‘Bitcoin hit fresh lows not seen in over a year Nov.20 as assets across the board shed millions’
Are stablecoins the answer to bitcoin’s instability? What purpose do these stablecoins actually serve? Let’s look at what stablecoins are in general.
Stablecoin is a type of cryptocurrency which can either be backed by fiat currencies or exchange traded commodities (such as gold, silver, other precious and industrial metals, etc) and are used to reduce price volatility. The above definition is what is called a centralized stablecoin, which are the more popular type of stablecoins.
“Any application which requires a low threshold of volatility to be viable on a blockchain, consumer loans for example, simply cannot be denominated in a currency which fluctuates 10–20 percent in a day, like Bitcoin and Ether.”
-Gregory DiPrisco from MarkerDAO
Cryptocurrency prices are volatile, their prices can change by up to 10% in hours. This price volatility pushes investors away from cryptocurrencies like bitcoins as well as altcoins. People are sceptical about investing in risky stocks and bitcoin is classified as a risky stock due to its volatile nature. Fiat money on the other hand, is relatively stable over long time horizons and regulated by a central authority. Fiat money is pegged to assets like gold and foreign exchange reserves. This is where stablecoins come to play.
Stablecoins are used to reduce these price volatilities of cryptocurrencies by bridging the gap between fiat currencies and cryptocurrencies. They are classified into centralized stablecoins and decentralized stablecoins. Centralized stablecoins consists of Fiat-currency backed stablecoins and Exchange–traded commodities backed stablecoins. Decentralized stablecoins are classified into cryptocurrency backed stablecoins and seigniorage stablecoins.
A perfectly engineered stablecoin is the key to achieve all three essential properties of a currency:
- Medium of exchange (ability to trade goods and services without bartering)
- Store of value (means of maintaining wealth over time)
- Unit of account (measurement unit to define and compare market values)
Fiat-currency backed stablecoins
Fiat- currency backed stablecoins like the name implies, are pegged to fiat currencies like the US dollar, Euro or the Swiss franc in a fixed ratio. These stablecoins value are based on the backing fiat currency which are maintained by independent custodians and are audited regularly. The trust in these independent custodians are crucial for the stability of the stablecoin. These type of stablecoins are traded on exchanges and are redeemable from the issuer. Although fiat- currency backed stablecoins are used to reduce price volatility of cryptocurrencies they are also faced with the risk of their backing currency losing its value. Examples of fiat- currency backed stablecoins are USD Tether (USDT) , Gemini dollar etc.
A lot of firms are looking into using stablecoins. IBM announced that its testing a crypto-dollar stable coin using stellar. One of the Big Fours – PwC announced plans last month to build a stablecoin backed to the USD. PwC’s overall interest here is to build broader trust so it can help millions of new users gain digital assets.
Exchange- traded commodities backed stablecoins
These type of stablecoins are backed by exchange traded commodities e.g gold, silver as well as commodities like oil in a fixed ratio. The value of these stablecoins depends on the value of the backing assets. Holders of exchange-traded commodities backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. An example of this is Digix Gold token(DGX).
Cryptocurrency backed stable coins
These stablecoins are backed by cryptocurrencies rather than fiat currencies. Fiat collateralization typically happens off-chain, the cryptocurrency used to back this type of stablecoins is done on-chain, using smart contracts in a more decentralized fashion.These stablecoins are over- collateralized in order to reduce price volatility. This means that one needs to deposit, for example, $200 worth of ETH to receive $100 worth in stablecoins in return. In this case, even if the price of the underlying asset depreciates by 20%, the stablecoin can still keep its price stable as there are still $160 worth in ETH collateral backing the value of the stablecoin. The supply of the cryptocurrency backed stablecoins are regulated on-chain, using smart contracts. This type of backing is a bit more technical and complex. An example of this Havven.
Seigniorage stable coins are fully digitalized and non-reliant on any type of collateral, with their supply and price controlled only by the program code. Seigniorage stablecoins are characterized by full decentralization and high scalability. An example of this is the Kowala stablecoin which is yet to go live
Having examined these different types of stablecoins, why then is the price of bitcoin dropping rapidly? What happened to stablecoins being the ‘Holy Grail of Cryptocurrency’?
In the past year, Tether which is a fiat backed stablecoin and one of the most popularly traded stablecoin, has faced controversy over its possible role in manipulating the crypto markets towards the massive rally and subsequent crash experienced from December 2017 to January 2018. Tether has been accused of not being transparent especially in its continuous efforts in printing $250 million worth of new coins every few months without any real USD to back it up. This gives them the purchasing power to pump the price of BTC and other cryptocurrencies at will. Tether has been identified by some to be a ‘crypto version of the Federal reserve’ and has been accused of being the reason behind the high BTC price in 2017.
Are these stablecoins behind the current drop in bitcoin prices, or the contentious hard forks experienced by bitcoin or is the meltdown in US stocks more to blame for people fleeing these risky assets called cryptocurrencies?