Introduction to Stable Coins

By Victor Hogrefe & Aviv Milner

The Problem with Crypto Currencies

As the prices of Bitcoin and other crypto assets soar, and digital currency becomes more and more recognized by the mainstream, the question that everyone is bashfully avoiding is why merchant and business adoption is so slow. You cannot buy coffee, or shoes, or a dinner with Bitcoin, or any other cryptocurrency, and no one seems to be addressing the real reason why. Instead, we are presented with one of two arguments: either it will simply take more time for mainstream adoption to really take off, or there are regulatory or technical concerns which deter small businesses, who are the first likely adopters. While there are some brave companies that are broadcasting their foray into crypto with Bitcoin Accepted Here stickers, widespread adoption has been lacking. Reasons for this slow and disappointing development include the following:

Volatility

Businesses won’t adopt Bitcoin, etc. because they simply cannot afford to. A company needs to pay rent, buy supplies, sell products and services, and pay its employees on an exact schedule. Cash flow is incredibly important for small businesses to survive, where insolvency and bankruptcy are real concerns. Accepting Bitcoin, for these companies, is a bit like accepting lottery tickets as money; the enormous volatility in the crypto markets make it impossible to predict whether a company’s balance sheet will be in the black or in the red on the exact day it has to pay its employees, or when rent or taxes are due. The risk is simply too great, and there is no real incentive to adopt crypto that outweighs the dis-incentive of volatility risk.

Some argue that Bitcoin will eventually achieve stability, and that it’s violent market behavior is currently due to growing pains and relatively low trading volume compared to other major currencies. Further it has been suggested that the futures and derivatives markets will bring stability to crypto assets, because institutional investors will look to achieve predictable and specific price targets. While trading volume and market maturity may help reign in volatility, there is simply no precedent that suggests we can achieve stability on a level of a major currency.



Gold, one of the most mature markets in the world, sees regular fluctuations of more than 10% per year, losing more than 27% in 2013 alone. Ironically, the volatility of Gold has increased over time, rather than decreased, which suggests there is no real positive correlation between market maturity and price stability.

Deflationary Incentives

It is a well-established economic fact that inflation is one of the drivers of consumer spending. If we can be reasonably certain that our money will be slightly less valuable in the future, we are incentivized to spend it now, which is good for the economy. Bitcoin on the other hand is famously deflationary, because there is a limited supply and growing demand. It is clear that spending Bitcoin now is almost always a mistake, because spending it in the future will likely be more beneficial due to its increased value. Thus, consumer spending is discouraged.

There is a contradictory mindset in the Bitcoin community which proclaims that Bitcoin will be the new world currency, and yet instructs its members to “HODL,” a meme derived from a misspelling of the word “hold” and sometimes mistakenly used as an acronym for “Hold On for Dear Life”. The meme expresses both the belief that selling Bitcoin is almost a betrayal of its principles, and a distaste for those who sell their coins due to short term market fluctuations. While there are those who use Bitcoin in their day-to-day life as a matter of principle, they are arguably wrong to do so, and elect to act against their own self-interest in the hopes of fulfilling the dream of universal acceptance which is unlikely to manifest itself in reality.

Lending and Borrowing Markets

Lending and borrowing are one of the most important, if not the most important activities of the financial world. Without loans and lines of credit, businesses could not function, and very few people could afford houses and cars. Loans only work well because we have faith in the stability of money. If, for instance, we lend someone one Bitcoin at a value of $20 thousand and the price collapses down to $6 thousand, as it has in early 2018, we lost an enormous amount of money. If, on the other hand, we borrow one Bitcoin and its price triples, we may never be able to pay back the loan, especially if the price of Bitcoin keeps rising. We would have to declare bankruptcy or be stooped in eternal debt, which makes the prospect of borrowing extremely risky.

For these and other reasons, it is unlikely we will ever see mass adoption of Bitcoin as a coin of commerce, because it is fundamentally a commodity and not a currency. It is digital gold, which has an important place in the new economy, but will not replace the Dollar, Yen, or Euro. In order to do business, and engage in the long-term activity of finance and commerce, we need more than just a valuable token; we need stability.

Stable Coins

There has been considerable effort and innovation put into solving the problem of volatility, and it has not yet garnered the attention it deserves. Stable coins are a new class of cryptocurrencies under development which hope to revolutionize the crypto world, and the world economy by bringing decentralized monetary policy into the blockchain space.

We can group the various stable coin projects into three distinct categories, which evolved chronologically and are discussed below. However, the most important conceptual insight that stable coins all share is the proposition that money is a product, produced by a company and subject to market forces, just like any other product. This is true for both cryptocurrency and conventional money like the USD, which is created and regulated by the government and Federal Reserve. It is much easier to understand the mechanics and ideas behind stable coins with this simple concept in mind.

Tokenizing Physical Goods, The First Generation

Most crypto traders who are active on Bitfinx and Binance have heard of, and used, the USD-Tether. Tether is a crypto currency that was invented for a simple reason: to let exchanges and traders interact with one another in US Dollars, without actually switching between crypto and fiat money all the time. Keeping everything on the blockchain instead of going back and forth between fiat money and digital tokens saves enormously on administrative costs, taxes, and time; it is vastly more efficient.

The mechanism behind Tether is straight forward: The Tether company creates one coin for every US Dollar it receives and locks away in its bank account. Thus, a one-to-one backing guarantees price stability against the dollar, because everyone already trusts the dollar. The Tether coin uses the Omni protocol to ride on top of the Bitcoin blockchain, guaranteeing secure transactions and transparency.