In many countries around the world, there is no way to keep government-issued currencies completely stable. Investopedia explains “because fiat money (currency that a government has declared legal tender but has no intrinsic value of its own) is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, like the U.S. dollar bill, the money will no longer hold any value.” Unlike gold which can be used for anything from design and fashion to electronic and aerospace parts, the US dollar or even Euro are both at risk of diminishing purchasing power, fluctuating exchange rates, and overall inflation.
The goal of these government-issued currencies is to keep inflation fluctuations as stable as possible so that the currency can still be used. Unfortunately, stability is not always a given and an example of this is happening right now in Venezuela. Currently, Venezuela has the highest inflation rate in the world. According to Forbes, “the socialist nation has experienced a swift fall in oil prices, throwing the entire economy into turmoil. Experts say that Venezuelan inflation could go as high as 1,600%, leaving many people without basic necessities.”
Could cryptocurrencies prevent economic turmoil?
When we look at a case like that of Venezuela, we see political unrest and turmoil caused by the current state of the economy. Even before this year’s economic collapse, many people were living off a government stipend that equates to roughly $9 a month. According to Forbes, “with the Venezuelan bolivar essentially worthless and supplies rapidly running out, Bitcoin is rising as an answer. According to Bitcoin brokerage Surbitcoin.com, the number of Venezuelan users skyrocketed, from 450 in August 2014 to more than 85,000 in November 2016.” In desperate times, many Venezuelans have taken to cryptocurrency mining for income.
Change.com’s article on The Secret, Dangerous World of Venezuelan Bitcoin Mining explains, “one of the many advantages bitcoin has over the bolivar is that it’s free from price controls. Hugo Chavez imposed a disastrous fixed-exchange system in 2003, and today the state’s most advantageous rate is set at 662 bolivars per dollar, while the black market rate is nearly 3,000 bolivars per dollar. This discrepancy has led to exponential growth at Venezuela’s largest cryptocurrency exchange, SurBitcoin. The site makes it easy to trade bolivars for bitcoins, which can then be sold for dollars. By using bitcoins as an intermediary currency, it’s possible to beat the black market rate with less hassle and risk. Many Venezuelan miners also rely on SurBitcoin to trade their revenues for bolivars, which they use to cover expenses like rent and food.”
Although the government is keeping a close eye on mining and trying to cut down operations by charging citizens with related crimes, they have not outright banned mining. The issue with mining is that it uses a significant amount of power and Venezuela has issues with consistent power streams. Change.org explains, “the country suffers from severe power shortages. Rather than raise prices to throttle demand, the government has resorted to cutting supply selectively.” In the case of Venezuela, you could argue cryptomining is the best use of power for the nation in years. Finally, citizens have the ability to trade across borders with a currency that has enough value to trade with other nations for food, goods and other necessities. “It’s not just miners who benefit. By routinely selling some of their bitcoin winnings for bolivars to buy food on the black market, miners make it possible for non-miners to trade bolivars for bitcoins and also participate in this new economy.”
The Downside of Cryptocurrency
In situations like that of Venezuela, citizens are putting more faith in cryptocurrencies than their own government. While many are already desperate for some source of revenue in Venezuela, mining for Bitcoin, for example, whether its value is at $12,000 a coin or $400, is a revenue stream for many who don’t have other options. However, what about Bitcoin in terms of an investment? For example, those who are preparing for an economy collapse may want to put money in an account outside of the country’s banks. While massive volatility may initially make Bitcoin attractive to different types of investors, investing is a huge risk too. Ideally, the goal of a cryptocurrency is that it stays stable in its purchasing power. With low inflation, this keeps users holding on to their currency rather than trying to dump it to make money or to prevent further loss. Reaching this ideal level has been coined, no pun intended, a “stablecoin.”
What are stablecoins?
As we see in the case of Venezuela, a stable currency is important to combat inflation, manage changes in exchange rates and to overcome market volatility. While money can be made by exploiting the volatility of Bitcoin, for example, it isn’t practical for day-to-day use. As a result, we are seeing a rise in “stablecoin”, defined simply as cryptocurrency with stable prices, that is tied to a stable asset such as the US dollar. The stablecoin maintains its value regardless of what is going on with cryptocurrency markets, which makes it more acceptable to both users and merchants.
Types of stablecoins
In general, there are three different types of stable coins. We’ll define each of them and provide an example.
- Fiat collateralized is a stablecoin that is backed by a central authority with a fiat currency as collateral and uses a token to represent the centrally held fiat currency.
Tether is the best-known example of a fiat collateralized stablecoin. Blockonomi, a publication focused on Cryptocurrencies, fintech and the blockchain economy, describes Tether as an, “Ethereum-based ERC20 token that’s billed as the ‘U.S. dollar token.’ That’s because each tether is said to be pegged to fiat reserves 1:1, with these reserves being maintained in as-yet undisclosed bank accounts under Tether Limited’s control. Tether Limited, of course, is the organization heading up the token project.”
Hunan Naseer, a cryptocurrency investor and contributor to Cryptovest, describes one of the drawbacks of this approach, “having the whole collateral held in a fiat currency, in a traditional bank, goes against the principles of decentralization. If anything, the fiat-backed USDT is vulnerable to governmental interference, changing banking laws and financial regulations, and may leave token holders without any recourse in any of the aforementioned events.”
- Crypto collateralized is another type of stablecoin. In this model, the stable coin is backed by a cryptocurrency such as Bitcoin or Ethereum instead of fiat collateral. To overcome the volatility in these cryptocurrencies, the stablecoin is “overcollateralized” meaning that the stablecoin is backed by cryptocurrency that has a greater value than the stablecoins that are issued.
Maker DAO’s Dai is an example of a decentralized crypto collateralized stablecoin smart contract platform. According to Maker, the company, “ backs and stabilizes the value of Dai through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.”
Advantages of this approach are the decentralization (no need for auditors), lack of third-party involvement, and transparency but it is less secire and stable than fiat collateralized.
- Non-Collateralized. According to a May 14, 2018 Cryptos Herald article entitled, Stable Coins Analysis: Is There A Viable Solution For The Future, “Non-collateralized stable coins aim to closely mimic fiat currencies by not having any asset-backed collateral. Instead, price stability is achieved through an approach called seigniorage shares, a processed that was conceived by Robert Sams, founder and CEO of Clearmatics Technologies LTD. Through this approach, smart contracts can be programmed to resemble a reserve bank, enabling it to increase and decrease the supply of money in order for the value to remain as close as possible to the value of a pegged asset, such as USD.” Using the concept of supply and demand, minting coins is based on how the coin is trading, and is done to maintain the value of the coins.
One example of a non-collateralized stablecoin is a currency called Basis. The Basis coin is aimed at keeping its price at $1. Accoring to Timothy B. Lee /
Senior tech policy reporter for ARS Technica, “Basis coins won’t be directly backed by dollars or any other asset. Instead, the Basis blockchain will attempt to adjust the supply of Basis coins over time to maintain a peg to the dollar, much as foreign central banks expand and contract their own money supplies to maintain a stable currency value.”
Lee goes on to say,” This system should work as long as the market expects the total demand for coins to rise in the future. If the market expects coin demand to rise over the long run, it will see shares as a profitable investment opportunity and so there will be a robust market for shares the system can use to prop up coins’ value during temporary downturns.”
Overall, stablecoin projects have the attention and even backing of some of the world’s largest organizations. Cointelegraph reported that ‘Reserve,’ a stabilized token that maintains a peg by using smart contracts to lock up other crypto assets instead of fiat, had the backing of PayPal’s cofounder Peter Thiel and the crypto exchange site Coinbase.
Now, even IBM is getting involved in projects. IBM,who recently announced a Stellar-based blockchain payment network, also has announced a Stellar stablecoin project.
Stellar’s blockchain technology is built on the Ripple protocol and is aimed at working with developing markets instead of directly with established banks and other financial institutions. According to IBM, stablecoins will be used to connect two fiat currencies. Two different financial institutions will have to agree on the stablecoin and use their existing payment systems to process the transaction. IBM has used Stellar since 2017, facilitating-cross border payments and now, testing the new stablecoin. Jesse Lund, vice president of global blockchain at IBM explained to Rueters, “IBM will explore use cases with business networks that we have developed, as a user of the token. We see this as a way of bringing financial settlement into the transactional business network that we have been building.”
For IBM’s existing cross-border blockchain solution efforts, Stellar and the development of the stablecoin, could play a huge role in improving current systems. In an interview with Fortune, IBM’s Bridget van Kralingen, senior vice president of global industries, platforms and blockchain, explained that the new project could present a “tremendous opportunity” to streamline and improve costs associated with cross-border transactions.
Today, we see efforts to push both blockchain solutions and cryptocurrencies to market. Right now, people are investing in cryptocurrencies because of the potential for huge profits. It is important to look at the products being developed, and the solutions being offered as well. Although Bitcoin fluctuations are attractive to investors, until these numbers become more stable, it’s not very practical to use it as an actual currency. The idea of a stablecoin is to hold its value regardless of the cryptocurrency market.