When we think of the functions of currency, it’s said to not only be a store of value but also serve as a means of exchange for various goods and services. However, much of the criticisms that follow the cryptocurrency market comes from the sentiment that its high market volatility makes it unpredictable, and impractical as being a legitimate payment method. It’s largely due to the fact that many coins are still operating within a relatively small market cap, and so prices are still affected by daily buy and sell orders, unlike say more established currencies such as the US Dollar and the British Pound.
This is why today, we see that most cryptocurrencies can’t experience both the true benefits of digital currencies e.g. decentralisation, faster settlement times, and become a true means of payment since its price changes are so frequent where one day your Ethereum may be worth “x”, but tomorrow it might be worth “y”.
It seems those within the crypto space recognised this, and sought some means of a resolution. Stablecoins are a type of cryptocurrency linked to an asset that doesn’t fluctuate in value much, like the US dollar. They are essentially an attempt to create a cryptocurrency that isn’t volatile.
Whilst there are also cryptocurrency-backed Stablecoins, this blog takes a look at those backed by “fiat”. Fiat money is government-issued currency such as the US dollar, Canadian dollar, Great British Pound, Euro, Yen.
According to 101Blockchain, there are more than 200 Stablecoins either already in circulation or under development. The first created, and most popular, is Tether (USDT). Tether, issued by Tether Limited, was launched in 2014. It currently has a market capitalization of approximately 68 Billion making it the fourth-largest crypto in terms of the total value. Another popular Stablecoin, US Dollar Coin (USDC), launched and issued by Circle in September 2018 currently sits at a market capitalization of approximately 30 Billion. Both are Fiat-backed Stablecoins, meaning that their value is pegged to a real-world currency, in this case, both the US Dollar. For example, the trading price of USDC is currently $1, and is expected to stay at that price in relation to the dollar, no matter what.
How do Stablecoins maintain their price?
Trust, really, is an essential component to the value of any asset since it owes to its buyers, that it’s worth is indeed warranted. Take, for example, precious metals, such as gold and silver. If we didn’t believe these commodities were indeed “precious,” deserving of the premium we pay, their prices simply wouldn’t be at the heights seen today.
The same concept applies to currencies and, in particular, to the subject of this blog — Stablecoins. With Stablecoins, it is crucial that issuers provide reassurance that its value is genuinely equal to the value of the asset to which it is being pegged. And how do they do this?
Well, those such as Tether and Dollar Coin, back the asset with a form of collateral, in this case, fiat – the US Dollar.
Here, the trust proposed to its buyers is that each USDT/C existing is backed by an actual US Dollar. So for every USDT/C, there is a corresponding USD, and this is important since if buyers did not have any basis to derive a value from the new currency, they would sell it off, and its price would no longer be “stable” nor equal to the US Dollar price at $1.
Another way in which this price is maintained can be through algorithmic pegging. This is where a company makes use of a smart contract, to write code that limits or increases the supply of a Stablecoin in order to maintain it at a consistent price. So for example, say there’s a Stablecoin algorithmically pegged to the US Dollar, if all of a sudden, lots of people start to buy it on an exchange, its price would begin to rise, and the peg – broken. The algorithm however would prevent this by then increasing the supply back to the level of the pegged price. And vice versa when demand decreases limits the supply of the Stablecoin cryptocurrency. These types of Stablecoins are said to be often hard to implement in practice, so most of the popular Stablecoins we see today such as USDC, USDT are those which are collateral-backed.
What are some of the proposed benefits of Stablecoins?
- Well since they are non-volatile, the most obvious use case would be to finally take advantage of cryptocurrency benefits of decentralisation and fast settlement times and have it as a medium of exchange for goods and services. However, since this is still a relatively new financial innovation, and still within the development of its regulation, it’s really not accepted anywhere as a legitimate payment method.
- As a result, the utility of Stablecoins has shifted more so to be within cryptocurrency exchanges. For one, traders can use the benefit of faster settlement times as opposed to FIAT as well as bypassing blocks banks sometimes have in purchasing crypto, to send Stablecoins rather than FIAT between cryptocurrency exchanges. This is particularly helpful with arbitraging when the price of certain cryptocurrencies differ or has a gap from exchange to exchange. Traders can move funds between exchanges faster, more freely entering trades quicker, keeping the market more liquid all around.
- Importantly linked to this is that many traders use Stablecoins to protect from the risk of volatility of standard cryptocurrencies. For example, if one is trading Bitcoin and doesn’t want to risk the price of BTC falling against the Dollar, then they can just trade it for USDT or USDC, whilst maintaining their initial dollar value. Then once ready to reenter the market can trade the e.g USDT back to BTC. This is especially relevant for exchanges that do not allow the trade of Fiat currencies directly into cryptocurrencies. In these cases, the customer must convert to Stablecoin first.
What are some of the criticisms of Stablecoins?
- Centralization – Well most are aware that popular Stablecoin company Tether has been under various investigations and received fines concerning their transparency on their collateral. As mentioned earlier, such companies build trust by pegging each USDT to an actual US Dollar. Now a scenario involving the backer of a Stablecoin needing to literally hold assets 1:1 would presumably require some form some of central storage provider(i.e. a custody bank) which is precisely what the cryptocurrency ethos inherently seeks to avoid.
- Lack of transparency – Even more so, such companies have come under scrutiny because it is difficult for onlookers to have complete access to the books, and see that e.g. Tether is true to its word. Regulators have sought to crack down on this, and since 2018, Tether has received lots of public criticisms, calls to accountability and audit requests from skeptics who claim that they do not have enough USD collateral to back the amount of USDTether in circulation. Tether has been subject to probes by the US Government over allegations connected with insufficient transparency and has fought back against such claims. Earlier this year, Tether, after settling a lawsuit brought by the New York State Attorney General, renewed efforts to earn public trust and provide greater transparency to their inner workings. They eventually settled the case with New York State, and has provided efforts to earn public trust and provide greater transparency to their inner workings. They released a transparency report in August 2021 which can be found here.
A solution? Newer Fiat-backed Stablecoin companies such as True USD have sought to resolve this issue of transparency seen in the Stablecoin market by holding US Dollar collaterals in the bank accounts of multiple trust companies. These bank accounts are then published every day as well as subject to monthly audits.
- Long term use case – Critics also argue that as the market capitalization of the cryptocurrency market continues to grow, and prices become less volatile, as time goes on, Stablecoins may become less relevant. Many in the industry are awaiting a report from the U.S. Treasury on possible risks surrounding Stablecoin and with crypto attaining ever-greater stability we then might also see greater adoption of cryptocurrencies such as BTC, ETH, and more to name as a legitimate means of payment. We are already seeing this happen in countries such as El Salvador — so who knows what the future holds! 🔮
So, are you trading any Stablecoins? What are your thoughts on them? Where do you see them in the next 10 years? Tweet or message us on our social media channels @UpholdInc @AskUphold, we’d love to hear your thoughts! 📚