Yes. It’s the problem your Bitcoin diehard friends always told you about that fell on deaf ears. It’s the one you should have kept in mind and yet here you are storing it in your wallet … dun dun dun … Stablecoins!!!! (hush silence ensues).

Even though a virtual currency (it’s not inherently a cryptocurrency, which we will explain later on) pegged to a fiat currency may sound preposterous (we think Satoshi would agree) at first glance, it may be the bridge as the world transitions to blockchain-backed asset systems.

Before we dive into stablecoins, we should first define what is a stablecoin. A stablecoin is a virtual currency pegged to a fiat currency, which is backed (i.e., collateralized) by real-world fiat deposits or kept with parity with the US dollar via an algorithm. [1][2][3].

In our opinion, a stablecoin should not be considered a cryptocurrency when the stablecoin is backed solely by real-world fiat deposits. Rather, a stablecoin in this circumstance should be considered a virtual currency. When a stablecoin is backed either solely by cryptocurrencies, or cryptocurrencies in addition to real-world fiat deposits, then a stablecoin should be considered a cryptocurrency.

Inherent Upsides

Stablecoins have three inherent upsides in the cryptocurrency market.

First, stablecoins allow for hedging against the cryptocurrency market when volatility is high. [4].

Second, stablecoins provide a means for digitally storing relative units of fiat currency without the need for a third party such as a bank. [4].

Third, stablecoins allow market participants to avoid cashing out their digital assets to retain any gains, and associated tax and legal liability for converting cryptocurrencies into fiat currency.[4]

“ In general, stablecoins provide a digital alternative to cash and serve as a hedge against volatility.” -Amy Castor

Gateway to the Digital Asset World

Stablecoins can be the gateway for the world’s transition to blockchain-based asset systems.

First, stablecoins can ease beginner, investor, and trader concerns about market volatility because a stablecoin’s value stays relatively at 1 unit of fiat currency (e.g., $1 U.S. Dollar). [6].

Second, stablecoins are easier to understand for laypersons because of their background knowledge of fiat currency and digital payments. [6].

Lastly, stablecoins make it easier to send large amounts of relative fiat currency value to people all over the world because there are less fees and intermediaries involved. [6].

These three aspects of stablecoins make them an adequate digital asset bridge for beginners to blockchain-backed asset classes and to the cryptocurrency space overall.

The First Stablecoins

Stablecoins came-of-age with the issuance of Tether’s USD-backed token TetherUSD (USDT) on the Omni Layer, a protocol built on top of the Bitcoin blockchain, and NuBits cryptocurrency, NuBitsUSD (NBT) in 2014. [4][6][8].

Tether’s model is the predominant model for stablecoins as USDT is backed by Tether’s personally-held fiat deposits. [7]. NuBits model is most closely followed by MakerDAO. [8].

Though NuBits has fallen off, Tether has held fast since 2014 to become one of the top ten digital assets by market capitalization and volume on cryptocurrency exchanges. [9][10].

Rise In Popularity

Stablecoins have recently had a spike in popularity with the release of Gemini Trust Company, LLC’s Gemini Dollar (GUSD) and Paxos Trust Company, LLC’s Paxos Standard Token (PAX) tokens on the Ethereum blockchain in September. [4].

The recent rise in new stablecoins, including Trusttoken’s release of True USD (TUSD) earlier this year, has been, or at least should have been, expected for some time with the uncertainties surrounding Tether’s financial accounts for its stablecoin, Tether USD (USDT) (we’ll get to this shortly).[5].

Beyond the expected benefits of stablecoins, the issuance from two major U.S. companies, both subject to heavy compliance and regulatory schemes, should give traders and investors more assurances that their stablecoins are worth what they are worth. [5][2].

Inherent Downsides

Stablecoins are not without their own downsides, which may be more worrisome than those involved with more traditional cryptocurrencies.

All stablecoins face the following issues:

Sufficient Collateral;

Regular Audits;

Third Party Trust; and

Appreciation/Depreciation.

In the next section, we discuss the cautionary tale of Tether’s USD-backed token, USDT.

Tether’s Cautionary Tale

Tether’s rise to the top ten by market capitalization and volume on cryptocurrency exchanges has not come without controversy, with most warranted due to Tether’s own bad behavior. [7][9][10].

Tether’s Lack of Transparency

Tether’s rise has raised many concerns whether its’ USDT token is backed by sufficient USD deposits in Tether’s bank accounts. [7]. There have been few, if any, professional audits of Tether’s financial accounts, especially any that can allay the fears of investors and traders.[7].

These fears were realized in late 2017 to early 2018, when Tether and BitFinex, a Hong-Kong based cryptocurrency exchange deeply connected to Tether, dissolved it’s relationship with Friedman LLP, an accounting firm both hired to audit their accounts. [7].

It is not often that an accounting firm withdraws from an audit, and even less often that a reputable company simply lets such a thing slide without an appropriate response. [7]. The issue becomes even more pressing given Tether’s issuance of millions upon millions of USDT, with more than 850 million issued in the past year (currently around 2.2 Billion circulating, 3 Billion total supply)[11][7].

If Tether truly does not have sufficient USD deposits to back each USDT, then many investors and traders who use USDT as “substitute dollars,” may be in for a rude awakening. [7]. Furthermore, given that USDT is the second largest digital asset by daily trade volume, as reported by CoinMarketCap, if it turns out to be true that Tether lacks sufficient funds, we could see a major market crisis. [7][10].

Lastly, Tether’s worries become even worse in light of its relationship with BitFinex. [7]. Many allege BitFinex has a strong relationship with the ownership of Tether, to the point of being a majority owner. [7]. In 2016, BitFinex was hacked for for 120,000 Bitcoins. [7]. Not the first, nor the last exchange to be hacked, but BitFinex assured its customers that it would repay them for their lost value. [7]. However, no one knows for sure if BitFinex ever did. [7].

BitFinex offered its customers IOUs supposedly backed by BitFinex’s own funds through its BFX token, but without any professional audits of its books, no one can truly be sure those BFX tokens were worth the actual value BitFinex attributed to them. [7]. BitFinex’s lack of reputable audits, coupled with Tether’s own record, does not inspire confidence that Tether’s USDT token is backed by sufficient USD deposits. [7].

Stablecoin Downsides highlighted by the Tether debacle

Tether’s unfortunate tale highlights three issues any stablecoin will face.

First, many suspect that Tether does not have sufficient collateral, i.e., sufficient USD deposits to account for the amount of USDT. [7].

Second, Tether raises audit issues because of the lack of trustworthy and frequent audits. [7].

Third, Tether raises third party trust issues because holders of USDT have to not only trust that Tether does have sufficient deposits, but also that any third party associated with Tether, such as BitFinex, is not manipulating Tether’s records.[7]

The fourth issue is discussed in Recent Developments.

Collateral Models

Asset-backed models for stablecoins generally fall into these categories:

Fiat Deposits;

Escrow Accounts; and

Algorithmic.

Tether’s USDT is an example of fiat deposits where each USDT is backed 1:1 for Tether’s own money. [7].

Trusttoken’s TUSD is an example of escrow accounts where a customer will have to deposit fiat currency in an escrow account with a trust company, the trust company will verify the deposit and signal the TUSD smart-contract, then finally the TUSD smart-contract will issue TUSD tokens to the customer. [2][12].

MakerDAO is an example of algorithmic creation where Dai is generated by collateralizing Ethereum through a “dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.”[3].

Recent Developments

As can be seen recently, it seems these fears have not only started to concern, but are now being reflected in the cryptocurrency market as TEther has lost its’ peg to the U.S. dollar. [13].

Tether’s loss of parity to USD has led exchanges such as OKEX to add four stablecoins, “True USD (TUSD), USDCoin (USDC), Gemini Dollar (GUSD), Paxos Standard (PAX),” to its platform to account for Tether’s fall. [13]. Additionally, Tether’s loss of parity has led the prices for the aforementioned stablecoins to also lose their own peg with the U.S. dollar. [14].

Herein lies the fourth issue with stablecoins, when they lose their peg by appreciating or depreciating relative to 1 unit of fiat currency (e.g., $1 U.S. dollar). [14] (Though DAI did not face the same fluctuation issues at the time, good case for algorithmic stablecoins?).

Conclusion

Stablecoins can become the digital asset bridge to ease the transition to blockchain-based asset classes, but to do so, stablecoins need to manage their inherent downsides and avoid the pitfalls Tether’s USDT token has succumbed to from Tether’s own lack of transparency.[7].