What are stablecoins and how can they reconcile the crypto-community?

There is no doubt that there is a future for crypto-technologies, therefore, like all new and not yet fully known technology, the crypto-world has both its supporters and fierce critics. At the moment, some people disagree with each other, while others believe that the invention of cryptocurrency is just as important for humanity as the invention of the wheel was in its time. And there seems to be a solution capable of reconciling the two camps.

They are called stablecoins — and they have every chance to become the compromise which is so lacking in the crypto-industry.

What are they?

A stablecoin is a coin whose value is directly related to known assests which are familiar to people, be it a fiat currency (dollars, euros, pounds sterling) or other traditional market trading assests (gold or barrels of oil). This kind of security gives rise to the basic property of stablecoins — they are the least susceptible to fluctuations in price. Due to this, it would seem an ideal combination of the unfamiliar new and the familiar old has been achieved.

On the one hand, stablecoins represent a new stage in the development of the industry which is characterized by all the properties so beloved by crypto-gurus — security, decentralization, and transparency. On the other hand, stablecoins offer people a sense of reliability and confidence since they are slightly more familiar, and function as traditional money in many ways.

At the moment, stablecoins are available in three types:

Secured with fiat money.
Secured by crypto-currencies.
Secured by nothing.

Let’s consider each type separately.

Stablecoins which are secured by a currency (for example Tether, TrueUsd) are the simplest and most reliable type of stablecoins. They are simple in the fact that such stablecoins are linked with the usual currencies that people are familiar with at a ratio of 1:1. That is, if you plan to buy a stablecoin of this kind you just deposit $100 into a bank account and get exactly 100 coins on deposit.

However, the fact of using fiat money is both a plus and a minus.

First, since the stablecoins bought with fiat money are still seen through traditional financial institutions, you will need to go through a long, expensive, and sometimes very exhausting process of paying back the fiat money if you want to get rid of them.

Second, one of the key characteristics of a cryptocurrency is unusual for them since this type of stablecoin is centralized — a deposit, that is, the $100 you invested must be held in the hands of a trusted custodian, otherwise they will be vulnerable to theft.

Third, there are some problems with buying these alternative cryptocurrencies — to confirm the transparency of the system (it is usually ensured by a blockchain, which we do not need to talk about here) it is necessary to conduct real financial audits, because otherwise you can not be sure that the system has the full amount of the currency in reserve.

The process, to put it mildly, is not fast and not expensive but at the same time it is critical. For example, Tether has not shown any audit results yet and this has directly affected users’ confidence, and their level of loyalty is falling every day.

The stablecoins that are secured by cryptocurrency (for example, Dai) are a real blessing for crypto-anarchists who have managed to combine the spirit of rebellion and the desire for stability. These kind of coins work in much the same way as stablecoins secured by fiat currency except that the prefix «crypto» before the word «currency» adds a pinch of decentralization to these stablecoins which is so beloved by the crypto-community.

However, it is in the fact of their dependence on cryptocurrency that the main «problem» with this type of stablcoin. Their main characteristic, as the name implies, should be stability. Which no one can say in the case of cryptocurrencies, as their value shows significant and regular jumps in both directions.

This is solved in a rather simple way — with the help of a reserve. Roughly speaking, $1 of a stablecoin insures $2 of another coin, which allows them to restore relative stability. The already mentioned stablecoin Dai (MakerDAO) works according to this scheme and is pegged to the U.S. dollar and is supported by Ethereum.

The advantages of such stablecoins are their greater decentralization and transparency. Accordingly, they can relatively easily and quickly be discarded of, if necessary, and they do not require an external audit. However, since they are secured by a cryptocurrency they can very quickly lose their value because of the fall in value of the security deposit which, of course, is not very reliable. And yes, the complexity of implementing such a scheme for a stablecoin to work is higher than that of a stablecoin which is supported by fiat money.

Unsecured stablecoins (e.g. Basecoin) are a crypto-anarchists’ dream who do not take half measures, because only these types of stablecoins can boast of absolute independence and decentralization. There are neither crypto-currencies nor fiat funds backing them. Support is provided solely by the method of supply and demand and the so-called seignorage scheme (the buildup of money supply).

How is stability and reliability achieved in this case? With the help of one of the main achievements of blockchain technologies, smart contracts, that have become a kind of equivalent to a central bank for unprotected coins and allows building trustful relationships, even in the absence of confidence of the parties involved.

In the case of unsecured stablecoins, the function of a smart contract is to maintain the currency at a constant rate, focusing on supply and demand. With such a model, for example, it is impossible to sell the currency at a price of $2 if its price is $1, since the demand side is willing to pay only $1 and nothing more. As soon as any fluctuations in the price starts, the smart contract ensures its realignment, creating an additional number of coins until their value is restored again at around $1.

The main disadvantage is the price imbalance is not always built on its excess — it may happen that demand contributes to the reverse situation, where the price of one stablecoin will be less than one dollar. The optimal solution in this case would be the purchase of coins in the amount necessary to reduce the supply, but seigniorage for restoring the balance may simply not be enough. And in this case it will be necessary to issue securities offering to share future profits which, in fact, is a voluntary participation in the traditional pyramid — the participants invest in the future growth of a cryptocurrency. This does not guarantee anything. The scheme is difficult to predict future trends and is therefore difficult to implement. Finally, in the event of a market collapse, the depositor simply will not see anything.

What in the result?

To make any forecasts about the crypto-industry is very risky. And in this sense the forecasts for stablecoins is not very different. It is difficult to talk about their future development.

Despite the fact that the word «stability» lies in their name, the matter of their issuance, as well as their reliability, remains open as of now and a comprehensive solution has not been found yet.

A lot of doubts and criticism towards stablecoins are built on the fact that their very existence undermines the main ideas for which the world loved cryptocurrencies so much. If stablecoins are an ideal compromise, and therefore the future of the crypto-industry, than what can be done about undermining such a basic tenant as decentralization (the support from financial institutions is a sign of centralization)?

However, on the other side of the aisle are the people who have a wider view and believe that it is stablecoins that are not just the future of cryptocurrency, but the brave new world of the entire financial system that can reconcile the two sides: the supporters of traditional economics and crypto-economists. The main argument of these crypto-enthusiasts is to prove that stablecoins will become a new currency and have a reserve fund, but at the same time be controlled by different institutions and provide people with financial freedom.

Read in Alex Reinhardt’s article about a non-standard case in which the pluses of stablecoins and ordinary coins are combined:
Inflation in the Cryptocurrency World: Is It the End of Financial Stability?