Everything You Need to Know About Stablecoins — The DeFi Series
One concern that crypto skeptics might share is that cryptocurrencies such as Bitcoin are subject to significant price fluctuations. This, they might say, makes cryptocurrency impractical as a medium of exchange.
While the dollar and other widely-used currencies also fluctuate in value, consumers may be less likely to experience inflation or deflation of the dollar (or Euro, or other fiat currency) as immediately as they would a change in their Bitcoin’s value. Prices may go up over time, ultimately reducing the purchasing power of your paper money, but the changes are generally more subtle than those that affect cryptocurrency.
The crypto sector’s answer to these concerns about volatility: stablecoins.
What Are Stablecoins?
Investopedia defines stablecoins as “a new class of cryptocurrencies that attempts to offer price stability and are backed by a reserve asset”. Different stablecoins are backed by different types of “reserve assets”, including:
- Other cryptocurrencies, with the most popular coins like Bitcoin and Ethereum serving as value tethers for a lesser-known stablecoins
- Fiat currency, with the dollar being one example
- Tangible assets such as gold, silver, or other commodities with real value
The asset that backs a given stablecoin may affect how the issuer of the stablecoin sets a token’s price. For example, backing a stablecoin with Bitcoin obviously comes with a level of risk. If the price of Bitcoin drops significantly, then pricing stablecoins too high in relation to Bitcoin could leave the issuer of the stablecoin unable to exchange users’ coins for its equal value in Bitcoin.
Therefore, stablecoins tied to comparatively volatile assets like other cryptocurrencies must link value conservatively, ensuring that even if Bitcoin’s value dips significantly, they have a cushion to be able to redeem all of the stablecoins in circulation.
There are also unique considerations when the backing of a stablecoin is a commodity such as oil. Accounted for in the price of such a stablecoin is not only the value of having a real asset-backing, but also the cost of compliance by the coin issuer: legal fees, maintenance fees, and all of the real costs that come with keeping the operation above board. These fees may be greater than those required for a dollar- or Euro-backed stablecoin — there are simply more moving parts.
There is another class of stablecoin with no asset backing, referred to as Seigniorage-style or algorithmic stablecoin.
Rather than being tied to a commodity, these coins are even more fixed in terms of price and value. Their supply and price are built into code, and are generally managed by smart contracts to provide true stability.
What Are the Benefits of Stablecoins?
The primary benefit of stablecoins is a dead giveaway: they’re stable. Or, at least, they are viewed as stable relative to other cryptocurrency classes.
There are two primary benefits of stablecoins:
- They have less volatility than non-stablecoin tokens
- By reducing volatility, cryptocurrency becomes a more viable means of exchange
To illustrate the value of stablecoins, consider the following scenario.
Say that I would like to purchase a pizza or a motorcycle from you. I offer to pay you the price of the pie or the bike in Bitcoin or Ether, but you’ve got some understandable concerns:
Sure, the value of the Bitcoin you are offering is equal to that of the product now, but will it be in five minutes? What about five days?
It could be more, could be significantly less. Merchants may not generally be willing to gamble that they will be left taking a loss on their product, particularly when other customers are willing to pay for the pizza or motorcycle with a more stable asset such as cash.
Furthermore, in order to minimize the risk of a value fluctuation after being paid with traditional cryptocurrency, a seller would have to rush to their digital wallet and convert the coin to dollars as quickly as possible. This costs them time, effort, and fees. Even then, they may still lose out on the transaction even before fees are considered.
With stablecoins, and especially those tied to an unchanging reserve of assets, this price volatility becomes far less of a concern. In turn, proponents see stablecoins as a more readily-usable medium of exchange.
What Is the Current State of Stablecoin Usage?
There are two different categories of stablecoin, and each may be assessed individually to gauge their popularity and usefulness. They are:
- Centralized stablecoins, also known as collateralized stablecoins
- Decentralized stablecoins
Centralized stablecoins are ones backed by real-value assets, and their volatility may vary from one coin to the next. For example, a stablecoin that is tied to the price of oil may be more volatile than one tied to a fixed reserve of untouched gold. These coins generally involve custodians to manage supply and handle administrative aspects of the coin ecosystem, as opposed to…
Decentralized stablecoins. This second category of stablecoins relies on algorithms, which is why they are sometimes known as algorithmic stablecoins, to maintain price consistency. These coin-regulating algorithms incentivize users to buy or sell based on intentional economic motivators, with the end goal of keeping the coin’s value within a predefined price range. That is, to keep the coin stable.
Generally speaking, the combined popularity of stablecoins is massive (in crypto terms) and growing. According to Bitcoin.com, the market capitalization for all stablecoins surpassed $20 billion as of early October.
Stablecoins may have more promise as a model for wider adoption than other types of cryptocurrencies. With major governments including China embracing digital currency and financial stalwarts like MasterCard jumping on board, the relative stability and economic viability of stablecoins may only shine a brighter light on the merits of this class of crypto.
How Do Regulators View Stablecoins?
Ask a question about regulation and (insert cryptocurrency-related topic here), and you’re liable to get a variation of the same answers:
- We can’t be certain
- Historical precedent indicates potential trouble
- It’s not looking good
- We can hope for the best
While doom and gloom may be a fair projection for the more cutting-edge, fraud-ripe crypto projects, there truly is reason for hope that regulators will not drop a heavy hand on stablecoins.
Yes, there is generally a need for some level of regulation in the crypto space. Where there is a way to take advantage of others for massive financial reward, there is a need for a system of checks and balances.
And yes, reports by powerful bodies such as the G-20 indicate that they are wary of stablecoins in particular. This may be legitimately viewed as a harbinger for future regulation.
But signs also exist to indicate the mainstream may be more receptive to stablecoins than they have been to other classes of crypto. The Office of the Comptroller of the Currency (OCC) now formally permits certain national banks to deal in funds generated from the issuance of stablecoins. The decision is limited to stablecoins backed by the U.S. dollar (read the details here), but from a regulatory standpoint it is a step in the right direction.
The hope is that regulators will see stablecoins as a critical component of the emerging digitalized economy, rather than a threat to centralized financial systems to be “squashed”.
Whether this hope becomes a reality is largely up to regulators, and the specific decisions they issue as stablecoins’ influence becomes increasingly difficult to ignore will be worth paying attention to.