The cryptocurrency market is incredibly fast-paced, with coins often fluctuating in value several times a day. This is evident in the case of Bitcoin's price, which saw an increase from a little above $5,000 to a record high of $19,783.21 in December 2017. The tendency of the market to fluctuate frequently is what draws investors in. This is because market volatility is a sign that as much as there could be a decrease in the value of a token, there could also be an increase that leads to profit.
Unfortunately, this volatility factor of the cryptocurrency market which endears it to investors is also a weakness when considering its real-world applications. Due to the rate at which the value of coins fluctuates, it would be impractical to use them for everyday purchases in which prices are fixed because of the lack of stability. For example, the price of a meal could be set at a certain amount of BTC, equal in value to $120. The next day the same amount of tokens may be worth $150 or even $100. In such a case, businesses, as well as consumers, would experience losses in purchasing power and there could be chaotic economic consequences.
For software applications that receive cryptocurrency payments, the constant fluctuation in value presents a problem as well. Developers are faced with the challenge of fixing prices for app purchasing power. To effectively accomplish this, they would need a cryptocurrency that is immune to market volatility. This currency would also need to be secure, private and scalable due to the need for global availability. The solution to this problem can be found in an emerging category of cryptocurrency known as stablecoin.
What is Stablecoin?
A stablecoin is a cryptocurrency which is backed to a stable asset such as the U.S. dollar, gold or silver. Before the United States adopted the use of free-floating dollars, it was tethered to gold in what was known as the gold standard. This meant that every dollar in circulation was tied to a portion of gold in a central reserve and market fluctuations could be controlled. Stablecoin operates based on a similar model.
In the case of purchasing a meal using stablecoins, the meal would have a constant price because the coin is pegged to assets that maintain a constant value or negligible fluctuations. Ideal stablecoins would be globally available, centralized and have low levels of volatility.
How Do Stablecoins Work?
There are three currently available models of Stablecoins: Fiat-collateralized model, Crypto-collateralized model, and Non-collateralized model.
Stablecoins based on the fiat-collateralized model are tethered in value to a reserve of fiat currency such as the U.S dollar in certain ratios. These ratios can often be 1:1, signifying that for every stablecoin issued by a company, $1 is added to their central fiat reserve to represent the value of that coin.
Similar to how the gold standard worked, each token can be exchanged for the number of underlying assets it represents, creating stability in the system. The fiat-collateralized model is also known as IOU issuance model and apart from fiat currency, coins can be tied to assets like gold or silver. Some companies that issue stablecoins using this model are Tether, Stably and TrueUSD.
- The model is simple and easily understandable by users.
- Coins in this model are stable even in the event of a cryptocurrency meltdown because they remain intact within a fiat reserve.
- Since the reserve is off-chain, the risk of fraud and exposure to hackers is minimized. For example, Stably, an issuer of stablecoins requires its customers to undergo an anti-money laundering application process before they are issued tokens.
- This model requires a centralized reserve which counteracts the decentralized nature of cryptocurrency. The reserve acts as a central bank, controlling the supply of coins.
- Transparency is also limited due to the centralization of the reserve because transactions carried out by the issuing company cannot easily be tracked on a blockchain. Users have to rely on the regular, expensive audits carried out on these companies.
In contrast with the fiat-collateralized model, stablecoins that operate on the crypto-collateralized model are not pegged to centralized real-world assets or reserves. Instead, they are tied to blockchain assets which render them vulnerable to market fluctuations. To solve this problem, the coins are overcollateralized with the help of underlying digital currencies.
For example, 50 stablecoins with the value of $1 each may be tethered to $150 worth of ETH. If ETH loses 20% of its current value, $120 worth of ETH will be left, which still leaves the original $50 worth of stable coins collateralized. If the $120 of Ether were liquidated, the original $50 would be returned to the user while the rest would go back to the issuer. Essentially, the stablecoins are so well-padded that market fluctuations are absorbed by the amount of cryptocurrency they are pegged to. If the price falls below the minimum collateral price, the coins are liquidated.
- The crypto-collateralized model is decentralized, making it easier to liquidate stablecoins at any point.
- Transactions carried out in this model are transparent, trackable and do not require audits.
- This model does not require a central reserve that dictates supply.
- During a cryptocurrency price crash where the value of the collateral coin drops below the minimum underlying collateral, the stablecoins are automatically liquidated.
- The model is more complex than its fiat counterpart and can prove difficult for users to understand.
- Capital is used inefficiently in a higher ratio than the tethered coin.
- It is not as stable as the fiat-collateralized model.
This model eliminates the need for stablecoins to be tied to any collateral, like the case of the free-floating U.S dollar which was no longer tied to gold after 1971. Instead, the stablecoins are backed by a smart contract that equates the value of each coin to $1.
If the trading price rises above $1, it means that there is a shortage of supply. This causes the smart contract to execute, and auction more coins on the open market to return the price to $1. After auctioning coins, the smart contract is left with profits, also known as seigniorage. If the trading price falls below $1, the smart contract uses the seigniorage to buy up coins that are already in circulation. This creates scarcity and increases the trading price of the coins.
- It is independent and completely decentralized.
- No collateral is required to tether the stablecoins
- The model uses a self-regulating mechanism which ensures continuity of function without external influence.
- It is complex.
- In the event of a cryptocurrency price crash, the stablecoins cannot be liquidated.
- The system requires continuous growth to function. Any long-lasting decline in price may cause users to lose trust.
The problem of market volatility has stood in the way of the mass-adoption of cryptocurrency for a long time. Stablecoins solve this problem and make it easier and safer to use digital coins for everyday purchases, including app payments. Although there is currently no perfect stablecoin due to the limitations of each model, there are ongoing experiments in the marketplace. Hopefully, these experiments will yield solutions and bring about an ideal price-stable cryptocurrency.