There’s a lot of talk about how cryptocurrencies are the future. Many people expect them to revolutionize how we do trade.
In any case, aren’t they a product of technology and innovation? And aren’t technology and innovation the driving forces behind change and convenience?
Cryptocurrencies have certainly come a long way. Since 2009 when Bitcoin was created, there has been no going back.
You would think that Bitcoin was all that was needed. Or maybe just a few alternatives would be good enough for the expected change. Not so.
New cryptocurrencies are always coming up faster than they can be counted. By the end of 2018, there were over 2,500 cryptocurrencies.
However, only 25 out of those made up 90% of the total market capitalization.
And you know what? Bitcoin took 59% of the total market capitalization of those 25. clearly, Bitcoin still reigns.
Still, the cryptocurrency journey has been long. But there is certainly some progress.
- Coinbase, a leading US crypto exchange saw user numbers grow from 0.4 million in Jan 2017 to 5.6 million by June 2018.
- Of all ICOs (the cryptocurrency version of IPOs), only 8% have become successful.
- Fraudsters have also developed an interest in cryptocurrencies. Each day, scams cost investors $9 million worth of cryptocurrencies.
But even with achievements, something still holds them back.
To a large extent, there’s one thing that is really making it difficult for cryptocurrencies to replace fiat money.
If this one thing is taken care of, then the revolution will indeed take place.
This challenge is the inability of cryptocurrencies to maintain stable prices.
As a means of exchange, it’s necessary that the payment method used should be stable. There’s no way a currency will be changing value radically as witnessed in the case of cryptocurrencies.
Consider the below graph showing the price of Bitcoin in the span of 1 week.
Source: Omenics
Making Cryptocurrencies Stable
Efforts have been made to make cryptocurrencies as stable as possible. Unfortunately, they haven’t paid off. The reason is connected to the fact that these currencies are decentralized in nature.
If you think of how fiat money works, the federal reserve (or any other central bank) is squarely in control.
From the supply to the value, the central bank is in charge of keeping things in order.
Of course, there are instances that even the central bank may find it difficult to do this. For example, in cases of extremely high inflation, all the normal actions which the central bank can take will offer little help.
Such cases are however more of an exception than the norm. So generally, the control of money is central. Eliminating this central control is part of the vision of cryptocurrencies.
And in all the research and innovation efforts, the solution seems to be stablecoins. At least as far as price stability is concerned.
The stability of cryptocurrencies will help drive adoption rates. Once that is done, there will be no stopping the revolution.
But what are these stablecoins and how are they solving the stability problem?
How Stablecoins Differ from Other Cryptocurrencies
First of all, stablecoins are cryptocurrencies. They therefore have the same underlying technology as Bitcoin, Ethereum and the others.
There is however a big difference which has been brought about by the need of stability as explained above.
Stablecoins are cryptos which are meant to serve only this one purpose. With price value being stable, it will be easier for coin holders to be able to more easily determine the value of their holdings.
Many of the stablecoins in operation attain their stability by undergirding their value using fiat money. The most common being the US dollar.
This is referred to as collateral.
Some however use different means to achieve the same results.
There are at least three common types of collateral used by stablecoins.
The type of collateral is what usually differentiates them from one another at the highest level.
TYPES OF STABLECOINS
The collateral used to make stablecoins stable is a form of asset. Since the asset has its own value, the value of the stablecoin then gets determined by the asset’s value.
Whereas some assets are simple to understand, like the US dollar asset, some are relatively complex.
Here is a brief discussion on the various types of collateral used.
Fiat-Collateralized
This is the most common and is also the easiest to understand of the three types.
As the easiest to understand, it’s also the one which has received the highest adoption.
And the currency used as collateral is the US dollar.
Stablecoins having the US dollar as the underlying asset have attracted a lot of attention from stock traders. Early adopters have also jumped onto the bandwagon. Those new to the crypto world also find it easy to embrace them due to their simplicity.
In this type, every coin is valued at $1. This means that the rate of the coin to the dollar is 1:1.
When the value of a coin is pegged at 1 US dollar, you can easily tell how much your investments are worth. In the real world of physical goods and services, you can determine how much you can own or do.
For example, using the coin value, you can easily determine whether you can buy a new TV, car, home etc.
The success in stability and adoption are however not without challenges.
Fiat-collateralized stablecoins have been accused of going against the principle of decentralization.
This is because fiat money is controlled by a central agency. All the control is therefore in the hands of that agency. As such, critics raise this as an issue and attempt to invalidate the coins.
An example of this is Tether (USDT).
Crypto-Collateralized
Another form of collateral is using a different cryptocurrency. This has its own set of challenges.
Naturally, all cryptos are unstable in their value. In order to achieve acceptable stability, these stablecoins peg their value on a mix of cryptocurrencies.
This provides a shield because the coin does not depend on only one crypto as collateral.
Still, these stablecoins are not fully stable and haven’t been embraced much. The fact that the mix of collateral is the same unstable cryptocurrencies makes it difficult to attain stability.
All the same, these are more accepted among the cryptocurrency community compared to the fiat-collateralized coins. This is because they maintain decentralization.
- An example of this is MakerDAO/DAI
Non-Collateralized
These stablecoins are the most technically advanced of all three. Their lack of collateral is based on complex algorithms which find their basis in economics.
Having no collateral, they rely on their own systems to control the supply and value of their coins. This is why they are also referred to as algorithmic stablecoins.
As such, these coins handle both these aspects using the code specified during creation.
The supply of any currency is directly connected to its value.
Therefore, to reduce an oversupply which reduces the value, the system comes up with “bonds” for selling. As speculators buy these, the supply of the coins reduces.
If the supply is too low, thereby increasing the price, more coins are issued. This has the effect of bringing the price back to the defined normal.
Algorithmic stablecoins utilize the system of Seigniorage Supply to achieve this. And interestingly, this mode of operation is actually what is done by central banks.
One of the ways central banks regulate the value of their currencies is by controlling supply. If there is an option which is truly technology driven, then it is this one.
As with the other types, a challenge exists for these too. The bonds can be a tricky investment option since they have to guarantee a profit.
An example of this is NuBits (USNBT).
BENEFITS OF USING STABLECOINS
Stablecoins have undoubtedly ushered in a new dawn. This is especially for early adopters of technology and speculators.
And as their stability continues dominating conversations, more entrants are coming into the market. This is how the market looked like as at May 2019.
Source: Finance Magnates
Their use has been embraced for a variety of reasons.
Here are some of them.
Make it Easy for Cryptocurrencies to be Adopted
The original cryptocurrencies were difficult to understand, thus difficult to both appreciate and embrace. All the technical jargon and explanations left many believing that this was for geeks.
It was difficult to prove their use in the real world of exchanging goods and services. But stablecoins are slightly different, especially the fiat-collateralized type.
When you explain to a layman that stablecoins are a form of digital money, it’s easy to see how. The fact that one coin has the same value of one US dollar makes it easy to be understood.
Once it’s understood, then adoption becomes easy. And if they can be widely accepted, then they will have achieved their goal.
Reduced Volatility
As their name suggests, these coins are intended to be stable in price. That is also the biggest reason for their development—reduce price volatility.
To this end, all the three types are promising acceptable results. But of the three, the fiat-backed stablecoins are the winners this far.
A coin like Tether has already experienced a lot of success on this basis.
The coins backed by other cryptocurrencies are yet to be widely embraced.
This is because of the underlying challenges with cryptocurrencies generally being unstable.
It thus doesn’t become easy to convince someone that a crypto will be stable yet it has its backing on an unstable asset.
Can Be Easily Valued
Stablecoins, especially the fiat-backed type can easily be valued. It’s actually as easy as just getting the account balance and using the dollar symbol to understand or communicate the value.
For example, you may have 1,000 Gemini Dollars. This simply means that you have 1,000 US dollars. This will make it easy for adoption into the daily transactions in the world.
For example, a camera may cost $100. To buy it, you will only need 100 Gemini dollars. This means that to enable payments at the POS, only a stablecoin payment option may be needed for the retail outlets.
When developers come up with these, everything will flow quite easily.
Faster and Cheaper Money Transfer
Being a digital solution, there are bound to be many advantages of this technology. One of them is that they facilitate faster and cheaper money transfer.
Imagine a situation where it usually cost your bank $2 to transfer money to your relative in another country. This is the total cost from the employee, power bill and audit for human error.
Now imagine all these removed. Probably the cost of system audits is 50 cents. If the bank is to use an advanced means for the transfer, it will be both cheaper and faster.
This is what JP Morgan is doing using their JPM Coin.
LIMITATIONS OF USING STABLECOINS
Nothing can be all advantageous and lack any disadvantages.
As stablecoins continue to grow towards maturity, it pays to consider their shortcomings.
This will help you determine whether to jump in right now or to adopt a wait-and-see attitude.
Most are Only Backed with the USD
There are several stablecoins which are already enjoying some degree of acceptance.
These are mostly the fiat-backed types. Whereas that is a good thing, there is one potential drawback.
Most of them are pegged on the US dollar.
This might be as a result of many of the companies being American. It might also be due to the fact that the US dollar is the currency used in international trade as well as in holding reserves.
Either way, this may prove problematic. Being new and with little proof of tested and verified long-running successes, over-reliance on the dollar may not be the best idea.
As it is, some countries and regions are already toying with the idea of abandoning the dollar for use with reserves. Some are suggesting different currencies for reserves while others are looking to return to gold.
Since stablecoins are aiming at replacing fiat money, consistency is a must. Just as fiat money was initially based on gold , the same needs to apply to stablecoins.
But having one currency as the backbone of stablecoins may not work for the long-term.
In any case, as a technological solution, other countries will obviously want their currencies to be the collateral.
And just how practical will it be, for instance, for China and Iran to run their stablecoins on the USD?
Do Not Factor in Inflation
If you are an investor, you know that you can never value your investments at a 1:1 rate to the dollar. Neither can you do the same with any currency.
Why?
There is inflation to be factored in.
One principle of investment says that the value of money held today is not the same as of money to be received tomorrow. This is referred to as the Time Value of Money.
For example, you may buy 1,000 stablecoins. At the moment of purchase, your investment is worth $1,000. However, what happens if the rate of inflation rises?
With a higher inflation rate, the value of money reduces.
The 1:1 rate of value stays the same. If $1 becomes less valuable, so does your investment. This means that stablecoins do not provide investors any considerable protection against inflation.
Fiat-Collateralized Type Aren’t Decentralized
As cryptocurrencies, stablecoins need to maintain a decentralized nature.
This is one of the criticisms the fiat-backed type is battling. And although it has already taken off and seems to be gaining popularity, some are rejecting it for being centralized.
The fiat-collateralized stablecoins have three main points of control.
The first is the underlying asset—in most cases the USD. The US dollar is itself controlled by a central agency. As such, it is a centralized system. Secondly, the money used to back the coins must be available in a physical sense for the sake of withdrawals back to USD.
That money is usually stored in a bank.
That is another party introduced right there. Mind you, the bank is controlled by its own management.
It’s also under the control of the same central agency controlling the USD—the federal reserve.
The third point of control is the organization running the stablecoin.
The way cryptocurrencies originally function, is by setting all the rules in the code. There is very little change from external sources that can be done to change how things work. If there is a need for change, forks are developed.
But in the case of these coins, change can be introduced at various levels. This is against the philosophy of cryptocurrencies being decentralized.
Requires Faith in the Underlying Asset
One of the biggest limitations is the need to have faith in the underlying asset.
If the coin is backed by the USD, then you must have faith in the USD.
You must first of all believe that it is a worthy asset to back your coins on. Although the US dollar has for decades enjoyed the faith of many, geopolitics can easily bring about changes to this.
And before that even happens, there is already a stablecoin backed by the Euro and a stablecoin backed by the Japanese Yen.
These inconsistencies might be okay for local trade. But for international trade, there has to be one asset being used just as the USD is currently being used.
CONCLUSION
Stablecoins are under continuous development and improvement.
Still, they have already established themselves as a possible future of money.
If only the challenges facing them can be conclusively addressed, then we might experience the biggest change of the millennium.
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