The Key to Adoption
There are a number of reasons why cryptocurrencies have not been adopted as a universal method of payment yet, including poor reputation, technical complexity, and regulatory uncertainty. However, one reason stands out above all: volatility.
First of all, it is simply not practical to price goods in a currency that might be worth half a few hours later. Even in a system that updates prices automatically, the client would simply be confused as to how much he is meant to pay. Secondly, merchants, understandably, do not like the risk associated with being paid in something that might be worth half the next day.
This problem has led to the search for more stable alternatives. Stablecoins aim to peg their value to fiat currencies or other real-world assets that promise price stability. Even the BBC has recently acknowledged the importance of this search for stability.
Making Price Guarantees in a Free Market
Providing a stable cryptocurrency is surprisingly difficult. The key problem simply is that cryptocurrency markets are free markets. In such a market, assets are worth whatever people are willing to pay for them.
Imagine pegging a cryptocurrency to the US Dollar. You cannot force someone to trade an asset at exactly 1 USD if the buyer is willing to pay more. The only possibility is to convince everyone in the system that the token really is worth 1 USD and not a single cent more or less. It’s in the nature of people to speculate and try to make money, so if there are agents in the system that believe the value may fluctuate, it will eventually fluctuate. Investors will turn this belief into a self-fulfilling prophecy.
To “guarantee” the value of an asset it needs to be backed with some sort of collateral, the same way gold bonds are backed by real gold. Currently, there are two ways of doing this: off-chain and on-chain.
An example of an off-chain backed stablecoin is Tether. Tether is pegged to the US Dollar through a centralized company. The simple idea is keeping 1 USD for each 1 USDT (Tether’s stablecoin) issued in an audited bank account. A reputable auditing firm certifies that the collateral really exists. There is an obvious problem with this approach. Both the Tether company and the auditing firm are trusted third parties, the very entities blockchain technology is meant to eliminate. If we trust such third parties, we might as well trust banks and use traditional fiat money. In fact, banks are probably the safer option as they are tightly regulated. Tether has been accused of not providing sufficient transparency and the project has caused some controversy in the past.
An alternative approach has been implemented by MakerDAO’s DAI stablecoin. This entirely on-chain approach issues DAI through a smart contract by locking Ether acting as collateral. The system is meant to assure that there is always sufficient Ether present to cover large and sudden price changes. So far, this system has managed to survive the large increases and subsequent value loses in the Ether cryptocurrency we have witnessed over the last year. MakerDAO has just announced a move towards multi-collateral DAI, a stable cryptocurrency backed by a number of digital assets, not just Ether.
Stablecoins are clearly an important tool going against the speculative nature of the volatile cryptocurrency eco-system. It is safe to say that both centralized and decentralized solutions both have to prove themselves by standing the test of time.