Stablecoins : Smooth sailing across the crypto wave, or a sham?

When Laszlo Hanyecz bought those two infamous pizzas for 10,000 Bitcoins, his coins were worth a mere $40. That was back in 2010. Since then, Bitcoin has morphed into much more than a means of exchange. We now use Bitcoin as a store of value to hedge against inflation, we use it in trading activities, and we use it to facilitate numerous Blockchain services such as DeFi and DApps. Bitcoins value experienced the first big increment in 2010, when it rose from zero to $0.09. Since then, it has seen sharp appreciation as well as sudden dips, depending largely on the perception of investors regarding its future worth, and investor panic due to hacking attacks and bugs in its blockchain.

Over the years, Bitcoin - and cryptocurrency in general had gained a reputation for being notoriously volatile. While this was an attractive feature for investors looking to make a quick buck through crypto trade, crypto had already begun to be used in more sophisticated financial activities, for example, a market for crypto based derivatives had also developed by this point. Additionally, an active DeFi ecosystem had flourished, which entirely relied on cryptocurrency. As a result, Crypto began to be regarded as an unsuitable and highly risky investment, which was hindering its mainstream adoption. This, indeed, spelled very bad news for blockchain developers and entrepreneurs who were keen on bringing the benefits of blockchain technology to the masses.

On December 15th, 2017, Bitcoin’s value skyrocketed to $19,345.49. This attracted the attention of big players, including governments and corporations, who began to develop their own cryptocurrencies. One of the main issues that many of these newer cryptocurrencies targeted to solve was the problem of price volatility. And thus began the influx of what is popularly known as Stablecoins in the crypto market. A Stablecoin, as we can already guess from its nomenclature, is a crypto currency whose value is stable, i.e, it is protected from price fluctuations either through computer algorithms or by pegging their value to real world assets. Stablecoins provide an answer to the problem of price volatility, while also delivering the utility of cryptocurrencies without needing to revert to traditional fiat money. Moreover, many exchanges have exempted gas fees for exchanging Stablecoins into fiat currency.

Since there are multiple methods of stabilizing the value of Stablecoins, we can differentiate between them and choose the type that is best suited for our investment needs. The selection of a method to control the price of a Stablecoin effects :

1) The degree of decentralization of its blockchain

2) The speculated range of price volatility attached to it and the effective degree of stability.

3) The existence of accountability in case of any grievances arising from its use.

As an investor, each of these points are important to consider before putting your hard earned money into Stablecoins. Keeping this in mind, let us explore the various options available to us currently.

Fiat backed Stablecoins : As the name suggests, the value of these Stablecoins is fixed by attaching them to the value of a fiat currency. The value of each of such Stablecoins is equal to the value of one unit of the fiat currency it is pegged to. Therefore, the supply of fiat backed Stablecoins is limited to the value of fiat currency reserves maintained by the issuer. Tether (USDT) is a fiat backed Stablecoin, whose value is pegged to the US dollar. Since the value and supply of these Stablecoins are dependent upon an external, centralized regulatory authority of fiat currency, such as a central bank, fiat pegged Stablecoins often enjoy a lesser decentralization than their counterparts. However, the reserves of this type of stablecoins are thoroughly and regularly audited, and they enjoy the stability of fiat money.

Crypto backed Stablecoins : The value of crypto backed Stablecoins is fixed to another cryptocurrency. The stability of these coins is dependent on the stability of the underlying crypto asset. Since crypto assets are more volatile, the reserves maintained by crypto backed Stablecoins are often larger than the amount of Stablecoins issued, in order to counter any sudden dips in the value of the underlying cryptocurrency. However, crypto backed Stablecoins enjoy a much greater degree of decentralization, owing to its foundations in blockchain technology. On the accountability factor, they rank lesser than fiat backed Stablecoins due to the general lack of regulation in the world of crypto. DAI is one such crypto backed Stablecoin which is pegged to Ethereum (ETH).

Non-cash Asset Backed Stablecoins : Stablecoins that are pegged to the value of other real-life assets such as Gold, oil, precious metals, etc fall into this category. These Stablecoins are redeemable for their collateralized value, as long as certain requirements are met regarding the measurements of collateral. Paxos Gold (PAXG) and Tether Gold (XAUT) are Gold backed Stablecoins. Since assets like Gold are considered fairly stable, the value of these Stablecoins enjoy the same stability. These reserves are also maintained by custodians.

Algorithmic Stablecoins : Algorithms control the supply of these Stablecoins in order to adjust their price in accordance with the price of a certain fiat currency that it tracks. No reserves are maintained, and since an automated computer function increases and decreases the supply of the Stablecoin to equate its price with that of the fiat currency, there is no need for an authority to regulate the maintenance of reserves. This leads to greater decentralization, accountability and stability. NuBits is a popular algorithmic Stablecoin.

Although Stablecoins can be the torchbearer for large scale crypto adoption, there are currently no regulatory principles that monitor issuers of Stablecoins and hold them accountable for  the maintenance of asset reserves. As a result, there have been infamous instances of fraud, such as the Bitnex and Tether incidents where the issuers hid huge losses and continued to claim one-on-one backing for their Stablecoins. Issuers of Stablecoins hold similar powers as that of central banks, and hence a regulatory framework is necessary for their mass adoption. Alternatively, CBDCs are being looked into to circumvent the risks associated with ill-regulated Stablecoins.

Stablecoins may be the solution that integrates cryptocurrency in the larger financial markets. They already influence a large market capitalization, and any mishaps in their management can cause tremendous financial loss not only to the crypto market, but also to the traditional financial system. If more research is allocated to the development of technologically secure algorithmic Stablecoins, we might not even require giving up the boons of decentralized currencies in order to gain stability and accountability through centrally controlled CBDCs. You can read more about cryptocurrency regulation and CBDCs here. However, like any other investment, Stablecoins are associated with some speculative risk, and investors must do extensive research before choosing to invest in them.

Disclaimer : This article is intended for informational purposes only. While we try our best to verify the contents of  our articles, DeFy cannot guarantee that this article, or any information we sourced from third parties which has been included in this article, are free of error. This article should not be substituted for investment/ financial advice. Any actions taken based on information contained in this article are at your own risk. DeFy does not claim to endorse views presented in this article as our own.

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