Stablecoins are cryptocurrencies made to minimize the volatility of the price of this stablecoin. as the crypto market recovers from the early-2018 correction, some prominent traders are leaving their money on the sidelines, waiting to see the result of a government subpoena issued to Bitfinex regarding an investigation into Tether, one of their subsidiaries.
Tether, which is a peg to the US Dollar, saw $3.2 Bn in trade volume in just the last 24 hours. Tether forms the basis of ‘USD’ trades on major exchanges including Bitfinex (which owns the company behind Tether) and Binance and is the only way to tie purchases to a fiat value. Tether has been responsible for pumps in prices whenever it was printed to add liquidity in a market – a report recently looked at how 87 out of 93 Tether infusions resulted in price surges. It’s also no surprise that the news of the subpoena to Bitfinex and Tether precipitated the BTC crash down from $10,000.
As the market struggles to find a place for what could be a fraudulent token, replacements for Tether’s role of being a stablecoin have been cropping up. Understanding how this function is important if rumours of Tether’s imminent collapse are to be believed.
Stability in rough waters
The biggest difficulty with managing crypto commodity investing and trading is that the crazy price movement in the market renders the entire portfolio volatile. Traders prefer to use ‘safe havens’ to lock in profits or cut losses – but these safe havens cannot be other cryptos that are just as shaky. The presence of a stable token to trade against provides that safe haven. Whenever you decide to move profits out of Bitcoin without removing money from the system, it’s easiest to move into another crypto; switching out to fiat currency means you’re locked into that exchange and can only ever interact with banks supporting that currency. However, holding a crypto allows movement between exchanges – and if the cryptocurrency in question also has a fixed value, it’s just as good as holding an actual Rupee or Dollar.
Of course, putting the ‘stable’ in the stablecoin is the hard part. Tether (the company) claimed to provide stability by backing every single Tether (USDT, the token) with an actual dollar. By maintaining a 1:1 peg against the Dollar, the USDT in circulation would always be stable since the token could be exchanged for a Dollar whenever one wished. In practice, Tether’s claim of having 1:1 reserves is probably untrue, meaning that the stability underpinning the stablecoin was in question. Other companies have come up with other stability mechanisms that don’t rely on a 1:1 reserve backing and could pave the way forward for a more reliable stablecoin.
Making a new base
Two major projects try to provide a stable price by creating a dynamic equilibrium in the market. While the first, Basecoin, creates a three-tiered crypto banking system, the second, MakerDAO collateralizes assets with a complex debt position.
Basecoin works by offering three tokens: Basecoins, Base shares and Base bonds. While the coins themselves are offered with a 1:1 backing, the shares and bonds help control liquidity in the market by
being unpegged and open to trade. When required, an automatic trade of the underlying bonds or shares fulfils capital needs. By adding dividends and interest on top of these instruments, a secondary market is created in which the trade of the shares and bonds is incentivized for people using Basecoins. In some ways, the operational framework that Basecoin operates in is akin to that of a central bank for fiat currencies.
MakerDAO’s system is a little more decentralized and as a result, a little more complex. By incentivizing market agents to borrow and hold Dai, the underlying stablecoin, Maker believes a market equilibrium will automatically provide the required liquidity. A deflation rate is tied into the currency, making it more valuable when an existing currency is offered as collateral. Such a position of debt, packaged as an instrument, transfers value from borrowers to holders. Maker’s own unpegged currency, the MKR, allows users to benefit from the apparent fees that the system generates on being used. The simulations in the whitepaper go into the mechanics of how such a market equilibrium is sustainable.
Market failures
Both Basecoin’s and MakerDAO’s models are still susceptible to unforeseen market swings such as rogue trading bots or sudden price crashes. In January, the Dai stablecoin traded under 75 cents (to the dollar), meaning a 25% devaluation from what was supposed to be a stable $1. Amid the comments prophesizing a possible doom, the market was reminded that nothing could insulate these systems from Black Swan events that brought the entire market down.
The mechanisms in which these systems function has some very vocal critics who dismiss the entire concept as failed: any system trying to leave stability to a market’s magical equilibrium whims was likely to see the same kind of crashes that the bond derivatives markets have seen. In addition, central banks have been shown, time and again, to recognize liquidity problems only ever in hindsight.
However, these concerns don’t seem to matter to the array of VC firms that have lined up to invest in both Basecoin and MakerDAO, with some firms even investing in both.
The jury’s still out on what the ideal stablecoin will look like, even if it’s one of the mechanisms these companies are using. Modelling such a key part of the crypto landscape on the legacy financial system seems a little backward, but it’s the fastest way to begin adding stability to a market swinging 30% in a day.
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