Why Crypto Needs Stablecoins (For Now)

Written by Michael Ippolito

Cryptocurrencies have represented an exciting opportunity for investors over the last couple years. If you had the foresight to get in before the massive run up in 2017, you may have enjoyed anywhere from 400% to 12,000% returns. Those sorts of impossible numbers are the reason for the current buzz, but general sentiment within the space is that it's time for the industry to grow up. You may have heard this phrase repeated ad nausesam at this point, but I'll repeat it because it's still pretty damn accurate - crypto is the wild west.

Stablecoins

Blockchain is the most significant technological breakthrough since the internet, and the excitement it's generated has driven one of the largest floods of retail investment in modern history. With all the attention and (relative) success cryptocurrencies have enjoyed over the past year, you could be forgiven for thinking the industry is well on its way to mainstream adoption. In reality, there's still a long ways to go.

The explosive growth in crypto has caused some serious growing pains for the industry. One of the primary bottlenecks is the nascence of the technology itself. While blockchain is often compared to the internet of the 90's, a growing number of industry leaders are saying that the 80's internet is really a more apt analogy. Some of the biggest issues that are hampering mainstream adoption and institutional investment include custodying of digital assets, ease of use, lack of integration with existing investing infrastructure, and liquidity.

Maybe the most relevant issue (and the most biggest existing roadblock for inflow of institutional money) is the volatility of the cryptocurrencies themselves. Because at the end of the day it doesn't matter how secure or decentralized or whatever your money is - all those benefits are null and void if you send a payment of $100 that's worth $50 when it arrives.

What are Stablecoins?

 Yes it is, and good question! Stablecoins are pretty much exactly what they sound like - a price stable cryptocurrency. This stability can be achieved (although it doesn't have to be) by pegging the value of the currency to an underlying asset, like the US dollar. Those of you who are familiar with the bloody history of currency pegs (think Mexican Peso Crisis or George Soros 'Breaking the Bank of England') may have some objections to this idea, but don't worry we're getting to that later.

Tether vs. Dai

Stablecoins are desirable (at least for now) because they solve the answer to the volatility problem. Right now, the degree of price fluctuation in digital assets mean that it really only makes sense to purchase if you are a speculator (i.e you are hoping to turn a profit on price movements).

The issue is that many people don't want to speculate. Plenty of people only want to enjoy the benefits of transacting in non-fiat currency (secure store of value, identity control, no involvement with banks, etc...). Also, many cryptocurrency use cases (debt underwriting, prediction markets, and smart contracts between businesses to name a few) simply aren't viable unless you have a cryptocurrency that has a high degree of stability.

Sorry HODLers, party's gotta end sometime though right?

Alright I get it, Stablecoins help out with the whole volatility thing. How exactly do they work?

There are three different categories of stablecoins that have been proposed. Each of these categories have pros and cons that have been elaborated on at length in a recent article on Medium by Haseeb Qureshi. I'll give you a brief summary of each here, but on a high level the three different types are fiat-collateralized, crypto-collateralized, and non-collateralized.

 

Fiat vs. Crypto

 

Fiat-collateralized

Fiat-collateralized are the most simple and obvious form of stablecoins. Create a cryptocurrency that's pegged to the US Dollar, and essentially you've just made a digital IOU good for $1. There are a number of advantages here. The cryptocurrency you've created gets to borrow stability from one of the most risk-free assets on the planet. It's simple, easy to understand and construct, has access to massive pools of liquidity, and functions like any other digital asset.

The disadvantage is you're re-centralizing something that's advantage was predicated on decentralization. A fiat-collateralized stablecoin requires a trusted third party custodian (aka, a point of weakness) to store enough fiat to clear and settle transactions. This entity would need to be highly regulated, require regular costly audits, rely on legacy inefficient payment rails, and your personal information would once again be less secure.

Crypto-collateralized

Another way to create a stablecoin is to collateralize it with crypto assets, typically Ether or Bitcoin. In this instance, the peg is less direct; rather than issuing a digital IOU for $1, you are creating a coin that is collateralized by the value of $1 in cryptocurrency.

So say we set a goal to issue $100 in new crypto-collateralized stablecoins. All we need to do is deposit $100 worth of Ether into an account to collateralize the stablecoins against (i.e in case someone wants to convert their money) and we're off to the races! No legacy payment rails slowing down the process, no third party custodians, sounds like a no-brainer am I right?

The issue with this setup is that this solution completely ignores the problem we were initially trying to solve; cryptocurrency volatility. The price of Bitcoin and Ether regularly fluctuate more than 20% over the course of a day. So it's conceivable that the $100 worth of Ether you issued your stablecoins against might only be worth $80 (or less) by the end of the day! The only way to resolve this little debacle is to over-collateralize and deposit, say, $200 worth of Ethereum against $100.

The issue here is that Ether has a total market cap of $60B, which might seem like a lot, but it's a drop in the bucket when you consider it against the size of the global derivatives market, which is worth an estimated $1.2 quadrillion. When it comes to crypto-collateralizaed stablecoins the most immediate challenge is accessing pools of liquidity to serve as collateral.

AOL BlockchainAlso - unpopular opinion here, there's no guarantee that any of the existing crypto's out there will end up lasting. Let's return for a second to the 'internet of the 80's' analogy for a second. To put that into context, AOL wasn't even founded until 1991! Yes bitcoin and Ethereum have managed to achieve some scale. So did Netscape and Yahoo at one point. It's still just too early to pick winners, so collateralizing with any of these projects is damn risky.

Just one man's opinion.

Non-collateralized

This one might seem a little radical, especially if you haven't been completely bought into the whole idea of cryptocurrencies yet (blasphemy, I know). I'm not going to fully dive into how this model works because it's relatively complex, but the gist is a concept called Seniorage Shares that was put forth by Robert Sams in 2014. The idea is to build a smart contract that acts as a central bank with one mandate; create a stablecoin whose value remains at $1. Because the 'smart-bank' maintains control of monetary policy, the bank's code controls currency issuance and distribution.

For instance, let's say that the stablecoin begins to trade at $2 - all this 'smart bank' would have to do is mint new stablecoins, auction them off to the public, and the excess supply would eventually put downward pressure on the price. The profit that the bank makes by auctioning off said coins when they are at a higher value than $1 is referred to as seniorage.That seniorage can then be used to purchase coins when they fall below the level of $1, reducing the supply in circulation and putting upward pressure on price.

Now, there are a host of issues here, but the pros and cons are a little outside of the scope of this article. For a more thorough explanation, check out Haseeb's article (this guy's really done his homework) but here's the gist: no one really knows if a system like this would work. If prices continue to fall faster than the 'smart bank' can bolster them, investors may continue to lose confidence and pull out money, resulting in a black swan event. There's another more subtle issue here though.

Advocates of this system point to the fact that there is no one who has direct control over monetary policy as a massive advantage of the system. The problem is, this isn't entirely true. Whoever is coding the 'smart bank' has a massive amount of influence over how the monetary policy plays out, and because of it's complexity, it would be very difficult to detect a backdoor that the designer builds in to benefit him or herself.

The Future of Stablecoins

Stablecoins are a good solution for some of the contemporary issues with cryptocurrency. They are an elegant solution to the excessive volatility that has hampered both function and adoption of existing projects. Additionally, a stablecoin that's pegged to an asset like the US dollar would allow for greater access to liquidity, and would be crucial in the formation of a crypto-based lending and derivatives market.

In my opinion, a stablecoin pegged to the US dollar looks like the best way to go. Yes, that means your coin will be subject to things like diminishing purchase power, fluctuating exchange rates, and inflation, but it's got one crucial element that none of the other coins do; simplicity. Most importantly, you don't need to teach anyone why this makes system makes sense. A stablecoin pegged to the US dollar is a (relatively) quick and easy fix to some difficult to solve problems in the world of cryptocurrency. 

Decentralized BankingHere's the one tiny issue with stablecoins though: they are (again, just my opinion here) completely ass-backward. The notion of a digital P2P cash was revolutionary because it was A) decentralized B) permissionless and C) not reliant on government backed fiat currency. At least for a stablecoin pegged against the US dollar, none of these tenants hold anymore. Monetary policy is back in the hands of the fed, your data is still insecure in the hands of third party custodians, and we're even relying on old infrastructure and payment rails to liquidate holdings.

In short, these coins are a necessary, but temporary solution. Eventually, we shouldn't even need stablecoins because the volatility and liquidity issues that are so pressing today will work themselves out as the market matures. There's nothing inherently volatile about a digital asset - it's just that they're so damn new and none of them really do anything yet, so they trade on sentiment.

Also, one final thought - we are so bad at learning from history it's almost hilarious. Again, it's beyond the scope of this article, but currency pegs are notoriously inflexible, difficult to maintain, and have disastrous consequences if broken. But let's just try it again anyway shall we? Maybe this time it'll be different :)

View All News Posts