When talking with someone who is new to cryptocurrencies, one of the initial questions that will come up is about their price volatility. Similar to shares, it is important to understand the underlying fundamentals of the cryptocurrency in question including its purpose. Some cryptocurrencies are designed to maintain constant value, referred to as “stablecoins.” This makes them less vulnerable to changes in volatility.
To get a better understanding of what this means, you first need the following basic information:
Cryptocurrencies are much more than just Bitcoin. CoinMarketCap displays over 1500 different tokens, but that’s only the beginning. In reality, a huge number of different cryptos are in circulation. The large quantity of tokens may be intimidating, so it is important to research and identify projects aiming to solve a problem, that are continuing to build in accordance with their roadmap.
No matter what Satoshi’s original idea was, Bitcoin is not currently capable of becoming a popular currency. The technical issues of slow transaction speed and the problems with mining, including energy consumption and centralization, make it unsuitable for this purpose. Despite being almost a decade old, Bitcoin’s dependability has ensured it to remain trusted as a form of reserve worth, identical to gold.
Although it may seem unlikely, there are a number of initiatives that hope to be the primary currency of the future. They address the primary problem that must be addressed when looking at Bitcoin as a form of money: its instability. This article will focus on the phenomenon of stablecoins, which are a kind of digital asset.
The issue of ups and downs in value is a major feature to consider when looking at a currency: it is paramount for a currency to remain steady in order for people to have trust in it. Constructing a unique currency necessitates a deep comprehension of both technical procedures and social phenomena. To attain the status of currency, it is essential for an item to be identified and endorsed by its patrons and build up their faith in it.
Cryptocurrencies, Stablecoins and CBDCs
The different kinds of modern digital assets or financial instruments can be divided into three major categories.
There is a large variety of digital assets that have been created by private entities. They have their own form of money and it is not based on the money of any ruling country. They employ cryptography to keep a record of dealings and possession of digital ‘coins’ in a digital list that is dispersed (and synchronized) among multiple ‘nodes’ (or computers) instead of depending on one centralized party to work the system. Bitcoin is the most well-known version of a digital currency which works with no central authority, while there are thousands of other similar versions in existence. Cryptocurrencies typically have no inherent worth, generally have no company or organization to back them up, and rely on the faith users have in the code that controls the system.
It can be said that although the term ‘cryptocurrency’ implies it is a type of currency, it is generally accepted that the existing cryptocurrencies do not possess the signature characteristics of true currency. This is the reason why some people choose to refer to them as ‘crypto-assets’. Many examinations of this point out that cryptocurrency is not very common as either a currency to buy goods or a sort of account measurement, and its pricing can fluctuate greatly, which makes it inappropriate to use as an investment or something to store money. In Australia, the currency law from 1965 does not recognize cryptocurrencies as legal tender, though this does not stop their usage if both parties agree to the exchange.
Stablecoins, a type of digital asset, are intended to have a steadier value than other crypto-assets or tokens, which should keep the worth consistent compared to the US dollar or gold. This is to help them become more profitable and desirable as a means of keeping money secure or as a way of paying for something. Supporters of these coins attempt to sustain a constant worth by retaining resources that are a back up for the existing coins. So far, the trustworthiness of the back supports for cryptocurrencies, especially Tether, which has the highest market value, has been shaky. Recently, the Commodity Futures Trading Commission in the US imposed a fine of forty-one million dollars on Tether for claiming inconsistently about assets being fully funded.
Within this group, it may be useful to distinguish between three possible broad types of stablecoins:
- The first category includes essentially all the existing stablecoins, such as Tether, USD Coin and Binance USD. These can be thought of as a bridge between fiat currency and cryptocurrency. They are being used both for payment or settlement for transactions involving cryptocurrencies or tokenized assets, and also as a store of value by people who may have traded in cryptocurrency and wish to then switch to a fiat currency claim but without leaving the distributed-ledger technology (DLT) ecosystem. They are typically issued onto public blockchains.
- The second category would be the types of stablecoins that are being proposed by some large investment banks. These are envisaged for use in more mainstream financial- or corporate-sector uses, including treasury payments and cross-border payments. The assets backing these coins might conceivably be deposits at central banks.
- Third, the proposed Facebook-led stablecoin, Diem, is an example of a stablecoin that would be aimed at retail use. For households or merchants using Diem coins in everyday transfers and payments, the system would have many of the attributes of a stored-value facility (SVF) or ‘e-money’, and the particular ledger technology behind it would probably not be important to users.
Central Bank Digital Currency
A potential form of digital funds, called a Central Bank Digital Currency (CBDC), could be issued by the central bank and allow users to have a claim against it. A retail (or general-purpose) CBDC would be similar to digital cash that could be accessed by all, likely on mobile phones or possibly via specialized gadgets like smart cards. It is possible that there could be a Central Bank Digital Currency which is only available to select individuals, similar to the settlement accounts that are given to central banks.
The currency used with a Central Bank Digital Currency would be the same as the money used in cash and settlement accounts, which is known as a fiat or sovereign currency. A CBDC would have a 1:1 exchange rate with other forms of currency, and likely be recognized as a legal form of payment.
It is expected that private-sector companies will be responsible for getting CBDCs (Central Bank Digital Currencies) to users, although they are issued by the central bank. It is thought that CBDCs can use DLT, however there is also the potential for them to utilize traditional databases as in the case of the Chinese CBDC that has been proposed.
How to Stabilize a Cryptocurrency: Live Examples
In order to keep the value of the exchange rate they have pledged stable in comparison to a particular government-backed currency, stablecoins must provide collateral. As a result, several types of stablecoins emerged depending on the collateral mechanism they used:
Fiat Collateralized Stablecoins
The quickest and straightforward way to create a stablecoin is also the most centralized. In summary, there is a controlling entity responsible for the issuance of the stablecoin that holds an equal dollar amount to the total that has been made available. This reserve provides assurance that the cryptocurrency is viable and can be exchanged into U.S. dollars at any point.
Even so, this approach comes with several issues. In the beginning, the entity that issues the stablecoin and supports its value has sole control over it. There are no other choices but to trust it. This approach is also expensive to use, especially on a large scale, because it requires setting aside a large sum of money equivalent to the amount of stablecoins in use.
This technique is employed by Tether (USDT), the most frequently used stablecoin. Despite its use, the USDT has been widely criticized due to its lack of transparency. There is no guaranteed way to confirm that the company, Tether, that created the USDT has the reserves of dollar that match the amount of USDT in use, which is estimated to be around 2.8 billion. Nevertheless, the relationship between Tether and Bitfinex (the 4th largest cryptocurrency exchange when taking into account levels of trading) raises worries about the chance of market control that could potentially be enabled.
In response to the opacity of USDT, TrueUSD was made to utilize the same process while providing greater assurance. TrustToken, the company behind TrueUSD, does not keep the token themselves; rather, they have a system of banks and financial services institutions that keep the funds locked in escrow for them. Cohen & Company releases a separate audit report twice a month to ensure that the TrustToken financiers have a set amount of money in escrow which compares to the quantity of TUSD for circulation.
The assurances presented appear to be more dependable than those for the USDT, though the same challenge remains: it is necessary to put trust in TrustToken and its associates, especially Cohen Company, to stay true to their word. It works until it doesn’t.
Crypto Collateralized Stablecoins
Although current fiat-backed digital currencies have lived up to their promise of maintaining stability, they are not giving cryptocurrencies the proper representation they need to be a viable decentralized substitute to traditional financal and monetary systems. To answer this concern, another type of stablecoins emerged. They rely on other digital currencies as a form of security and a collection of self-executing agreements to make their trading rate consistent with the asset upon which it is based.
This type of stablecoin, however, has its own issues; the primary one being the unsteady nature of the cryptocurrency used as surety. To take care of them, they require an asset of greater value than the stablecoins generated to be held as collateral, which makes wide-spread application challenging.
Stablecoins that embrace decentralization can be relied upon to serve a larger purpose in the future, solving the issues posed by the two other types of coins by providing a viable option that is ready to operate on a large scale. These projects are still in the development phase.
Many of them utilize algorithms which decrease or increase the quantity of the respective stablecoin in circulation to control its cost. If the cost surpasses a dollar, the available amount in circulation will rise; conversely, if it goes underneath, the amount present will diminish. The two most noteworthy projects in this group are Basis and Carbon.
Basis has a vision to construct an “automated central bank” which will maintain its value. They have a complicated system that uses three distinct forms of token. The objective is to create a basic imitation of the Federal Reserve System where investors can become involved.
Conversely, Carbon is attempting to put into practice an idea that Robert Sams came up with back in 2014 known as seigniorage shares. The concept is mainly conceptual at this point and has yet to be put into practice.
Distinguishing Between the New Digital Assets
While there are many ways to distinguish between the characteristics of the three types of digital assets – cryptocurrencies, stablecoins and CBDCs – there are two particular dimensions that are worth highlighting:
- Denomination and backing: There is a spectrum ranging from cryptocurrencies (which have their own unit, with no reference to any fiat currency and no asset backing, so that any value they might have is determined purely by what – if anything – others will pay for them) to stablecoins (which are typically denominated in fiat currencies or aim for stability against fiat currencies, and are backed by assets that are supposed to ensure redeemability at par) to CBDCs (which are denominated in fiat, or sovereign, currencies, and are fully convertible at par into other forms of money.
- Governance and technology: CBDCs would clearly have centralized (‘permissioned’) governance arrangements, as do some stablecoin arrangements, whereas this is typically not the case for (‘permissionless’) cryptocurrencies, where governance may rely on some form of consensus emerging to change the pre-existing software protocols for the system. And transaction verification would also be quite different for CBDCs and stablecoins. Unlike in cryptocurrencies, where entities compete to verify transactions, including via ‘proof of work’ mining competitions, CBDCs and stablecoins would likely rely on a smaller number of trusted entities to verify transactions.
Stablecoins: A Gift or a Curse for Cryptocurrencies?
Stablecoins are a recent yet fascinating innovation. A variety of different methods are being employed for numerous projects that are currently in the works. A less complicated taxonomy was proposed: some projects mix multiple types of security while others utilize totally distinct approaches.
Currently, stablecoins are primarily being used for speculation, but in the long-term, these could be a major factor in the widespread use of cryptocurrencies.