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Why Stablecoins Are Important in a Digital Economy

If the past five years have taught us anything, it’s that cryptocurrencies are here to stay. Despite the bubble bursting in 2018, followed by pronouncements of bitcoin’s demise for the umpteenth time since its inception, the development has carried on unabated.

Love it or hate it, the Internet now has its own money and the traditional financial system is taking notice, with all manner of on-ramps and bridges between the two systems having been erected in the last year alone. But up until recently crypto lacked one of the cornerstones of any mature market—stability— and this is precisely what stablecoins are here to offer.

Value is Relative

Most of us have come to terms with the fact that the money we keep in our wallets is only worth what it says it is due to the collective faith we place in the government that issues it. This shouldn’t be regarded as a controversial statement, particularly since our national currencies are no longer backed by gold or silver and especially since the financial crisis of 2008.

But it’s not the fact that value depends on trust that confuses us as much as it’s the fact that value is relative. The value of everything, even the all-mighty dollar, is never absolute, it’s always relative to something else you might want to purchase with it.

Stability vs Volatility

And it’s this relative value that’s been such an issue for the cryptocurrency space. Economies are powered by the flow of capital, by transactions between producers and consumers. Neither of these two groups enjoy volatility and when you don’t know what your money is going to be worth tomorrow, all bets are suddenly off. If it’s going to be worth more, then you don’t tend to spend it. If it’s going to be worth less, then you try and offload it for something else as quickly as possible.

What you’re not doing in either scenario is purchasing goods and services with it and you simply can’t run an economy like that. This is what has happened to crypto and it’s also why its first killer app was and still is trading. Only speculators enjoy such volatility.

Traditional Markets Have it Figured

In the traditional financial world the terrain has already been mapped. It’s not perfect but it works. The major currencies (US dollar, British pound, Japanese yen, Swiss franc, Canadian dollar, Australian dollar, New Zealand dollar) all fluctuate against each other within a very narrow range.

Then you have the equity markets where money goes to grow, where investors don’t just hope that the S&P 500 will continue going up year on year, they expect it to. And finally, once in a generation, when it all blows up in our faces, money floods into gold because it’s rare, shiny and people trust it.

To illustrate this, from 2015 to 2018, the euro appreciated by almost 7% against the US dollar, the S&P 500 appreciated by over 40% and gold appreciated by around 5.5%. In the same period bitcoin appreciated by around 9500%, then promptly dropped by 80% throughout 2018 when the market corrected.

For digital money to be anything other than just a godsend to traders, it has to be able to do everything it does so well (be secure, sovereign and instantly transferable for almost free) and be stable enough so that you can plan what you’re going to do with it next season.

Stablecoin

The Problem of Correlation

Correlation is the reason why it’s considered sound investing to diversify your portfolio. You don’t want to have all your eggs in one basket. Ideally you want your capital to be spread across a variety of assets with differing correlations so that should one of them tank, the others won’t follow and some may even go up.

If everything you own is correlated, then it all moves up and down in concert and you’re vulnerable to every downturn. Non-correlated assets are to investors what rare breeds are to birdwatchers. And, funnily enough, this is exactly what cryptocurrencies have been to savvy investors throughout their meteoric rise. A non-correlated asset with the potential for asymmetric returns.

However, within the crypto economy itself, by and large, everything is still correlated to bitcoin. Bitcoin goes up, altcoins rally even higher. Bitcoin goes down, altcoins tumble to oblivion. You see the problem.

CBDCs

When the financial system finally started paying attention to crypto a few years ago, CBDCs, or Central Bank Digital Currencies, started becoming a hot topic. The Bank of International Settlements even released a report on the subject. The idea being that if digital currencies really are the future of finance, then at some point central banks will also have to start issuing their own versions, like a digital dollar or euro.

The sentiment was positive but non-committal and to date no government has come out with one. Venezuela toyed with the idea of a national cryptocurrency called the petro, which would be backed by the country’s substantial oil reserves, but no-one bought it. Literally or figuratively.

So if the traditional financial system isn’t ready to come on board yet but Internet money desperately needs the stability that it has to offer, what next?

Enter Tether

Tether was the first widely used stablecoin. It’s a cryptocurrency pegged to the US dollar and the company behind it, Tether Limited, used to claim that every unit of USDT was backed by a US dollar held in reserve (in March of 2019 the company changed the terms of this backing to include “cash equivalents”).

As with everything in crypto, the first big use case was trading. Tether allowed you to trade your way in and out of bitcoin, ether and the 1000+ other altcoins, into something that looked and felt like crypto but behaved just like the US dollar. It tracked the value of USD but you could do things with it that you simply can’t with fiat dollars. For example, you could send it back and forth between different exchanges, all day long, taking advantage of price inefficiencies or simply trading less liquid, hard to find coins.

Try transferring your dollars from bank to bank in the same manner. Tether’s great irony was that many crypto enthusiasts, who got into the space because they couldn’t trust central banks and were ideologically positioned against them, ended up relying on a coin that explicitly derived its value from the US dollar. When the market crashed in 2018, Tether conferred all of crypto’s numerous benefits while still preserving the gains they had made during the bull market.

They could sell bitcoin for tether when bitcoin was up, and buy even more bitcoin back with tether when bitcoin was down. Tether has not been without its issues, not least the company’s lack of transparency, conflicts of interest inherent in its connection with the Bitfinex exchange and the fact that it has always been rumored to be running on fractional reserve.

In April of 2019, Letitia James, the New York Attorney General, accused the Bitfinex exchange of using Tether’s reserves to hide a loss of $850 million. Despite this it still remains the largest and most liquid of all the stablecoins.

Stablecoin
Beyond Speculation

Stablecoins may be a boon to traders but speculation is just scratching the surface of what they can do. Those of you who have been following the space for a few years, even casually, will recall all the fuss that was initially made over how bitcoin could revolutionize remittances, disintermediating middlemen like Western Union that charges the poorest among us a hefty fee just to send money home to their families.

Then, when bitcoin surged in 2017 and transaction fees went through the roof, the narrative changed to it being a store of value, rather than peer to peer money as Satoshi had envisioned in his or her whitepaper. Even with Segwit having addressed the skyrocketing fees that we saw at the height of the bubble, stablecoins like tether offer the ability to send what are effectively digital dollars anywhere in the world without any of the volatility risk.

They allow anyone, anywhere to convert the value they hold in their own local currency into a stable digital asset pegged to a more reliable fiat currency and flee corrupt, bankrupt and potentially dangerous regimes.

Then there are digital loans, derivatives, prediction markets and digital payments, all of which function much smoother and more efficiently when employing a currency that doesn’t swing wildly in value.

Also, think about all the value locked up in loyalty points, air miles and the like. In a fully tokenized economy all of these different balkanized assets can be made liquid, with stablecoins allowing users to trade in and out of them as required.

Stablecoins Aren’t All Created Equal

Broadly speaking, there are four different kinds of stablecoins, although there can be some overlap between them.

Pegged

Stablecoins can be pegged to a real world currency, but just like national currencies like the Hong Kong dollar or Lebanese pound, which are also pegged to the US dollar, they are not redeemable for US dollars. Tether is a stablecoin that is pegged 1 to 1 to the value of USD but is not redeemable for US dollars.

Redeemable

TrueUSD, a tether rival created by Trust Token, Inc. is pegged to the US dollar and is also fully redeemable for US dollars through an escrow account. The company also conducts regular third party audits of its USD holdings and is working on a feature to allow users a real time view of the fiat dollars it holds on reserve.

Collateralized

Collateralized stablecoins are similar to the coins we’ve seen above, the main difference being that the assets used to maintain stability can be other than fiat currencies. They also may or may not be redeemable for those assets. For example, Digix maintains the stability of its DGX coin by backing every unit with a fully redeemable gram of gold held in a vault in Singapore. DAI, another collateralized stablecoin, achieves US dollar parity in a completely novel algorithmic way.

Created by the MakerDAO project, DAI employs something called a Collateralized Debt Position (CDP). Users create DAI by locking up ether, the native currency of the ethereum blockchain, in a smart contact. Think of it as an autonomous loan. They can get back the ether they originally locked up by paying back the DAI they created plus interest. This is all done without any human intervention. The stability of DAI is maintained at parity to the US dollar by dynamically increasing or decreasing fees in order to make DAI more scarce or abundant, as the need arises.

Centralized

Big tech companies (Tesla notwithstanding) don’t tend to be very fond of the idea of open source software. For related reasons, many institutions that have now come to accept the usefulness of digital money, also want to dip their toes in but are not so keen on giving up the control that decentralization entails.

Many people would argue that it’s not a cryptocurrency if it’s not fully decentralized but this hasn’t prevented centralized organizations from working on their own digital coins. The aforementioned CBDC’s are an effort in this vein. It has also been reported that JP Morgan is developing its own JP Morgan coin and Facebook is also in the final stages of preparing a testnet for its own stablecoin, dubbed Project Libra.   

The Future?

It is now almost taken for granted that digital money is going to be a major part of our future. The past decade or so has revealed how perilous centralization can be in the digital domain, and we are gradually coming to see the usefulness of decentralization beyond money laundering and dark markets. The question remains who will be the major players going forward? Competition is key in this respect.

The coming years will see a great number of existing stablecoin projects fading from memory as a plethora of new ones come to the fore. It’s all part of an on-going process of refining what works, establishing best practices and filling new niche cases as and when they arise. There may even be a place for centralized corporate coins, like Facebook’s even if it’s only to on-board the masses. One thing is certain though, stablecoins are here to stay and you may well be using one yourself sooner than you expect. 

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