Cryptocurrencies are already well known, but the public opinion includes much skepticism concerning the high price volatility. For example, Bitcoin, the first cryptocurrency, is still considered as highly speculative by most investors. To tackle those problems, the concept of stablecoins evolved. The various types of creating a stablecoin all bear both potentials and risks to the success of the coin. Nevertheless, overall the potential outweighs the risks and creates the opportunity to replace FIAT money extensively in the long run.
Cryptocurrencies are often said to be extremely volatile and speculative, which makes them inoperable for trade. Thus, the establishment of cryptocurrencies as a means of payment is hindered. The need for price stability, proper cryptocurrency accounting, payment methods, and non-speculative cryptocurrencies, leads to the concept of stablecoins. Stablecoins can briefly be defined as cryptocurrencies that are artificially stabilized or pegged to decrease volatility (see Figure 1). Technically, these coins work as a derivative of an underlying, which e.g. could be a FIAT currency (a currency issued by a government and not backed by a physical commodity) or a physical asset.
Figure 1: Theoretical price development of stablecoins
To create a stablecoin the following three methods can be chosen: (1) FIAT-backed, (2) crypto-backed, and (3) uncollateralized.
The FIAT-backed stablecoin is hedged by off-chain assets, meaning, that users deposit one unit of the underlying asset and receive a stablecoin in return. Once a user returns the coin it is burned and the corresponding amount of FIAT currency is being paid out (see Figure 2). The advantage of this method is, that the coin replicates an asset, which is traded in a regulated market. Nevertheless, no deposit protection is in place and the issuer is obliged to guarantee the payback of the underlying asset.
Figure 2: Exchange system for coins
The second method, crypto-backed stabilization, technically represents the same process but with crypto-assets. This method, nevertheless, represents a soft peg, relying on a self-stabilizing mechanism, which enables investors to capitalize on arbitrage opportunities (i.e. one coin only costs 0.8 US-dollars but is worth one). The downside of this method is the need to overcollateralize the coins, since the underlying volatility may lead to a situation in which the collateral is not worth enough FIAT anymore. Therefore, the current minimum of collateralization is around 150%, which creates additional costs for users.
The uncollateralized or algorithm method leverages an algorithm, stabilizing the coin by buying or selling the coin itself and thus increasing or decreasing the coin’s supply. This mechanism leads to a rather stable price of the coin.
Figure 3: Algorithmic stabilization
So-called “e-money licenses” represent an important development, which enables FIAT prices (i.e. of a bond or a share) to be directly transformed into digital money prices.
When it comes to collateralization one has to distinguish between three types: (1) fully, (2) partially, and (3) not collateralized stablecoins. The term fully collateralized describes the need to hold reserves at least equaling the value of the circulating coin. Partially collateralized coins are not backed by 100% or more of liquid reserves, but only by a fraction of all deposits. Not collateralized stablecoins are not backed by collateral and are a synonym to algorithmic stabilization.
Despite the degree of collateralization, a lack of transparency, uncertainty, and distrust created through the issuer endanger price stability.
As already mentioned, a significant risk of private coin issuers defaulting due to bank run behavior and low profitability of collateralized coins is existent. In addition to those, the central coin issuer also is a target of political intervention, since governments can freeze the FIAT reserves and therefore, shut down the coin.
Despite the downsides, multiple possibilities arise through the issuing of stablecoins. Firstly, the user benefits from both the advantages of blockchain technology and the ones of traditional assets and FIAT currencies.
Especially important for countries in crisis or marked my hyperinflation is the ability to create a global currency.
The different types of methods to create stablecoins all bear advantages as well as disadvantages. Nevertheless, the upsides, if setup goal-oriented, outweigh the downsides and create great opportunities. These stablecoins could be a door opener for crypto solutions in all kinds of daily transactions.
Not only start-ups and crypto enthusiasts are optimistic about stablecoins, so are central banks. So-called central bank digital currencies (CBDCs) (also called digital base-money) can alter the acceptance and the development of the regulatory framework concerning crypto payment methods.