Stablecoins and the future of crypto
Stablecoins are the holy grail of crypto, combining the stability of fiat and the borderless, peer-to-peer nature of cryptocurrencies. But how do stablecoins work, and why should you care?
The idea behind bitcoin, as laid out by its creator in the very title of the original whitepaper, was to enable “a peer-to-peer electronic cash system”, a kind of digital money that could be transacted freely across the internet without borders or intermediaries.
Based on cryptography and a clever system of economic incentives, bitcoin was followed by countless other projects, opening the floodgates to a new asset class appropriately dubbed cryptocurrencies. By improving and iterating on this technology, cryptocurrencies have been trying to solve some of the limitations of traditional fiat currencies for a decade.
Why not just use bitcoin?
Despite showing great value and a growing global adoption, bitcoin and other crypto-native assets have been notoriously plagued by a level of volatility that has so far prevented them from working as actual currencies — and thus from being more widely used in our financial system.
Why would anyone pay with bitcoin for a coffee if the next day bitcoin price skyrockets (like it has done before recently) and that €3 coffee ends up costing €30? That plays into human psychology — people are less willing to spend an asset if they expect it to increase in value, and the other way around.
And it goes both ways, too. Why would a coffee vendor accept BTC for a €3 coffee if the next day it turns out that value has nosedived to €0.30? The vendor’s creditors would hardly be inclined to take bitcoin at face value.
So, if cryptocurrencies are to live up to their potential, they need to be incorporated into our current economy. That’s where stablecoins come in.
What are stablecoins?
From an economic perspective, stablecoins try to solve the volatility problem and create a bridge between crypto and the traditional economy. Their focus is on achieving the holy grail of monetary stability, effectively turning crypto into currencies as we understand them.
But to fully understand what this means are and why are stablecoins so important we need to unpack that statement and look at the key concepts behind it.
Defining a stable currency
Let’s start with a caveat. There is no such thing as perfect stability in economic systems. All value is subjective, and there is no objective, immutable metric to measure it. We can only measure the value of a thing by comparing it with another thing, thus establishing its price.
Moreover, due to changes in supply and demand for both assets (the thing being priced, and the thing being used to “measure” it), prices fluctuate over time. And time is key here, as prices can only be sensibly applied in the context of a given time frame. Given a large enough interval, even the most stable of assets won’t hold a constant value.
To make sense of this mess, the best we can do is to try and standardise the comparison by having a common yardstick to measure against. This is the fundamental idea behind money in all its incarnations.
But money is no different from any other product. Ultimately, no currency is 100% stable. For practical purposes, the concept of stability is an ideal approximation, the best-case scenario for an acceptable ratio of change in value.
Despite their many shortcomings, fiat currencies have achieved a reasonably high degree of stability and been successful in enabling a thriving, global financial ecosystem — one that most current cryptocurrencies are still struggling to emulate.
How do stablecoins work?
Stablecoins are essentially a type of cryptocurrency, and thus exist as tokens that can be transacted on a decentralised, peer-to-peer network.
Although there are projects who aim to build their own blockchain, most stablecoins currently use existing chains (such as Ethereum) as a platform for their tokens, taking advantage of their established infrastructure and network effect.
Trading on an Ethereum-based stablecoin, for example, is effectively no different than using any other Ethereum token.
Types of stablecoins
We can divide stablecoins into three broad categories according to their approach in trying to solve this problem. Traditional collateral-based, crypto collateral-based, and algorithmic-based seignorage. Let’s take a brief look at each approach and their key features.
Traditional collateral-based
The most straightforward approach, this type of stablecoin is issued by companies that hold traditional assets in deposits to back the value of their tokens.
These currencies leverage stability by pegging their value to the value of the underlying assets, and manipulating their token supply to maintain the exchange ratio constant in relation to the collateral.
The collateral can be single currency (such as the US dollar or Euro), a commodity (such as gold or silver), or a basket containing any combination thereof. In many cases, the issuing company offers the option of redeeming the assets themselves, thus ensuring some degree of liquidity for the tokens.
Working examples of this approach include Tether, Gemini, Paxos, and TrueUSD (pegged to the US dollar), Digix (backed by gold), and Globcoin (multiple currencies).
Pros: traditional collateral-based stablecoins are backed by time-tested assets, whose value has historically been much less prone to fluctuations than crypto. The ease of redemption and liquidity of the underlying currencies/commodities are a big plus. They are also highly scalable, as they form the basis for our current infrastructure and trust assumptions.
Cons: this approach requires a high level of trust in the issuing company to actually hold the assets, as well as to honour its liabilities — and there have been cases of lack of transparency leading up to the loss of the exchange rate peg.
Crypto collateral-based
The growth and consolidation of crypto markets has enabled another class of stablecoins, based solely on crypto assets. This approach hinges on the use of smart contracts to manage stability in the system, allowing for a purely on-chain stablecoin based on the value of the underlying crypto.
In such systems, a smart contract locks in crypto deposits on a given blockchain and issues tokens against this collateral. To counter volatility, deposits are overcollateralised, so that the token can withstand fluctuations without losing its designated value. A stable peg is kept through a carefully designed economic incentives through interest rates, and an automated liquidation mechanism to keep the system’s value in balance.
Although it requires trust in either an individual or company for the initial setup, if successful, such a stablecoin system should run without a centralised agent in charge, avoiding the pitfalls of mismanagement.
The most prominent example of a crypto collateral-based stablecoin is the DAI, currently being implemented by MakerDAO, which currently run on Ether (Ethereum’s native token) but plans on implementing multi-currency support in the near future.
Pros: this approach is perhaps the closest to the original ethos of cryptocurrencies. By leveraging value exclusively from on-chain assets, it allows for a more trustless mechanism, as well as partially isolating the system from (direct) external market manipulation. While such a currency still requires trust on the creators of the smart contracts, this requirement is arguably minimised by greater transparency and auditability.
Cons: due to the inherently volatile nature of the underlying assets, this approach necessarily requires overcollateralisation, which can be prohibitively expensive for some cases. Even when kept properly collateralised, the mechanisms to protect the peg during a consistent drop in demand are also largely untested. Also, trusting a smart contract has sometimes proven risky.
Algorithmic-based seignorage
Roughly speaking, the core idea behind this type of stablecoin is essentially the same behind central banks, but with no humans in charge. By using an algorithm to adjust the circulating supply based on demand for the currency, such a stablecoin would thus be able to keep a steady price.
Unlike collateralised models, there is no asset which can be redeemed or traded. Value derives solely from the expectation that its tokens will continue to hold value in the future. Price levels are kept by issuing more tokens when demand is high, and removing tokens as demand drops via a system of bonds and automated buybacks.
This is a highly speculative and yet largely unproven concept, as there are no implemented algorithmic stablecoins in circulation. Furthermore, the problems with this approach became even more apparent after Basis, one of the leading such projects, shut down due to regulatory concerns.
Pros: the rationale behind seignorage is reasonably solid, and has worked well enough in the past centuries to enable a robust financial system in places where it was well-managed. Adding the elements of transparency via on-chain algorithmic decisions could potentially improve on this model.
Cons: the whole concept hangs on actually building an algorithm that is both capable of reacting fast enough, and adaptive enough to resist manipulation. It is unclear if current technology can live up to these requirements, or if it will ever be. And even if the technical challenges are solved, the legal aspects will still prove hard to solve.
A stable future?
Stablecoins are one of the fastest-growing types of cryptocurrency today, and the activity in the space does not seem like it will slow down anytime soon. According to a report by Blockchain.com, there are currently 54 identified stablecoins, with nearly half of them being live. To date, over $260 million have been injected in stablecoin projects, and the interest is likely due to continue to grow as the underlying infrastructure evolves and matures. Although still far from other crypto assets, they are quickly gaining ground.
Without some degree of price stability, cryptocurrencies can’t compete to offer complex financial instruments and use cases such as loans or insurance, and may struggle to gain mainstream adoption. Therefore, there is little doubt that stablecoins will play a pivotal role in the industry as they effectively enable the practical use of crypto in the global financial system.
However, it is not all blue skies ahead, as there are still many challenges before this future materialises.
In addition to the obvious technical hurdles, the other decisive factor that will shape the future of stablecoins — and crypto in general — is regulation. The borderless, censorship-resistant nature of cryptocurrencies is sometimes at odds with the existing legal framework, as the recent shutdown of the Basis project shows. Stablecoins will be at the forefront of the war of attrition between traditional legal systems and disruptive potential of crypto.
Whatever the outcome of that may be, stablecoins are adding an invaluable boost to the momentum of the blockchain revolution, and the future of crypto is looking ever more stable.
Originally published at https://www.cloudbet.com on March 31, 2019.
