Stablecoins: Currencies of the Future or Crypto Stalemate?

James McKay
James McKay research  takes an in-depth look at stablecoins - why they exist, the differences between crypto and fiat-backed stablecoins, and what the future might hold for them.

 

Throughout history, there has been an inherent need for peoples and cultures to have a means to store value and exchange goods and services. The first currencies that moved beyond barter systems were primarily in the form of receipts representing commodities stored in central or communal locations, such as grain silos in the temples of ancient Egypt.  With the spread of Man around the globe,new forms of currency were developed. These took one of two forms – items that represented value without inherently storing it, such as beads, shells and tally sticks, and items that stored value in and of themselves, such as gold, silver, and gems. 

Over time, as various currencies flourished and others fell by the wayside, their most important characteristics of durability, fungibility, portability, tradability, stability, and value storage, emerged through a process of ‘natural selection.'

As the latest revolution in currencies, cryptocurrencies have adopted many of these characteristics. However, in addition to being digital and therefore non-portable, they have also fallen short in areas of stability, and, by extension, tradability. Indeed, it is their extreme volatility that is the most significant factor preventing their wider adoption.

Volatility: the cryptocurrency’s Achilles heel

Most countries today are on what’s known as a fiat currency system: the currency we use is not backed with an equivalent amount of precious metal, or other commodities that are prone to price fluctuations  Rather, the currency’s value relies on the “full faith and credit” of the issuing government, and it is this quality that lends fiat currencies much of their stability.

For cryptocurrencies, this full faith and credit aspect is far murkier, and that, coupled with speculation and some other factors, gives rise to frequent bursts of tremendous volatility in the market.  Not only does this make it challenging to predict price action, but also means merchants and people in general are hesitant to adopt cryptocurrencies as a viable form of payment for goods and services.

day_CryptoCompare_Index_BTC_USD_366_11532947756296.pngBTC Volatility 12 Months. Source: CryptoCompare

day_CryptoCompare_Index_ETH_USD_366_11532947938717.pngETH Volatility 12 Months. Source: CryptoCompare

Stablecoins are a form of cryptocurrency especially designed to address these issues of volatility.

Two distinct categories of  stablecoin have been developed: crypto-backed stablecoins, which have their value backed by stores of a second cryptocurrency, usually bitcoin or ether, and fiat-backed stablecoins, which have their value backed by real-world fiat currencies like the US dollar or euro. 

Same side of a different coin: crypto-backed stablecoins

Crypto-backed, or distributed,  stablecoins seek to counteract price volatility  by ensuring each unit is fully backed with a reserved amount of a popular cryptocurrency.  Put simply, for every unit of crypto-backed stablecoin currency X minted, a pre-determined amount of cryptocurrency Y is locked up in reserve to maintain its value.

Although comparisons to the gold standard systems used in the US and, UK are accurate to a point, stablecoins are designed to automatically adjust their supply according to market price– issuing new units when they rise in price, and selling/contracting when they fall to bring about price stability. It is this selfcorrecting quality that has led some in the crypto space to refer to them as the ‘holy grail’ of cryptocurrencies and  in financial technology.

As one of the most popular crypto-backed stablecoins, MakerDAO has the Dai (DAI) coin, a ERC-20 token, as its currency unit, and stores its value in ether. For a user to create Dai coins on the Maker platform, they must do so by utilising ethereum through Maker’s smart contract system to create a Collateralised Debt Positon, or CDP.

Specifically, a CDP is generated through a collateralisation process that involves the conversion of ether to ‘pooled ether’ (PETH), which is currently the only collateral type accepted on the platform, and this is followed by placing an order for a set amount of Dai from the CDP itself. Once this order for Dai is placed, the equivalent amount of PETH is locked away in the smart contract and cannot be accessed until the outstanding Dai debt is serviced. When users want to retrieve their collateral, they must send a transaction to Maker, however this can only be done after the outstanding debt in the CDP serviced, plus interest on this debt, known as the ‘stability fee.’

The other token existing alongside Dai is the  Maker coin (MKR), which primarily functions as a governance token to main the MakerDAO ecosystem,  as well as playing a role in  the collateralising and unlocking process.

Maker monitors Dai’s collateral currency (ether), and if the price crashes, new Maker coins are issued and sold to make up the shortfall, reducing the Maker coin price in the process. However, if the collateral currency remains stable, Maker coins are not needed and the supply contracts by destroying a certain volume of Maker coins.

The Maker platform is able to overcome the central issue of cryptocurrency volatility by simply not storing the value in ether – rather - users purchasing Dai lock up a set amount of ether to mint Dai which is then managed against ether’s USD value to sell off or stabilize the ecosystem based on changes in value. This complex interaction of these mechanisms help to reinforce the stable value of the crypto-backed stablecoin in spite of underlying crypto collateral volatility.

day_CryptoCompare_Index_DAI_USD_366_11532949980202.pngSource: CryptoCompare

Although MakerDAO has found a nimble technological solution around the volatility problem, we have yet to see how much volatility these stable coins would need to be subjected to experience any catastrophic shifts in value.

The MakerDAO platform does technically make provisions for such a scenario through a ‘Global Settlement’ option, which is designed to shut down the entire Maker complex to ensure all users receive their net value of assets. How this would work in practice, however, remains to be seen.

Other weaknesses include issues of governance, malicious hacking attacks, black swan events, and perhaps most importantly, utility – at this point in their lifecycle, even the largest cryptocurrencies like bitcoin and ether are still not widely adopted.

Systemic Stability:  fiat-backed stablecoins

Fiat-backed stablecoinsoperate as cryptocurrencies but store their value in real-world fiat currencies such as the US dollar or Euro.  This keeps their value relatively stable, and active measures are taken to maintain that stability Some of the most popular and talked-about fiat-backed stablecoins include Tether, TrueUSD, and the upcoming stablecoin from Circle and Goldman Sachs, USD Coin.   These coins are popular because they are seen as safe, reliable, and stable, and their fiat collateralization means that they have a wider adoption in the cryptocurrency world, with a number of big players backing each. 

Circle, in particular, has generated a lot of buzz, as the USD Coin they are planning to launch is designed to be regulated and based on existing US monetary transaction law, with transparent auditing and system design – something that Tether and other stablecoins do not yet offer.

In the meantime, with Circle still on the horizon, Tether remains the most popular fiat-backed stablecoin in terms of market share ($2.7 billion, making it the eleventh largest cryptocurrency overall)

Tether offers USD coins in the form of USDT, which maintain a value of $1 USD per 1 USDT.  Like all cryptocurrencies, it is built on open, distributed blockchain technology for security and transparency, and due to its size and popularity, is available on a large number of popular cryptocurrency exchanges.  Tether is backed by US dollars which it holds in reserve as the collateral for the currency.  And, true to its nature as a fiat-backed stablecoin, the value has remained remarkably stable, with few fluctuations in value typically as a result from large shifts in  in value when the underlying value of the US dollar.

 

bitcoin dollar.jpg

 

Overall, these fiat-backed stablecoins address some of the problems of cryptocurrencies and form a “middle ground” between traditional currencies and cryptocurrencies, and traditional currencies and crypto-backed stablecoins.  This includes volatility – being based on real-world currencies that are generally stable goes some way to reducing the cryptocurrency volatility issue.

However, there are also risks associated with fiat-backed stablecoins, too.  The essential characteristic and raison d'être of cryptocurrencies is that they are decentralised and democratic – they do not rely on any sovereign government or central bank.  This is part of their appeal – a global, unbiased monetary system for transferring funds and buying goods and services. 

Pegging the value of a stablecoin to a real-world fiat currency immediately brings in a degree of centralisation to the system, since it is now effectively beholden to the authority of a central bank or government, thus making it moresusceptible to being shut down summarily.

Further, in the case of many coins, the question of governance, transparency, and system reliability are suspect.  Existing fiat-backed cryptocurrencies do not necessarily get audited in a traditional fashion, nor have the level of transparency that a traditional currency system does, and therefore, there are open questions as to their stability, longevity, and operations – all of which could adversely affect their adoption or utility. 

dai market cap.pngSource: CoinMarketCap

screenshot-coinmarketcap.com-2018.07.30-13-43-34.pngSource: CoinMarketCap

Despite these shortcomings, many see fiat-backed stablecoins as the ideal solution, bridging the gap between traditional currencies and the volatile cryptocoins, to provide the best of both worlds.  This has largely resulted in their growing popularity and a market capitalization far exceeding that of Dai and other crypto-backed stablecoins.  People want usable cryptocurrencies which offer all the decentralised, semi-anonymous and utilitarian benefits, with a reliable, stable valuation, so they are naturally flocking to fiat-backed stablecoins.  And, like most currencies, the more individuals and businesses who place their faith in them, the more likely they are to survive and succeed. 

What does the future hold for stablecoins?

Given the speed of their ascendancy and the attention they are garnering in the market, both stablecoin variants are likely to be around for some time to come. If cryptocurrencies are to survive in general, a stable and viable currency will need to be developed and adopted, and that will require some balance between the free-wheeling world of the crypto “Wild West,” and the regulatory structures that characterise traditional currency systems.  And, although stablecoins appear to have that balance, it is impossible to know truly what the future holds.

A lot of that uncertainly stems from the unknowns surrounding the actions of governments and financial institutions in the stablecoin space.  The support of various fiat-backed stablecoins by major financial players, such as Goldman Sachs in the case of Circle’s USD Coin, is a promising sign for stablecoins.  That said, it is quite clear that the continued growth of cryptocurrencies will reach a critical mass or  tipping point, beyond which .  gGovernments will not sit idly by and relinquish control of the medium of exchange, and, by extension, tax revenues, to a stable cryptocurrency even if backed by fiat.  However,they also may have limited options to intervene, such that forging alliances with financial institutions and fiat-backed stablecoins, and implementing some regulatory regimes over them may be the path of least resistance.  This tacit endorsement would also have the effect of rapidly increasing adoption of a particular stablecoin or set of stablecoins. 

Stablecoins may not be the ‘holy grail’ – they still require better governance, transparency, and perhaps a more diversified store of value, for the US dollar or Euro are far from perfect sources of collateral.

Further, systems to make fiat-backed or crypto-backed stablecoins easier to understand, purchase, trade, and utilise are as critical to their future success as the ultimate outcomes of government involvement.  For now, however, stablecoins are the first step towards a usable cryptocurrency system that might one day supplant our existing fiat currencies – though likely not any time soon.

 

Crypto-Fund Assets at All-Time High Despite Bear Market

  • 239 new crypto-related investment and venture funds pulled up their shutters in 2018, according to Crypto Fund Research
  • Total assets under management by the 741 funds the company tracks now exceeds $10bn 
  • While the boom largely came in early 2018, 42 funds shut down in the later part of the year 

A record 239 crypto funds launched in 2018, leading to a record amount of assets under management. However, fund closures also spiked, according to Crypto Fund Research.

According to new research, the last 12 months has proved a tumultuous year for investment funds looking to ride the late-2017 boom in cryptocurrencies. 

A new report from Crypto Fund Research, which looks to provide a comprehensive listing of the firms offering crypto-related investment opportunities, reckons that the last 13 months has seen a record number of fund launches, but also a relatively large number of closures. According to its figures, 239 new funds launched during 2018, a record number, but that as prices fell back 80% on their early-year highs, the latter part of 2018 also saw over 40 fund closures. 

While 2017 had seen 224 fund open their doors to investors, closures were negligible as the market capitalisation of cryptocurrencies sky-rocketed in late Autumn and Winter of that year. With Bitcoin hitting its all-time high in mid-December 2017, it is perhaps unsurprising to see that the vast majority of the 2018 launches came in Q1 of the year, with a quarter of the total - 64, opening in January alone.

Crypto Fund Research Shows Growth in number of crypto funds

Equally predictably, according to Josh Gnaizda, CEO of Crypto Fund Research, the ensuing three-quarters of the year saw a marked downturn in interest as prices and volumes settled into a steady, year-long decline.  

“Since that time,” he says, “we’ve seen not only fewer launches, but also an increasing number of funds being dissolved."

“We expect this trend to continue in the short-term,” he added. 

Only 10 new funds came on-line in December. With crypto prices also standing at something like 1/6th of  where they were in January, it provides something of a correlation between the two metrics.  

The net effect of these starts, closures, and declining prices however, is that the total amount of assets under management in the crypto fund space is at its highest level ever. Indeed, the net inflow of money to new and existing funds has been enough to push total investment in the 741 funds listed by Crypto Fund Research to over $10bn - a net rise of over $3.5bn over the course of 2018. Assets under management of Crypto funds grows

The new interest in the crypto space seen during the year meant that almost 20% of all new hedge funds created during 2018 were crypto-driven. Similarly, around a quarter of all new US venture capital funds were dedicated to investing in the technology. Overall, the sector is dominated by ‘smaller’ concerns, with over half (398) having less than five employees, and a similar number (360) having less than $10m of assets under management. 

The United States has been, and will continue to be, the primary driver in the increase in funds overall. It currently hosts close to half of all 741 funds covered by the analysis - with San Francisco and New York both serving as home to around a third of those. Only 104 of the 272 crypto funds the research locates in the USA are register with the SEC at the time of writing. 

Top 10 Largest Crypto Funds

Of the 39 funds Crypto Fund Research identifies as having assets of more than $100m, it lists its Top 10 as being Arrington XRP Capital, BlockTower Capital, Brian Kelly Capital Management, Digital Currency Group, Fenbushi Capital, Galaxy Digital Assets Fund, Metastable Capital, Pantera Capital, Polychain Capital, and Protocol Capital. It notes this Top 10 is in “no particular order” and is “based primarily on their overall prominence.” 

Galaxy Digital head, high-profile crypto bull, and former Goldman Sachs partner, Michael Novogratz has repeatedly used social media and interviews to note how difficult a year 2018 has been for investors in crypto. Most recently, he described the current market as “a grind”, but encouraged investors to “stay the course” - having made predictions of All-Time Highs for Bitcoin in 2019 - and once again expressed his confidence that institutional money would come into the space and drive the market northwards again.