Camps are divided when it comes to stablecoins.

The arguments have a similar ring to those surrounding ETFs. On one hand, ETFs promote adoption and encourage new investors. On the other, there’s a compromise in decentralization – with potential thousands or millions of people using the ETF as an investment vehicle, the ETF council suddenly has a disproportionate amount of weight to throw around when it comes to consensus making.

Things are even more complicated than that with stablecoins – let’s dive in.

Stability at What Cost? Types of Stablecoin and Their Risks

There are a few different types of stablecoins.

Crypto-collateralized

Fiat-collateralized

Non-collateralized

It’s a simplification, but it covers the bases. Non-collateralized coins are controlled by a “central bank” of smart contracts. Crypto enthusiasts don’t like to hear words like “central bank” when it comes to crypto too often, but this is a little different – if correctly executed, the smart contract system should control the rate of inflation indefinitely and without human input. It does this by taking selling bond tokens redeemable for the cryptocurrency at a discount rate – users buy the tokens and make a profit by redeeming them.

Sounds cool, and it is – but there’s a catch. This system heavily relies on market demand. If people trust the stablecoin, no problem. But if they lose interest, or if a news story hurts demand, or a competing currency, the bank is programmed to keep selling bond tokens. If no-one buys them, the price crashes, game over.

Crypto-collateralized tokens are a little different – MakerDAO is an example of this type of currency. The currency is backed by Ethereum in this case, and if the price starts to fall, the stablecoin system sells Eth and buys more stablecoins to prop up the price. This has its own issues – the price of Ethereum recently crashed so hard that the co-founder had to implement massive layoffs throughout the sister-project, ConsenSys. To plan for volatility, you need a lot of collateral – and even then the project relies on demand.

Pros? Decentralized

Cons? Not so stable after all

That brings us to fiat-collateralized coins.

Centralized Stablecoins

Tether is the go-to example here. These projects are centralized and rely on users exchanging, for example, $1 for 1 dollar-pegged stablecoin. The crypto-token is (allegedly) backed by $1 USD, or whatever fiat currency it’s pegged to – Tether is a good example of why this is problematic.

The project acts as a centralized intermediary between traders and crypto, holding their funds in some offshore bank account and insisting that it’s all above board.

Hmm… sounds like the exact kind of shady situation that prompted the invention of Bitcoin, no? These types of stablecoins have a lot in common with banks, and basically just offer convenience at the cost of introducing centralized intermediaries into cryptocurrency.

everything about stablecoins screams of centralization and trust in intermediaries.

hint: fiat currencies are less risky than stablecoins and easier to work with. https://t.co/w2EsdeGtqQ — pascalb?uvier ? (@pascalbouvier) December 11, 2018

We’ve written about Tether before and the many scandals surrounding the rumours that the currency isn’t backed by the fiat it claims to hold. After firing their auditors and refusing to disclose bank statements or even locations, the founders could easily be embezzling investor funds and claiming that their currency is backed when it’s not.

The idea of Tether is that the project can destroy Tether tokens to control inflation and redeem them for USD when people want out. If it’s unbacked and a market panic causes too many people to withdraw at once, they won’t have enough USD to meet demand, collapsing the stablecoin and wreaking unimaginable havoc in the crypto markets, likely triggering a major crash.

This type of situation is exactly what caused the bank collapse of 2008, and arguably the birth of Bitcoin in the following year. Stablecoins are convenient, but the damage done by centralizing a movement based on decentralization simply for the sake of convenience doesn’t bear thinking about, because human greed and error will win out every time.

Crypto is our chance to correct the financial mistakes of our financial past – let’s hope that we’re not about to repeat them.