#Payments11 Mar

Stablecoins – A Guide To Backing Concepts And Application

Mercuryo

How do they actually manage to remain stable?

How do they actually manage to remain stable?

Stablecoins, as the name implies, as coins that have some stable value, which is in direct opposition to volatility, which is inherent to the cryptocurrency market. Since volatility makes the use of cryptocurrencies impossible or impractical for daily operations, the need arose for a new class of assets capable of ensuring a stable price with pegging to assets that would ensure said stability.

The main idea behind stablecoins is to provide opportunities in the cryptocurrency world and the banking industry, making them more attractive as a medium of exchange and a store of value. Stablecoins are also a popular instrument in lending mechanisms thanks to their price stability.

Means of Achieving Stability

Since stablecoins are required to have stable values due to their namesake, there are different methods for achieving such market prices. Four main types of stablecoins can be classified:

·  Fiat-backed, which are pegged to real-world currencies like the US Dollar. This makes such stablecoins suitable for use in daily operations;

·  Commodity-backed, which have their value tied to real-world commodities;

·  Cryptocurrency-backed, which are secured by double the real-world asset value of the cryptocurrency pegged to the stablecoin. Such assets ensure decentralization while cryptocurrency reserves absorb the effects of market volatility;

·  Unbacked, also known as Seigniorage coins – a class of stablecoins that operates on a demand and supply and transaction commission basis.

A more detailed look at the types of stablecoins will provide a better understanding of their functioning, as well as their advantages and disadvantages.

Fiat-Backed

The idea of fiat-backed stablecoins is that their price is tethered directly to a selected real-world currency. The emission of such stablecoins requires the emitting party to have a sufficient amount of the selected fiat currency in its bank reserves to back every coin issued into circulation. The given method provides the highest level of price stability, as the fiat of choice is usually the US Dollar. USDT – Tether and TUSD – TrueUSDT are the best-known fiat-backed stablecoins.

Advantages

Price stability is the main advantage of fiat-backed stablecoins, as their underlying asset is not as volatile as most others. Technical simplicity is another major advantage, as such assets do not require complex systems for evaluating their price and can be directly tied to any major fiat currency exchanges to determine their market value. This makes such stablecoins attractive for both financial operations and as concepts for issuing such assets.

Disadvantages

The presence of intermediaries in controlling fiat-backed stablecoins in the form of emitting organizations and others managing the reserves and connection to fiat gateways makes such assets susceptible to external control and influence. This largely eliminates the virtues of decentralization. Another disadvantage is centralization, since 1 to 1 exchange ratios can only be achieved through connection to the traditional financial world. Other disadvantages include the need for regular audits and slow transaction speeds due to the need to resort to fiat gateways.

Commodity-Backed

As the name implies, commodity-backed stablecoins are directly linked by their values to some real-world commodities. Such commodities include crude oil, precious metals, diamonds, even artwork or hot-dogs. The Venezuelan Petro is a famous example of an oil-backed stablecoin, which had its value pegged to the Venezuelan government’s oil reserves Such assets are uncommon and have not found popularity on the market.

Advantages

The sole advantage of commodity-backed stablecoins is their relative stability of price and tethering to a tangible asset that can be sold on the open market to level out prices.

Disadvantages

Commodity-backed stablecoins require immense amounts of backing to remain liquid. That poses significant challenges before their developers, such as having storage space, obtaining government licensing for natural resource deposits and much more. In addition, commodity prices are not that stable.

Cryptocurrency-Backed

Such stablecoins require highly-liquid digital assets as their backbone, which is usually either Bitcoin, Ethereum, Ripple, or some other popular coin with high capitalization. Exchange rate volatility is still present even if the issuers decide to peg the asset to a basket of cryptocurrencies. However, user confidence increases along with price stability.

Advantages

Decentralization and full transparency are the main advantages of cryptocurrency-backed stablecoins, as such assets have their reserves located on the blockchain, allowing for faster transaction speeds and open audit mechanisms. Other benefits include the availability of higher liquidity levels and faster implementation of changes in line with emerging regulations.

Disadvantages

A lower degree of stability is a major disadvantage inherent to the underlying digit asset base. Other disadvantages include high dependence on the viability of the underlying assets and the complexity of the technical structure, which requires connections to major crypto exchanges for aggregating a median price for the backing assets.

Unbacked Stablecoins

Also known as Seigniorage coins, or algorithm stablecoins, such assets are somewhat rare, as they rely on the principle of extracting commissions from payment transactions passing through the issuer’s servers. Such stablecoins rely on an algorithmic approach to regulating cryptocurrency supplies, much like Central Banks aiming to regulate inflation. 

Such assets rely on smart contracts that automatically expand and contract supply using algorithms to maintain value. Stablecoins of this kind rely on the rules set forth in their code. Those rules maintain the balance of supply and demand. Among the rules are incentive mechanisms for the participants, which stimulate transactions and allow the platform to make profits.

Seigniorage is the difference between the value of money and the cost to produce it, or the economic cost of producing a currency. If seigniorage is positive – an economic profit is achieved. Negative seigniorage will result in an economic loss. By controlling the supply and demand of a currency by increasing coin supply and decreasing the number of issued coins, or vice versa, it is possible to maintain the value of a digital asset at a desired level.

The mechanisms involved in seigniorage coins are rather straightforward – demand and supply are the key. New assets are issued to stabilize prices in case of demand hikes. The reverse happens in case of demand drops, as coins are bought back to reduce the amount available in circulation.

Advantages

Transparency is the main advantage of Seigniorage stablecoins, as all of their transactions and smart contracts are blockchain-based and can be easily audited. Decentralization is also fully ensured by such coins, adhering to the main virtues of cryptocurrencies.

Disadvantages

Technical complexity is a given with Seigniorage coins, as their price stability requires complex mathematical calculations and technical connections to aggregators. In addition, most critics of such coins question their logic, arguing that pegging them to fiat assets would produce considerably higher stability.

General Characteristics

Fiat-backed stablecoins dominate the market, mostly because their volatility is almost completely negated thanks to backing through relatively stable real-world currency reserves. And though the concept of cryptocurrencies denies traditional assets and the class was created as a disruptive technology for decentralization, the volatility inherent to such assets as Bitcoin and Ethereum makes them impractical as backing for an asset whose value resides in its stability.

Thanks to the combination of decentralization and the added benefit of relative predictability in their price, stablecoins have become popular and are being successfully traded on the open market. The relative price stability and high market demand are giving holders of such assets the opportunities necessary to trade them with benefit and take advantage of their daily applications as means of payments.

An added factor giving stablecoins the necessary adoption and recognition is the fact that traditional currency backing attaches to the stablecoin all related legal restrictions and regulations, giving such assets a quasi-legal status in some states. And though stablecoins are not as liquid as most cryptocurrencies, they are experiencing greater levels of trust than most of their traditional counterparts.

General Limitations

Though more stable than cryptocurrency and commodity backed stablecoins, such fiat-backed assets as USDT are still susceptible to depreciation. The US Dollar has been losing ground in recent years and the British Pound is a good example of depreciation in light of geopolitical turmoil and uncertainty, such as Brexit, which has significantly undermined the British currency’s positions globally.

Some states, such as China are toying with the idea of launching CBDCs, while Russia has recently evaluated the prospects of creating a digital Ruble. The latter prospect was abandoned, as the government of the Russian Federation found no significant advantages in the emission of such an asset for use by the general population.

And though stablecoins have financial potential as alternative instruments, their application is tethered solely to local laws and regulations. Countries with high inflation will not welcome the use of such assets, especially if they are tethered to foreign currencies.

Conclusion

The global pandemic has devalued many national currencies and resulted in the increased emission and adoption of cryptocurrencies as both means of payment and value storage. In light of the depreciation of the US Dollar and the high inflation on most domestic markets, cryptocurrencies are becoming a favorite for both investors and average users as an alternative to traditional financial instruments.

Stablecoins are projected to move from price stabilization to third-party validation mechanisms in 2021 as the number of related projects grows in light of increasing market adoption and trading volumes. A clear indicator of such a development is that in January 2021, the US Treasury OCC published a document outlining new guidance for banks. The document suggests banks to resort to public blockchains and stablecoins for conducting banking functions. Such a development could lead to stablecoins being connected to SWIFT and other payment systems.

More articles

#Payments31 Aug

The Rise of Gig Economy and Challenges of Mass Payouts

#Payments13 Aug

What You Need to Know About Merchant Category Codes

#Payments19 Jul

The Future of B2B Payments