The Ins and Outs of Stablecoins

According to a report from the crypto-wallet provider blockchain, the amount of stablecoin projects carried out within 2018 have skyrocketed.

It seems stablecoins have become the new rave in the cryptocurrency sector, with developers from one end of the world to another racing to get projects to market.

A stablecoin is an ideal form of cryptocurrency that can be pegged to other stable prices or assets.

Some of its main attractions include the fact that it’s global, has no affiliation to any central bank and is rarely subject to fluctuations.

Why Are Stablecoins Important?

Users are currently worried about the fluctuations of their cryptocurrency.

However, stablecoins can provide them with benefits both in the short and long-term. They are not only a practical tool in helping day-to-day financial operations, but can also provide a stable alternative to finance loans, mortgages and derivatives in the long-term as well.

Someone pointed out that the widespread adoption of stablecoins will unlock the enormous potential of the blockchain — provided that they serve as a medium of exchange, a store of value and a unit of account at the same time.

Exchanges

Stablecoins can be used as a liquidity tool for cryptocurrency exchanges. Individuals and investors can currently buy with fiat currencies and trade out from cryptocurrency during periods of high volatility, as well as in some jurisdictions with low regulatory issues to address.

Global Currencies

Furthermore, stablecoins could become a universal medium of exchange: trustworthy, decentralized and cheap cross-border transactions are more and more needed by those who don’t want to rely on the centralized forms of currency.

It is self-evident that stablecoins will be especially appealing for people living in countries characterized by unstable monetary systems and will allow access for the unbanked to the global financial system.

Types of Stablecoins

Three underlying methods have been used by stablecoin projects so far.

1. Fiat-Collateralized Stablecoins

These are the least complex (or more straightforward) form of creating a stable currency. Coins are issued 1:1 after a certain amount of fiat currency or established assets such as gold or diamonds has been deposited as collateral.

Generally speaking, the adoption of these stablecoins requires trust in a centralized third party, to which the issuer delegates the task of holding the underlying reserve.

Examples of fiat-collateralized stablecoins include Tether (USDT,) USD Coin (USDC) and Dai (DAI.)

2. Crypto-Collateralized Stablecoins

These are similar to the fiat-collateralized form, albeit the collateral used in this case is another cryptocurrency. Crypto-collateralised stablecoins are dependent on the stability of the cryptocurrency on the other side of the equation. Hence they require a fluctuating reserve to maintain a peg.

The model is decentralized to allow users to liquidate their holdings into the crypto-collateral with ease. However, if a black swan event occurs, in which the underlying asset is rendered useless, the stablecoin could also be affected.

MakerDAO (DAO) is the most popular crypto-collateralized stablecoin for the time being. Havven (HAV) is worth mentioning too, although it uses the maker/taker market philosophy to achieve the required stability.

3. Non-Collateralised (or Algorithmic) Stablecoins

The stablecoins in this third category has no collateral, with its stability relying on a combination of smart-contracts and algorithms.

One might say that non-collateralised stablecoins expand and contract the supply of the price-stable currency and/or other variables similar to how a central bank deals with fiat currency, albeit in a decentralized manner.

An algorithm is used to ensure price stability and take immediate action during price fluctuations.

An example of this is Basis — formerly known as Basecoin. Among the others, Xank, which will launch early next year, will allow the peg to be set by a protocol governance mechanism, algorithmically adjusting the count of Xank coins on a per-transaction basis.

Downsides of Stablecoins

Crypto-collateralized stablecoins have come under heavy criticism by stakeholders who believe that over-collateralized stablecoins would still be rendered useless if a black swan event occurs.

Furthermore, antagonists of fiat-collateralised stablecoins don’t think that pegging a cryptocurrency to a fiat currency is a feasible approach to solve volatility issues. Reason being that the US Dollar, for example, is subject to fluctuations, experiencing reducing purchasing power as a result of inflation and unstable exchange rates.

Also, some fiat currencies like the Saudi Arabian Riyal when pegged against the US Dollar gets too expensive for long-term use. Additionally, relying on the use of the US Dollar as a pegged cryptocurrency would eventually turn it into another USD derivative, and a national legal tender in the long-run.

What’s more, fiat-collateralized stablecoins usually rely on the bank system — which begs the question; what happens if the issuer’s bank account gets seized? AML/CTF laws and many different government actions could affect the availability of the reserve.

Non-collateralised stablecoins are susceptible to death spirals, especially now when the model is still in its experimental stage. The success of the coin often depends on the new entrants absorbed into the system and an increase in demand. Hence the model has been likened to a pyramid scheme, in a rash attempt to identify the model’s weaknesses.

Finally, risks related to algorithmic manipulations may arise, with software updates and involuntary bugs introduced by the developers potentially ruining the monetary policy.

Regulatory Challenges

Broadly speaking, stablecoins are more subject to regulatory issues compared to the rest of the cryptocurrency market, due to the uncertainty on the matter.

As it happened with Bitcoin and other altcoins, stablecoins were a fact far before lawmakers, governments and regulators understood their nature and how to deal with them.

One of the most problematic issues is trying to establish whether stablecoins are subject to national securities and money service laws or not.

The State-of-Art of the Stablecoin’s Industry

The independent news resource Stable.Report recently surveyed 37 stablecoin issuers, revealing that over half of them estimate these recent iterations of digital money’s market capitalization will reach USD 99bn within three to five years. While 22% of them hypotheses a USD 1tn-market in the same period.

Stable.Report also gathered 25 stablecoin issuers from 16 countries, together with investors, exchanges, service providers and legal experts at The Reform Club in London last month for the Stablecoins: Collaboration Towards Mass Adoption event.

The attendees pledged to join forces and form a collective network to start working together and create a representative organization to help drive a widespread adoption of stablecoins. That is why the Stablecoin.Foundation has been founded as the global professional trade association.

Stable.Report and Stablecoin.Foundation has partnered with BECON.global for the next trade event: Stablecoin New York, scheduled for the 26th November at the Becon House in Manhattan.

Disclaimer

This article should not be construed as a recommendation, endorsement, opinion or approval of any kind. It has been written for information only and should not be relied on for legal purposes. Professional advice should always be sought before taking action based on the information provided. The author is part of the advisory team of Noku. Opinions express are his own.

Originally published at www.datadriveninvestor.com on November 13, 2018.


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