3 - Stablecoins: the search for stability

Summary

The short turbulent history of cryptocurrencies demonstrated several key issues, central among them the lack of trust and extreme volatility. These made Bitcoin and other cryptocurrencies only useful for speculative investment and not as a means of payment. There were two periods of boom and bust with Bitcoin: the first in late 2013/early 2014, that ended with the high-profile hack of the Mt Gox exchange and the second in late 2017/early 2018, when the market capitalization of Bitcoin, Ether and other cryptoassets peaked at $830 billion before crashing. It became clear that the extreme volatility of existing cryptocurrencies meant that they could not be used as a means of payment, a store of value, or a unit of account. The introduction of stablecoins directly addressed the need to reduce volatility by tying digital assets to more reliable, that is, more stable assets such as the US dollar, gold and oil. They were intended to offer the best of both worlds: instant processing, security and privacy of payments and the stable valuations of fiat currencies.

We can breakdown stablecoins into three main types based on how they work: collateralized, crypto-collateralized and non-collateralized. Collateralized stablecoins are linked to a fiat currency, such as the US dollar. Other forms of collateral can include precious metals, or commodities such as oil. Most in fact are linked to US dollars on a one-to-one basis. The reserves are supposedly maintained by custodians and are regularly audited. Crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve currency is very likely to be prone to volatility, these stablecoins are over-collateralized by maintaining a much larger number of cryptocurrencies as a reserve for issuing a lower number of stablecoins. For example, $2,000 worth of Ether may be held as a reserve for issuing $1,000 worth of crypto-backed stablecoins, allowing for 50 per cent swings in the reserve currency. They are supposed to have more frequent audits and monitoring to ensure price stability. Most of these stablecoins use an approach called collateralized debt positions (CDP), a complicated approach that involves the user of the stablecoin opening a CDP by depositing digital assets into a service provider's smart contract, such as Zig.