the main uses of USDC tokens is a bridge for fiat and cryptocurrency in DeFi (Decentralized Finance) applications. USDC assures holders that 1 USDC is always backed by 1 USD.
A stablecoin can be backed by hard assets like precious metals, land or oil. These tokens are pegged to the price of the commodity, so prices are still subject to fluctuations. Take, for example gold. The price of gold has been fluctuating based on chart analysis, so using it as a peg to a stablecoin may not seem effective. If that is the case, why even use commodities to back the price of a stablecoin?
The reason has to do with access as an investment vehicle. Issuing a share in a commodity can be difficult. Storing and shipping oil, delivering gold bullion bars or granting custody of land to a holder is not something that can be easily accomplished. By tokenization to stablecoins, the investors can purchase a commodity without actually holding the physical hard asset. They have exposure to it through the stablecoin.
Examples of commodity backed tokens include Paxos Gold (PAXG) and Digix (DGX) tokens. Paxos is an ERC-20 token on the Ethereum blockchain that gives investors a chance to hold gold without going through the traditional process of owning it. Digix is in itself an ecosystem that provides investment in gold through stablecoins with 1 DGX to 1 ounce of gold valuation.
Stablecoins can also be backed by other cryptocurrency as the underlying collateral or asset. The token takes the cryptocurrency collateral and locks it into a smart contract. A smart contract is a program that runs on the blockchain. The token is issued based on the conditions set in the smart contract code with a valuation based on the cryptocurreny’s price. The use of this type of stablecoin is for borrowing against the collateral deposited in the smart contract.
Maker DAO’s DAI token is a great example of this. A user who wants to hold DAI deposits their digital asset into what is called a CDP (Collateralized Debt Position) for locking. In return the user receives a certain amount based on overcollateralization of their deposit. With CDP, a ratio of 150% means for every $100 of DAI issued, a user must provide $150 of collateral. A user can then use the DAI, but must pay back their dues on the CDP or else their collateral will get liquidated.
It may not sound good at first because using volatile cryptocurrency as collateral does not seem to be the purpose of backing stablecoins. It is really about being able to borrow against your digital asset’s value without surrendering it. In DeFi, users can borrow using crypto as collateral with a chance to get back their deposit. The money they borrow is issued as stablecoin tokens with a value that is based on the fiat price of the digital asset.
Algorithmic stablecoins can be quite complex to understand. They offer a different way of stabilizing prices. They are based on computer code called algorithms to determine the balance in token prices, based on assets that are being tracked. This can be fiat currency or a basket of digital assets and commodities. The system is programmed to reduce the tokens in circulation if the market price falls below the price of the asset it tracks. If the token exceeds the price of the fiat currency it tracks, then new tokens are created and put into circulation. This brings the stablecoin value down, or deflates its price.
Neutrino (USDN) is an example of an algorithmic stablecoin that also uses crypto-collateralization. USDN was designed for algorithmic financial products. It is pegged to the USD and backed by the WAVES token. USDN is being utilized in DeFi as a stable ERC-20 token that issues its own versions of the Chinese Yuan and Japanese Yen. It can also consist of a basket of commodities to back USDN that can be redeemed for real-world assets.
Another popular algorithmic stablecoin is Ampleforth (AMPL). According to its developers, the price of AMPL changes each day. When the price is high, balances increase. When the price is low, the balances decrease. Is this even a stablecoin? It works on the principle of adjustable money supply. It retains the percentage of the token supply holders own. Through a rebase process, it continuously tries to maintain a price as close to $1, which incentivizes AMPL holders.
Popular Use Cases
Traders use stablecoins to hold their position without exiting the cryptocurrency market. They can trade for stablecoins to preserve the value of their digital asset holdings to a stable asset like the US Dollar (USD). Stablecoin prices can hold the value of a trader’s gains during a bear cycle. Traders can also keep their holdings in spot wallets on exchanges, ready to trade without having to convert from fiat and back to cryptocurrency. It can save traders from high fees charged by exchanges during currency conversion. The data on the volume of stablecoins traded daily on exchanges (e.g. USDT, USDC on Coinmarketcap) show just how important they are in the cryptocurrency market. In 2021, the total market cap of stablecoins has surpassed $100 Billion (Source: Statista).
Fintech companies have started accepting stablecoin deposits into interest-earning accounts. These financial products yield higher returns on interest than traditional banks. Companies that have innovated in this space include Celsius and BlockFi. While these products are giving banks a run for their money, it is becoming highly regulated. Users can still use these products, but the provider must follow the guidelines from regulators. An alternative is to use decentralized platforms (e.g. Aave), but they may also fall under scrutiny if they are not decentralized enough.
Stablecoins are also popular with products on DeFi protocols used for lending and liquidity pools. They make use of stablecoins that are deposited in smart contracts. The protocols then use stablecoins for lending to borrowers at collateralized rates or other financial transactions. A good example is TerraUSD (UST), which is the first stablecoin to provide interest earnings. Through the Anchor protocol, UST holders can earn up to 20% interest. Other popular protocols include Compound and Curve.Finance. The use of stablecoins for swaps and trading is also providing much-needed liquidity in the DeFi space.
Perhaps the most immediate use case is the advantage of stablecoins as a medium of exchange that bridges the gap between fiat and cryptocurrency. The Office of the Comptroller of the Currency (OCC) in the US has recognized that banks can use stablecoins for payments. When it comes to making payments, even the Harvard Business Review (HBR) has written about the potential of stablecoins for payments and financial services. Credit card and payment processing company VISA has announced support for payments in crypto using the USDC stablecoin. With these options available for payments, stablecoins have a general purpose.
Stablecoins Are Not CBDC
The US and other governments have made announcements about exploring the CBDC (Central Bank Digital Currency). They are not the same as stablecoins since CBDC is a form of digital fiat currency and not cryptocurrency. The unit of CBDC remains the same as its fiat equivalent but does not use a decentralized public ledger. The CBDC is a centralized blockchain that is controlled by a government’s Central Bank. The issuance of currency is also directly from the government and not by a consensus mechanism that involves incentivized nodes.
If CBDC were to be implemented as public blockchains, it will not exactly fall in line with what regulators want. The purpose of CBDC is more about making payments to the government easier to audit and track and being able to control the issuance of funds. With CBDC, the government can issue money with expiration dates and limits since it is now computerized. It also makes it easier for accounting purposes for the government to track what users are spending their money on. This can be used to track the issuance of food stamps, for example.
Stablecoins don’t have direct involvement with the government but with a project team or an organization. There are actual companies behind the issuance of stablecoins like USDT(Tether Limited), USDC (Centre Consortium), and UST (Terraform Labs). They are cryptocurrencies because of their use of public blockchains, which provide a decentralized way of validating transactions on a network that does not require intermediaries.
Future Applications And Regulatory Compliance
The foreign remittance market is huge due to the amount of money overseas foreign workers send back to their home countries (est. $548 Billion in 2019). It has somewhat experienced a setback in 2020 due to the COVID-19 pandemic, but there will be a continued demand for cross border money transfers from immigrant communities. Stablecoins can help with frictionless money transfers since it can be direct from wallet to wallet. Its price stability is also favorable since it does not change value during the transfer. This also does not require a third party payment processor used by international wire transfers over the slower SWIFT network through banks.
There is a huge market for stablecoin use with salary payments. One example is New Zealand allowing workers to receive their salary in stablecoins. This is unprecedented, but there is already demand for crypto instead of fiat for payments. Stablecoins would also be ideal since they have a stable price value. Companies can use stablecoins for workers based overseas as an alternative way to send payments.
The market for retail transactions has long been dominated by payment giants like VISA and Mastercard. Integrating crypto was an issue early on due to its price volatility. However, stablecoins can be the answer to making payments due to their stable features. A transaction paid with stablecoins does not experience the price swings in the general cryptocurrency market. This preserves the value paid for an item during a transaction.
In terms of finance, stablecoins are already showing their advantages. It can become a further store of value with potential for higher-yielding interest compared to banks. Fintech companies are already providing this type of service to users, but regulators are now investigating them for compliance. The SEC has come after Coinbase for offering 4% APY to holders of the USDC stablecoin. With such potential benefits, it may become a better technology for consumer finance and institutional investing, but it will require compliance with financial laws (e.g. KYC, AML, ATF).
In the US, the PWG (President’s Working Group) has compiled a report regarding stablecoins. It describes the digital asset and the risks and recommendations that the government needs to address. There are concerns that certain stablecoins may not have full backing with the currency it is pegged to. The stablecoins concerned may also be deemed a security.
There is also the question of the dangers stablecoins pose to the current financial system (e.g. Money Laundering, Illicit Activities). Since they are also not fully regulated, there is no FDIC insurance for consumer protection. FDIC covers financial services like savings, checking, and deposit accounts, but it has no mandatory implementation with stablecoins. These concerns will need to be addressed since stablecoins are likely to be used for transaction payments. The PWG is passing the implementation of policies to the US Congress, to decide on regulations.
The potential for stablecoins is there, with further opportunities in financial solutions. If it can provide a solution to common issues in finance, then it should be welcomed. It bridges fiat and cryptocurrency, helps minimize friction in cross border payments, hedges against price volatility, and allows for new payment methods.
The main problem it faces is regulation regarding its use as a form of legal tender. Stablecoin developers will most likely have to comply with requirements in order to satisfy regulators. While they are recognized as a form of digital payment, it is still up to the courts to decide on their legality. Further regulatory clarity would help clear the way for the mass adoption and use of stablecoins.
(Photo Credit by Pixabay)
First published in The Capital — 4/27/22
Disclaimer: This is not in any way financial advice, but for educational purposes only. DYOR always to verify information.