What you need to know about stablecoins
8th November, 2018
It is difficult to stay informed of the latest developments in the fast-moving world of cryptocurrencies. Trends that come and go, predictions that follow yet another pattern, talented developer teams scattered around the world. And many projects aiming to improve upon a cryptocurrency blueprint, weakness or function. Such recent addition to the cryptocurrency landscape are the so called stablecoins, most often associated with the crypto token Tether https://tether.to/. A recent report found that “the number of active stablecoin projects has dramatically increased over the past 12-18 months and more than a dozen project teams have stated they plan to launch in the coming weeks/months”. There are now over 50 in development globally. To keep up with the trend, we will dive into the alternative universe of stablecoins.
Stablecoins are cryptocurrencies whose prices are backed by real-world asset, like a fiat currency or gold (or sometimes an algorithm). As a result, the tokes are supposed to trade at a fixed value relative to another asset such as the U.S. dollar or gold. This most important feature of the stablecoins is an attempt to solve the volatility problem associated with most cryptocurrencies and to solicit all those on the sidelines of the crypto movement who are still reluctant to join in due to the drastic price fluctuations. Crucially, these tokens offer access to the crypto ecosystem built on the stability and endurance of the existing financial system.
There are two main type of stablecoins: reserve-backed and algorithmic. Reserve-backed stablecoins resemble the paper money when it was pegged to the gold standard. In the same way cash used to be backed by gold reserves in a central bank, reserve-backed stablecoins are backed one-for-one by reserves of the currency they are linked to. An example of a reserved-backed stablecoin is the Tether. It is designed as a token worth 1 USD. The 1 USD used for the purchase of 1 Tether is kept untouched in the bank until somebody redeems the stablecoin for its USD value. The second type of stablecoin is one that is not backed by any reserves but instead controlled by an algorithm. In this case software rules try to match supply with demand to maintain a peg to an asset such as the USD. Algorithm stablecoins, such as Terra, Carbon and Fragments, are much more complicated to design and execute and are still very much in a development phase.
Well-executed and delivered stablecoins will make a huge difference to consumers. Cross-border transactions, person-to-person and micro-payments will become far easier, and cheaper. But the immediate and most common use case for stablecoins is as a liquidity tool for cryptocurrency exchanges. Many exchanges have been shut out of mainstream banking and can’t accept dollar or euro deposits. Clients on the other hands want to buy with dollars and to be able to trade out of cryptos into dollars at times of high volatility. Stablecoins offer an elegant solution to this problem. However, proponents of stablecoins think the technology could allow for far more complex financial products to be built on crypto — such as insurance, smart contract dividend payments, and loans.
The challenges that stablecoins are facing are not intrinsic to them. Scaling is an issue that many in the crypto industry are trying to tackle. For reserve-backed stablecoins to reach a level where liquidity is extensive enough to support interesting applications of technology, backers will have to invest millions, if not billions, in each coin. This could harm the growth pace of a project and defuse its competitive advantage. Another potential hurdle is regulatory scrutiny. Central banks may be quicker to act on stablecoins than they were on cryptos like bitcoin because stablecoins more closely resemble fiat money and could have effects on monetary policy. And then there is the issue of confidence, security and liquidity as demonstrated by the recent developments around Tether.
Stablecoins as an investment
Stablecoins might be useful to you, if you can redeem stablecoins quickly and easily and trust the issuer. In other words, if you don’t mind the centralization risk of a fully-backed coin, this is something that you may be able to use in lieu of dollars in your bank account. Algorithmic coins are a lot riskier as they are not fully backed and that means there’s risk of losing money simply due to market forces.
Stablecoins are centralized cryptocurrencies whose relative stability is a direct result from their “association” with a real-world asset. In that sense, they are a lot more practical than most altcoins because there is an actual peg to a common unit of account. That goes against the decentralization effort of the crypto industry, but also serves as a solid measure against the crypto price volatility and the lack of trust by the broader public and financial authorities.