Stablecoins: The Best of Both Worlds, But Not Without Compromises

Cryptocurrencies are notoriously volatile, preventing them from being used as mediums of exchange. However, stablecoins aim to change that, and this article discusses how.

Satoshi Nakamoto envisioned that “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”, and that is the essence of Bitcoin - decentralized money. However, the fluctuations in price (just yesterday BTC rose from under $7,000 to over $8,000) render Bitcoin ineffective when it comes to a medium of exchange and a store of value.

Ask any business which accepts cryptocurrency payments and you’ll realize how challenging the accounting process becomes when the value of their digital assets is not even remotely stable. Similarly, if a business pays out salaries in crypto, they can’t purely decide upon a BTC figure because one month they could be paying out $20,000 and the next month it could only be $10,000.

While we can’t deny the advantages of digital currencies, particularly their decentralized natures, near instant transactions times, privacy-centric features and seamless cross-border accessibility (regardless of geographical and political boundaries) - at the end of the day most of us turn towards USD, GBP, EUR or other fiat currencies because they are stable.

The question then arises, can we have stable cryptocurrencies or stablecoins?

The notion is very alluring - a digital currency which brings the best of both worlds - but is such a currency even possible? Let’s discuss.

How Do Stablecoins Work?

Simply put, in order for a digital currency to be stable, it needs to be pegged to something (collateralized), and in most cases, these pegs are fiat currencies.

For instance, if an entity decides to issue new tokens which are supposed to be worth a carrot each, the easiest way to ensure that stability is to deposit one carrot for each token released into the market.

While this is not an organic way to move forward, it is an efficient solution which makes sense; however, it is not without its compromises.

USDT as a Fiat-Collateralized Stablecoin

Tether or USDT is a great stablecoin example, backed by USD. According to Tether Limited, each Tether is redeemable for a dollar, which is why you’ll see that its price never fluctuates more than a few cents.

In reality, Tether is just like an IOU, and somewhere, in a bank, controlled by Tether Limited, there should be nearly $2.3 billion, backing each USDT in circulation.

“Should be” is the key term here, because when we’re using USDT, we are effectively trusting Tether Limited to be maintaining the USD peg (unless they are regularly audited - something the company avoids).

Moreover, having the whole collateral held in a fiat currency, in a traditional bank, goes against the principles of decentralization. If anything, the fiat-backed USDT is vulnerable to governmental interference, changing banking laws and financial regulations, and may leave token holders without any recourse in any of the aforementioned events.

Finally, with a stablecoin like USDT, if you wanted to exchange your tokens for cash, you would have to resort to traditional payment systems, such as wire transfers, which again fall under governmental controls, are slow and costly.

Given all this, we can see that a fiat-backed stablecoin achieves price stability at the cost of decentralization, security and privacy. However, USDT is widely used on crypto exchanges as a store of value, especially when traders and investors want to secure profits from highly volatile crypto markets.

Crypto-Collateralized Stablecoins? (Havven as an Example)

To avoid some of the issues that come with a fiat-pegged stablecoin, we could look at a crypto-collateralized digital currency model.

Firstly, since cryptocurrencies are by nature volatile, we need to figure out a model which allows for a stablecoin to be pegged to an unstable digital currency.

One way to create such a stablecoin is to over-collateralize - which means each stablecoin is backed by a cryptocurrency (like ETH or BTC) with a value higher than what is being issued.

For instance, if we want to issue a crypto-backed stablecoin valued at $1, we could do that by collateralizing it against $5 worth of ETH and protecting it from market volatility.

One example of such a stablecoin is Havven, which introduces a dual-token model, comprising of Nomins and Havvens.

Users holding Havven tokens are able to issue new Nomins worth 20% of their Havven holdings (and thereby collateralized by the remaining 80%), and in exchange, they receive a portion of the transaction fees.

In such a model, collateral providers are incentivized by fees and currency users get a stablecoin valued at a certain price and protected against price fluctuations.

However, even this model is not without its issues. Firstly, it depends heavily on the underlying cryptocurrency (in this example ETH), and even though the stablecoin is over-collateralized, it is not uncommon for the crypto market to suffer from deep corrections that can last over long periods of time.

Secondly, the system is inefficient when it comes to capital usage and as the ratio cited above suggests, you have to lock-in a large amount of digital currency to issue a small fraction of its value as a stablecoin. The advantages on the other hand, include decentralization and higher liquidity, and at the end of the day, such a model could prove profitable for collateral providers if the stablecoin reaches mass adoption.

Conclusion: The Price of a Stablecoin

A decentralized, secure and private stablecoin is the dream, but as of now, the possible models are not without compromises. If we want the ultimate price stability, the answer is a fiat peg, but that takes us towards centralization and its pitfalls. To avoid those, we can go the crypto route, but that is not the most efficient model and cannot guarantee stability to the same extent.

Other examples of stablecoins include the gold-backed DigixDAO and True USD which use similar models. At the end of the day, stablecoin users pick their own compromises and move ahead until alternative models are introduced, but they definitely raise interesting questions, which if solved, could lead to a mass-adopted crypto stablecoin.