Bitcoin may be the first and biggest cryptocurrency, but it’s terrible at being a currency. Bitcoin enthusiasts know that better than anyone — one of the most well-known events in Bitcoin history involves one of its first real-life purchases, when Laszlo Hanyecz bought two Papa John’s pies by trading 10,000 bitcoin to settle the $41 bill. Had he held on to his crypto, they would be worth over $400 million today. That’s some expensive pizza. 

In most people’s minds Bitcoin, and likely any cryptocurrency, is synonymous with volatility. News reports on crypto markets highlight outrageous swings in price, such as Bitcoin losing half of its value in a few hours, or Dogecoin going up 800% in a similar timespan. This volatility makes cryptos terrible currencies, and that’s before you take into account other considerations, like Bitcoin taking thirty seconds to confirm a transaction, or exorbitant fees on individual transactions. 

However, crypto evangelists are convinced that soon the traditional financial system will have a competent competitor in blockchain-run currencies, if it’s not overthrown by them entirely. So how will users perform everyday transactions, and how will financial instruments be created and used?

Enter ‘stablecoins,’ cryptocurrencies that, by design, attempt to remain as stable in value over time as possible. 

Unlike other cryptocurrencies,  Stablecoins are rarely the subject of breathless coverage due to wild swings in value, but they make up two of the top five cryptocurrencies by market capitalization, according to CoinMarketCap.

The management of stablecoins and the mechanisms by which they’re stabilized rank among the most important stories in DeFi. Here’s what you need to know. 

Stabilizing the stablecoins

For most stablecoins, the mechanics are pretty much interchangeable — a user deposits a certain amount of currency, usually the U.S. dollar, into a virtual wallet, and a smart contract (a program that runs on blockchain-based systems) gobbles up the dollars and issues an equivalent number of stablecoins in exchange. 

However, there are several different approaches currently used to stabilize the stablecoins. The simplest one is to have a store of USD to back up each and every coin. The two currencies in the top five cryptos that I mentioned above, Tether (USDT) and USD coin (USDC) both use this method. 

Or, at least, they claim to. Tether, which is issued by a Hong Kong-based company owned by the same company that controls the Bitfinex crypto exchange, has a messy history concerning disclosures of exactly how much of its stablecoin is backed by cash. The company agreed to pay an $18.5 million dollar fine and to withdraw Tether and Bitfinex from New York in February 2021 to settle a lawsuit brought by state Attorney General Letitia James that alleged the company misled investors about how much of its currency was backed by reserve assets. Tether has refused to admit wrongdoing.

The hedge fund Fir Tree has major concerns about the future of Tether, and is putting its money on the line in response by shorting the cryptocurrency. Previous attempts at shorting the cryptocurrency had sometimes failed because no one would take the other side of the bet, which makes sense when you consider that the upside risk associated with most short plays, namely, that the stock will go up instead of down, isn’t likely to be a risk here: if Tether’s reserves collapse, its value relative to the dollar will fall, and the short play will be in the money, but if Tether succeeds at its mission, its value will never rise above $1 USD.

In comparison to Tether, which has a current market cap of over $80 billion, the second-biggest stablecoin, USDC, has merely $53 billion in circulation. However, it’s often seen as a safer bet compared to Tether, as it’s based in the United States, is run by a consortium that includes members of the crypto exchange Coinbase, and has historically been more transparent about its assets. Visa even allows the use of USDC to settle payments on its network.

Algorithmic allocations

Pegging the value of a stablecoin to a single currency, even one as stable as the U.S. dollar, is something that hardcore fans of decentralization have understandable qualms about. The U.S. dollar probably won’t collapse anytime soon, but everyone thought the same of the housing market once, and we all know what happened there. 

While the three biggest stablecoins, Tether, USD Coin, and BUSD (a stablecoin used by the crypto exchange Binance), all claim to be backed by cash or cash-like assets, algorithmic stablecoins use predetermined processes in order to keep their price stable without relying on collateralized assets. In practice, this often means burning or minting coins to restrict or increase supply as needed.

TerraUSD, the fourth-biggest stablecoin, is one example of an algorithmic stablecoin. It works based on a complicated ‘seigniorage’ system where Terra coins can be exchanged for Luna coins, whose value can rise or fall with the rest of the crypto market. 

Ask different DeFi experts and you’ll get different opinions on the relative risk of algorithmic coins — some will praise the fact that they’re not tied to a central entity like the U.S. government, while others believe that they’re doomed to fail

Reserve reservations 

The U.S. dollar (USD) has been used as the world’s reserve currency since the end of the second World War, originally because the dollar itself was tied to the value of gold. Though President Nixon ‘shocked’ the world by severing those ties, the U.S. dollar has remained the most important global currency. Could stablecoins provide a viable alternative? 

Historically, the U.S. dollar’s competitors have been scarce. The EU almost collapsed under the weight of its debt, so the Euro is out. China, with the world’s second-largest economy, has tried in vain to increase global acceptance of the yuan, but compared to the 40% of global transactions that are denominated in U.S. dollars, the yuan’s 3% seems trivial. 

However, a single government having such a heavy hand in international finance leads to understandable concerns among many –and not just crypto-friendly, pro-small-government libertarians. Russia’s recent invasion of Ukraine has led the U.S. to impose crippling sanctions in response, effectively cutting off Russia’s central bank from being able to access its USD reserves. Some countries may have concerns in the future about holding on to USD, but no sensible country would park any of its reserves in Bitcoin. A decentralized stablecoin, however, could gain traction in the future, according to a 2020 report from the International Monetary Fund. 

What’s next?

With the explosion of interest in stablecoins over the past few years has come increased scrutiny from lawmakers. The U.S. government might not be able to beat these stablecoins — that’s the whole purpose of all this decentralization — so might it join them instead?

Biden’s recent crypto-focused executive order encouraged the Federal Reserve, currently helmed by Jerome Powell, to continue researching the prospect of a Central Bank Digital Currency. The U.S. isn’t the only country weighing whether to roll out a CBDC, and nine countries — Nigeria, the Bahamas, and seven countries in the Caribbean — have already launched one. 

A CBDC would be considered a fiat currency, since it’s issued by a government and not backed up by an asset like gold.But  it would also be digital in the way that cryptocurrencies are, increasing interoperability between the traditional finance and DeFi world. 

Whether American consumers would be more interested in a government-backed digital currency or a decentralized one will vary based on their confidence in the government. What can’t be disputed is that as the DeFi world grows, stablecoins will grow along with it.

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