At the dawn of cryptocurrencies, it was extremely difficult to make transactions between different types of crypto assets or between fiat currencies (for example, US dollars, euros, Japanese yen) and cryptocurrencies. Legitimate and trustworthy cryptocurrency exchange companies were in short supply, and decentralized exchanges supported by decentralized finance (DeFi) had not yet been created. Both veterans and newcomers have relied heavily on peer-to-peer trading to enter and exit cryptocurrency investments.
The conversion from a fiat currency to a cryptocurrency and back also brought significant difficulties for a number of reasons. First of all, banks and other financial institutions often quickly blocked any transactions between their depositors and cryptocurrency companies. In many cases, local authorities even required them to refrain from offering any services to companies in the crypto space. And since the US dollar, euro, rubles and other fiat currencies are almost always physical and not digital outside of the banking system, converting physical fiat money into digital currencies during exchange was an impossible task.
It will take several years before the crypto space develops a way to transform the relative stability provided by fiat currencies from the physical world to the digital world without having to rely on the traditional banking system. This is how financial instruments known as “stablecoins”were born.
Stablecoins? I’ll take two, please
Stablecoins are a new type of cryptocurrency that tries to track the value of an asset or money to which its price is tied. For example, the most common stablecoins used today in the cryptocurrency markets are based on the US dollar. Thus, although the US dollar may fluctuate in value compared to a basket of goods (i.e. inflation), or with a basket of currencies (i.e. currency fluctuations), any stablecoin pegged to the dollar must match its value one to one at any given time. Today, two main types of stablecoins are used: secured and algorithmic.
Secured stablecoins are currently the most common in the world. Secured stablecoins support the binding of the price to the underlying asset, allocating a proportionate amount of the asset as a security or reserve that provides the value of a digital stable coin that will be sold through the blockchain.
For example, if you want to receive a USD coin in the amount of 1 million US dollars, you will need to transfer 1 million US dollars to the bank account of a company that participates in the management of the USDC stablecoin itself, for example, Coinbase or Circle.
Or, if you wanted to issue $1 million worth of PAX Gold, I would need to transfer $1 million to the Paxos Trust Company, which would then be used to purchase an equivalent amount of gold at market prices.
Although stablecoins are usually considered in the context of fiat currencies, such as the US dollar, or precious metals, such as gold, it is important to remember that any cryptocurrency tied to the value of an asset, whether through reserves or algorithmically, can be a stablecoin. For example, if you tokenize the ownership of your house and use it as a reserve asset that supports tokens, these tokens can be classified as a type of stablecoin.
The main difference between a secured and an algorithmic stablecoin is that the latter is not secured by any collateral or reserve assets. Algorithmic stablecoins still strive to maintain a price binding to a specific asset, for example, to the US dollar or an ounce of gold, but they do this without having any underlying asset that provides their value. Instead, the program code on the basis of which the algorithmic stablecoin is built tries to maintain the price binding by changing the offer of the stablecoin itself.
Is its price too high because of too much demand? An algorithm that supports a stablecoin will simply give out more coins to all existing holders in order to balance supply and demand, and return its value to the desired price. The opposite action occurs when there are too many tokens, or, in other words, when the demand for a stablecoin is insufficient.
Although stablecoins without and with insufficient collateral, including those based on algorithms, provide a wide range of advantages, they often experience greater price instability than secured stablecoins, and are probably more likely to lose their binding to the underlying asset, or completely fail.
Why do I need stablecoins?
The main purpose of stablecoins in today’s cryptocurrency markets is to provide fast conversion between other cryptocurrencies, such as Bitcoin and Ether, and fiat currencies without the need to actually cash out the fiat currencies themselves, which, thanks to outdated banking and settlement systems, usually takes two to three working days or longer.
For example, a trader can sell his Ethereum for Tether, the largest stable coin by market capitalization, on the Coinbase exchange, which is located in the United States, and then transfer his Tether to the Binance exchange, which is based in Malta, to buy Bitcoin. All these transactions together can be completed in 15 minutes, or even less. Performing a similar transaction across international borders through a legacy banking system can take several days or weeks, and require a large number of fees charged by each intermediary from the transaction.
Due to the simplicity and efficiency of converting a fiat currency into a cryptocurrency provided by stablecoins, a large amount of liquidity can be maintained directly in the cryptocurrency blockchains themselves with limited participation, if any, from banks or other intermediaries not related to cryptocurrencies. And this liquidity is often considered as a key component of ensuring the smoothness and low cost of transactions denominated in cryptocurrency.
Do stablecoins really pose a risk to global financial security?
A common opinion that you may hear from skeptics is that stablecoins can be a destabilizing force in the cryptocurrency markets and possibly even in the global financial system as a whole. The US dollar-based Tether stablecoin often bears the brunt of this criticism, but from time to time algorithmic and other versions with collateral that are not fully backed by reserve assets are also included.
The criticism, in fact, boils down to fears that the cryptocurrency equivalent of “fleeing from the bank” can happen with any stablecoin that is not provided with unambiguously reserve assets. For example, it is now well known that Tether is not fully backed by reserves in US dollars. In fact, in May 2021, the company that manages Tether revealed that only 2.9% of the reserves supporting it are actually denominated in cash.
Thus, the fear is that if a large number of people try to exchange their Tether for physical US dollars at the same time, the Tether company may not be able to fulfill its repurchase obligations, and investor confidence in the most stable USDT coin may be undermined. The current market capitalization of Tether currently exceeds 62 billion US dollars and represents a significant amount of fiat liquidity in the cryptocurrency markets. In fact, the ability to easily make transactions in the cryptocurrency markets can be disrupted if one or more of the large stablecoins used fail.
However, bankers and government officials accuse Tether and other stablecoins of vulnerability to banking operations that can destabilize financial markets. Most of us remember how many banks around the world went bankrupt during the global financial crisis of 2007-2008. And the fiat currencies themselves are generally in the worst condition, since they are not backed by “real” assets, such as gold, or their supply is not regulated. objective algorithms.
If a fiat currency of any size fails, whether it is the US dollar, the ruble or the Mongolian tugrik, the part of the financial market that interacts with the bankrupt currency will be catastrophically damaged. After all, paper currencies are actually backed by only two things: the promises of politicians and military power.
In this context, should we really worry that stablecoins will have a huge impact on global financial security? No.
Speaking about the ban on stablecoins, many central banks simply maintain the pace of the given rhetoric, distracting attention from the release of their digital currencies – CBDC, which will be the main weapon in the fight against cryptocurrencies.