To date, cryptocurrencies have predominantly been bought and traded as speculative investments, rather than as a means to purchase products and services.
The extreme price volatility-sometimes fluctuating by double-figure percentages in a single day-is fuelled by speculation rather than real-world developments and the relative infancy of the underlying technology, regulations and governance affects one of the paramount characteristics of a currency: its stability.
Instability is a big hurdle to overcome on the road to mass adoption and the stablecoin concept is rapidly evolving as a solution to this problem.
Tethered
A stablecoin is a cryptocurrency that has its price pegged to a much less volatile asset or basket of assets, such as the US Dollar (USD), gold, or a portfolio of traded commodities. This type of coin has risen in status this year, most notably due to Facebook’s Libra whitepaper and JP Morgan’s announcement of their own stablecoin.
By doing this, the value of the cryptocurrency, which would otherwise be subject to the wild gyrations of the market, becomes much more stable and practical for common usage, all while retaining the trading, delivery and network benefits offered by blockchain technology.
Currently, stablecoins primarily function to offer a safe haven for crypto traders during periods of high market instability. Transferring value between the traditional and crypto worlds is time-consuming and often costly: so simply trading into a stablecoin from other cryptocurrencies helps traders to retain and store value.
There are three main types of stablecoin:
- Fiat-backed;
- Commodity-backed, and;
- Cryptocurrency-backed.
Fiat-backed stablecoins
Fiat-backed stablecoins were the first kind to enter the cryptocurrency market and remain the most common type.
Just as the name implies, the value of the coin is pegged to a fiat currency. UPEUR, a Euro-backed stablecoin and USDT, a USD-backed coin created by Tether, are two such examples.
The fiat reserves that back the coin must correspond with the supply of stablecoins at at least a 1:1 ratio. Verifying this has been a particular point of controversy for Tether, who have been regularly criticised for a lack of transparency. Despite this, due to its hedging capabilities in what has consistently been a bear market until recently, Tether has been and continues to be a regular fixture in the top 10 cryptos for trading volume.
The success of this type of coin heavily depends on the security and trustworthiness of the custodian holding the backing asset, and therein lies its key issue. By relying on a single entity, the structure is inherently centralised and vulnerable to the risks that come with having a single point of failure. It is important, then, that the company uses a regulated custodian to ensure correct and proper processes and oversight.
Commodity-backed stablecoins
Commodity-backed stablecoins are much less susceptible to inflation than fiat-backed given the relative difficulty involved in mining the materials.
Gold and oil are fungible assets which have maintained their value solidly over time, so both are obvious candidates for backing this type of coin. Again, this structure requires an independent custodian to hold the commodity, but the tangibility of the assets present real value that coin holders can redeem if they wish.
Digix Gold Tokens (DGX) are the biggest current example of a commodity-backed stablecoin. The gold is secured in a vault and the status of ownership for each bar is registered on the Ethereum blockchain. Their reserves are subject to audits every three months, bringing added security and trust for coin holders.
Cryptocurrency-backed stablecoins
It may seem counterintuitive to peg a coin to the value of cryptocurrencies which we’ve established can be volatile, but backing for crypto-backed coins is provided by a pool of the top performing cryptocurrencies rather than just a single crypto, thereby reducing volatility risk. In addition they benefit from maintaining the pure decentralisation, transparency and efficiency that blockchain technology offers, which is a great appeal to sections of the crypto community.
The most prominent crypto-backed stablecoin is the Dai, created by MakerDAO.
Spotlight on Dai
Dai is a stablecoin that exists solely on the Ethereum blockchain, so it doesn’t rely on any centralised entity for governance or auditing of the underlying assets. As well as being backed solely by Ether, its value is pegged to the US Dollar, with a target value of 1 Dai per 1 USD.
However, MakerDAO have struggled to maintain their peg, trading below 1 USD for significant periods of time. To counteract this, they introduced a “Stability Fee” in February this year, which aimed to make Dai loans more expensive, thereby retracting market supply and pushing the price of a Dai up closer to the dollar. As previously mentioned, stablecoins are currently generally best used as a hedging tool in a bear market for crypto traders, so lagging demand is to be expected to an extent. But as the market has picked up, the value of Dai has still struggled to reach 1 USD.
As a fully decentralised stablecoin, MakerDAO also came up against significant governance issues when they tried to execute a decrease in the Stability Fee back in May. Their proposal initially failed as they did not get the number of votes required from their community to reach a consensus. Following that, they placed an Executive Vote into the voting system to push the amendment through, which brought the true decentralisation of their structure into disrepute.
Seignorage-style stablecoins
Seignorage-style stablecoins are slightly different to the coins mentioned above, but certainly still relevant to this post. They are not asset-backed; their price is determined algorithmically based on supply and demand for the coin.
As the total demand for the coins increases, new coins are minted and distributed to reduce the price back to stable levels. Typically, as with the aforementioned coins, this is as close to 1 USD as possible. As demand decreases, coins are taken out of circulation to stabilise the price.
Radix, a distributed protocol with its own stablecoin, algorithmically buys back “Rads” and burns them in the event that the value of the coin decreases. Another such coin, Basis, manages this by issuing “Base Bonds” and selling them in an open auction.
Much like crypto-backed stablecoins, seignorage-style coins exist solely on a blockchain, so there is no need for custody or external auditing — all of the data is transparently stored for all to see. What’s more, the automatic adjustment of the prices and the absence of collateral reduces the volatility of the stablecoin’s value, especially relative to their crypto-backed counterparts.
A bright future
The question of mainstream adoption still echoes across the crypto landscape. Especially in the UK, the regulatory environment is buzzing with crypto-related discussion and, while stablecoins have not hit the mainstream just yet, they offer a sensible but suitably dynamic solution to the problems that crypto has faced as a means of exchange.
The concept has not yet met its intended goal-that is, to be a catalyst for real-world crypto adoption-and is instead being used predominantly as a leveraging tool for traders. So, much more is still to be done in the quest for widespread, decentralised crypto payments.
As we develop our custodial capabilities at Torca, we look forward to playing a prominent role in the ongoing evolution of stablecoins.
Originally published at https://torca.io on August 14, 2019.
