What is a stablecoin and how will it affect cryptocurrency?

The role cryptocurrencies will play in society is still being questioned but the crypto community has taken one step further to bringing cryptocurrencies to the masses with its latest development. So, what is a stablecoin and how will it impact cryptocurrency as a whole?

Cryptocurrency
Source: Bloomberg

‘Unlike cryptocurrencies such as bitcoin, which are highly volatile, stablecoins provide people with the pragmatic, helpful benefits of a cryptocurrency without having to worry about distressing price changes since they are grounded in the real world,’ – Brigitte Luginbuehl, chief executive of SwissRealCoin.

Cryptocurrencies continue their rollercoaster journey in the hope of finding their place in society. The total value of the thousands of cryptocurrencies that have surfaced over the years, fuelled by building hype among ‘normal folk’, soared over the almighty sum of $800 billion in January 2018. The crypto community was celebrating its success at catching the attention of the media and the masses - the start of what seemed the inevitable transition toward cryptocurrencies. But, so far, their hangover has only been getting worse as 2018 progresses. Their overall value has sunk closer to $200 billion, and while the true crypto enthusiasts remain loyal as ever, the perception among everyone else is that cryptocurrencies are dicey, high-risk and complex.

Learn more on what cryptocurrencies are and how they work

Cryptocurrencies and the blockchains on which they operate have demonstrated their potential but they have proven impractical for everyday use thus far for several reasons, the first being the extreme volatility in prices. If the community is to forge a currency for the modern-day era then it must be an effective medium of exchange, able to store its value, and act as a unit of account. But volatility is bad for all three.

Read more on the search for bitcoin’s founder and the inventor of cryptocurrency

But the story of cryptocurrencies is one of self-discovery, with new coins aiming to iron out the bumps that emerge and build on the success of others. The market quickly realised bitcoin was unsuitable as a transactional coin as its value soared into the tens of thousands. This inspired the creation of litecoin, acting as the silver to bitcoin’s gold, but it too has fallen out of favour due to sharp movements in price.

Read more on the founder of litecoin, Charlie Lee

The development continues and the latest invention by the crypto community aims to rein in prices of cryptocurrencies and inject some stability in what has so far been a wild and unruly market. Stablecoins, as they are called, mimic the stability that traditional fiat currencies (like the US dollar) provide while retaining all the other useful characteristics of cryptocurrencies that allow fast, private and cheap transfers of value by anyone, regardless of where they are, with an Internet connection.

Read more about looking beyond bitcoin

But, with these stablecoins encountering their own problems and some writing off the market altogether - with the Financial Times recently declaring that the ‘cryptocurrency bubble has burst’ - is it too late to bring stability to the unpredictable world of cryptocurrencies?

What is a stablecoin cryptocurrency?

A stablecoin is a cryptocurrency that is pegged to an asset such as the US dollar or gold, helping to reduce the volatility in price fluctuations that are seen by some other cryptocurrencies. This makes it more suitable for people to use them for everyday transactions as it minimises the threat of sharp price movements in short periods of time.

One of the reasons the earlier cryptocurrencies have struggled to get both consumers to use the likes of bitcoin to pay for everyday items and businesses to accept them is the volatile price movements. A 5% to 10% movement in the price of bitcoin and other larger cryptocurrencies during a single day is not uncommon. If you are using bitcoin to pay for everyday items such as milk, priced in more stable fiat currencies like the dollar or sterling, then the cost of everyday life will change dramatically as bitcoin wavers up and down. It simply doesn’t work.

This has spurred on crypto community, remembering that cryptocurrencies have no central authority and is decentralised, unlike fiat currencies that are controlled by central banks, to find a way to reduce the volatility of cryptocurrencies. However, this is not easy to do without contravening the basic principles of cryptocurrencies.

What are the basic principles of a cryptocurrency?

Although there is no central authority to define the basic principles of cryptocurrencies there are widely-accepted characteristics that any transaction-based coin should have. These are:

  1. Decentralised: no single person or entity controls a cryptocurrency
  2. Consensus-controlled supply: being decentralised means the supply of the cryptocurrency is either determined by a consensus among the users of the cryptocurrency or a pre-determined set of rules of how new coins are introduced to the market, like mining. No single user or authority can ‘print’ more cryptocurrency
  3. Scalability: able to scale-up to handle high volumes of transactions and to provide fast transactions
  4. Price stability: have a stable price to make them practical to use in daily life and to lower the risk associated with them. Scalability will help to minimise volatility in prices
  5. Fast, limitless transactions: cryptocurrency can be sent to anyone, anywhere and at any time using the decentralised Internet-based network at minimal or zero cost, without the need of a third party such as a bank
  6. Transparency: the design and technical aspects of the cryptocurrency and the blockchain that it operates are available to everyone, and all transactions are recorded in a public ledger that all other users can access and verify
  7. Privacy: while all transactions are recorded, the identities of all users are kept anonymous. Public keys are used by both users involved in a transaction, with the sender and receiver identified by the unique numbers of each and every public key

What are the different types of stablecoins in the cryptocurrency market?

There are three distinct types of stablecoins that are based on different models. These are:

  1. Centralised IOUs: this model sees a central authority hold the assets that its coin is pegged to. The authority then issues tokens that claim their value from whatever the underlying asset is
  2. Collateral-backed: this takes the IOU system a step further. The underlying asset that the coin is pegged to is itself managed by a decentralised system like the coin. The underlying asset is held as collateral, installing trust between users while allowing the coin to operate without a central authority
  3. Seigniorage: this method does not involve backing the coin or token with an underlying asset, but instead derives its stability from algorithms that dictate supply and demand. If there was a fixed supply of a coin then increased demand automatically leads to increased prices, but the seignorage model aims to add more coins or reduce the amount of coins as demand fluctuates to keep prices stable, much like a central bank does with fiat currencies

What are the benefits and drawbacks of each stablecoin model?

Each of these have their own benefits and drawbacks. The centralised IOU system is, as implied in the name, centralised. Users have to rely and completely trust the central authority to not only hold the underlying asset that the coin derives its value from but also that it will honour the IOUs being traded.

Collateral-backed coins solve the middleman problem and do not need a central authority to facilitate everything. Coins are created by a user depositing some form of collateral into an account that is managed by a smart contract. This means the collateral acts as the underlying asset, and can be transferred or sold based on certain algorithms, like if the value of the asset hits a certain threshold or if one party fails to deliver their end of the deal. Problem is, because collateral has to be something that can be deposited and governed by smart contracts, most use other cryptocurrencies that can be volatile, like Ethereum, potentially undermining the collateral that supports the coin’s value.

Read more about blockchain smart contracts (neither smart nor contracts)

The seignorage model aims to create a decentralised cryptocurrency that acts like a centralised fiat currency. When demand for a fiat currency rises by a certain amount the central bank in charge of the currency will print more money to stop the price from soaring too high, and buy currency when demand is falling to stop the price from falling too low. Under the seignorage model the concept remains the same, and therefore the value of the coin is expected to be stable. While there are different approaches being used one of the most well-known ones is the ‘shares and bonds’ method. This sees initial tokens created and linked to another asset like the dollar, and as demand rises more tokens are issued and when it falls discounted bonds are offered to entice users to sell their coin and take it out of supply. But issuing more tokens is easier than contracting supply, particularly if it is a truly decentralised system.

Each approach being taken by the crypto community to solve the problem of volatility has its own supporters and critics, but the seignorage model is by far the most radical and ambitious attempt yet to create a coin that shares all of the essential principles of cryptocurrencies but not some of the major downfalls that have so far held back their adoption and soured perception. But the fact that this model and all the others are not perfect encapsulates the very nature of cryptocurrencies: a lesson learnt.

What are the top stablecoins available in the cryptocurrency market?

A swathe of stablecoins have already entered the market. Below are three of the most well-known stablecoins. All of them have adopted a different model.

Tether cryptocurrency: a stablecoin pegged to the US dollar

The concept of Tether is simple, on paper at least. For every tether that exists there is a US dollar, meaning the value of one tether should always match one dollar. This is a centralised IOU model, whereby the central issuer (Tether the company) holds the US dollars on behalf of the users to uphold the value of tether and provide price stability.

But tether has been shrouded in controversy ever since questions were raised about whether Tether had the billions of US dollars in the bank to back up the billions of tether in issue. The company dismissed its first auditors and, although it insists it is fully audited, the evidence produced so far has been unconvincing. There is major doubt that it has the $2.7 billion to match the 2.7 billion tethers in circulation and that the stablecoin is being pumped out with artificial value just to prop up the prices of other cryptocurrencies. Supporting this is the fact that, while exchanging dollars for tether is easy enough, swapping your tether back into dollars is thought to be considerably harder. The company has stated on several occasions that it was unable to convert any tethers into dollars. Although some argue this sets off warning sirens about how much dollar it has in the bank, others say it is because it wants people to exchange their tether into other cryptocurrencies, like bitcoin, and then convert that into fiat currency.

Tether is a great example of the highs and lows that the crypto community endures. The idea of injecting crypto power into fiat currency is welcome, but all of its problems stem from the fact it is centralised. Users have to trust Tether that it has the money it says it does and that it will facilitate the transactions on the network and, so far, Tether is yet to earn its badge of trust.

Decentralisation is regarded as one of if not the number one trait of a cryptocurrency and Tether has done nothing to convince that a centralised cryptocurrency is the way forward. If part of cryptocurrencies is shutting the door to so-called opaque and dishonest banks then the very least a centralised cryptocurrency has to do is prove it can be more transparent and do a better job at managing people’s money.

Read more about Tether and the other challenges cryptocurrencies face in 2018

Dai cryptocurrency: a decentralised stablecoin built on Ethereum

With all of Tether’s problems spawning from the fact it is centralised this next stablecoin could prove to have the solution. Dai is a decentralised cryptocurrency that is built around Ethereum, a much larger cryptocurrency that is centred on smart contracts to make it stand out from other top cryptos like bitcoin.

Read more on what Ethereum is and how it works

Ethereum is used as collateral to support the price of Dai. The Ethereum is held in a smart contract, which means there is not a need for a central authority to hold it on behalf of the users. Dai is, however, not free from problems. It may be decentralised but the underlying asset that gives Dai its value is nowhere near as stable as the fiat currencies like the dollar. As Ethereum is sensitive to large price swings, those wishing to use Dai have to over collateralise as a form of protection: placing $500 worth of Ethereum as collateral for $400 worth of Dai, for example, to provide a buffer in case Ethereum suffers a sharp drop in price.

Dai wins points for being decentralised but the foundation it is built on – the thing that gives this stablecoin its stability – is itself not free from volatility. Its fate is in the hands of Ethereum. The creator of Dai, MakerDAO, is also responsible for the Maker cryptocurrency. Both are among the 200 biggest cryptocurrencies in the world.

Basecoin cryptocurrency: a stablecoin with no underlying asset

Basecoin is an example of the seignorage model and an entirely different approach to stablecoins. It is not pegged to any underlying asset such as a fiat currency or another cryptocurrency. Basecoin is known for pioneering what is referred to as the ‘bonds and shares’ method to manage supply, using algorithms to expand or contract the amount of basecoin in circulation, much like a normal central bank does with fiat currency. This management of supply is what gives basecoin its stability.

If there is a fixed supply in circulation and demand rises then the price of basecoin will rise, but this will eventually trigger an algorithm (making it decentralised), which then automatically issues new basecoins to prevent the price soaring too high and keep it within a targeted price range. This is the same as a central bank printing more money.

That is easy enough, but contracting supply when demand falters and prices begin to drop is a different challenge. When this happens basecoin issues ‘bonds’ that are sold to users at discount. Users are therefore incentivised to buy these bonds using their basecoin, which are then taken out of circulation. Eventually, more basecoins will be issued and the first to receive them will be the bondholders: allowing them to recoup their basecoins and book a profit (the difference between the price of the discounted bond and the price of the basecoin when issued). Importantly, if there are no bondholders then those holding shares will be issued their basecoins first. These shares are essentially priority claims on the next round of basecoins to be issued – like purchasing a share and expecting a dividend in the future.

But, as is evident, the entire system is built on one promise: every time supply is contracted and bonds are issued, supply will be increased by issuing further basecoins at some point in the future. In addition, bondholders have no obligation to cash in on the basecoin being issued, meaning there is a threat that the amount of bondholders could build. This would not only raise the risk attached to the bonds, which could lead to demands for better incentives, but also the risk that a sharp sell-off of basecoin would quickly wipe out the value of the bonds. Basecoin has a method of managing supply and demand, but it has not quite figured out the best way of ensuring an even balance between the two.

Can stablecoins really bring stability to highly volatile cryptocurrencies?

‘Are stable-value assets necessary? Given the high level of interest in “blockchain technology” coupled with the disinterest in “bitcoin the currency” that we see among so many in the mainstream world, perhaps the time is ripe for stable-currency or multi-currency systems to take over,’ – Vitalik Buterin, founder and creator of Ethereum. 

Learn more about the founder of Ethereum, Vitalik Buterin

Stablecoins are another stage of evolution for the cryptocurrency market. They go some way to resolving the problems that have hindered mass adoption of cryptocurrencies and limited their use, but ultimately the crypto community has a long way to go before it has a coin that can win over the masses. If cryptocurrencies are to be the next generation of digital cash then it has to be fast, cheap and private. But scalability has proven difficult thus far, hampering the speed of transactions (a particular hindrance amid volatility) and their ability to cope with global demand. This is also why the potential of cryptocurrencies and their blockchains to facilitate other financial products, such as loans, credit, remittances and insurance to name just some, have failed to come to fruition.

The debate around stablecoins heightens the importance of decentralisation, but also shows why this could become increasingly hard. It is fair to question how a truly decentralised stablecoin can maintain a fast and accurate exchange rate with its underlying asset without a third-party exchange of some sort and, although they are designed to be stable, they still need to prove they can handle heavy fluctuations in price if they are to show they can run on par with fiat currencies.

Click here to compare the different cryptocurrencies

The fact many stablecoins have also pegged themselves to the dollar could be a deterrent for those outside the US. Withdrawing fiat currencies by cashing in cryptocurrencies is still seen as a difficult task in general, but even if you convert, for example, your tether into dollars you then have to convert that into your currency of choice, undermining the free or cheap nature of cryptocurrencies.

Still, at the bottom line many will question the point of stablecoins in the first place. What is the point in creating a cryptocurrency reliant on the fiat currencies that they are trying to replace? Why invent a decentralised cryptocurrency that is ultimately influenced by an underlying asset that is centralised? And why, in that case, don’t we just stick to what we have at the moment?

If stablecoins are to be the breakthrough to thrust cryptocurrencies into everyday use then it will have to answer these questions. A stablecoin that could be pegged to all of the biggest currencies while taking into account economic indicators such as growth and inflation may be, albeit complex, one solution. But for now, stablecoins are just the latest ambitious experiment by the crypto community. From an investors point of view it has reinforced the idea that they should be putting their money into the companies creating cryptocurrencies and those developing the impressive blockchain technology that most believe has a more certain future – not the cryptocurrencies themselves.

Learn more about the difference between buying and trading cryptocurrencies

Still, the fast evolving and rapidly developing world of cryptocurrencies can seem like it is getting lost in its own design and demonstrating the lack of organisation and haphazardness of the industry, but every new concept and innovative idea – success or failure – is another small step toward cryptocurrencies finding their place in modern society.

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