Purpose of the article: This note aims to familiarize readers with certain classic monetary concepts so that they can then be applied to the analysis of each type of stablecoin and their advantages and disadvantages determined. The article also attempts to answer the question: « Can stablecoins replace traditional currencies? »
Summary:
• The volatility of crypto assets prevents them from being considered currencies because it hinders their essential functions (store of value, unit of account, and medium of exchange).
• Some stablecoins permanently remove the barrier of volatility. However, this does not mean that their use as currency becomes effective.
• There are currently three main types of stablecoins, classified according to how they work.
Since their emergence in 2009, cryptoassets have continued to raise many hopes but also many fears. Born in the wake of the 2008 crisis, the Bitcoin protocol and blockchain technology are the vehicle for a novel political and monetary project: to establish a secure means of payment without the traditional intermediaries of banks and governments.
However, numerous reasons have so far prevented their use as a currency in terms of its functions as a store of value, unit of account, and medium of exchange.
One of the main obstacles to its potential use as a currency is its volatility. The chart below shows the significant variations in the Bitcoin volatility index relative to the dollar since 2011.
(Source)
This volatility is an obstacle to cryptoassets truly having the potential to become currencies and thus returning to their original designation as « cryptocurrencies. »
However, an innovation introduced over a year ago in the world of blockchain is in the process of removing the barrier of volatility: stablecoins.
The initial aim of this article is to understand how the volatility of cryptoassets hinders their development as currencies, before looking at the different types of stablecoins that exist today in order to explain how they work, their advantages, and their risks.
Currency: a complex object with interconnected functions
It is impossible to understand currency through just one of its functions. When one of these functions is compromised by volatility, the others suffer as well. Indeed, if the relative price of the object we use as currency keeps changing, its three primary functions suffer. Without stability, the function of a standard of measurement is nullified: the prices of goods measured with this « currency » would constantly change.
On the other hand, the store of value function is not strictly nullified, but it is significantly altered in at least two possible ways. If the price of this « currency » falls, the value stored in this form also decreases. On the other hand, if its price increases, the store of value function is not strictly compromised in the short term.
Finally, how can this volatility impact the function of intermediary of exchange? First, if this « currency » does not allow for the correct measurement of the prices of traded goods, the number of commercial transactions will tend to decrease due to uncertainty about the value of the goods. How can you be sure you’re not being « ripped off » if the price of bread keeps changing? Faced with this uncertainty, you are very likely to decide not to buy bread.
But that’s not all. The impact of volatility on the store of value function also has consequences for its role as a medium of exchange, regardless of the direction of price movements.
If the price of this « currency » falls, its holders will quickly seek to get rid of it, which represents an incentive to consume on the demand side and is reminiscent of the mechanism of « melting » currencies: when these lose value, it is better to get rid of them by consuming goods and services rather than hoarding them.
On the supply side, producers have a different perspective. They would be much less inclined to accept it as a means of payment if they expect it to depreciate.
Conversely, if this « currency » appreciates, then its holders will not want to spend it, which will also harm trade.
When they succeed in permanently resolving what is considered a problem with regard to the use of cryptoassets as currency, namely volatility, stablecoins may represent a technical advance capable of making the initial political project of the Bitcoin protocol more feasible: enabling the existence of a means of payment without institutional intermediaries such as banks or governments.
Three types of stablecoins, three sets of advantages and disadvantages
Stablecoins can be classified into three main groups according to how they work and how they attempt to curb volatility. It is clear that we are seeing fairly traditional monetary mechanisms at work, and we can therefore predict which ones are best suited to achieving the purpose for which stablecoins were created.
1. The first group consists of stablecoins « backed » by a traditional currency, according to the currency principle[1].
TrueUSD and Theter, for example, fall into this category. In this case, reserves are built up in traditional currencies equivalent to the amount of stablecoins in circulation. In this way, the market adjusts not by price but by quantity. If a buyer wants to purchase stablecoins at a price lower than the fixed price, they will not find a seller, as all sellers will have the option of selling stablecoins at a higher price to the organization that built up the reserves. Conversely, if a seller wants to sell stablecoins at a price higher than the fixed price, they will not find any buyers because the organization that has built up reserves will always be able to sell at the fixed price, which must logically be lower.
Creating the conditions for the market to regulate itself through quantities while fixing the price is an idea that has been tried and tested many times and predates the advent of cryptoassets. Indeed, it is precisely this principle that is applied to French local currencies, whose issuance depends strictly on the amount of euros in reserve in order to guarantee parity with the euro for all users. The same principle was applied to the Argentine economy as a whole between January 1, 1992, and January 6, 2002. The aim was to curb hyperinflation and establish parity between the peso and the dollar. This meant that the quantity of pesos in circulation had to be equivalent to the quantity of USD held by the country’s Central Bank.
In the case of stablecoins, however, the application of this principle is not without its problems. There are many suspicions surrounding Tether: its promoters have not built up reserves equivalent to the Tether in circulation. This information undermines confidence in this asset, which is essential for its use as a currency.
It should be noted, however, that this first group of stablecoins, given that their operation is inspired by the currency principle, is best able to guarantee the elimination of volatility, unlike the next two groups, which are subject to significant limitations.
2. The second set of stablecoins follows the same logic as the previous one, with the exception that the reserve currency is replaced by a basket of assets.
This basket of assets may consist of commodities or other cryptoassets, for example. This group includes commodity-collateralized and crypto-collateralized stablecoins. Let’s use the latter to understand how this second group works. What is fixed here is the price of the stablecoin measured in cryptoassets. However, their volatility can be a problem.
Let’s take the example of Haaven, the Australian stablecoin backed by cryptoassets. To simplify the explanation, let’s imagine that it is backed only by bitcoin. To fix the price of Haaven in USD, the value—measured in USD—of the bitcoins held by the organization must be equivalent to the total value of Haaven in circulation. This raises the question of Bitcoin’s volatility. If a principle similar to the currency principle were to be applied, the reasoning would be as follows:
In order to issue USD 100 of Haaven, the organization must build up bitcoin reserves equal to USD 100, which represents a quantity Q of bitcoins—denoted QBtc—on a given date. If the price of bitcoin suddenly falls, the value held in reserve will no longer be sufficient to cover the value of Haaven in circulation because the quantity QBtc is fixed. The issuing organization then has several options: abandon the currency principle and switch to a banking principle system or let the Haaven exchange rate float.
Ultimately, neither of these scenarios is desirable, the first for reasons of trust and the second because it simply calls into question the very purpose of stablecoins. To avoid this unfortunate situation, stablecoins in the second group—of which crypto-collateralized stablecoins are a special case—operate with reserves that are greater in value than the value of the currency in circulation. For example, the equivalent of $150 in bitcoins may be required to issue the equivalent of $75 in stablecoins. If the price of bitcoin falls by 30%, for example, the stablecoin remains fully covered in this scenario. It follows that at equivalent value and below the 100% coverage threshold, the relative price of bitcoin/Heaven is also stable.
Two obvious limitations then become apparent. The first is the high opportunity cost of holding this type of stablecoin. At this price, it is better to hold a liquid financial asset whose exchange rate risk is covered at a lower cost. The second, much more serious limitation stems from the volatility of the assets in reserve. If the price of bitcoin were to fall well below the 30% given in the example and collapse, the stablecoin would no longer be hedged. As volatility cannot be completely ruled out, it seems unlikely that this group of stablecoins will grow excessively.
3. The last type of stablecoin is known as « unhedged. »
An example of this is Basis. This group operates on a rather different logic than the previous ones. No reserves are set aside, so users cannot convert their stablecoins into assets with the issuing organization. In other words, the price of these stablecoins is set on a market in which the issuing organization cannot intervene through the channels seen so far.
If the initially fixed price of the stablecoin deviates from the equilibrium price due to an imbalance between supply and demand, the only variable that can be adjusted is the quantity of stablecoins in circulation. This adjustment is made by means of a smart contract through which liquidity is injected or withdrawn in order to bring the price of the stablecoin closer to the initially set value. For example, if the price of a stablecoin falls from one euro to 90 cents, the smart contract will withdraw stablecoins from circulation so that they become scarcer and their price increases in order to move closer to one euro.
However, this has major limitations: the issuing body must be able to withdraw stablecoins, which means that some of them must not be held by third parties. Furthermore, a fixed exchange rate system without reserves can be extremely unstable. The slightest imbalance between supply and demand will have an impact on the money supply, as the organization must subordinate it to the imperative of price stability. However, if the imbalance is too great or too sudden, the organization will not be able to withdraw liquidity proportionally, for example, because some of it will be held by agents. The price lock will inevitably break. This scenario, which is far from unlikely, means that this type of stablecoin is stable in name only and is unlikely to be a viable long-term solution for overcoming the volatility of cryptoassets.
Stablecoins: marginal innovation or currency of the future?
While the first set of stablecoins appears to be technically capable of fulfilling the three functions of money following the elimination of volatility, in order to qualify as money, the function of intermediary of exchange must also be effective. In other words, if an object can be used as money but agents do not use it as such, we cannot really call it « money. » For example, the bills of exchange issued by the central banks of the Argentine provinces during the 2001 crisis served as currency in a context of chronic liquidity shortages in the national currency, but today they are nothing more than inert pieces of paper that a few Argentines have kept as souvenirs.
It seems unlikely today that stablecoins will replace traditional currencies as a medium of exchange. On the one hand, they have certain intrinsic limitations, such as a lack of decentralization, the time required to validate transactions on the blockchain, and their still high acquisition cost.
On the other hand, even when stablecoins overcome the barrier of volatility and can therefore potentially be used as currency due to their characteristics, we must remember that currency is first and foremost an institution. Its value depends on the value we collectively assign to it, the trust we place in it, our belief that others will accept it as a means of payment (mimetic trust), that what was accepted yesterday will be accepted today (methodical trust), which in turn depend on the trust we have in the central institution that manages it (hierarchical trust).
Added to this is a phenomenon well known to institutional economists, « path dependency, » whereby the decisions we make today depend largely on decisions made in the past, which helps to perpetuate practices over time. On the monetary front, it is very difficult for agents who are accustomed to using traditional currencies and caught up in chains of payments of claims and debts denominated in national currencies to switch en masse to cryptocurrencies, except in the event of a major shock, despite the partial resolution of the volatility of cryptoassets.
Conclusion
Nevertheless, we must not underestimate the power of blockchain-related innovations, starting with blockchain itself as a disruptive and potentially liberating technology. In this sense, Mark Zuckerberg’s recent announcements have already provoked an outcry, including within the French Ministry of Economy. The Facebook group has unveiled plans to launch its own cryptocurrency, Libra, backed by a basket of currencies, based on the logic of the first set of stablecoins.
Given the inevitability of this innovation, regulatory issues are now being discussed at the G7 and in the major financial centers.
[1] The currency principle implies that in order to establish parity between currency A and currency B, reserves in currency B equivalent to the amount of currency A in circulation must be built up.
[2] The banking principle assumes that the value of the reserves held in currency A is less than the value of currency B in circulation. In order to ensure parity between currency A in reserve and currency B in circulation, the flow of « inflows » must be equal to or greater than the flow of « outflows. » If the latter were to be greater, then the institution would not be able to sustainably convert currency B into currency A at the initial fixed rate because it would no longer have enough currency A to give in exchange. In other words, the exchange rate of currency B would necessarily fall and depreciate in the absence of sufficient reserves of currency A.
[3] A smart contract is a self-executing contract that runs on a blockchain. The most common example is the refund of an airline ticket in the event of a flight cancellation. All the smart contract needs to do is record the input « flight canceled » to trigger its execution and automatically refund the affected passenger.
