Introduction The Decentralized Finance (DeFi) Revolution is taking over traditional finance (TradFi) and centralized exchanges (CEX), with billions in...
For many, stablecoins have brought with them the long-promised utility function to the cryptocurrency world. A magical key that has finally unlocked digital assets, bringing in millions of new users and billions of dollars. While this has proved to be true in 2020, there are also risks involved in moving all your money into stablecoins. Like many problems in life, there simply isn’t a panacea, or an elixir to quell all worries and risks — especially when it comes to a new type of financial instrument, no matter how “stable” it is. After all, stablecoins aren’t technically anything new. While their digital properties are a breath of fresh air for the stagnated world of finance, most are nothing more than fiat-based currencies held on mobile phones or digital wallets. It is with this in mind that we wanted to highlight some risks involved in moving money into stablecoins.
The Problem with Centralization
This is probably the biggest risk currently associated with stablecoins, and something that goes completely against the general ethos of what blockchain technology is supposed to be about. As the saying goes, blockchain was designed to truly decentralize the information age so that no single party has complete control or dominance over any aspect of our technological world. It was supposed to bring with it a layer of transparency and immutability that technology like the internet simply does not provide. For the most part, this has held true. Transactions are fully transparent and immutable on public blockchains. As a result, they are not controlled, and cannot be altered by a single party. Unfortunately, for stablecoins, this does not hold true, as often there is a single entity that controls and operates the stablecoin with off-chain transactions and deals. Take USDT for example, the most widely traded stablecoin on the market. In reality, USDT is controlled by a company called Tether — which operates just as any other profit maximizing company does, in its own best interest. Tether controls both the supply and distribution rate of USDT, and does not answer to outsiders for how they want to manipulate the market supply. Being a centrally backed asset interferes with the nature of blockchain technology, albeit not technically. This lack of decentralization poses obvious risks to anyone holding USDT since a collapse of Tether for any reason also then means a collapse in USDT, possibly sending the value of your digital USD crashing to zero. The best way to combat this is probably the same way most investment managers would advise you to, through diversification of assets. By diversifying your array of stablecoins, at the very least you can protect yourself against a singular collapse of an organization in charge of the asset.
A Lack of Transparency
While on the topic of USDT and Tether, we need to talk about transparency, or rather the lack thereof. While Tether isn’t the only company who has faced auditing issues in the past, it is probably the most well-known example as it was accused of using over $800 million of its funds to cover up a major Bitfinex Loss. Further investigations revealed that Tether at one point only had about 75% of its issued funds backed by fiat USD — with the rest being collateralized by a series of assets including Bitcoin. This prompted a strong rebuke by governing agencies, asking why Tether would use a volatile currency like Bitcoin as collateral when the entire point of creating USDT was to prevent against the volatility of digital currencies like Bitcoin. Not only is this question fair, but it is also incredibly important. As we discussed above, Tether does not owe anyone transparency or decentralization, but the value of its token, 1 USDT is only pegged to 1 USD because people believe Tether really has the fiat currency locked away somewhere safe. But, if Tether actually only has 76 cents out of 1 USD stored up in a vault, then the coin isn’t actually pegged to 1 USD and its token holders will rapidly pull out all their USDT sending its liquidity down a cliff and possibly crashing its value. For the average user, this isn’t really something they themselves can prevent through diversification. Rather, the only way to combat this is through system wide protocols and audits that force any stablecoin organization to prove their collateralized assets genuinely equals the amount of supply they’ve issued to the market. Unfortunately, this is something much harder in practice than in theory.
Economic Instability and Inflation Issues
Here’s the thing about being pegged to fiat currencies… you’re at the whim of fiat currencies and therefore the central governing bodies behind them. As we’ve seen throughout history, governing bodies are not always the most economically well-informed people when making fiscal decisions, often causing massive nation-wide inflation and crashing the local currency. Simply put, there is a reason why most stablecoins are pegged to high performing and stable currencies like the USD or the EUR as opposed to the Argentinian Peso. This is because USD, and by extension the US Treasury, carries with it an aura of stability that has withstood at least the last half century. If stablecoins were issued in a much worse run economic fiat currency, no one would exchange their money for it, which means that the stablecoin would have no liquidity and therefore no value. However, this also puts your stablecoins at risk against global black swan events, or sudden economic downturns which can lead to inflation. Is the USD likely to suddenly crash drastically? No, chances are that is highly unlikely. But is it impossible? No, it definitely is possible. In an alternate reality where the US-China trade war escalates, and the pandemic continues to ravage its economy, we might have seen a very real scenario of hyper-inflation in the United States. So while this wouldn’t affect the amount of stablecoins you have in your wallet, it would affect the real purchasing power you have with them — which means ultimately, it affects your wealth. This notion is one of the principal reasons why people have moved their fiat currencies to digital versions like stablecoins, but it doesn’t fully protect them from larger, more macroeconomic problems resulting in economic instability and inflation. To be frank, there isn’t really much we can do about this — other than returning to a life of trading more useful, tangible assets like sheep or chickens. Don’t laugh, we might not be that far off from a world where eventually stablecoins are backed by livestock or vegetation instead of fiat currencies, as long as they are still in demand.
It’s Difficult to Algorithmically Maintain a Perfect Peg
A lesser well-known type of stablecoin is the algorithmically backed type, also known as seigniorage. These types of coins are not backed by any type of collateral, whether that is a basket of digital ones like DAI or traditional fiat one’s like USDT. Instead, they rely on an algorithm (or game theory) that buys up supply or produces it based on market fluctuations. How it works is as follows. Let’s say the price of our coin drops to $0.80, meaning that supply in the market is higher than demand. The algorithm would calculate just exactly how much excess supply is optimal, and buy up that amount to bring the price back up to $1 exactly. This sounds great in theory, having an AI-powered algorithm to constantly ensure stability in a blink of an eye, but there are underlying issues as well. For starters, this doesn’t work during black swan like events when there is a sudden drop in demand. Let’s say that some drastic event happens, and over 80% of users pull their money from this stablecoin. The algorithm would then be instructed to buy up enough supply to bring the price back up to $1, but what happens if there isn’t any future demand for this stablecoin any more because of the drastic event? Algorithmically backed stablecoins essentially rely on the future demand of their asset to constantly grow and shrink in supply to remain optimal, but if there isn’t a future demand, the model crashes. On top of that, these algorithms are often incredibly complex and difficult to execute in addition to being a brand spanking new technology, making them far too unreliable to gain the broad public’s trust this moment.
Challenges with Regulations, or the Lack Thereof
There are two main issues when it comes to regulation. Towards the end of 2019, when stablecoins were just emerging from their cocoons, the G7 summit strongly declared the serious risks involved in using them as international settlements. Most of these risks stemmed around money laundering, taxation, and terrorism financing. While an argument can be made that the legacy banking systems rely too heavily on traditional banks and their fees to adopt stablecoins, some truths remain in the statements. Stablecoins, like all digital currencies, possess inherent risks to the underworld. It makes it much easier to pay an arms-dealer in cryptocurrency than it is with a bank check nowadays. Stablecoins take this risk one-step further, as they are not as volatile as altcoins, so criminals are more likely to transact in stablecoins because their values are more or less set in stone as opposed to constantly fluctuating. But the bigger issue with regulations is the lack thereof. In a blink of an eye, regulators can crash an exchange as they have recently done with OKEx, and shut them down either temporarily or permanently. And since you don’t have any legal binding to the fiat collateral stored at these exchanges other than the “I agree” button you pressed during sign-up, there isn’t much you can do. This makes regulations important in not just protecting the industry from criminal cross border transactions, but also from governing bodies and law enforcement themselves. Until proper regulations are put in place to safeguard your digital assets, it is probably not wise to fully commit to stablecoins. Another risk we might see is where a stablecoin (or bitcoin) has been labeled as ‘dirty.’ Since the blockchain is public to everyone, the regulator can track this specific stablecoin’s transaction history and claim your fiat bank account aided in previous malicious transactions – essentially freezing your personal accounts too.
It is difficult to argue with the astronomical rise seen by stablecoins over the last 12 months, and in no way are we suggesting that this is merely a bubble or flash in the pan. However, it is important to remain even keeled in these situations and understand that there are risks involved with anything, especially digital currencies — even if they are as stable as stablecoins. This dynamic space is only going to evolve, grow and fragment into new areas at light speed. This is exciting, and for many this is exactly what the blockchain space needs. We look forward to seeing how the risks we’ve listed above play out over the next year, and who knows — maybe we’ll write about new risks that have emerged by the next time we write this article.
To learn more about the benefits of using stablecoins and how they can improve your business operations as well as position you as a pioneer in the adoption of disruptive technology, reach out to us here. We will gladly walk your organization through the steps of building a stablecoin with our all-in-one solution. Whether it is the code, compliance, distribution, or marketing, we’ve got you covered.
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