Stablecoins Are Not The Future of Crypto — They Are The Present.
During the chilly crypto winter of 2018, one sector of the cryptocurrency industry was still booming. Stablecoins. In this article we will try to get a global view of the Stablecoins and understand their importance for the crypto space, then discuss the issues Stablecoins are experiencing and some innovative solutions.
What is a Stablecoin?
A stablecoin is a non-volatile cryptocurrency, typically pegged to a currency such as USD or EUR. Cryptocurrencies are notorious for their volatility, subject to the market’s supply and demand cycles. To alleviate this problem, Stablecoins are designed to minimize their volatility by being backed by an underlying asset.
Most Stablecoins are backed by a currency collateral, held by a trusted third-party entity (usually a bank). To issue one unit of a stablecoin in this case, $1 or €1 must be deposited to the corresponding bank account. This 1 to 1 correspondence between Stablecoins and the collateral deposit ensures the peg stability.
The largest of these currency-backed Stablecoins is USD Tether, also known as USDT. It currently holds 75% of the global stablecoin market share, however it suffers from notorious transparency and regulation issues.
Another type of Stablecoins are backed by a cryptocurrency collateral. The best known of them is DAI, issued by the MakerDAO Foundation. It’s a decentralized stablecoin whose USD peg is maintained by a set of smart contracts on the Ethereum blockchain and collateral in ETH. It is a fascinating project in its complexity, and we will discuss its achievements and difficulties.
As of today, Stablecoins hold a $3.71B market cap, a solid 1.71% of the total cryptocurrency market cap.
Market cap data courtesy of CryptoSlate.com
Why do we need Stablecoins?
“The true key to unlocking the great potential of blockchain will come with the widespread adoption of Stablecoins.” — Rune Christensen, Founder of MakerDAO
Stablecoins were created first and foremost to solve a major problem with cryptocurrencies: volatility.
Volatility is a huge obstacle for adoption of Bitcoin and other cryptos in commerce. Merchants are reluctant to accept crypto, knowing that its value can drop by, say 20%, in a day. Stablecoins absolutely solve. Just convert your Bitcoin to a stablecoin and pay with it to a merchant who is confident in the value of the received fees.
As it happens, cryptocurrencies still haven’t reached major adoption with e-commerce, but stablecoins have found another“killer app”: cryptocurrency exchanges.
Exchanges always needed two things:
- A FIAT on-ramp, i.e. a convenient way to exchange fiat into cryptocurrency.
- A way for traders to protect themselves from crypto volatility without exiting into fiat.
Stablecoins have been proven as the perfect answer to these requirements. Nowadays, you can sell your cryptocurrency holdings into USDT or another stablecoin used by the particular exchange, if you expect the crypto to go down and protect your deposit this way without moving your money into fiat.
Stablecoins also serve as a fiat onramp for various major exchanges. When a large institutional customer enters the cryptomarket, they usually deposit their fiat to a bank, receive corresponding stablecoin value and use it for trading on an exchange.
Stablecoin here is like a bridge between the traditional and the crypto financial worlds.
Until 2018 most exchanges used USD Tether for these purposes, but as an unregulated business Tether suffered from a bad reputation, particularly in the US where the financial authorities are still trying to bring it down.We will discuss these issues in more detail in the next section.
Large non-US based exchanges, such as Binance and Bitfinex (which is related to the Tether team) still mostly use USDT along with the other stablecoins mentioned above.
To summarize, stablecoins are a means to combine the stability of fiat money with all the advantages of the blockchain: fast, uncensorable transactions. They are also an invalueable tool for traders hedging their deposits.
The Problem With Popular Stablecoins
As we saw above, stablecoins are not without their share of problems. The largest stablecoin by marketshare, Tether/USDT, is a posterboy for the cryptocurrency industry problems with regulations.
Since Tether doesn’t exactly follow international KYC/AML regulations, the vast majority of banks are weary of dealing with it. That’s why Tether had to move its cash deposits between small banks in offshore locations and deal with other unregulated financial service providers.
Recently, Crypto Capital LLC, a company registered in the US has been indicted for bank fraud in connection with providing financial services to Bitfinex and Tether.
Tether has been using unregulated financial services in an attempt to evade US government regulation, and this makes their finances inherently opaque. Investors cannot really know if the USDT stablecoins are backed by an actual USD collateral.
This lack of transparency introduces an additional risk to an already volatile cryptocurrency industry.
There are two major risks involved with Tether:
1. An investor in USDT must trust on a blind faith basis that it’s sufficiently backed by cash deposits. There is no transparent way to verify Tether’s finances. A lot has been said about their financial situation, but at the end of the day there is no independent way for investors to know for sure.
2. Governments, particularly the US government, might seize Tether’s cash collateral at any point in time because Tether violates financial regulations.
Other Stablecoins issued by US-based exchanges, like GUSD and USDC are more transparent and are audited by trusted third parties. However, being based in the US results in one major downside. Complying with US financial regulation requires a capability to censor (i.e. blacklist) transactions on demand. In other words, holders of such an asset can suddenly discover that their balance has disappeared because of a government action. This makes it very risky for international investors to use these Stablecoins on a regular basis.
A new generation of Stablecoins has been created to deal with the problems described above. Let’s take a look into two of these.
xEuro has been created in order to provide a liquid stablecoin for the European and global markets, with rapid exchange to and from fiat. It brings to the table full transparency and compliance with European financial regulations.
xEuro Stablecoins are minted as soon as a verified user deposits cash into the operator’s bank account. Correspondingly, when xEuro Stablecoins are sent back to the smart contract’s address, they are burned (i.e. taken out of circulation), and cash is sent back to the user. This way, the number of xEuro Stablecoins in circulation and the cash collateral in the bank account are always equal.
The xEuro’s bank account balance is transparently shown on the operator’s website, and anyone can verify the balance changes when they buy or return the xEuro stablecoin.
xEuro’s Regulatory Compliance
To comply with the European financial regulations, xEuro is operated by an Estonian company Etna Development OÜ, which holds a license for virtual currencies operations in Estonia, and by extension, in the EU.
For the AML/KYC compliance (i.e. anti-money laundering and “know your customer” regulations), only digitally verified users can purchase xEuros. The digital verification is done via Cryptonomica, a digital identity verification service registered in the UK. This guarantees that illegal operators don’t have access to purchasing xEuro stablecoin, and eliminates the risk of government action against the system.
Even though xEuro operates under European financial regulations, US laws are taken into account as well. Since there is no expectation of profit with a stablecoin, xEuro is not considered a security, thus it can be used legally by US citizens.
To summarize, xEuro is a EU-based solution to the risks that we have outlined with Tether/USDT. xEuro’s solution to Tether’s troubles is full regulatory compliance, strict user verification and full banking transparency.
EURS is another new euro-pegged stablecoin that offers full transparency. Its reserve account balances are audited by a trusted Maltese accounting firm BDO Malta and according to their reports, around 32M EURS are in circulation, backed by cash reserves.
Stasis approaches the compliance issues in a somewhat different manner to xEuro. Where xEuro can be sold to any digitally verified person who can transfer EUR to their bank account, Stasis is designed to interact with exchanges and payment systems.
xEuro and Stasis are good examples for a new generation of Stablecoins, who unlike their predecessors (looking at you, Tether) are happy to provide full transparency into their bank accounts and operate strictly within the bounds of the law. Unlike the US-based stablecoins like USDC, xEuro is neither required to nor is capable of censoring transactions.
There is another popular angle for innovation in the stablecoin sector, and it is crypto-collateralized stablecoins.
While stablecoins like USDT and xEuro are backed by cash in the bank, the crypto-collateralized stablecoins are backed by cryptocurrencies. This is incredible, because it takes the traditional financial system completely out of the equation.
For example, with the most popular of these systems, MakerDAO, you simply lock your ETH in a smart contract (technically called a CDP — a “collateralized debt position”) and receive the DAI stable coin. When you deposit your DAI, you get your ETH back.
This has both significant upsides and downsides compared to the fiat-backed stable coins.
The advantage is that, as mentioned, the banking system is not part of the process. The system is 100% transparent and decentralized and the collateral cannot get seized by the government, as it is locked in blockchain smart contracts.
The downside is paradoxically the same as the upside: the banking system is not part of the process, so there is no way to exchange the stablecoin for fiat money. In this system we are limited to transacting in cryptocurrency only.
This means that crypto-collateralized Stablecoins like MakerDAO’s DAI can be used for commerce and for trading, but not for FIAT on-ramp, i.e. not for moving funds from fiat into cryptocurrency and back.
There is another significant downside with a system like MakerDAO. When you lock in your cryptocurrency and receive a loan in Stablecoins, you pay an interest rate. Lately, this interest rate has been frequently raised by the MakerDAO foundation. A user might have taken out a loan in DAI stablecoin with a 2% annual interest rate (called “stability fee” in MakerDAO) and a few months later they have to pay 19.5% annual interest rate.
With Tether and xEuro the transaction commissions are fixed and fairly small, yet with the crypto-collateralized there is an addition volatility with interest fees — they are subject to change at any moment (or at least when the voting token holders support such a change).
Stablecoins are incredibly important for the cryptocurrency industry as a whole, both as a means to reduce volatility for crypto commerce and to provide a gateway between the traditional finance (fiat money) and cryptocurrency.
At the moment, popular Stablecoins like Tether suffer from transparency and regulation issues and a new generation of stablecoins attempts to solve this via different routes, like full regulatory compliance in the case of xEuro, or fully migrating to the blockchain world, like MakerDAO.
These developments in the stablecoin industry will drive more adoption for cryptocurrencies and reduce risks and frictions associated with government regulations.
Stablecoins Are Not The Future of Crypto. They Are The Present. was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.