Stability Solutions: An Overview
Defined broadly, stablecoins are any fungible, transferable tokens that are closer to major fiat currencies in terms of price stability, than to cryptocurrencies which can fluctuate greatly in value on a day-to-day basis. While cryptocurrency speculation is driven in no small part by price volatility, wild swings in price have worked against their adoption as both units of account and mediums of exchange.
A merchant who wishes to take advantage of cryptocurrency's desirable properties yet minimize exchange risk in the process has several options available to them which we will explore here.
The most straightforward approach for a merchant is to not exchange the cryptocurrency they received whatsoever, treating it as any other monetary instrument, spending it on expenses or distributing it to investors. This approach takes advantage of the original design of most established cryptocurrencies, allowing for the permissionlessness, simplicity and noncustodial security promised. Despite the numerous advantages to simply keeping and using all received crypto, not every business can afford to stomach the accompanying volatility. This practice is therefore typically limited to cryptocurrency-related businesses, businesses where permissionlessness and privacy command enough premium to overcome volatility, or businesses that can afford to keep enough liquidity as buffer relative to their crypto volume.
Adoption of the simple "keep the coins" practice greatly lowers development complexity, and is the default for a number of payment processing services.
An option that has been with the cryptocurrency scene since the beginning, a direct exchange to fiat currencies such as the US dollar effectively turns the transaction into a fiat payment with extra cryptocurrency steps. As effective as the local fiat of the merchant, it cancels out many of the advantages of using crypto, often leading to a worse experience for merchants than straight fiat transactions.
While exchanging to fiat greatly increases regulatory burden and complexity, companies that have successfully gained a toehold providing the service can be quite profitable with a reasonably deep moat against competitors.
Very popular among exchanges and sometimes presented as viable merchant solutions, custodial stablecoins are fungible tokens issued by organizations who hold non-crypto assets as backing for tokens that are pegged to fiat value. They may carry some of the desirable properties of permissionless cryptocurrency as long as their issuing organization remains solvent.
Frowned upon by many due to their single points of failure and regulatory risk, custodial stablecoins are nevertheless very straightforward to understand, use and take advantage of in more complex schemes, making them a popular choice among traders and speculators.
Examples: USDT, USDC, BUSD
Touted as permissionless alternatives to custodial stablecoins, algorithmic stablecoins typically issue tokens that are redeemable against over-collateralized backing assets via smart contract.
A wide range of value stabilization mechanisms are experimented, with some adventurous tokens even challenging the concept of over-collateralization as a basis of value. Their dependency on ownerless smart contracts instead of a single custodial gatekeeper generally underlies their claim to permissionlessness, although the precise algorithm and quality of the underlying assets can affect that claim on a case by case basis.
Theoretically solving some of the issues associated with custodial stablecoins, their increased complexity and the fact that they come with their own single-point-of-failure risks has limited their usage.
Example: DAI, UST
Instead of exchanging volatile cryptocurrency into more a more stable medium, another way to reduce risk is to participate in a hedging contract, where volatility is transferred from the stability-seeking hedging party to a speculator with appetite for risk. A practice long used in the commodity world, hedging contracts offer a very different approach to hedging. Each contract is independent from another, offering maximum flexibility in parameters, while also eliminating the single point to failure typically found in pegs of fungible tokens. Using contracts instead of fungible tokens is typically a more complex and involved process for the hedger, although the process can potentially be abstracted by software.
A budding approach that has few players, hedging contracts has been field-tested and is currently pioneered by General Protocols on the Bitcoin Cash chain.
Example: AnyHedge on Bitcoin Cash
These approaches can be evaluated in terms of the following criteria:
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This article forms part of the General Protocols Blog, a collection of cross-platform links showcasing our team's community activity, Bitcoin Cash projects, UTXO development, and general crypto musings.