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Stablecoins: Combining the Crypto and Fiat Standards

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Written by   15
4 months ago

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In the early days of cryptocurrency, it was extremely difficult to execute trades between different types of cryptocurrencies or between fiat currencies (e.g., USD, Euro, JPY) and cryptocurrencies. Legitimate and trustworthy cryptocurrency exchange companies were in short supply and decentralized exchanges, as enabled by decentralized finance (DeFi), had not yet been created. Veterans and newbies alike were largely reliant on peer-to-peer trading in order to enter and exit cryptocurrency investments.

Conversions from fiat to cryptocurrency and back again also introduced significant complexity for a variety of reasons. First and foremost, banks and other financial institutions were often quick to block any type of transaction between their depositors and cryptocurrency companies. In many cases, they were even required by local governments to refrain from offering any services to companies within the crypto space. And since the U.S. dollar, Euro, and other fiat currencies are almost exclusively physical rather than digital outside of the banking system, converting physical fiat into digital cryptocurrencies on a cryptocurrency exchange was an impossible task.

It would take several years before the cryptocurrency space would devise a way to convert the relative stability offered by fiat currencies from the physical world into the digital world without having to rely on the traditional banking system. In so doing, the financial tools known as “stablecoins” were born.

Stablecoins? I’ll Take Two Please

Stablecoins represent a new type of cryptocurrency that attempts to track the value of the asset or money to which its price is pegged. For example, the most common stablecoins used in cryptocurrency markets today are based on the U.S. dollar. So while the U.S. dollar may fluctuate in value compared to a basket of goods (i.e., inflation) or to a basket of currencies (i.e., forex fluctuations), any stablecoin pegged to the U.S. dollar should match its value one-to-one at any point in time. There are two primary types of stablecoins in use today: collateralized and algorithmic.

Collateralized

Collateralized stablecoins are by far the most common in the world today. Collateralized stablecoins maintain their price peg to the underlying asset by setting aside a commensurate amount of the asset as collateral or a reserve securing the value of the digital stablecoin that will be traded over a blockchain. For example, if I want to obtain $1 million U.S. dollars worth of the USD Coin, I would need to transfer $1 million dollars into a bank account of a company that participates in governing the USDC stablecoin itself, like Coinbase or Circle. Or if I wanted to mint $1 million U.S. dollars worth of PAX Gold, I would need to transfer $1 million dollars to the Paxos Trust Company, which would then be used to purchase an equivalent amount of gold at market prices to be locked up in their vaults.

While stablecoins are commonly thought of in the context of fiat currencies like the U.S. dollar or precious metals like gold, it’s important to remember that any cryptocurrency pegged to the value of an asset, whether through reserves or algorithmically, can be a stablecoin. For example, if you tokenize ownership of your house and use it as the reserve asset backing the tokens, those tokens could be classified as a type of stablecoin.

Algorithmic Stablecoins

The primary difference between a collateralized and algorithmic stablecoin is that the latter is not backed by any collateral or reserve assets. Algorithmic stablecoins still seek to maintain a price peg to a specific asset, such as the U.S. dollar or an ounce of gold, but they do so without having any underlying asset securing their value. Instead, the software code upon which an algorithmic stablecoin is built attempts to maintain the price peg by altering the supply of the stablecoin itself. Is its price too high because there is too much demand? The algorithm backing the stablecoin will simply issue more coins to all existing holders to balance supply and demand and bring its value back to the desired price. The reverse is also true when there are too many tokens, or in other words, when there is insufficient demand for the stablecoin.

While non-collateralized and undercollateralized stablecoins, including those based on algorithms, provide a wide range of benefits, they often experience more price instability than collateralized stablecoins, and are perhaps more likely to lose their peg to the underlying asset or fail completely.

Why Do I Need Stablecoins?

The primary purpose served by stablecoins in today’s cryptocurrency markets is enabling the quick conversion between other cryptocurrencies, such as Bitcoin and Ether, and fiat currencies without actually having to cash out to the fiat currencies themselves which, thanks to the legacy banking and settlement systems, commonly takes a minimum of two to three business days or longer. As an example, a trader can sell their Ethereum for Tether, the largest stablecoin by market cap, on Coinbase’s exchange, which is based in the United States, and then transfer their Tether to Binance’s exchange, which is based in Malta, to buy Bitcoin. All of those transactions together could take place within 15 minutes or less. To execute a similar transaction across international borders through the legacy banking system could easily take days or weeks and involve a high number of fees levied by each intermediary to the transaction.

Because of the ease and immediacy of fiat-to-crypto conversions enabled by stablecoins, a large amount of liquidity is able to be maintained directly on the cryptocurrency blockchains themselves, with limited involvement, if any, by banks or other non-crypto intermediaries. And that liquidity is often seen as a key component of keeping transactions denominated in cryptocurrency smooth and low-cost.

Are Stablecoins Really a Risk to Global Financial Security?

A common sentiment that you may hear from naysayers is that stablecoins can be a destabilizing force within cryptocurrency markets and perhaps even in the global financial system at large. The U.S. dollar-based stablecoin Tether often takes the brunt of this criticism, but algorithmic and other under collateralized versions, not being fully backed by reserve assets, are also included from time to time.

The criticism essentially amounts to concerns that the cryptocurrency equivalent of a “bank run” may happen to any stablecoin that isn’t backed one-to-one by asset reserves. As an example, it is now common knowledge that Tether is not backed fully by U.S. dollar reserves. In fact, in May 2021 the company that manages Tether revealed that only 2.9% of the reserves backing it are actually denominated in cold hard cash. So the concern is that if a large number of people attempted to redeem their Tether for physical U.S. dollars all at the same time, the Tether company could be unable to meet its redemption obligations and investor confidence in the Tether stablecoin itself could be shaken. The current market cap of Tether is currently over $62 billion U.S. dollars and it represents a significant amount of fiat liquidity within cryptocurrency markets. In reality, the ability to easily transact within cryptocurrency markets could be negatively impacted if one or more of the large stablecoins in use were to fail.

That said, it’s a bit like the pot calling the kettle black when bankers and government officials accuse Tether and other stablecoins of being susceptible to a bank run that could destabilize financial markets. Most of us will remember how many banks around the world went bankrupt during the global financial crisis of 2007 - 2008. And fiat currencies themselves are in a worse state altogether since they are not backed by “real” assets like gold or have their supply managed by unbiased algorithms. Should a fiat currency of any size fail, whether it be the U.S. dollar or the Croatian kuna, the portion of the financial market that interacts with the failed currency would be catastrophically damaged. After all, fiat currencies are in reality backed by only two things: promises from politicians and military might. 

With that context, should we really be worried that stablecoins will have an outsized impact on global financial security? I’ll let you decide.

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