Stablecoins: are they really the promised solution to volatility?

For those that are looking to crypto as a way of making purchases, rather than just as an asset akin to stocks, stablecoins represent the likely future. However, this type of asset still has some major challenges of its own to overcome before consumers should start viewing it as a genuine and permanent alternative.

One of the most cutting criticisms of more “traditional” forms of crypto is its wild volatility. Stablecoins are viewed by some as the panacea to this volatility. In the seminal Bitcoin whitepaper, Satoshi spoke of Bitcoin being used as a means of payment. However, when intraday price swings of north of five per cent are not uncommon, the purchasing power of Bitcoin can vary greatly day to day. Stable and consistent purchasing power is one of the hallmarks of a “good” means of payment. As such, Satoshi’s vision for Bitcoin, to be an iteration of electronic cash, is becoming less and less likely. With Bitcoin growing to resemble something completely different to fiat, stablecoins have emerged as an alternative digital asset to be used as a means of payment.

The stability of stablecoins is thanks to their respective “pegs” to an external benchmark, for example USD or the gold price. Two main mechanisms have emerged as a means of stablecoins maintaining their pegs – the first is collateralisation and the second is algorithms. 

Examples of collateralised stablecoins include popular coin Tether (USDT) or DAI. USDT’s USD peg is maintained through the holding of USD reserves by an independent custodian. In some regard, this centralised holding of USD conflicts with the decentralised trope of crypto. USDT’s value remains beholden to the US government, as it only maintains its peg and value so long as the USD collateral held is backed by sovereign credit. 

As an alternative, DAI is collateralised through a basket of crypto assets. However, there remains a reliance on a centralised holding of these assets and the price volatility in the underlying basket can lead to significant over-collateralisation.  

Where collateralised stablecoins fail in holding true to the fundamental blockchain principle of decentrality, algorithmic stablecoins use a smart contract consensus mechanism to mimic the way central banks influence the money supply. However, in practice, algorithmic stablecoins have become renowned for losing their pegs and are highly susceptible to bank run-like events, whereby holders of the coin decide to on mass exchange their holdings for fiat or another cryptocurrency. 

The price of popular algorithmic stablecoin Terra has only twice dropped well below parity with USD, and in both instances was able to regain relative equilibrium reasonably quickly. Interestingly, Terra has recently launched a Bitcoin reserve to assist in maintaining its peg. Some suggest this is evidence of the algorithmic stablecoin community losing faith in its own product. 

In early April algo-backed stablecoin Neutrino (USDN) lost its peg and fell more than 26 per cent in a 24-hour period. At the time of writing USDN sits at relative parity with USD at $0.987. This follows the failure of Iron Finance’s stablecoin IRON that lost its peg in June 2021 after a bank run-like event.

While algorithmic stablecoins demonstrate a step forward for minimising price volatility, all the while maintaining decentrality, they remain a risky investment. When purchasing algo stablecoins, those wanting to escape the wild price swings of other cryptocurrency would be well advised to remember the age old adage “buyer beware.”