What makes a stablecoin a “stable” coin?

Cryptocurrencies are often said to be extremely volatile and speculative, which makes them inoperable for trade. Thus, the establishment of cryptocurrencies as a means of payment is hindered. The need for price stability, proper cryptocurrency accounting, payment methods, and non-speculative cryptocurrencies, leads to the concept of stablecoins. Stablecoins can briefly be defined as cryptocurrencies that are artificially stabilized or pegged to decrease volatility (see Figure 1). Technically, these coins work as a derivative of an underlying, which e.g. could be a FIAT currency (a currency issued by a government and not backed by a physical commodity) or a physical asset.1 This allows the mostly lower volatility of the assets to be transferred onto the stablecoins. Besides, stablecoins enable investors to exchange cryptocurrencies into traditional assets without leaving the crypto ecosystem.1 The currently most famous stablecoin is Tether, which is a FIAT-backed currency mirroring the US-dollar. Also, various digital versions of relevant FIAT currencies are discussed. Those require a stablecoin being pegged to the respective base currency if a blockchain-based solution is chosen.2

How a cryptocurrency turns into a stablecoin – stabilizing methods

To create a stablecoin the following three methods can be chosen: (1) FIAT-backed, (2) crypto-backed, and (3) uncollateralized.

FIAT-backed stabilization:

The FIAT-backed stablecoin is hedged by off-chain assets, meaning, that users deposit one unit of the underlying asset and receive a stablecoin in return. Once a user returns the coin it is burned and the corresponding amount of FIAT currency is being paid out (see Figure 2). The advantage of this method is, that the coin replicates an asset, which is traded in a regulated market. Nevertheless, no deposit protection is in place and the issuer is obliged to guarantee the payback of the underlying asset.1 Since these liquid deposits pay low interest rates multiple issuers of this type of stablecoin face profitability problems.3 Examples of this stabilizing method are Tether, Digix Gold, Paxos Standard, TrueUSD, Gemini Dollar, and Stably.4

Crypto-backed stabilization:

The second method, crypto-backed stabilization, technically represents the same process but with crypto-assets. This method, nevertheless, represents a soft peg, relying on a self-stabilizing mechanism, which enables investors to capitalize on arbitrage opportunities (i.e. one coin only costs 0.8 US-dollars but is worth one). The downside of this method is the need to overcollateralize the coins, since the underlying volatility may lead to a situation in which the collateral is not worth enough FIAT anymore. Therefore, the current minimum of collateralization is around 150%, which creates additional costs for users.3 Examples for this type of coin are DAI, Havven/Synthetics, and Bitshares.

Uncollateralized stabilization:

The uncollateralized or algorithm method leverages an algorithm, stabilizing the coin by buying or selling the coin itself and thus increasing or decreasing the coin’s supply. This mechanism leads to a rather stable price of the coin.1 The buying of coins is processed by the issuance of crypto bonds paid for with coins, the selling by burning the coins3 (see Figure 3). Since no collateral is included in this method over-collateralization is prevented, nevertheless, due to lagging corrections of the coin supply the volatility is higher.1 Not being able to sell the crypto bonds would lead to a breakdown of the peg and leave the stablecoin useless. Basis, Nubits, which both recently have been closed, CarbonUSD and Reserve are prominent examples of this type.3

So-called “e-money licenses” represent an important development, which enables FIAT prices (i.e. of a bond or a share) to be directly transformed into digital money prices.5 Since the used digital currencies have to be pegged to the FIAT currency, stablecoins will play an important role in this process.2

Different levels of collateralization and the corresponding risks

When it comes to collateralization one has to distinguish between three types: (1) fully, (2) partially, and (3) not collateralized stablecoins. The term fully collateralized describes the need to hold reserves at least equaling the value of the circulating coin. Partially collateralized coins are not backed by 100% or more of liquid reserves, but only by a fraction of all deposits. Not collateralized stablecoins are not backed by collateral and are a synonym to algorithmic stabilization.

Despite the degree of collateralization, a lack of transparency, uncertainty, and distrust created through the issuer endanger price stability.6 Tether, initially categorized as being fully collateralized, got exposed as being only partially collateralized.7 The lack of transparency enabled the concealment of this fact. By applying daily reserve reports and audits, carried out by a trusted auditor, the issuer of Stasis tries to increase transparency.3 Besides Tether, DAI, a crypto-backed stablecoin, struggles with maintaining stability.7 This is tried to be counteracted by raising a stability fee upon the process of buying DAI coins. Kim8 states, that these fees have been risen further lately and, that the peg became more stable through this but is a bit too low (1 DAI = ~0.975 USD). Facebook’s cryptocurrency Libra, on the other hand, faces another problem, not directly linked to collateralization. With Facebook running the coin as a mostly centralized organization, it could gain control over the users’ finances. Since Facebook has been involved in previous data abuse scandals experts see the Libra coin as extremely threatening.9

Reasons for skepticism

As already mentioned, a significant risk of private coin issuers defaulting due to bank run behavior and low profitability of collateralized coins is existent. In addition to those, the central coin issuer also is a target of political intervention, since governments can freeze the FIAT reserves and therefore, shut down the coin.3 These factors collectively endanger the success of a stablecoin and can lead to the breakdown of the system.

Possibilities of a stablecoin

Despite the downsides, multiple possibilities arise through the issuing of stablecoins. Firstly, the user benefits from both the advantages of blockchain technology and the ones of traditional assets and FIAT currencies. 1 Additionally, current exchanges, facilitating crypto-to-FIAT transactions, would not be of use anymore, which decreases the incurred fees for the user. Thus the commercial use of stablecoins as a means of payment in e.g. the retail sector is enabled.1 The establishment of stablecoins in trade, payment, and accounting would enable decreased cost, processing times and less possibility of fraud across all industries.

Especially important for countries in crisis or marked my hyperinflation is the ability to create a global currency.4 This currency would not only be accessible worldwide but could also provide needed stability across country borders.

Conclusion

The different types of methods to create stablecoins all bear advantages as well as disadvantages. Nevertheless, the upsides, if setup goal-oriented, outweigh the downsides and create great opportunities. These stablecoins could be a door opener for crypto solutions in all kinds of daily transactions.

Not only start-ups and crypto enthusiasts are optimistic about stablecoins, so are central banks. So-called central bank digital currencies (CBDCs) (also called digital base-money) can alter the acceptance and the development of the regulatory framework concerning crypto payment methods.10 It nevertheless stays unclear, if stablecoins will replace FIAT currencies in the future. What can be said is, that the opportunities of stablecoins are promising. If the risks can be tackled and controlled, policymakers introduce corresponding legislature and the reserve issues discussed are excluded, stablecoins are very attractive as the future of digital money.