Stablecoins – Everything You Need to Know About the Holy Grail of Cryptocurrency

Winson Ng September 14, 2018

4,570 9 minutes read

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The Cryptocurrency market has been extremely bearish for the past 8 months.

Most ‘skilled’ traders who boasted about making lots of money over the past year are now quietly suffering in silence. It ain’t easy, but if you’re a HODler like myself, price instability shouldn’t be an issue.

HODLing Bitcoin is not easy, it is a test of mental strength and perseverance.

Cryptocurrencies are volatile. It’s a tell-tale sign that this is a nascent industry rife with unchecked speculation. My investments appreciated as much as 50% during the November – December 2017 bull market. Right now it has depreciated up to 80%.

Bitcoin has a volatility of more than 70% in a year yet it is secured by time and energy, two of the fundamental units of scarcity and value in the universe. Should we measure btc in fiat then?

The problem with cryptocurrencies for some people is that there isn’t a quick way out of the market when it starts to free fall like it did over the past week.

Fiat on and off-ramps via exchanges can be extremely slow due to banking delays. So what easier way than to introduce a Crypto that pegs itself to a traditional fiat currency like the USD or EUR…

Introducing the Stablecoin

I first heard about the Stablecoin a couple of months back. They’re something engineered from the traditional world of finance similar to a fiat currency peg. Countries that experiences rapid inflation like Argentina has to peg its pesos to the US dollar in order to mitigate the rising cost of living.

No big worries right?

Not quite. while the promise of stability in Stablecoins such as the USDT (a.k.a. tether) which is backed 1:1 with the US Dollar, led many to believe that it is the holy grail of cryptocurrencies; the history of nations has taught us a very valuable lesson from these currency pegs, they do break and cause a complete financial meltdown.

Just to name a few:

Why Risk it with Stablecoins?

A fully audited and reputable stablecoin would be a better means of accepting digital payments than credit cards. With credit cards there are charge-backs, and that cannot happen with a Stablecoin, which is a form of crypto.

Meanwhile, if a Stablecoin can handle a significant level of throughput at a much lower cost, it could be huge for retail payments.

This would be a game-changer for Cryptocurrencies.

Imagine you’re in your favorite coffee shop trying to pay for your cup of Cappuccino with your Crypto, but after the transaction is confirmed, the price of your crypto appreciated as much as 30% against your fiat currency. Now, instead of paying X btc, you could have been paying 30% less in btc for your cup of coffee.

If you’re a merchant accepting crypto for your business. It’s more difficult when you have to bear the cost of losses from depreciating crypto assets. Let’s say a shopkeeper receives o.1 ETH ~ $100 for a product, by the time he sells his crypto in an exchange, it could have dropped another 10% causing him to lose ~$10 in price. This of course can be an offset if his ETH increases in value instead of decreasing.

As you can see, the volatility in crypto is creating a lot of problems for mainstream adoption in terms as a Medium of Exchange (MoE). A Stablecoin pegged to a fiat currency like USD or EUR would give crypto users peace of mind when spending or receiving crypto.

Having said that, pegging cryptocurrencies can be downright dangerous if you take it for granted.

The 3 Categories of Stablecoins

Real World Collateral Stablecoins

As the title suggests, these stablecoins are backed by fiat currencies such as USD or EUR.

USD Tether (USDT) is the best and most popular example of this stablecoin which is owned and operated by Bitfinex. It claims to hold $1 in reserve for every unit of USDT issued.

Hence, saying that Tethers are redeemable for USD on a 1:1 basis.

There are a few problems with this:

First, we have to trust them completely and hope that they are honest about it. Say if they were to under-collateralize the digital assets (like a bank), issuing more USDTs than what they in USDs, this is like printing more money out of thin air.

While USDTs are visible on its blockchain, the fiat they claim to be a collateral isn’t. You need third party audits to prove that it is what they claim to be.

Converting your USDTs may not be so straightforward, there are still many regulatory barriers. Read on, and you’ll understand why…

Controversy with USDT

So far, many observers have been speculating that they are indeed issuing tethers without its equivalent value in USD and are asking for audits to ensure its integrity.

There’s a fear going on that the recent price rise was helped by printing of USDT (Tether) that is not backed by USD in a bank account.

I urge @bitfinex and @Tether_to to perform a 3rd party audit to prove their reserves. Please do the right thing. Thanks.

— Charlie Lee [LTC⚡] (@SatoshiLite) November 30, 2017

USDT dissolved their relations with their original auditor, Friedman LLP after they asked for additional information which USDT wasn’t willing to give.

In fact, audio recordings implicating USDT with fraud spread virally across social media back in February 2018. In these recordings, the principals behind Tether and Bitfinex made startling admissions to bank fraud, money laundering and so much more.

What Impact Can USDT fraud do to the Cryptocurrency market?

I can imagine many people calling any news related to negativity as FUD, but still we in the Crypto space have to remain vigilant against all bad actors internally or externally.

Most figure that USDT only makes up a small percentage of the market cap in Crypto. But a JP Morgan estimate indicated that for every USDT used to purchase cryptocurrency, the market cap inflates by around $50.

That means, if more unbacked USDTs were to be injected into the market, and that reflects many incremental orders of magnitude in the market cap, and people start to panic sell their worthless USDTs, the whole market could go belly up.

Once the fraud becomes apparent, all hell would break loose.

Credit Anthony Xie - Hodlblog — Credit Anthony Xie – Hodlblog

According to /u/arsonbunny, here’s how it could play out:

Tether-enabled exchanges will see a massive spike in Bitcoin and cryptocurrency prices as everyone leaves Tether. Noobs in these exchanges will think they are now millionaires until they realize they are rich in tethers but poor in dollars.
Exchanges that have not integrated Tether will experience large drops in Bitcoin and altcoins as experienced investors flee crypto into USD.
There will be a flight of Bitcoin from Tether-integrated exchanges to non-Tether exchanges with fiat off-ramps. Exchanges running small fractional reserves will be exposed, further increasing calls for greater reserves requirements.
The exchanges might slam the doors shut on withdrawals.
Many exchanges that own large balances of Tether, especially Bitfinex, will likely become insolvent.

If we don’t learn from our past mistakes, we’re bound to repeat them

People have trusted central banks and their governments in the past. They have blindly place their trust in their monetary policies and yet time and time again, they have misguided us.

Satoshi Nakamoto introduced Bitcoin so that we don’t have to ever trust anyone when it comes to our money. Don’t repeat the same mistake twice.

Crypto-collateral Stablecoins

After seeing how real world assets backing stablecoins have so many issues of integrity, fraud and greed, let’s take a look at the ones that uses crypto itself as collateral.

How does it Work?

To stabilize a coin with Ethereum for example, issue 1 stablecoin worth $1 collaterized by $2 worth of Ethereum (as opposed to $1 USD). Say if ETH drops by 50%, the stablecoin would absorb the shock and will still be valued at $1.

Crypto-collaterized stablecoins do not require trusting an intermediary or a custodian to back this up, they use smart contracts on the blockchain, free from human control.

Each stablecoin issued has its fixed assets in reserve based on the free market.

Weaknesses

Unfortunately, if the collateral were to fall hard enough, it would break its peg.
Crypto-collateral Stablecoins are not capital efficient because it requires a ratio higher than a 1:1.
It only achieves stability when prices fluctuate around neutral or in the positive direction.

BitUSD is one such stablecoin created n 2013.

Christopher Georgen does a good job explaining how BitUSD works:

Suppose that Alice wishes to create $1.00 worth of bitUSD (1 bitUSD).
To do so, she must lock away $1.00 worth of Bitshares (the company’s own issued cryptocurrency) plus some excess collateral amount to ensure that she has enough Bitshares locked away even if the price relative to USD drops.
Once she has locked away this total amount, she receives 1 bitUSD from the BitShares network.
Alice now sells this 1 bitUSD to Bob for $1.05 worth of Bitshares. Alice insists on charging Bob more than $1.00 because her collateral is at risk should the bitUSD/Bitshares price shift.
Bob can redeem the 1 bitUSD he holds by submitting this request to the BitShares network. In such an event, an open market position with the least-collateral is forced to accept Bob’s bitUSD in exchange for an amount of Bitshares determined by the current price.

This example only works if and only if the price of Bitshares continues to rise in value. What if the price drops, how can Bob ever redeem his money back from his Bitshares?

MakerDAO Dai is another Crypto-collateral stablecoin which uses the Dai token to maintain a peg with $1 worth of Ether plus some excess collateral.

From the chart above, you can see how the stablecoin starts to crash whenever it drops below certain prices.

Everything is sunshine when the prices go up, but when the prices go down, expect the owners to start selling their ETH collateral to maintain their peg. But with market meltdowns, selling their collateral won’t be enough because they won’t be able to keep up with the sheer volume of sell-orders.

No Collateral Stablecoins

Let’s pretend to create an imaginary currency that should always be valued at $1 regardless of any circumstances.

When Demand > Supply, prices will rise. Solution = introduce more supply by issuing new tokens until it regains its $1 value.

When Supply > Demand, prices will fall. Solution = reduce supply by buying back the tokens yourself so that the price stabilizes at $1.

The Catch?

Its always possible to issue new tokens out of thin air, but there is a limit to how much they can buy back because of limited resources.

Basecoin is an example of a Stablecoin without any collateral.

They solve this problem by issuing two different types of tokens:

Base bonds
Base shares

Early adopters of Basecoin were given Base Shares. As the price of Basecoin rises above $1, these basecoins are given to Base Share holders as dividends.

Then it is sold in the market, to increase the supply, bringing the price back to $1.

When prices fall below the dollar, Base bonds are sold in the market for Basecoin. These bonds cost a basecoin each and it’s similar to an IOU that promises to repay the bond holder $1 when the price of Basecoin rises back up in the future.

The only problem is, both bag holders only benefits when there is a demand in Basecoins. Prices must go up up up to maintain its peg. Meaning they need a constant influx of new buyers.

Otherwise, why would anyone want Base Shares if no new coins were ever needed? Or if the price drops, who would want Base Bonds if they can never fulfill their obligation to repay the $1?

This is why, a stablecoin with no collateral is normally dubbed a pyramid scheme. Similar to any flashy ICO or MLM scheme that requires a charismatic leader or a snake-oil salesmen.

Conclusion

Stablecoins is a short term fix for the volatility in Cryptocurrencies.

Institutional and financial organizations are looking intensely at stablecoins as plumbing solution for the entire cryptosphere.

They need a better way for digital payments to be made in Crypto ASAP instead of waiting for more liquidity and influx of new buyers and sellers to stabilize the volatility in cryptocurrencies.

In the meantime, a fully audited stablecoin has already emerged called the Gemini Coin (GUSD).

Fully pegged 1:1 to the US dollar, its whitepaper suggests the separation of custodianship, issuance and developer logic is more unique and vastly different from its cousins, the USDT or DAI.

Hosted on the Ethereum blockchain, the GUSD will be audited by an independent accounting firm and smart contracts will govern strict control over them.

This is a semi-centralize method to tame the beast that exists within this highly complex market.

Stablecoins are a man-made concerted effort to stabilize the market for good. Unfortunately this cannot happen to markets that are often disruptive in nature.

Look at any profound technological revolutions in the past and you will find them to be highly unstable at the start. Its the nature of disruption.

Shaking up the status quo will often result in strong market forces. You can only tame the beast when the market matures.

Perhaps the holy grail of cryptocurrencies are Stablecoins like the Gemini coin, or simply more real-life use cases. Constant speculation in ICOs can only bring us so far.

So What are your thoughts?

Right now Bitcoin on its own is a Stablecoin for citizens living in countries like Venezuela, Turkey, Zimbabwe and Argentina.

A country that suffers from oppression and financial tyranny needs a decentralize, borderless, neutral, censorship-resistant and immutable currency that allows them to Store their assets without losing them to hyperinflation.

Can you imagine living in a country where you have to pay 1 million bolivars just to buy a cup of coffee. Its sad, really sad.