Cryptocurrencies are notoriously volatile, with falls of 20% in a day not uncommon. It’s one of the reasons why some people are nervous about entering the market.
Stablecoins, however, aim to bring stability to a hot market by acting as an anchor.
Stablecoins are designed to hold their value, even when the rest of the market is swinging wildly.
But they don’t always work…
The stablecoin debate was ignited recently by Tether (USDT). The world’s largest stablecoin, which is supposed to remain at $1, lost more than 15% of its value in a day, falling off its crucial $1 peg.
So what is a stablecoin? And how can we make them more secure and trustworthy?
Stablecoins Are “Pegged” to a Stable Asset
As we’ll see in this article, there are many different ways to keep a cryptocurrency stable, but it usually involves fixing the price to something else.
Stablecoins fall into four different categories depending on how they are backed:
1. Fiat-backed stablecoins – pegged to a fiat currency, like the dollar. This is the most common form of stablecoin.
2. Crypto-backed stablecoins – backed by another cryptocurrency, but “over-collateralized” to absorb the bigger swings in value.
3. Non-backed stablecoins – pegged to nothing, but regulated by an automated central bank system. This is much like how normal currencies work.
4. Asset-backed stablecoins – pegged to an asset like gold, oil, or diamonds.
Let’s look at each one in more detail.
1. Fiat-Backed Stablecoins
Coins backed by fiat currencies are certainly the most popular stable cryptocurrencies. The US Dollar is the most common fiat currency used as a collateral.
In this method, every token is backed on a 1:1 basis against real USD deposited in a bank account. If a stablecoin holder wants to liquidate his position, the coins will be destroyed and the deposited USD will be paid out.
However, as recent developments of Tether have shown, it is often not as simple as it seems.
Read more: What is Tether? The Controversial Stablecoin
To build trust in the coin, we need to know it really is backed by dollars on a 1:1 basis.
Tether claims its reserves are 100% backed by real dollars. But a major issue is the auditing aspect – an independent review to confirm the claims. If the issuer does not provide public audits on a regular basis, people quickly assume the tokens are created out of thin air.
That’s exactly what happened to Tether when it crashed well below its $1 peg.
But Fiat is Flawed…
Then there’s the debate around fiat currencies in general. Since the abolishment of the gold standard in 1971, fiat currencies are constantly losing value through inflation.
As a consequence of the economic crisis in 2008, Satoshi Nakamoto invented bitcoin as a hedge against the current monetary system. With that in mind, it appears quite ironic that bitcoin supporters are now using fiat-backed cryptocurrencies.
If you still want to use a fiat-backed stablecoin, you might want to take a look at the alternatives of the notorious Tether. Three emerging stars in the stablecoin sectors are the True USD, the Gemini Dollar, and the Paxos Standard Token.
The companies behind those tokens claim that they are fully regulated under US law and aim to provide audits on a monthly basis.
Coinbase has also added support for a stablecoin issued by Circle, USDC. In addition, we might see a coin that is backed by Swiss Francs in the near future.
2. Crypto-Backed Stablecoins
A promising alternative to fiat-backed coins is tokens that are collateralized with volatile cryptocurrencies.
In order to maintain price stability, the tokens need to be over-collateralized by 50 to 100%.
Assuming you want to buy $1,000 worth of stablecoins, you will need to deposit crypto assets worth at least $1,500. This over-collateralization will be used to absorb the volatility of the underlying asset. If the price of the assets drop by 25%, the stablecoin will still be able to maintain its value.
Threat of a Falling Market
However, in the world of cryptocurrencies, where assets previously dropped by 90% and more, it could make sense to deposit 100% or even more of the initial value. If your collateral is in danger, due to plummeting prices, you immediately need to increase your position. Otherwise, it will be liquidated.
Experts frequently warned of a so-called “black swan event”, wherein a crypto-backed stablecoin would lose its value in case of a heavy market crash.
Using Crypto-Backed Stablecoins to Speculate
The main incentive for locking assets that actually carry a greater value is the fact that you can use the stablecoins as leverage (i.e. bet on an asset with more money than you actually have).
If you think the price of a particular altcoin will rise in the future, you can easily use you stablecoins to buy even more altcoins.
The platform uses smart contracts in order to keep the price stable. In the future, MakerDAO plans on allowing other cryptocurrencies as well as tokenized real-world assets, like gold or stocks.
3. Non-Backed Stablecoins
After two methods backed by collateralized assets, it’s time to take a look at a radically different approach: a stablecoin that isn’t backed by anything at all.
While it might sound like a bizarre idea at first, it’s exactly how the dollar works.
Since 1971 when the dollar moved away from the gold standard, it is solely backed by the belief that one unit will have the same buying power on the next day. So why shouldn’t this work in the cryptocurrency world as well?
Examples include bitUSD, which was founded by EOS, BitShares and Steemit inventor, Daniel Larimer. BitUSD was one of the first non-collateralized stablecoins on the market.
Since late 2014, the price managed to stay more or less around the one dollar range. Its market capitalization is not as high as with other stablecoins, at only around $10 million.
A very promising candidate for becoming a way bigger non-backed stablecoin is a cryptocurrency called Basis. The company raised $133 million in a private placement through various venture capitalists in 2018.
An Automated Central Bank?
Basis works by expanding on an idea by macroeconomist Robert Sams. It means the blockchain acts like an automated, or algorithmic, central bank.
It’s actually a very simple idea. If the price of one coin rises above one dollar, the blockchain will issue and sell new coins to the market until the price falls down to one dollar again (it uses a smart contract to do so).
During this stage, the smart contract generates profit by selling new coins. These will be kept as a reserve.
If the price falls below the value of one dollar, the smart contract will use the reserves to buy back coins from the market.
4. Asset-Backed Stablecoins
Cryptocurrencies backed by real-world assets are the latest members of the stablecoin family. But this type of stablecoin tries a completely different approach than its relatives.
In these cases, the price of the stablecoin is defined by its underlying asset whether it’s diamonds, oil, gold, or something else entirely.
Perhaps the most high-profile case is petro – a cryptocurrency created by the Venezuelan government. Its value is backed by the price of an oil barrel. The petro, however, has been wrapped up in controversy since its launch.
The UK Royal Mint was also planning a digital gold token, but it has since suspended the project.
We’ve also seen the launch of gold-backed coins. The DigixDao’s Gold Token is the best known. Although the value of gold generally increases in the long term, its price still fluctuates quite a lot on a typical day. This means it might not be the best candidate for a stable currency in the short run, but rather as a safe investment for the future.
Stablecoins “Necessary to Replace Payment Systems”?
Sir Christopher Pissarides, Economic Nobel Prize winner of 2010, concludes that asset-backed stablecoins might have a great impact on the adoption of digital currencies.
According to Pissarides, who is involved in a diamond-backed cryptocurrency called DiamCoin:
“Blockchain technology has the potential to disrupt the current financial system, but it is still mainly used for speculation. If we can eliminate the volatility and bring in stability, we now have the financial tool necessary to replace the archaic payment systems in place today.”
Whether a stablecoin is backed by real-world assets, fiat, crypto, or nothing, we probably need to wait a few more years until we can really see which stablecoin class proves to be the least volatile cryptocurrency.
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