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Fintech and innovation series: Stablecoins – stable, but not very?

24 January, 2019Renier Lemmens

In the first in a series of articles, Renier Lemmens, our Visiting Professor of Fintech and Innovation and Senior Advisor on Digital Education, explores the potential value of stablecoins.

Cryptocurrencies are supposed to create a better medium of exchange, one that is transparent, secure, private and trusted when used across a distributed network such as the internet. However a currency, in theory at least, is also a store of value and a unit of account.

Bitcoin 2018The actual value of cryptocurrencies, though, especially that of bitcoin is up for debate and fluctuates wildly – mostly in response to speculation. Not only did BTC lose more than 80% of its value over the last year, even in the first few weeks of Jan 2019 there was massive volatility. One would be hard-pressed to find a fiat currency with such wild swings – and certainly such a currency would not be used in trading and settlement, even if it were accepted as a unit of account. Most other cryptocurrencies exhibit similar trading patterns.

Bitcoin 01_2019Bitcoin, therefore, cannot really function as a currency. Consequently, widespread adoption of BTC in payments is still far away – and may indeed never happen.

Enter stablecoins

What to do? Enter stablecoins. Stablecoins are pegged to stable assets such as fiat currencies or gold. Their value is, in theory, as predictable as that of the underlying asset.

Stablecoins, thus, potentially have the benefits of cryptocurrency without the volatility. Almost 60 stablecoins have been issued globally – with the number growing week by week. Tether (USDT) is the best-known example.

Stablecoins can benefit businesses and consumers who need to make international payments quickly and securely, without the high fees charged by banks, or the delays that can come from using incumbent payment systems. Bitcoins, in principle, already make that possible but stablecoins avoid exposure to a volatile asset that could suddenly decrease in value. Holders of more volatile cryptocurrencies could move their funds quickly into stablecoins as and when needed, without incurring steep transaction fees. Potentially, Stablecoins could also help citizens of countries with weak or mismanaged fiat currencies hedge inflation or exchange rate volatility at minimal cost.

True USD Price Index - historical chart and market capThe vast majority fall into three categories based on how the stablecoin is collateralized:

  • - Fiat-collateralized (centralized)
  • - Crypto-collateralized (decentralized)
  • - Non-collateralized (algorithmic) 

Fiat-collateralized

Fiat-collateralized, or fiat-backed, stablecoins have holdings of fiat currencies such as the US dollar or Euro that ensure a predictable unit value. Active measures are taken to maintain the peg. Fiat-collateralization represents a huge opportunity for mass adoption of stablecoins. The biggest risk to this model is counterparty risk. These stablecoins require trust in a centralized entity – something that is in and of itself at odds with the decentralised philosophy underpinning blockchain.

Akin to the erstwhile Gold Standard in central banking, the fiat-collateralized stablecoin model relies on trust that the asset that backs it is there. When trust is lacking, value can quickly erode and the model collapses. We saw some of that with Tether last year. This can be addressed through transparent independent audit – but the concern about a non-government backed, and as of now unregulated, single-point-of-failure remains.

Crypto-collateralized

Crypto-collateralized stablecoins use crypto assets as backing to stabilise the system and smooth out volatility. An example is MakerDAO/DAI, a decentralized system using smart contract technology and Ethereum’s value to achieve stability of Dai tokens. The biggest risk to this stablecoin model is the volatility of the underlying collateral.

I am skeptical about this approach – to me it sounds too much like pegging USD to a basket of highly volatile currencies. It will all work fine within a certain bandwidth but is certain to fail beyond a certain scale, especially if combined with major volatility and price drops in the underlying assets.

Non-collateralized

In algorithmic stablecoins, also referred to as seigniorage shares and future growth-backed stablecoins, expansion and reduction of the coin supply is mathematically determined. There is no collateral backing its issuance. Ironically, central banks typically maintain the stability and supply of their fiat currencies through similar mechanics. However, central banks of strong currencies are backed by track record, transparency, a national asset base and the ability, ultimately, of the exchequer to raise taxes. This category of stablecoins is backed only by continued collective confidence in growth. Therefore, they require sustained market ‘confidence’ to avoid oblivion – just like regular cryptocurrency.

A space worth watching

So - while there is interesting innovation in this space, we are some way from the ‘perfect’ model that addresses the fundamental concerns and weaknesses while unlocking the full opportunity. Yet, stablecoins is a space worth watching as it is more likely to arrive at solutions that have a shot at ubiquity than non-collateralised cryptocurrencies.

Renier-LemmensContinue to follow Renier Lemmens series on Fintech and Innovation. Next, he will be looking at 'unbundling the bank'.

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