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Stablecoins: One Step Forward, Two Steps Back

Oct 12, 2018

  • Stablecoins are digital tokens that are meant to provide stability and security in the cryptocurrency market -- they are designed to serve as a unit of account, medium of exchange, and store of value. 
  • Stablecoins have been all over cryptocurrency news in recent weeks: on September 10th, 2018 the New York State Department of Financial Services approved two US Dollar (USD)-pegged stablecoins -- the Gemini Dollar (GUSD) and the Paxos Standard (PAX); Japanese IT giant, GMO Internet, announced on October 9th, 2018 that they are rolling out a Japanese Yen-pegged stablecoin, dubbed GMO Japanese Yen (GJY); and on the same day, an employee of the People’s Bank of China suggested the Chinese central bank explore a Chinese Yuan-pegged stablecoin.  
  • There are three main types of stablecoins:
            1.) Fiat-Collateralized, which are stablecoins pegged to a fiat currency and collateralized 1:1 by that fiat currency held in reserves. 

            2.) Crypto-Collateralized, which are stablecoins pegged directly to a cryptocurrency. These stablecoins are typically over-collaterlized to compensate for price fluctuations in the underlying cryptocurrency, allowing the stablecoin to maintain price stability. The main issue with crypto-collateralized stablecoins, however, arises if the underlying asset loses its value, causing the stablecoin to be worthless.  

           3.) Non-Collateralized, which are stablecoins backed by nothing other than the expectation that they will maintain a certain value. These stablecoins typically employ smart contracts to algorithmically expand and contract the supply of the stablecoin to meet demand.  

       Source: Hackernoon

  • There are significant drawbacks to the introduction of stablecoins, specifically fiat-collateralized stablecoins, into cryptocurrency markets:  
  • USD-backed stablecoins, for example, introduce the problems associated with centralized currencies into cryptocurrency markets. The USD's purchasing power fluctuates with changes in inflation and volatility in foreign currency exchange rates, which in turn causes USD-pegged stablecoins’ cryptocurrency purchasing power to fluctuate with changes in inflation and foreign fiat-currency exchange rate.  For this reason, fiat-collateralized stablecoins move away from ideals cryptocurrency markets were originally founded on.  
  • Another problem with fiat-collateralized stablecoins is that they are essentially just another fiat currency derivative. In the case of a USD-backed stablecoin, the stablecoin is essentially a USD derivative that could potentially be subject to legal tender laws and other securities regulations.  
  • Crypto-collateralized stablecoins are far from perfect too. Although in most cases crypto-collateralized stablecoins are over-collateralized to compensate for potential price fluctuations of the underlying cryptocurrency, a large enough price decline in the underlying cryptocurrency would cause the crypto-collateralized stablecoin to implode, regardless of how over-collateralized it was. This is essentially what we saw during the 2008 Great Recession when mortage-backed securities lost their value due to foreclosures on their underlying mortgages.
  • Stablecoins are meant to introduce a medium of exchange, store of value, and unit of account into the cryptocurrency market, which is something cryptocurrency markets desperately need. The fact of the matter, however, is that crypto-collateralized and fiat-collateralized stablecoins do not accomplish these goals. Until a development team is able to introduce a universally accepted, non-collateralized stablecoin that does not compromise privacy, security, or decentralization, stablecoins will remain as an incomplete answer to a complex problem in cryptocurrency markets.