Are Stablecoins The Answer To Price Volatility?
By Raffael Kuhn on ALTCOIN MAGAZINE
Zurich, 2019– The cryptocurrency market is volatile. Over the last several years most investors have had to deal with it. When an asset undergoes large price swings over a short period of time it is important to be able to adjust as fast and as cost-efficiently as possible.
In order to achieve that, cryptocurrencies should be exchangeable with more stable assets such as selected safe-haven fiat currencies or precious metals such as gold. At present, this process is still cumbersome, inefficient and costly. This is one of the obstacles that has led many individuals to refrain from investing in cryptocurrencies. Similarly, it has kept institutional investors distant from cryptocurrency markets as higher levels of volatility combined with limited liquidity aggregates to exceptionally high levels of risk. Besides that, high volatility represents a major issue for the wider adoption of cryptocurrencies as a means of payment and for blockchain technology in payments as a whole.
The 60-Day price volatility of BTC/USD (in black), LTC/USD (in green) and Gold/USD (in red) Source :https://www.buybitcoinworldwide.com/volatility-index/
Stablecoins might offer a solution. They are a particular type of cryptocurrencies, that are pegged to another relatively stable asset such as the U. S. dollar, the Swiss franc or gold. The following three types of stablecoins are the most common at the moment: Fiat-collateralized, crypto-collateralized and non-collateralized (algorithmic-based).
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are backed by a fiat currency or a commodity (most commonly gold). In order to ensure a stable price, a certain amount of fiat currency or commodity is pledged as collateral and the stablecoins are issued 1:1 against it. An investor can now buy stablecoins and is then able to trade crypto against crypto without having to exchange to fiat currencies. Additionally, if an investor wishes to exchange the stablecoin with the underlying asset, the custodian will covert it in return for the collateral. This is the simplest and most price-robust way to create a stablecoin. But, it comes with certain trade-offs. It requires centralization in a way that one custodian has control over the collateral, and it can be expensive because the custodian needs to be audited regularly to be trustworthy. The controversy about whether Tether is fully collateralized or not shows how important this aspect is. A rather ironic attribute of fiat-collateralized stablecoins is the fact that they are still linked to the fiat world. In a, rather unlikely but possible, scenario where the people lose trust in the fiat system and flee to cryptocurrencies, the fiat-backed stablecoins would collapse as well.
The following examples of projects claim to have achieved a Fiat-collateralized price stable coin:
· Tether (https://tether.to)
· TrueUSD (https://www.trusttoken.com)
· DigixGold — Gold as collateral (https://digix.global)
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins function in a similar manner as fiat-collateralized stablecoins, with the difference that collateral is not represented by a fiat currency or a commodity but rather by another cryptocurrency. The advantage is that the whole process takes place on the blockchain. Because cryptocurrencies are more volatile than most fiat currencies, this type of stablecoins often needs to be over-collateralized to achieve similar price stability. Assume a market participant deposits 200USD worth of bitcoin and then issues 100 stablecoins valued at 1USD. At this point the position is over-collateralized (or collateralized with 200%). Should bitcoin’s price decrease by 40% the market participant is still able to keep the price stable at 1USD because the collateral position is still worth 120USD. The risk of this method is represented by the fact that if the collateral value decreases by more than 50%, the market participant will not be in the position to keep its price at 1USD per coin. But what incentives are there to create such stablecoins? An interesting but rather risky method is the usage of crypto-collateralized stablecoins as a form of leverage. For instance, the stablecoin issuer deposits 200USD worth of Bitcoin and then issues 100 stablecoin each worth 1USD. The position is now collateralized with 200%. With the 100 stablecoins he issued, he can buy 100USD more worth of Bitcoin and now has a cumulative position of 300USD in bitcoin. At this time, if Bitcoin goes up 2 times, they now have $600 worth of Bitcoin instead of 400 USD with the initial deposited amount.
Below are some examples of projects who claim to have achieved a crypto-collateralized price stable coin:
· MakerDao/Dai (https://makerdao.com/en/)
· Synthetix (https://www.synthetix.io)
· Staticoin (http://staticoin.com)
Non-Collateralized Stablecoins
The third category of stablecoins are neither fiat-backed nor crypto-backed. In this case, the stablecoin is not backed by anything but the expectation that the price will be 1USD. One way to create such a stablecoin is the so-called seignorage share. The basic idea is that the smart contract is modeled in a similar way to how a central bank acts. Let us assume the target price of the stablecoin is 1USD. If the coin is trading at 2USD this implies the supply is too low. In order to correct this, the smart contract can mint new coins and then auction them on the open market. By that increasing supply until the price returns to 1USD. This would leave the smart contract with some extra profits, which are referred to as seignorage. The difficult part is when there is too much supply, in other words, the price is below 1USD. In that case, the smart contract has to buy coins on the open market in order to reduce the supply until the stablecoin trades again at 1USD. These purchases are financed with the profit, the seignorage. If profits are not sufficient for the purchase, the stablecoin issuer will distribute so-called seignorage shares, which entitle the holder to the issuer’s future profits. Below are non-collateralized stablecoin projects, who claim to have achieved price stability with this method:
· Basis (https://www.basis.io)
· Kowala Coin (https://www.kowala.tech)
Source : https://hackernoon.com/stablecoins-designing-a-price-stable-cryptocurrency-6bf24e2689e5
Crypto Exchanges And Stablecoins
Stablecoins represents a crucial element for crypto exchanges. And they are especially important in the case of crypto exchanges that have a weak link between fiat and crypto. In a bear market, such stablecoins can mitigate losses, in a bull market they can be used to realize profits. And while cryptocurrencies experience big swings, even in the short term, investors can park their money in stablecoins without fears of their investments experiencing excessive value swings. Several crypto exchanges have communicated their intention to launch their own stablecoins.
2019 is going to be an interesting year for stablecoins. The European Banking Authority (“EBA”) has recently issued a report in which it announced that stablecoins would fall under the Electronic Money Directive (EMD2). The implications for blockchain companies are that they would need to be authorized as electronic money institutions in order to issue and trade stablecoins. The Swiss Financial Market Supervisory Authority (“FINMA”) has so far been promoting a similar view which means that stablecoins require compliance with AML regulations
Swiss Crypto Exchange
For further information please contact our team at contact@scx.ch
Sources:
- https://www.theblockcrypto.com/tiny/bis-report-70-of-central-banks-show-interest-in-cbdc-research-but-few-plan-implementations/
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