Stablecoins are known as the "holy grail" of cryptocurrencies. They fill a need that cryptocurrencies have not been able to fulfill so far, a desire for price stability. But why is it so important and why is it so hard to do?
What are stablecoins and why are they needed?
The technology behind Bitcoin and Ethereum is revolutionary and has opened up many possible applications. However, several characteristics make them difficult to use every day as an alternative to fiat currency:
high volatility.
This feature is positive for traders, as it can allow for higher profit margins. This is a significant downside for investors looking for a currency to store value. This, along with high transaction fees, is also one of the main reasons why many businesses don't accept currencies like Bitcoin as a method of payment. When a currency fluctuates for several hours, it is not easy to use it as a means of payment. Stablecoins are supposed to provide a solution to this problem. Stablecoins should be the solution to profit from safe haven investments. These are cryptocurrencies that are less sensitive to price movements. The idea of a price stable cryptocurrency has been around since the beginning of 2014. However, the first such projects only started in 2017 with Basecoin, Carbon or Maker DAO. Three basic characteristics of a stable currency:
• Unit of account
• Medium of exchange
• Store values
How does the concept of stablecoins work?
Each stablecoin project has evolved its mechanics, but in general they can be reduced to three basic models:
1. Centralized IOU issuance — fiat-backed
This is the model used by Tether, for example. Here, a centralized entity holds assets and issues tokens in exchange. These tokens are then a kind of debt recognition. This gives the digital token a value, which represents a claim to an asset other than a particular subject.
What is an IOU in Finance?
An IOU is a written but largely informal acknowledgment that a debt exists between two parties and the amount that the borrower owes the lender. Signed by the borrower, it usually indicates the date the debt is paid off but often omits other details, such as the payment schedule or interest payable. It cannot be sold or transferred to another party and offers little legal recourse to the lender if it is not respected by the borrower. However, the problem with this approach is that it is centralized. In this model, some essential trust must be placed in the issuer that they own the relevant assets in order to be able to pay the tokens. This model leads to serious counterparty risk for token holders. The example of Tether illustrates this difficulty, the company's solvency and legitimacy have been publicly questioned many times in the past.
2. crypto-backed collateral
The second approach is to create stablecoins backed by other trusted assets on the blockchain. This model was originally developed by Bit Shares but is also used by other stable coins. Security is backed by decentralized cryptocurrencies like Terra Luna and UST (Decentralized Stablecoin). This approach has the advantage of being decentralized. Collateral is securely deposited in a smart contract, so users cannot rely on third parties. The problem with this approach, however, is that collateral stablecoins are meant to cover a volatile cryptocurrency itself. If the value of this cryptocurrency falls too quickly, the issued stablecoins may no longer be safe enough. The solution would be excessive collateral. However, this will lead to inefficient use of capital and larger amounts will have to be frozen as collateral compared to the first model.
3. Seignorage shares — no collateral stablecoin?
An unsecured stablecoin is a price-stable cryptocurrency that is not backed by collateral. Most implementations currently use an algorithm or system. Many stablecoins are issued or purchased on the open market depending on the current price of the coin. It's about doing the opposite correction to keep the price as stable as possible. The advantage of this system is that it is independent of other currencies. Furthermore, the system is decentralized as it is not under the control of a third party but is controlled exclusively by the algorithm.
However, the shared sovereignty model also has its disadvantages. The system needs constant growth to remain stable. It is also difficult to analyze and predict the extent to which the system can remain operational. Therefore, it is difficult to determine to what extent the system will collapse and to what extent it can be sustained.
The most serious downside, however, is that no security is sent in the event of a crash, as the stablecoin's value is not tied to any other asset in this case.
Conclusion about stablecoins
The idea of stablecoins is essential. While cryptocurrencies offer decentralization, their prices are volatile and therefore unsuitable for a store of value. However, there is still no optimal solution to the problem. The three models presented all have advantages and disadvantages.
The shared sovereignty model is the most promising, provided that a solution to the security risk can be found. Indeed, it is the only of the three models that do not claim any other currency and will therefore be independent and free from external controls.
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