What are stablecoins and why do they matter?

What are stablecoins?

It seems like stablecoins are everywhere in the crypto conversation lately.

People are talking about them because they are viewed as a way to calm heavily fluctuating cryptomarkets.

How that will actually happen is something we’ll take a look at in a minute.

But it’s worth noting that the other reason that people are talking about stablecoins is that they are controversial — not so much as an idea, but on how they will actually be implemented.

What are stablecoins?

Stablecoins are cryptocurrencies that are pegged or backed by some other asset. Some forms of stablecoins are tied to analog assets, such as the dollar or a commodity like a bar of gold or a barrel of oil. Other forms of stablecoins are backed by cryptocurrencies, or even exist as self-correcting, algorithmically-controlled systems.

In essence, stablecoins hold the promise of a half-step between traditional assets and crypto assets, taking the best from both worlds while resulting in a more accessible and efficient form of finance.

Stablecoins have so much potential that they are frequently referred to in the crypto press as the “holy grail of the financial world.”

Summarizing this Forbes article, which outlines stablecoins and explains where and how they might work, an optimal cryptocurrency has four main characteristics:

  1. Decentralized: This is a central tenet shared by cryptocurrencies proponents. Decentralization currently exists on a spectrum among various cryptocurrency projects, but the fundamental idea is that crypto systems should not rely on, or be controlled by, a central point of failure or powerful agent capable of censorship such as a government, corporation, or bank (read more about non-custodial wallets). The goal of decentralization is to create robust security and a means of community control. The trade-off is often efficiency.
  2. Privacy: Another of the fundamentals of cryptocurrency systems is the concept that privacy should be baked into the underlying protocols that make up crypto’s infrastructure. Like decentralization, privacy within crypto systems exists on a spectrum. But the idea that new forms of digital value should be censorship resistant and insulated from surveillance are viewed as core pieces of cryptocurrency architecture.
  3. Scalability: In order for cryptocurrencies to compete with traditional fiat currencies, they need to be able to scale. Right now, the ability to grow beyond niche projects is one of the biggest issues facing cryptocurrencies. Scaling bottlenecks increase transaction times and increase the cost per transaction. Scaling will also enable increased liquidity in the crypto space, which will in turn help with volatility.
  4. Price stability: In order for cryptocurrencies to be used as a digital version of cash, the price needs to be stable. Bitcoin was first conceived as a peer-to-peer payment system, but now Bitcoin is acting as a better store of value than it is a cash-like system. Part of the reason is that a currency needs to hold its value steady so that it can be exchanged. If the price of one bitcoin fluctuates in value by several hundred dollars in one day, then it makes it hard for people to confidently use the system like cash. This works both ways because if the value of bitcoin is falling, people might feel like they are losing money. But if the value grows rapidly then there is more of an incentive to hoard bitcoin and not use it for purchases.

So, working from that general rubric, stablecoins directly address the price stability component, which is one of the fundamental needs for a cryptocurrency to function optimally.  

A brief history of stablecoins

The idea of a stablecoin, or of pegging one asset to another to help keep values consistent, is not a new concept. It’s something that several governments have been doing with their own currencies for decades.

National governments have the same motivation as crypto economies to deal in stable assets. Volatility in any kind of currency scheme can lead to wild speculation and boom and bust values.

Countries have developed currency pegs in order to avoid cycles of high and low national currency valuations. But the stability comes with a tradeoff because while currency pegs encourage stability, they also mean that the central bank of one government might be constrained by the policies and goals of the government controlling the peg.

Historically, there have been a few different ways of implementing currency pegs at the national scale. Some countries just start using another country’s currency in lieu of their own as legal tender. Other governments have decided to set a fixed peg, while others determine an acceptable range and let their currency float within a range in relation to the peg.

Even within the cryptocurrency world, people have been experimenting, with mixed results, with stablecoin design and setup.

State of stablecoins

So far there are several kinds of stablecoins emerging, each with their own advantages and disadvantages. (For a lengthier explanation of stablecoin models check out this post on HackerNoon, which also calls stablecoins the holy grail of cryptocurrencies).

  1. Fiat-collateralized: This is the crypto version that most closely resembles the traditional currency peg outlined above. Because of its familiarity, it’s been the style of stablecoin that’s been the longest in development. The most recent project that has gained a lot of attention in the crypto space is Tether, which is backed by US Dollars. The advantage of a fiat-backed crypto stablecoin is that moving traditional assets into cryptocurrencies becomes easier. Also getting things like paychecks, or taking out a loan in crypto might be more straightforward with a fiat peg. The disadvantage is that fiat-backed stablecoins are generally susceptible to centralization, and require some kind of accounting system or treasury that is so far similar to traditional banks and finance.
  2. Crypto-collateralized: Crypto-backed stablecoins use pools of cryptocurrency to help provide the backing required to maintain price stability. The advantage of using other crypto as collateral is that the system is programmable because it is based on digital assets, so moving value is all computer code-based. The disadvantage is that crypto-backed systems are not as insulated from market fluctuations as fiat-backed systems.
  3. Algorithmically-controlled: This is the latest innovation within the stablecoin space. Rather than backing crypto with fiat or other crypto, algorithmically controlled stablecoins are based on a central bank-style system. But instead of the monetary policy under the control of officials or as a reflection of national values, the monetary policy can be programmed to achieve growth and inflation objectives. The advantage is that this system is customizable, responsive, and code-based. The disadvantage is that so far these systems require the same level of trust as traditional monetary policy.

The stablecoin challenge

Creating the “holy grail of cryptocurrencies” is not without its challenges.

The first, and maybe the biggest challenge, is that some of the early stablecoin infrastructure is creating a reliance on centralized systems rather than on decentralized systems.

Since fiat-collateralized stablecoins rely on holding fiat reserves or other strong linkages to traditional finance and banking, they lean on centralized architectures.

And so far, the alternative to centralized, fiat-backed stablecoins are more complex arrangements that require a high degree of trust.

Lastly, even when traditional currencies are pegged against one another, the peg doesn’t hold, and the currencies become decoupled. In other words, despite best efforts, there’s no guarantee that a stablecoin system will work as planned.

Nevertheless, cryptocurrencies also need to be price stable, which would open up the systems to other uses beyond speculation, including savings, credit, loans, etc.

A stablecoin alternative

In a recent piece written for CoinDesk, Abra founder and CEO, Bill Barhydt explained that there’s also another significant application for stablecoins.

“In my mind, the most promising and often overlooked application for stablecoins is their utility as on-ramps for assets moving from traditional financial markets into crypto. I like to use the analogy that if cryptocurrencies are like the Matrix – a digitally-native technology that is completely apart from the physical world – then stablecoins can be like the hard line between these two worlds. In this case, the hard line would exist between the new world of computer-code-based value, e.g. bitcoin, and the traditional value system based on physical assets, e.g. fiat or the U.S. dollar. Right now, it’s hard to get the two worlds to interoperate – there’s a lot of needless friction that comes at the costs of time and money. Relying on legacy tools to enter cryptocurrency systems still limits access for billions of unbanked or underbanked people across the globe,” he wrote.

The technology powering Abra follows the framework of the stablecoin model, and for the same reasons. But instead of using fiat currency to collateralized crypto positions, Abra’s platform uses Bitcoin and Litecoin to create synthetic assets. These kinds of assets, in turn, allow Abra users are able to manage the volatility of their portfolios by taking advantage of a blockchain-based hedging mechanism that eliminates exposure to market shifts.

Referring back to the four characteristics of optimal cryptocurrency systems from top of this piece (decentralized, private, scalable, and stable), crypto-collateralized stablecoins offer a combination of design and security features that keep them aligned with cryptocurrency systems, while also maintaining layers of safety and security.

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