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Stablecoins backed by fiat and other assets are becoming increasingly common, with many more solutions entering the market each year.
Bitcoin (BTC) and other cryptocurrencies have ushered in a brand-new era of finance. Cryptocurrencies, at their most simple form, allow people to transact in a completely trustless, open, and effective manner, eliminating the centralised intermediaries and counterparty risk traditionally associated with digital money transactions.
Value can now be exchanged on a global scale in seconds/minutes and for incredibly low fees thanks to blockchain technologies — but that’s not everything. However, Bitcoin and Ether (ETH) are too unreliable to be used as currency, which has hampered their widespread adoption.
While Bitcoin and blockchain technologies are still in their infancy, uncertainty remains prevalent in the market, leading to the creation of stablecoins, which combine the best of both worlds. Tether (USDT) and USD Coin are two common examples (USDC).
Although cryptocurrencies are unreliable in and of themselves, their underlying technologies may be used to build assets indexed to and supported by more secure assets such as fiat currencies, precious metals, and others. These stablecoins are mostly used for everyday transfers and trade settlements. Certain stablecoins have become highly common due to their peg to the US dollar, with a market capitalisation of more than $51 billion for USDT and about $14 billion for Coinbase-backed USDC.
Stablecoins have emerged as a new asset class in their own right, with their special assets gaining traction among both retail and institutional demographics. Decentralized finance and nonfungible tokens are the industry’s next game changers, and along with stablecoins, they provide new and promising opportunities for financial inclusion.
Centralized and decentralized stablecoins
The definition of coins such as USDT is straightforward. Companies backing these stable cryptocurrencies, in principle, hold a pool of the underlying asset — in this case, the US dollar — and release the equivalent sum of blockchain-based tokens.
Stablecoins, on the other hand, have their own set of problems. The most common concern is that stablecoin issuers would misuse their reserves and audits in order to issue unbacked tokens. Although iFinex, the parent company of crypto exchange Bitfinex and a USDT issuer, insists that USDT is always 100 percent backed by deposits, others in the industry are suspicious, as shown by the recently concluded court case between the New York Attorney General’s office and Tether.
Because of the above problems, developers and entrepreneurs in the space have created decentralised stablecoin schemes, the most famous of which is MakerDAO and its USD pegged token, the Dai. MakerDAO creates a decentralised and verifiable reserve for stablecoin issuance using Ether (ETH).
Such options are available as well. Kava has used a similar system to build USD-pegged crypto-backed stablecoins, enabling consumers to have liquidity for various assets such as Bitcoin and XRP in order to issue USD-pegged stablecoins. According to John Wu, president of Ava Labs, the team that is assisting in the creation of Avalanche:
“Decentralized stablecoins have played a vital role in the growth of DeFi. Without the innovation of MakerDAO to create synthetic U.S. dollars backed by crypto, the ecosystem would not be nearly as mature as it is today.”
Although it is a new idea, it can be hazardous to those that have liquidity to the scheme. Given that Dai is backed by Ether, participants must have a high collateralization ratio while still being subjected to the possibility of being completely liquidated if the price of Ether falls dramatically.
Wu listed a newly released FRAX stablecoin that incorporates collateral and algorithmic supply controls while discussing the introduction of new concepts such as the hybrid stablecoin, adding: “The innovations provided by the likes of MakerDAO and Kava come, however, at a high risk, which is exacerbated by the high congestion rates of the Ethereum blockchain.”
The issue with the underlying asset
Decentralized stablecoins are an alternative to simple stablecoins like USDT, but the instability in cryptocurrencies renders them risky for liquidity suppliers, stablecoin investors, and consumers. Several businesses are now attempting to develop a solution that will enable decentralised and centralised stablecoins to “meet in the middle.”
Five5Five, for example, has developed and will shortly introduce a new stablecoin concept in which a stablecoin can be pegged to the US dollar while eliminating the risk associated with volatile cryptocurrency reserves. The USD Reserve (USDR) is a gold-backed coin with a one-to-one exchange rate with the US dollar.
This approach guards against the risk of liquidation and market volatility associated with decentralised stablecoins. At the same time, such a coin may be backed by a high collateralization cost, allowing it to offset price fluctuations or abrupt changes. In this case, the corporation has decided to issue the stablecoin on the Bitcoin Ultimatum blockchain, which is a decentralised ecosystem of smart contracts, leased-proof-of-stake mining algorithms in combination with proof-of-authority, private transfers, and leasing and staking solutions. According to Eric Ma, CEO of Bitcoin Ultimatum:
“The BTCU blockchain was particularly selected for the development of the USD Reserve (USDR) stablecoin because of its capabilities, such as high-speed transactions, ability to conduct anonymous transactions, improved scalability, smart contract capabilities and multi-chain interoperability.”
While other projects have also tried to tackle the issue of protecting users against the volatility of the underlying asset by using “baskets” of fiat currencies instead of one single currency, to issue a stablecoin that is pegged to various assets, most have so far failed to achieve this feat — most notably, the Libra project by Facebook, which has been stopped on its heels by regulators, much like Sogur.
Keepers of USDR will be able to protect against the inflation of a single fiat currency — USD — because the coin is protected by gold rather than fiat or a speculative cryptocurrency. “The internet needs a reserve currency,” Jeremy Harbour, CEO and operator of Five5Five, told Cointelegraph. The sheer demand for stablecoins shows that the problem is still at the heart of these stablecoins.” He went on to say that the company acquired the gold deposits “in partnership with artisanal gold miners, bringing much-needed capital into some of the poorest places in the world to provide much-needed direct investment into their communities.”
While USDR attempts to build a stablecoin for the US dollar that safeguards consumers from inflation and downward market fluctuations, and MakerDAO and Kava have attempted to offer a trustless alternative using cryptocurrencies, other ventures have taken a simplified path.
Stablecoins backed by precious metals such as gold are issued by projects such as DigixDAO and Paxos. However, they continue to focus on consolidated reserves, which raises the same concerns that threaten USDT, USDC, and, to a lesser extent, USDR.
Aurus has released precious-metal-based coins for gold, silver, and platinum that are backed and pegged to these properties in order to address this problem and provide consumers with a semi-decentralized alternative for precious-metal backed stablecoins.
Instead of relying on centralised deposits, Aurus collaborates with various metal suppliers and foundries to build precious-metal-backed tokens with dispersed reserves, meaning that users are never exposed to single points of failure. Aurus CEO Guido van Stijn stated:
“We could have built a centralized solution, but if we want mass adoption for products like AurusGOLD and AurusSILVER, we need the acceptance of the precious metals industry itself while making our system open and beneficial for everyone.”
The road ahead
Although none of the solutions listed above are optimal, the thinking process behind the continued production of stablecoins is very visible. So much so that governments are developing their own stablecoins, such as central bank digital currencies, with countries like China now exploring these schemes.
Many people are concerned that CBDCs will be nothing more than simulated copies of fiat currencies that will depend on centralised blockchains and have little meaningful creativity. As a result, it would be fascinating to see if the cryptocurrency group begins to innovate and create innovative alternatives for stablecoins, while Bitcoin continues on its journey to achieving its ultimate aim of totally eliminating conventional currencies — something that might or may not happen.