It’s been a wild ride for cryptocurrencies over the past couple of years. From the 2017 surge to the 2018 crash, entire industries surrounding the space have risen and contracted in a matter of months. Despite the increased attention on and investment in the crypto space, there are unresolved issues plaguing the industry and hampering its potential impact on a macro scale. Is the stablecoin–a new form of digital currency whose price is linked to another asset–the solution to the crypto industry’s problems? And if so, which applications of digital currency can stablecoins enable?
Cryptocurrency Has Missed The Mark
The primary problem plaguing the cryptocurrency industry today is high price volatility. This volatility is both a driver and result of the lack of public (whether institutional or individual) trust in cryptocurrency as a reliable and balanced currency option. Why is there a lack of trust? Poor and undefined regulation surely plays a role–the public is disconcerted by the lack of a structured framework to guide its adoption of crypto and therefore views it as a speculative investment. However, the lack of trust is also a byproduct of how the industry has shaped and framed itself to date.
In the cryptocurrency industry’s quest to market digital currency as a new frontier–a previously unexplored and fundamentally different space–it has ventured too far away from traditional currencies. Crypto companies have long focused on what they are not: traditional, physical, centralized. But in this process, they have failed to properly appreciate that real-world assets like fiat currency or precious metals have achieved what appears elusive to cryptocurrencies today: a history of trust and durability. This is the real and lasting value of any currency, and must be better incorporated into the digital currency model across both trading and storage–an undoubtedly challenging proposition. As the BIS, an organization of the world’s central banks, noted in its 2018 Annual Economic Report:
Sustained episodes of stable money are historically much more of an exception than the norm. In fact, trust has failed so frequently that history is a graveyard of currencies. Museums around the world devote entire sections to this graveyard – for example, room 68 of the British Museum displays stones, shells, tobacco, countless coins and pieces of paper, along with many other objects that lost their acceptability as exchange and found their way to this room.
As much as cryptocurrencies offer incremental value beyond traditional currencies such as transparency, convenience, and speed, without a stronger foundation grounded in trust and durability, cryptocurrencies will not realize their full potential. The cryptocurrency industry must begin to view itself more as the next evolution of currency, taking what has come before it and building on top, as opposed to the new imagination of currency, tearing down what has come before it and building from scratch.
Rise Of The Stablecoin
The stablecoin–a new form of cryptocurrency pegged to another asset such as fiat currency (the U.S. dollar, euro etc.), precious metal, or another cryptocurrency–theoretically represents the crypto industry’s response to the above issue. Stablecoins can be thought of as the (unproven) low risk and reliable crypto option. Their value lies in their ability to store and efficiently transfer rather than grow wealth, and they bridge the gap between physical and digital currency.
There are two broad types of stablecoins: collateralized and uncollateralized/algorithmic. Collateralized stablecoins are reserve-backed by real-world assets (fiat or commodities) or backed by other cryptocurrencies, while uncollateralized stablecoins are pegged algorithmically.
For each real-world asset backed coin, an equivalent value in U.S. dollars or gold as an example is set aside in a bank. Trust is built and maintained in partnership with a centralized financial institution. This means real-world asset backed coins should be fully and easily redeemable for their associated assets, and that coins should not be created and circulated except when this holds true. The most popular real-world backed (and overall) stablecoin, Tether, maintains an overwhelming percentage of the total stablecoin market capitalization, although this share has declined significantly–around 10 percentage points–in October 2018. Other notable real-world backed stablecoins include TrueUSD, USD Coin, Paxos Standard, and Gemini Dollar.
Crypto-collateralized coins are backed by other cryptocurrencies. Because cryptocurrencies are less stable than real-world assets, crypto-collateralized coins are over-collateralized. Whereas a U.S. dollar pegged stable coin would be pegged 1:1 (US$1 for 1 stablecoin), an ethereum backed stablecoin might be pegged 2:1 (US$2 worth of ethereum for US$1 worth of the stablecoin) to ensure stability even with large fluctuation. The primary crypto-collateralized stablecoin, Maker Dai, is pegged to the U.S. dollar, but backed by ethereum.
The final type of stablecoin, uncollateralized or algorithmic stablecoin, is fully decentralized and is stabilized by algorithms dictating its value. These algorithms maintain value and stability by controlling the supply of the uncollateralized stablecoin–shrinking and growing it as needed. Basecoin is an example of an uncollateralized stablecoin: when the coin value dips below US$1, coin supply contracts (coin holders buy bonds using their coins, after which the used coins are destroyed) to increase the price, and the reverse holds true when the value exceeds US$1.
How Stable Are Stablecoins?
Stablecoins are at the very beginning of their evolution, and as such operate and are viewed by most as untested works in progress. The extent to which these coins are or can become truly ‘stable’–consistently and precisely pegged to and backed by their associated asset–will determine whether they are judged as the latest crypto craze, or as the legitimizer of cryptocurrency. Achieving stability is no easy task, regardless of currency type. In many less mature economies, even fiat currency is rife with volatility. Look no further than Argentina, Venezuela and Turkey in the past several months as recent examples of wildly fluctuating fiat currencies. Moreover, as the BIS Annual Report attests to above, sustained currency stability is an exceptional occurrence throughout history.
Stablecoins have already had their share of controversy and growing pains in their short lifespan, and the jury is out on whether these struggles should be attributed to the coins’ immaturity or to fundamental flaws in their construction.
Real-world collateralized coins, in theory the most proven stablecoin model given their centralized store of value, have not yet proven themselves to be reliable. Tether specifically has come under attack because of questions surrounding its accounting and the process through which each of its coins is backed by U.S. dollars 1:1. The company has consistently been reluctant to provide audits of its reserves, and stands accused of manipulating the value of other cryptocurrencies because of a suspect relationship between it and the Bitfinex exchange (the two companies share executive leadership).
On October 15th, Tether broke its 1:1 link with the U.S. dollar, with one USDT token falling below US$1, jeopardizing its stability. Additionally, this past week, news broke that Tether had destroyed 500 million USDT tokens, a tactic many believe is the company’s way of intentionally contracting supply. The USDT token has recovered since its fall, but questions remain and its share of the total stablecoin market cap took a substantial hit. Apart from Tether, other real-world collateralized stablecoins have and continue to fluctuate slightly above or below US$1, enough to question whether a true 1:1 peg is possible. Even if real-world collateralized coins are able to eventually stabilize, crypto purists argue that the fact that real-world collateralized coins require a central third party clashes with the very premise of cryptocurrency.
As far as the other types of stablecoins, one might argue the inverse of the above point: that crypto-collateralized stablecoins undermine the very premise of the stablecoin. While they offer more decentralization than real-world collateralized stablecoins, because these coins peg one historically volatile cryptocurrency to another, what’s to say that the coin serving as backer could not fluctuate enough to irreparably undermine the stability of the backed coin? Following this line of thinking, algorithmically-based coins are even further removed from a real and proven model of backing, and are far more complex than real-world collateralized stablecoins. Holders of uncollateralized tokens lack a claim on any underlying assets in the event of token collapse.
No single stablecoin has been able to achieve the balance of centralization and decentralization, while maintaining speed, transparency, simplicity, and consequently trust. Despite this fact, the number of new projects and investment has only grown in 2018. Stablecoin projects, of which there are around 50 either live or in development, have raised a combined US$350 million in investment capital, attracting attention from financial institutions within and outside of the crypto world. Major exchanges have begun to embrace stablecoins, and Tether ranks 8th in total market cap among all cryptocurrencies at the time of writing despite its recent woes. This is a testament to the wide-ranging potential of the stablecoin. If true stability (or truer stability than existing alternatives) is achieved, stablecoins could serve to unlock the potential of cryptocurrency and expand its application and impact.
Stablecoin Use Cases
The primary use case for stablecoin in its current conception is a tool to bypass restrictions arising from the clash between traditional financial institutions and crypto institutions. Many crypto exchanges can’t deal directly in fiat currency, so stablecoins act as a valuable substitute: a medium of exchange and a store of value. They allow investors to have more control over their funds–effectively both moving between cash and crypto and storing their funds in reserve without undermining their value, especially in periods of volatility. Stablecoins also offer exchanges access to the much needed liquidity they can’t access through banks using traditional means.
This use case scratches the surface of what a truly stable coin can enable: the next generation of financial products and services built on the blockchain and transacted leveraging the benefits of digital currency. This includes insurance-related products, better and more equitable credit networks and loans, smart contract dividend payments, and more. These products might not currently be viable on a large scale because of the volatility associated with standard cryptocurrencies, however stablecoins could change that, lending credibility to existing products and catalyzing the research and development of new products.
On an even broader macro level, the achievement of a stable coin could help citizens in developing countries gain reliable access to price-stable cryptocurrency assets. As noted above, throughout history currency devaluation has caused havoc in unstable economies. For those citizens holding a currency in collapse (or even experiencing high inflation rates), the idea of transferring wealth into a stable cryptocurrency is an appealing proposition, essentially replacing a volatile currency with the substitute for a more stable currency.
A Novel Approach
The potential impact of stablecoins is too great to ignore, however they currently fall short of this promise. How can stablecoins evolve? How can they boost their stability and subsequent adoption? One solution being pursued by a select few stablecoin companies is creating hybrid models of stablecoins combining multiple types of backing.
Vault, a Canadian-Swiss company backed by a consortium of precious metal focused private equity funds, is taking such an approach, and is planning to launch its USDVault stablecoin by the end of 2018. There are other stablecoins using multiple concurrent mechanisms reinforcing stabilization such as multiple fiat currencies, but The USDVault token is unique in that it is the only U.S. dollar pegged and gold backed stablecoin–a formidable combination. Furthermore, the tokens are fully redeemable for either U.S. dollars or gold.
As Vault Co-Founder and CEO Ranjeet Sodhi explains: “LBMA gold bullion (physical gold) is purchased only when a customer buys the USDVault token by sending their funds to our fiduciary partner. The funds are sent to a trust via our fiduciary partners and this trust then purchases an equivalent amount of gold bullion (which is stored in fully insured Swiss vaults). The trust also executes a gold hedge, and in parallel instructs Vault to issue the USDVault token to the customer’s wallet.” This process ensures not only increased stability, but also increased transparency as all transactions are overseen by third party fiduciary partners, avoiding the issues presently casting a shadow over Tether.
The USDVault token will be targeted toward institutional investors at first, with individual investors soon to follow. Tokens will be available both directly via Vault, and also via partner exchanges. The company plans to charge small issuance, redemption, and vaulting fees to generate revenue.
Time will tell whether the dollar pegged, gold backed model can achieve what other stablecoin models haven’t been able to, but the launch of multi-backed coins like USDVault is a step in the right direction. As more and better stablecoin projects launch, each will be able to learn from its predecessors and competitors, and to incorporate best practices to minimize risk and maximize stability.
The Future of Stablecoins
Stablecoins have already accomplished a crucial goal for the crypto industry: highlighting the need to identify ways to better build trust into crypto. As stablecoin projects strive to generate trust, patience and support is required both from the crypto industry and from the centralized banking industry. This comes in the form of financial backing to ensure liquidity, regulatory backing with an understanding that stablecoins are the closest things to real-world collateralized assets that exist in the crypto world, and the backing of crypto exchanges in promoting stablecoins on their platforms.
If these conditions are met, it’s entirely possible that down the road, the currency solution of the future will be equal parts cash and crypto, centralization and decentralization, speed and security. All in the name of achieving the pinnacle of currency: true and lasting stability.