These days, with Facebook’s Libra facing regulatory scrutiny and the People’s Bank of China rushing to issue its own digital currency, the concept of stablecoins pegged in value to traditional currencies and other assets is entering the mainstream vernacular.
Problem is, much of the talk is increasingly negative. Regulators are taking Facebook to task for trying to create a global digital currency at a time when its credibility is in question. And Tether, one of the most common crypto-affiliated stablecoins, has been under fire with U.S. federal regulators for its lack of transparency about whether it’s pegged on a 1:1 basis to the US Dollar.
Despite common concerns over stablecoin regulatory compliance, stablecoins done correctly can yield enormous potential to address two major failings in the current financial system: the estimated 1.7 billion global ‘unbanked’, and the inefficient cross-border payment systems that exist.
Stablecoins aim to combine the speed, immutability and low transaction cost of cryptocurrencies with the stability of traditional currencies. Until now, there have been three different approaches to achieving truly stable value for stablecoins.
Three different types of stablecoins
The first and most common form of stablecoin is to simply peg the value of every digitally issued coin to the value of an asset or a basket of assets held in custody by the issuer. In practice, this means for every $1 stablecoin, the issuer of the asset will hold $1 in their bank account. This also ensures that the stablecoin can at any point be redeemed for $1.
The second type of stablecoins are stablecoins which are pegged to cryptocurrencies, so-called crypto-collateralized stablecoins. Since cryptocurrencies are very volatile, stablecoins pegged to crypto make use of sophisticated algorithms and strict governance to ensure the value of the coin can be maintained. The most prominent example of a crypto-collateralized stablecoin is MakerDao with its stablecoin DAI that is maintaining a value of around $1.
Thirdly, a more theoretical but not yet really common approach is to make use of seigniorage shares to maintain the value of a stablecoin. This would mean a stablecoin is technically not backed by anything (similar to central bank currencies) and the value will be stabilized by issuing more when the price is above the set value and taking coins out of the supply when the price falls below the threshold. Until now, only one company, basis.io, has attempted to issue a stablecoin based on this mechanism, and it shut down due to regulatory problems.
For this article, we will focus on the stablecoin type that is most viable today: fiat-collateralized stablecoins.
Currently, more than 200 companies have announced plans to issue stablecoins. and 66 are already actively offering their stablecoins to the broader public (Consensys 2019).
What has held stablecoins back until now?
The lack of transparency have plagued stablecoin providers until recently. Even though stablecoins take advantage of a decentralized blockchain network to manage transactions, the process of issuing new coins and storing fiat remain very centralized, with murky statements from stablecoin providers about how they issue, what’s held in reserve and other key metrics that give investors confidence in the stability of the financial system.
An Alliance of leading blockchain companies including Cred, Uphold, CertiK, Blockchain at Berkeley and OmiseGO have raised the bar, offering a set of stablecoins (UPUSD, UPEUR) that demonstrate a 1:1 substantiation on the blockchain. Each Universal Protocol stablecoin operates under a universal and transparent reserve standard that can be audited and verified through a transparency page. Investors can at any time check and see how much is in the reserve at any time. This gives investors unprecedented access to information about the stablecoin. If successful, such an approach could help the entire industry. Many stablecoin issuers might avoid the temptation the over-issue one’s own coin if others are showing true transparency.
Why stablecoins remain vital to blockchain
A majority of stablecoins are pegged to a real-life asset, the most popular currency being the US Dollar. In the crypto-world, stablecoins have quickly established themselves as a vital part of the ecosystem with listings across all major exchanges. In a recent study, r3 identified the most common use-cases for stablecoins as: Locking in profits, tax havens and to move money outside of the banking system.
As such the biggest users of stablecoins are still traders, crypto trading firms, hedge funds and speculators. With increasing regulatory oversight on digital assets, the use of stablecoins as tax havens or to move money outside of the banking system, might become null and void very soon. While stablecoins will still serve to lock in profits, the more interesting use-case could turn out to be addressing the aforementioned problems of our time: the lack of financial inclusion and inefficient remittances.
Ironically, another challenge that stablecoin issuers share with central banks is that the most important currency for them is not necessarily the one they hold in storage, but trust.
If users lost trust in a certain stablecoin this could lead to something similar to bank-runs in the traditional financial world. A scenario, where everyone tries to sell-off their stablecoin, but no one is willing to buy it for the value that it was originally issued at, which ultimately leads to a decreasing price.
The regulatory environment in which stablecoins transact will surely mature. And with this, stablecoin issuers will have to face thorough checks on accountability. Nevertheless, the stability of a coin and acceptance by merchants won’t solely be dependant on their balance sheet, but more on how far they have managed to establish trust and set up a transparent process, that allows anyone to track proceeds of currency holdings.
About Universal Protocol Alliance
A coalition of cryptocurrency companies and blockchain pioneers, the Universal Protocol Alliance seeks to accelerate the adoption of blockchain as a mainstream financial technology by making digital assets more accessible, secure and convenient to own. The Alliance Members consist of Bittrex, Cred, Uphold, OmiseGO, Blockchain at Berkeley, and CertiK. www.universalprotocol.io