This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision

In the year of bear markets and curbed enthusiasm, stablecoins have emerged as the asset class with which many of the crypto community associate high hopes for the long-anticipated mass adoption. As these cryptocurrencies have come to be viewed as a promising tool to alleviate volatility – presumably the major hurdle in the way of digital assets becoming a vehicle of everyday transactions for millions of consumers – they enjoy massive media coverage, community and investor attention, and merit somewhat over-the-top labels such as “The Holy Grail of cryptocurrencies.”

Yet great success comes with great responsibility, and increased public attention has brought increased scrutiny on many of the more salient projects, resulting in a pool of pointed criticisms. These arguments deserve a thorough review by anyone who aspires to keep up with the developments in the segment of the crypto industry that perhaps moves even faster than others.

As any other important sector in the field, the stablecoin space presents a major ideological battlefield for crypto purists and crypto pragmatists. The models that have gained the most traction to date – namely, the fiat-backed stablecoins such as Tether – are also those that sacrifice the traditional virtues of decentralization and antagonism toward the legacy of financial system. Pragmatists believe that, albeit they indeed may be the artifacts of the centralized economy, asset-backed stablecoins can spark adoption and serve as a bridge between the incumbent economy and its more decentralized future.

Speaking to Cointelegraph, Eric Ervin, the Founder and CEO of the financial firm Blockforce Capital, summarized this outlook:

“The true value that asset-backed stablecoins bring to the blockchain industry is that they will provide a realistic solution for the use of cryptocurrency in everyday transactions. For all the promise and hype surrounding Bitcoin and various other altcoins as a medium for everyday consumer transactions, price volatility and a lack of widespread understanding has curbed mass adoption. Stablecoins offer a viable solution as anyone that has used a credit card or made an electronic funds transfer has essentially already used and can understand ‘e-cash.’ Stablecoins offer the ability to decrease settlement times from days to seconds and remove many, if not all, intermediaries, such as credit card networks, payment processors, clearing networks (e.g., ACH, RTP, SWIFT), and even banks.”

Functional advantages notwithstanding, a large share of the crypto community would never rally behind any centralized currency that is pegged to the U.S. dollar. Over the last several months, an enthusiastic movement of developers determined to produce viable decentralized alternatives came up with a variety of often ingenious and complex stablecoin designs. These models either use other digital assets as collateral, or are not collateralized at all, relying instead on algorithmic mechanisms of price stabilization.

As much as they are distinct in terms of design, volatility-reducing mechanisms utilized, and faithfulness to the tenets of crypto anarchism, these types of stablecoins are different in the ways they could fail.

Worst case scenarios

Off-chain collateral designs: Tether

The problems with fiat-backed cryptocurrencies, of which Tether (#8 according to CoinMarketCap.com at the time of this writing) is an unavoidable example, are all well known. Tether is centrally governed, which means that users have to trust the company that issues the asset entirely. At the same time, the Tether user agreement explicitly states that the system does not “guarantee any right of redemption or exchange of Tethers by us for money.” For someone who is not a priori excited about cryptocurrencies, this could be enough to render the idea of exchanging proper U.S. government-backed dollars for some digital tokens a questionable one. Finally, the entity behind the asset claims that every USDT in circulation is backed by one U.S. dollar in the back account, but failed to undergo a proper third-party audit so far. As Eric Ervin puts it:

“Tether still lacks the operational standards competitors are promising. A huge head start will only take them so far and Tether has been reluctant to provide information about the soundness of the USD reserves backing USDT until Tether provides a full, unbiased attestation of USDT’s soundness, they will have a long way to go to establish legitimacy with institutional organizations.”

Speaking of fiat-backed stablecoins more generally, Rafael Delfin, Head of Research at Brave New Coin, voices centralization concerns:

“We consider this emerging type of crypto asset of great significance to further the development of the ecosystem. However, not all stablecoins are created equal, as some projects allow issuers to freeze funds. I personally favor the projects building stablecoin protocols that embrace Bitcoin's core values of decentralization, algorithmic issuance, and censorship resistance.”

Yet despite all these woes, Tether has an undeniable upper hand over its more sophisticated and more decentralized competitors: it has been live for a while now, and, with a capitalization of over $1.5 billion, it enjoys a relatively wide global use. This alone is a reason to consider it viable and useful.

Nevin Freeman, co-founder of Reserve, spoke with Cointelegraph from Angola, where he is currently discussing with local banks and telecom carriers a roadmap for making cryptocurrency a reality there. The weapon of choice would be a fiat-backed stablecoin:

“Yes, we think Angola is a place where stable cryptocurrency really makes sense to hold and use. Most developed nations don't really need it right now. We think that ‘fiatcoins’ are the best available stablecoins right now, but that their days may be numbered since governments can decide to shut them off, and have done so for equivalent virtual currencies in the past.”

Speaking of the possibility of collapse, Freeman explained that the users of off-chain collateral coins face two major types of risks: the counterparty risk, which has to do with the need to trust that those who manage the money centrally will act in good will, and the third-party risk, which is about outside actors such as hackers and governments posing a threat to users’ money. The latter threat, Freeman hints, is a real one. However, he believes that such a scenario for fiat-pegged assets would be less dreadful than the potential collapse of their more decentralized alternatives:

“I think the asset-backed coins may get shut down but most likely in an orderly way.”

Digital asset collateral designs: Dai

This class of stablecoins comprises those assets that are pegged to other cryptocurrencies or baskets of them. The Dai Stablecoin is issued and controlled by a decentralized autonomous organization (DAO) called Maker. Even though Dai’s price also mirrors that of the U.S. dollar, it is actually backed by ETH. In order to obtain Dai, users would have to transfer ETH, which will be locked by the DAO. The system relies on a decentralized price-feed “oracle” to adjust the token value.

As with other crypto-backed stablecoins, Dai’s major potential point of failure comes from volatility inherent to collateral assets – from routine “collateral volatility,” to vulnerability, to so-called “black swan” events, whereby the value of the underlying asset dramatically collapses at a speed faster than the system can sustain.

With regard to Dai itself, stablecoin sceptics such as Preston Byrne often point out that the token is overcollateralized to ETH, so that creating $1 worth of Dai will take >$1 worth of ETH. Byrne is convinced that this does little beyond increasing users’ exposure to the value of the underlying coin – and, by extension, to its volatility. However, thorough analysis of the Maker protocol suggests that the model is robust and capable of ensuring stability. Researchers at Reserve believe that while Dai lacks price stabilization mechanisms and will be unable to scale to become a global solution, it has sufficient checks to keep investors safe from catastrophic price crashes.

Non-collateralized designs: Basis

Finally, some developers choose to avoid pegging their stablecoins to other assets altogether. Instead, they might design self-sustaining models that incorporate additional layers of game-theoretic incentives to encourage self-interested user behavior that would be instrumental in sustaining the peg. Perhaps the most famous representative of this cohort, Basis, relies on two types of assets that coexist on the platform: proper stablecoins and supporting bonds. If the coin’s price goes below the designated peg level, the system issues bonds that it sells to coin holders, who are supposed to be attracted by the perspective of being paid interest from the future coin issuance. Meanwhile, the coins used to buy the bonds are destroyed, thus reducing supply and driving the price back up.

As many observers point out, this incentive structure is clearly premised on the expectation that the platform will grow indefinitely, which is not warranted. The bond payout to a user depends on how many other users are subsequently drawn to the system, so in order for the protocol to work as expected, coin holders have to share unquestioned faith in it. Moreover, as a study by Reserve analysts highlights, Basis’ strategy stipulates an initial period of off-chain stabilization, i.e. pegging to fiat for some time before switching to full on-chain stabilization. The plan also suggests that on this off-chain stage the coin will be backed by no more than 80 percent of the actual value, leading the researchers to expect that “under conditions that are arguably quite likely, the peg is likely to fail irrecoverably.”

What’s next

As this brief survey demonstrates, existing stablecoin models represent a spectrum of tradeoffs between functionality, scalability, and decentralization, and offer varying levels of security and vulnerability to failures. Intensifying competition in the field will definitely push the more viable designs to the surface, and there is hope that eventually solutions that are at the same time secure, scalable, and decentralized will emerge in the market. Meanwhile, experts look at the sector’s near prospects rather optimistically. As Brave New Coin’s, Rafael Delfin, points out,

“Year-over-year Tether's market capitalization has grown 4x and its 24-hour volume has increased by 10x. We do expect similar growth for the entire stable coin sector, and while strong network effects and first mover advantage will still be at play, these factors will be less relevant for assets that are almost perfect substitutes.”

Eric Ervin echoes this sentiment:

“We firmly believe that consolidation will take place and the projects that survive will be the ones that garner the most adoption. While the stablecoin market doesn’t have to be a winner take all environment, market cap will be won by having more trust than the competition. That competition will only help increase interest and confidence, and in-turn adoption of the asset class.”

Yet the road to wide adoption will certainly be a rocky one. As Nevin Freeman reminds, it is critical to avoid hasty steps, as both people’s money and reputation of the crypto industry at large will be on the line: