Stablecoin: What you need to know

Rob Chong
May 25, 2019

The stablecoin originated with the creation of Realcoin in July 2014, which later rebranded to Tether on November 20th the same year. The creation of Tether launched the stablecoin craze, with more than a dozen stablecoins currently on the market. Stablecoins are seen as the cryptosphere’s response to the price volatility experienced by most other cryptocurrencies, including Bitcoin. This article will look into the purpose and viability of stablecoins.

What is a stablecoin?

A stablecoin is a cryptocurrency that is designed to minimize the effects of price volatility. To minimize price fluctuations, the value of a stablecoin can be pegged to a fiat currency or a relatively more stable commodity such as precious metals, making it less volatile. Stablecoins directly backed by fiat currencies or commodities are said to be centralized, whereas those collateralized by other cryptocurrencies are referred to as decentralized.

Why do stablecoins exist?

Cryptocurrencies like Bitcoin and Ethereum are highly volatile. It is not uncommon to see price fluctuations of 10-20% over a single day. That makes everyday usage of most cryptocurrencies inconvenient, to say the least.

With such high volatility, it is difficult to use cryptocurrencies as a medium of exchange for transactions. Merchants cannot afford to be paid with a currency that may lose all their profits the next day; likewise, consumers cannot accept highly fluctuating costs. Stablecoins attempt to solve this problem by pegging its value to other assets, in order to keep its value relatively constant.

Are stablecoins regulated?

While cryptocurrencies are controversial as a medium of exchange, some stablecoins are created with the hopes of gaining mainstream acceptance through approval from regulators. For example, Gemini dollar and the Paxos Standard are licensed by the New York State Department of Financial Services (NYDFS).

Stablecoin issuers are very likely under an obligation to the buyback or redemption of tokens from the holders. This may constitute a debenture if the stablecoin represents the issuer’s indebtedness to the holder to pay back the pegged amount per stablecoin. Therefore, stablecoins are very likely to be considered as debentures and securities, unless proven otherwise.

In the context of the Monetary Authority of Singapore (MAS), stablecoins are considered as debentures, and the issuer needs to hold a capital markets services (CMS) license for dealing in capital markets products that are securities under the country’s Securities and Future Act (SFA).

Most stablecoins will be considered digital money under the Payment Services Bill (PSB), which will come into effect in the very near future. The issuer must be licensed under the PSB, unless excluded under the bill.

Types of Stablecoins

  • Stablecoin Type 1 – Fiat collateralized

In this type of stablecoin, every token issued is pegged to a fiat currency (e.g. USD, EUR, Swiss Franc or SGD). The issuer deposits fiat currency into their bank account and issues a token that is sold to customers.

In this model, issuers have to maintain large reserves in a bank to make a pegged exchange rate work, in this case, 1:1. The issuer must also buy or sell its stablecoin on crypto exchanges to keep its value in line with the pegged currency.

  • Stablecoin Type 2 – Crypto collateralized

The second type of stablecoin is collateralized by another cryptocurrency, such as Ethereum, instead of a ‘real-world’ asset or fiat currency. This exposes investors to both the risk of the stablecoin losing its peg and the high volatility of the underlying cryptocurrency, despite it being over-collateralized.

In this model, since the collateral backing the stablecoin is itself another decentralized crypto asset, both the crypto-backed stablecoin and underlying cryptocurrency is relative. Both will likely devalue at the same time with market volatility. Therefore, the collateralized cryptocurrency will have a much lower market value during bear markets, which may not be enough in value for collateralization.

  • Stablecoin Type 3 – Non-collateralized

The third type of stablecoin is not collateralized by any assets but maintains its value by expanding and contracting the supply of the price-stable currency based on demand, similar to what a central bank does with fiat currencies.

In this model, the initial allocation of stablecoin tokens is first created; then the tokens are pegged to some other assetslikely fiat currency, USDusing the Quantity Theory of Money (QTM). As total demand for the stablecoin increases or decreases, the supply automatically changes in response to maintain the value of the stablecoin.

As the network grows, so does demand for the stablecoin. Given a fixed supply, an increase in demand will cause the price to increase. In this seigniorage share model, increased demand causes the system to issue new stablecoins, thus increasing supply, and ultimately lowering the price to the target level. Increasing the supply is easy; it’s the same as Quantitative Easing (QE), which was used to try to restore the US economy by flooding the market with new bonds. However, reducing the supply remains a challenge for this model.

Risks of stablecoins

At a time when cryptocurrencies’ volatility discourages their widespread use in commerce, stablecoins do provide an attractive alternative. Stablecoins can reduce the operating risks of crypto exchanges, improve the efficiency of blockchain-based payment systems, and offer investors a crypto-centric alternative to cashing out to fiat.

The hype surrounding stablecoins, however, may be setting them up to fail. These projects are promising perpetual stability. But things change, and sooner or later, each of these pegged coins will break.

Preston Byrne, a cryptocurrency pioneer and founder of Monax, once wrote that fiat-world examples of pegged assets form “an object lesson in why you don’t try to peg currencies: because you are unable to hold the peg any longer than you can afford to subsidize your differences of opinion with the market.”

As history has taught us over and over, currency pegs can break and cause widespread catastrophe when they do. Pegging cryptocurrencies to fiat currencies (which are controlled by centralized institutions) undermines the whole purpose of decentralization. After all, the value of the cryptocurrency depends on real-world assets, such as the USD.

Stablecoins affect market capitalization. Every purchased stablecoin, whether it is backed by a physical unit or not, will inflate the market cap. This creates a false indication of the market size.

While some may see stablecoins as the future of cryptocurrency in e-commerce or online transactions, it must be noted that cryptocurrency is still young and evolving. There is no guarantee of the continuity of any crypto projects, and sustainability is still a big question, especially in this bear market. Lastly, cryptocurrencies were not meant to replace fiat currencies at all, but to allow two parties to transact without a third party.

Conclusion

  • Regulations

From the above three types of stablecoins, all have some security-like features and, therefore, may fall under the definition of a security token and be subject to security regulations.

  • Custody

Since the reserves of the underlying fiat currencies or assets are crucial to maintaining the price of the stablecoins, without a qualified third-party custodian, there’s nothing to prevent theft of the assets by the issuer. This applies to all tokenized real-world assets or securities.

  • Insurance

Currently, there are a few FDIC-insured stablecoins, namely Gemini Dollar (GUSD) and USD Anchor backed by IBM. Although stablecoins that are backed by FDIC-insured banks lend credibility and a sense of security to investors, this adds to the cost of creating stablecoins.

  • Third-party Audit

This is essential for every stablecoin as the only way to ensure that the issuer does not partake in any fraudulent activities.

Stablecoins and digital money are the future of commerce. They represent a new form of electronic money that is more convenient to use. They are also more flexible than debit cards on e-commerce platforms, online purchases in games, and large cross-border transactions. Digital money will further revolutionize e-commerce, cross-border transactions, and P2P transactions, but as this evolves, there is the risk of fraud (without third-party audits), theft (fractionally reserved coins), and loss (uninsured deposits).

About the author
Rob Chong

Co-founder - Radical Research

Rob Chong have more than 15 years of Business Development/Origination experience in Asia Pacific markets and 5 years experience in Oil & Gas markets analysis. He believes in "Kaizen" which is continuous improvement. He is currently running 2 startups, RadX.Work and Radical Finance. These are tech and research firms respectively.

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