The Big Discussion: Are Stablecoins Quintessentially “Shitcoins”

Stablecoins have been praised as the solution to crypto’s volatility problem with the potential to revolutionize crypto trading and expand crypto adoption by making cryptos more attractive to merchants due to reduced price risk.

The Winklevoss Twins recently launched the Gemini Dollar, touting it as the world’s first fully regulated stablecoin that will change the crypto market. A deep dive into how stablecoins work, however, reveals that these ‘revolutionary’ cryptocurrencies may create just as many problems as they solve.

The Oxymoron of a Centralised Cryptocurrency

When learning about cryptocurrencies, one of the first things one learns is that they do not contain identifying information about their holders and they are not issued or managed by any centralized authority. Cryptocurrencies are at least in theory supposed to be decentralized. When a coin is tethered to an existing fiat like the U.S. Dollar, however, this makes it develop a much higher centralization risk factor, and that can be terrible news indeed.

First of all, the entire value of the stablecoin, i.e., its unchanging value lies in the market’s belief that the cash reserves are backing it does exist (we can only hope..)  and are of the amount claimed. If there is any doubt as to whether an equivalent fiat amount backs a stablecoin, the market’s reaction will be swift and dramatic – it won’t be a “stable” coin anymore! (Remember Tether fiasco?)

For this reason, a new generation of stablecoins has decided to go down the road of obtaining regulatory approval and government licenses to convince investors of their integrity. Gemini Dollar is a new U.S. dollar-pegged stablecoin launched by Cameron and Tyler Winklevoss through their Gemini crypto exchange platform.

According to information released to the press, the Gemini dollar is fully regulated under New York’s so-called Bit License framework. This means that investors can rest assured that a regulator somewhere has made sure that Gemini’s claims are valid, which makes the coin’s stability more likely to be sustainable than a non-regulated alternative. This also means that U.S. State and Federal lawfully bind its dollar reserves along with banking and money transmission rules.

In other words, the Gemini Dollar exists because a centralized government authority permits it to. If an anti-crypto regulatory stance were to come into play for whatever reason, the Gemini Dollar would be effectively dead in the water. Once the centralized financial guarantee behind its $1 value disappears, its value will plummet drastically, making it practically worthless.

The fundamental problem here is that crypto assets are inherently unstable and highly volatile. Regardless of the promise held by crypto for the future, the U.S. Dollar and other fiat currencies remain the standard by which markets measure their performance. Trying to use a stablecoin to get around the price volatility risk inherent in crypto trading is trying to create a bridge between market activities and government-backed asset holdings which offer the most security.

Such bridges already exist and have done so for centuries. They are called banknotes.

A stablecoin is an attempt to reinvent the wheel by essentially creating a government-backed banknote for the crypto market. That is not a cryptocurrency at all. It is merely government-regulated digital money whose supply and a regulatory agency fully controls usage. For crypto trading and speculative market plays, this may work out, but it is safe to say that this kills the myth about stablecoins someday being able to upend fiat or crypto top dogs like bitcoin.

They are just digital fiat with full centralized government control and high risk of falling to zero if the market expresses any doubt in the veracity of the fiat holdings supposedly underpinning them.

Their probability of scaling is also by no means assured, which means that for now, their primary use case is within the narrow context of crypto asset trading. Rather than using U.S. Dollars which are effectively a promise backed by the strength of the U.S. economy, investors can use stablecoins, which are a promise backed by the strength of the US Dollar – plus ca change for investors, and irrelevant to everyone else.

How ‘Stable’ is a Stablecoin?

As mentioned earlier, the base stability of stablecoins is itself highly debatable given the right market circumstances. For a collateralized stablecoin to grow, it needs to show proof that it has equivalent cash reserves for every token issued. Inevitably, this poses a considerable scaling problem as it is just not possible to park vast and increasing sums of money for an indefinite period as a backing asset for a stablecoin.

Once the market senses that a stablecoin has reached its reserve limit, a swift correction often ensues. Some stablecoins try to get around this by being only partly collateralized or fully uncollateralized, but these frameworks only come with their own set of problems too.

In a partly framework where the stablecoin’s backers only hold say 50 percent of the coin’s market value, what happens is similar to what happens in conventional currency trading markets when a central bank holds only a proportion of the dollar reserves keeping a currency at a certain price level.

Once investors sense that commensurate dollar reserves do not back the asset’s price, they sell their holdings of that currency, placing downward pressure on its price and worsening the country’s inflation.

This scenario is then magnified by orders of magnitude in fully uncollateralized stablecoins where they sometimes attempt to game the market by issuing crypto bonds which it uses to buy back its currency if the price begins to fall, offering investors the bonds at a discount with interest, which on paper should work as an incentive.

In practice, as any trainee central banker can say, this effectively works like a Ponzi scheme, with the platform’s ability to make good on the interest payments dependent on its continued and endless growth. This is unsustainable, and after a point, the whole structure comes crashing down, much like governments from Venezuela, and Zimbabwe found out over the past decade.Writing on this phenomenon, Barry Eichengreen, a Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund said in a recent article:

“All of this will be familiar to anyone who has encountered even a single study of speculative attacks on pegged exchange rates, or to anyone who has had a coffee with an emerging-market central banker. But this doesn’t mean that it is familiar to the wet-behind-the-ears software engineers touting stable coins. And it doesn’t mean that the flaws in their currently fashionable schemes will be familiar to investors.”

The unavoidable conclusion from all of this is that apart from a narrow set of problems relating to liquidity in crypto trading, stablecoins do not currently offer much of a use case.

Until such a time as crypto like bitcoin becomes the base currency in which our lives are denominated (used for paying bills, mortgages, rent, groceries, gas, restaurants and so on). But, stablecoins do not have much of a use in the outside world, unlike bitcoin which is making good on Satoshi’s vision of fundamentally disrupting the fiat money monopoly.

Expert Commentary Supporting Stablecoins

Jimmy Zhong, CEO of IOST, told BTCManager:

“Overall, I believe that the creation of stablecoins is beneficial to space, particularly with the recent creation of the Gemini Dollar. Skepticism about Tether has abounded since its launch, but a fully guaranteed fiat pairing like Gemini can potentially spark more widespread institutional interest in cryptocurrencies.”

Josh Fraser, co-founder of Origin, remarked:

“If payment were to be collected in a volatile currency like Ethereum, either the buyer or the seller would end up getting screwed, as the price will inevitably change between the time of the booking and the time it is fulfilled. This becomes even more problematic when there are fixed costs to the goods or services being provided, as the currency fluctuations could leave the seller underwater on a sale.”

He added Origin is planning on “allowing marketplace sellers to accept any stablecoins they want as long as they are ERC20-compliant.”