A Problem with Cryptocurrencies
Cryptocurrencies, even big papa Bitcoin, will see their valuation fluctuate wildly on a day-to-day basis. This “volatility” introduces uncertainty into being able to predict the underlying value of a transaction. As a result, the underlying purpose of many cryptocurrencies — that of being a “medium of exchange” is compromised. In fact, the value of most coins in the market tend to be based more on speculation than actual utility.
The boom-and-bust cycle of crypto can be exciting to watch, but it highlights the unreliable nature of a currency to buy and sell goods and services. Most businesses aren’t interested in accepting cryptocurrency as payment if it has the potential to tank in value the next day.
A Crypto Solution:
As nothing but code, it is possible for a cryptocurrency to peg its value to either one asset specifically, or a bucket of assets in general and thereby create a “Stable Coin”. In such a way, someone who used a stablecoin would be able to leverage all of the benefits of cryptocurrency — the fast transactions, the low fees, the security and immutability, the digital native currency and the added sense of privacy — without losing some of the guarantees that traditional fiat currency gives, namely the trust and stability that comes with being backed by a national government.
Stablecoins were created to provide a simple, stable, scalable and secure method of performing digital transactions. Defined simply, they are a cryptocurrency that is collateralized (or “backed”) by the value of an underlying asset — the asset itself varies from coin to coin.
There are four (4) main types of stablecoins — as defined by how the coin is backed. Those types are:
- Algorithmic or “Non-collateralized”
Algorithmic or “Non-Collateralized”
The primary example of this sort of stablecoin is Basis — the stablecoin project that shuttered its doors in late 2018 because it found that its work was too difficult to complete due to regulatory pressures. Basis has, so far, been the best example of an Algorithmic stablecoin. (The expression they use is: “Seignorage-style”.)
This stablecoin maintains its value through its money supply. Similar to a central bank’s approach to printing and destroying currency, an algorithm built into a smart contract is used to gauge when demand is increasing which would trigger the minting of new coins to lower the price-per-coin. When demand is decreasing and the price-per-coin drops, the algorithm destroys coins until the price returns to its predetermined peg.
One of the most famous types of stablecoin — MakerDAO’s “dai” is an example of a crypto-backed stablecoin. Even though the dai is pegged to the US Dollar — the assets backing the price are actually in ether and other cryptocurrencies, not US dollars, and they are locked in the governing smart contract.
A criticism of the crypto-backed stable coin is that they require over-collateralization. This means that the value of the asset backing the coin is more than the value of the coin itself. For example, if you are generating $300 worth of Dai — then there would have to be more than $300 worth of ether held as collateral.
Other examples include: Synthetix (aka Havven), Staticoin.
Examples of this type of coin include Digitx Gold, Tiberius Coin and the SwissRealCoin. These coins are backed by commodities — either of a single type or, as is the case with Tiberius, a bucket of like commodities (Tiberius is backed by a set of 7 precious metals that are used in technology).
While called a “stablecoin” — the value of these coins has the ability to move up and down based on the movement of its underlying asset. However, this particular stablecoin flavor has driven the movement to “Tokenize everything!”. By creating a digital token that represents a small slice of Swiss real estate, SwissRealCoin enables a larger pool of investors to own a fraction of plot of land and realize the increase in value that it may represent.
The most common type of stablecoin is the “fiat backed” stablecoin. Tether (USDT), USD Coin (USDC), TrueUSD (TUSD), Paxos Standard (PAX) and the Gemini Dollar (GUSD) are all examples of cryptocurrency pegged to the value of the US Dollar. Other stablecoins exist, pegging their value to other fiat currencies and — with the advent of Libra — to a potential bucket of fiat currencies.
While there is enormous value in a stablecoin pegged to a single fiat currency, there is significant criticism for these projects in that they rely heavily on a custodian of a parent company, which requires periodic audits and represents a single point of failure. Notably, both the Paxos Standard and the Gemini Dollar have been approved by the New York Department of Financial Services for use — clearing the hurdle that saw Basis shutter its doors in late 2018.
Join us in the next post when we discuss what someone can DO with a stablecoin.