How Stablecoins Work and the Balance They Strike for Managing Price Volatility

Cryptocurrencies are well known for their extreme volatility, as it’s not uncommon to see coins such as Bitcoin and Ethereum rise or fall by 10-20% in a 24 hour time-span. Although this level of volatility is beneficial to traders and investors, it also hinders cryptocurrency’s real-world adoption.

From a practical perspective, businesses do not want to transact in a currency marked by volatility and risk. It would be difficult, for example, to pay an employee’s salary in Bitcoin if the purchasing power of his paycheck is constantly in flux. Volatility also makes it difficult for consumers to make daily transactions using cryptocurrencies. Imagine Bob paying $7 dollars for a cup of coffee one day only to find out the next day that the same cup now costs $5.

Designed to tackle this issue of volatility, there’s an emerging class of cryptocurrencies known as stablecoins that present themselves as price-stable assets in an ever-fluctuating market.

At its core, a stablecoin is an asset that offers price stability characteristics that make it suitable as a medium of exchange, unit of account, and/or a store of value. As a currency, a stablecoin should be global and not tied to any centralized monetary authority that can control its supply. Stablecoins can vary by design, but the two most popular asset-backing methods are an IOU issuance model and a cryptoasset-collateralized model.

IOU Issuance Model

With this model, a business issues stablecoins at a 1-to-1 ratio to an underlying asset in its bank account (basically, each coin is tied to an existing asset in the bank). These assets can take numerous forms. For example, a corporation could have fiat currencies such as the USD sitting in its bank account, or they could back their stablecoins with physical assets, such as gold or silver. Issued stablecoins derive their stability and value from the fact that each token can be exchanged for the underlying asset, similar to how dollar bills used to represent a sum of gold under the gold standard. 

Tether (USDT) is the most popular example of an existing stablecoin that utilizes the IOU model. Each USDT has a value equivalent to that of a single US dollar. Thus, to ensure that the value of a single Tether is always the same as the value of a dollar, for each coin that is issued, there must be a corresponding dollar in Tether’s bank account.

However, one limitation of this issuance model is that it is centralized. Individuals must trust that the issuing entity does in fact possess the underlying assets that are being represented with each issued stablecoin. This limitation has made itself clear with Tether, as Tether Limited, the company behind the coin, faces ongoing scrutiny due to its increasing supply and lack of third-party auditing to determine if the company possesses the funds needed to cover Tether’s circulating supply.

Cryptocurrency-Collateralized Model

Under this model, stablecoins are not backed by centralized assets such as the Euro or USD; instead, they are backed by digital assets such as Bitcoin. The key advantage to this model is that it can be established in a trustless manner. For instance, the underlying assets that back the stablecoins can be held in a trustless smart contract. Thus, the amount of assets held by the smart contract are transparent and can be independently verified.

A common concern with this model is that the underlying assets themselves, which in this case would be cryptocurrencies such as Bitcoin, are volatile, seemingly running contrary to the stablecoin’s purpose. As such, this method may often involve over-collateralization so that any price fluctuations can be absorbed. To give an example, a smart contract can be established to hold $400 worth of Bitcoin, which would serve as collateral for the issuance of $200 worth of stablecoins. However, there is always the risk that a black swan event could negatively affect a stablecoin’s underlying value. Such an event is likely to result in the under-collateralization and subsequent destabilization of the issued stablecoins.

Conclusion

Individuals within the cryptocurrency space are always searching for the catalyst that will result in the mass-adoption of cryptocurrencies. While there are many factors that can contribute to such an event, it is clear that tackling market volatility is crucial for facilitating mass-adoption. Stablecoins strengthen the use case for cryptocurrencies by serving as a non-volatile tool that can be used by both businesses and consumers to fulfill their monetary needs. Producing the perfect stablecoin that brings about mass-adoption is a difficult task, though, given the limitations inherent to both stablecoin models. Still, there are a number of promising stablecoin projects that are aiming to overcome these problems to bring about a price-stable cryptocurrency for the crypto ecosystem.

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