A Beginner’s Guide To Stablecoins

22nd May, 2019 by

In the beginning, there was Bitcoin. And it was good. However, it wasn’t good enough to persuade the public it represented the future of online payments. Thefts from digital wallets and the spiraling environmental impact of mining new coins created huge PR problems, while Government reactions have ranged from skeptical to nakedly hostile.

One of the main criticisms leveled against Bitcoin is a lack of pricing consistency. Having become a football for stock market investors to kick around, Bitcoin’s fluctuating value has led early adopters like Microsoft to withdraw support. Several hard forks haven’t helped, with Bitcoin Cash, Gold and SV all competing against the original currency. As a result, interest has grown in developing cryptocurrencies pegged to a real-world currency or commodity. And this is the ethos behind stablecoins – price stabilized virtual currencies, which are being launched at an astonishing rate around the world.

Flip a coin

Stablecoins fall into three main classifications:

  • Centralized ones pegged to tangible fiat currency at a fixed ratio.
  • Centralized ones pegged to a basket of commodities, such as precious metals and bond markets.
  • Decentralized ones pegged to other cryptocurrencies.

This latter category carries far greater risk since the burgeoning crypto market is hardly renowned for its stability. China is considering banning the practice of Bitcoin mining on environmental grounds, which would be seismic considering its citizens are presently undertaking 75% of global mining. Without mining, Bitcoin would cease to function and its value would drop to zero, dragging down any cryptos pegged to it.

Bitcoin’s ongoing travails have reduced support for decentralized stablecoins, in tandem with stories such as Tether being used to underwrite crypto exchange losses. Pegging a new coin to a tangible asset reassures investors while the new cryptocurrency is establishing itself in a highly congested marketplace. From global banks to OEMs, companies are launching their own stablecoins on a daily basis. Social investing platform eToro introduced eight proprietary coins last month and is promising to release more in the coming weeks.

Each stablecoin is generated and distributed according to prevailing market conditions, unlike fiat currencies whose volume can only be increased through painful quantitative easing. The process of pegging is carried out at a fixed ratio – one dollar to one stablecoin, for instance. This relies on the coin’s developer or underwriter retaining significant reserves in the pegged currency or asset class to cover a sudden run on the stablecoin if investors want their money back. NuBits broke its peg twice due to insufficient reserves when Bitcoin’s value spiked, and its reputation is unlikely to recover.

Closing the stable door

A key attribute of cryptocurrencies to date has been their independence from heavily regulated fiat currencies. Pegging them to the value of gold, Sterling, or Toyota shares, for example, maintains a connection to the real world, but that isn’t always advantageous. If the price of oil drops, stablecoins pegged to it would suffer accordingly. Nevertheless, this may be less risky than associating with other decentralized currencies. Even $133 million of funding couldn’t prevent the non-collateralized Basis stablecoin startup closing last December.

Providing that sufficient reserves are maintained, the benefits of a secure and instant digital cash platform can be enjoyed around the world, without exchange rates or privacy concerns. However, despite hopes that they might one day underpin peer-to-peer transactions, stablecoins are still a significant financial risk. A market leader may emerge and achieve mainstream acceptance, but high-profile failures like Basis suggest that the smart money remains in fiat currencies and real-world assets – for now, at least.

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