Stablecoins: The Best of Both Worlds

Blockchain has poised to disrupt industries, as it enables entities to establish trust and transparency seamlessly. Its potential to digitize, decentralize and securely record transactions of digital assets has been revolutionizing the traditional business network. Addressing the complexities, vulnerabilities, costs and inefficiencies of current transaction systems, blockchain technology have taken the worlds of Finance and Technology by storm. Bitcoin, the groundbreaking application of Blockchain technology was the first modern crypto-currency, and is still the biggest in terms of market capitalization, volume acceptance and notoriety. However, investments in cryptocurrencies has been at a constant risk of losing value due to market fluctuations of 20% or more on any given day. And the latest downhill trend of cryptocurrency prices has placed the market in a troublesome and fragile position.

Inherent instability of bitcoins and other cryptocurrencies makes them incompatible with the concept of an unit of account or a store of value. Extreme price volatility coupled with rising transaction fees is a big obstacle to the widespread adoption of cryptocurrencies. What we need is, a cryptocurrency that can offer the best of both worlds - transparency, security, immutability and scalability of cryptocurrencies, along with the trust and stable valuations of fiat currencies. Stablecoins, the emerging class of cryptocurrencies hope to achieve this very goal.

“Stablecoin is a cryptocurrency that is collateralized to an underlying asset with a stable value such as gold or fiat currencies.“

Value of the stablecoin will be backed by the real-world assets in reserve by the issuer, which makes it centralized by definition. At the same time, pegging of stablecoins to assets gives these coins price stability which improves the adoption rate of cryptocurrencies among everyday users. According to Stable Report, a Crypto research group, 120 stablecoin projects are underway and the value of stablecoins stands at about $3 billion. In fact, the plunging market values of cryptocurrencies have been forcing investors to seek relief in stablecoins.

There are mainly four types of stablecoins:

1. Fiat-collateralized stablecoins
2. Commodity-collateralized stablecoins
3. Crypto-collateralized stablecoins
4. Non-collateralized stablecoins

The most common types of stablecoins that are pegged to fiat currencies like USD, EUR or GBP. Fiat-collateralized coins follows the most simple and straightforward concept where 1 stablecoin is equivalent to 1 unit of currency. Whenever a fiat-collateralized stablecoin is produced, an equal value of fiat currency will be placed in reserve by the coin’s issuer. Whenever the coins are redeemed for cash, the equivalent stablecoins are destroyed or taken out of circulation. Since these stablecoins follows the simplest structure, it would improve its widespread adoption.

Currently, Tether (USTD) is one of the most popular stablecoin with highest daily trading volumes, just after Bitcoin. However, Tether’s refusal to undergo a transparent audit process or disclose its banking relationships has sparked great controversies in recent times. While the rumours of Tether’s alleged price manipulation continues to swirl, other companies are bringing new stablecoins to the crypto market. Some of the popular names include TrueUSD (TUSD), LBXPeg, Candy, Paxos Standard (PAX) and Gemini Dollar (GUSD).

The most important downside of fiat-collateralized stablecoin is its centralized nature which makes the coins highly prone to various vulnerabilities and risks. Since the coin issuing process is highly reliant on the issuing party, costly audits and regulatory compliance are a necessity.

As the name implies, these stablecoins are pegged to interchangeable assets. Even though the most common commodity to be collateralized is gold, there are also stablecoins backed by oil, real estate, and baskets of different precious metals or stones. For a stablecoin backed by gold, one coin will represent a specific value of gold. All the valuable assets pegged to coins are held in real physical asset reserves and safe vaults.

Digix Gold (DGX), built on Ethereum network is an example of the biggest commodity-backed stablecoin. 1 DGX represents 1 gram of gold . DGX creators claim to have fully-audited and stored the gold in a vault in Singapore. Tiberius Coin (TCX) backed by a combination of seven precious metals used in technology hardware and SwissRealCoin (SRC) backed by a portfolio of Swiss real estate are other popular commodity-backed stablecoins in the crypto market. Since commodity-backed stablecoins are also centralized, the coins are subjected to drawbacks in terms of transparency of issuance or audits.

Crypto-collateralized stablecoins are decentralized stablecoins that are backed by other top-ranked digital currencies. Rather than being backed by a single crypto currency, these class of coins are pegged to a mix of digital currencies so that it allows better distribution of volatility risks. Furthermore, crypto-backed stablecoins are over-collaterized so that it can withstand the extreme price fluctuations of underlying cryptocurrencies. Since these stablecoins follow a decentralized structure, investors can reap benefits such as transparency, security and efficiency. Yet, the biggest downside of crypto-collateralized stablecoin is the volatility of underlying currency. In fact, if the value of underlying currencies plunges below a threshold level, then the stablecoins are liquidated automatically.

MakerDAO (DAI) is the most prominent example of crypto-collateralized stablecoin. It is fully decentralized and asset-backed stablecoin with a face-value pegged to USD and backed by ETH locked up in the autonomous system of smart contracts.

Non-collateralized or Algorithmic stablecoins are not backed by any asset or currency, other than the expectation that they will retain a certain value. Let us take US dollar as an example. US dollar used to be backed by gold ages ago, but it is no longer backed by an underlying asset. Yet dollars are perfectly stable because people believe in their value. Non-collateralized stablecoins follows the same idea and uses an algorithmically governed approach called Seignorage Shares, envisioned by Robert Sams.

The idea of Seignorage Shares is to control monetary supply by modeling a smart contract as a central bank with the single mandate to issue a currency that will trade at $1. When demand increases, new stablecoins are created to reduce price and bring back stability. On the other hand, if the trading is too low, then seignorage-backed stablecoins are brought up to reduce the circulating supply.

The best example for seignorage-style coin is Basis that peg its value to USD through algorithmic adjustments of coin’s supply. Since algorithmic stablecoins are the most decentralized and independent form of stablecoins, they ensure transparency, security and stability. However, the biggest downside of Seignorage-style coin is that its value is based on a promise of future growth. In case of a black swan event, there is no collateral to liquidate the coin back into, which detracts away investors from choosing this model of currency.

Although still in its early stages, stablecoins have many potential applications in real life scenarios. They can be used for peer-to-peer (P2P) payments, affordable and faster remittances, protection from local currency crashes, improved cryptocurrency exchanges and as a everyday currency.

While stablecoins present a long list of benefits, there are some downsides too. Most of the stablecoins follow a centralized structure which raises concerns on transparency and trust. Regulatory compliance is another concern as it compromises the efficiency of conversion process. And there is always the risk of market crashes and price instability of underlying assets which would be disastrous for the stablecoin.

Stablecoins are the newbies in crypto economy and they have a long way to go before entering mainstream. Each type of stablecoin has its own set of pros and cons, and it would be impossible to predict what future has in store for these emerging class of crypto-currencies.