29 - Fiat backed stablecoins
One major problem in the digital asset space is volatility. Asset prices fluctuate 20%, 30%, 40% or more in a given week; and investors need a way to quickly exit when markets get choppy. At the dawn of the industry, it was hard for digital asset companies to get access to traditional financial infrastructure. This meant that selling digital assets into the most stable asset today–the US dollar– was challenging. The solution? Stablecoins, which gave traders a way to move quickly in and out of digital asset positions without needing to move into actual US dollars. They provide all the stability of the dollar without requiring the trader to exit the blockchain based ecosystem. Today, the total amount of value held in stablecoins is just over $153B. The massive amount of capital stored in these assets is driven by easy cross asset liquidity on exchanges like Coinbase but also thanks to the role the play in the wild west of decentralized finance.
Fiat backed stablecoins
Stablecoins are digital assets that are designed to derive and maintain their value against another asset with a non-fluctuating (stable) value. Said another way, stablecoin value is created by maintaining a peg or anchoring its price to another asset. First world country currencies are the most stable assets in today’s markets, with the US dollar considered the most least volatile and most reliable. The three most high profile stablecoins in the digital asset space are coins USDT, USDC, BUSD.
Stablecoins were first created in 2014; and while there has been debate as to which stablecoin came first, the most well known of that era and still today is US dollar Tether (USDT). USDT falls under the broader category called “fiat backed” stablecoins, which are stablecoins backed 1 to 1 with US dollars stored in a bank account. If an investor wants to create a stablecoin, they'll send dollars to a management company’s bank account. Once the dollars are received, the company then issues the customer the equivalent stablecoin to a wallet address of their choosing.
Fiat backed digital assets and specifically USDT have come under criticism in the past for not being transparent about how many dollars actually back the total circulating supply. In fact, many people believe that the 2017 rally in the price of Bitcoin (BTC) was a result of the company controlling Tether issuing more USDT than they had USD in their account. Doing this would effectively allow people to buy BTC with fake dollars significantly increasing demand for BTC. Knowing whether this claim was true at the time is impossible; but as recent attestations performed by an audit firm MHA shows, Tether is adequately backed by cash like assets: US Treasuries and commercial paper. These investments are not dollars, but they are highly liquid assets.
The issue with fiat backed stablecoins is that they require a third party to control the creation of the asset. In the case of Tether, Ifinex, the company that owns the digital asset exchange bitfinex, controls the bank account holding the funds backing Tether and the smart contract that issues Tether. Having this level of control allows Ifinex to determine what to do with the dollars that back Tether but also control the use of Tether issued on a blockchain. In the past, Tether has frozen USDT held in suspicious accounts. The design is effective for maintaining control but it in many ways run counter to the libertarian ideals about freedom of wealth that were the foundation of the blockchain industry.
Stablecoins around the world
Despite the issues that Tether and other fiat backed stablecoins face, they have enjoyed massive adoption. As of the writing of this piece, 89% of the total market cap is made up of three fiat dollar backed stable coins: USDT, USDC, and BUSD. An interesting aspect of this adoption is that more than would be expected is happening outside of the United States. Stablecoins were first created to provide a solution to the issue of market volatility and limited access by crypto investors to traditional financial infrastructure. Due to legal restrictions or the slowness of the aging technology, investors needed an alternative. These issues are some that another population faces: citizens of countries with unstable governments.
We are blessed to live in a country where societal stability is assumed and where our currency is used internationally. In other poorer and more unstable places, people don’t have such luxuries. One of the major selling points of blockchain technology is the fact that no one can be prevented from accessing them regardless of where they are located or who you are. Individuals living in countries where currencies depreciate by double or triple digit percentages annually (Venezula, Sudan, Lebanon, etc) and that do not have access to the US banking system (most of the developing world) are looking for a way to store and maintain their wealth. Many of them have landed on US backed stablecoins as their best solution. Some long time proponents of BTC will cringe as the asset being desired is still controlled by the US Federal Reserve; but for most people around the world, the United States and our dollar is the greatest safe haven asset that exists. BTC is just as if not more– volatile than their local currency and not widely accepted the way the US dollar is.
Investing in volatile assets is challenging and requires easy access to some form of stability. When companies began to service the fledgling digital asset industry, it was hard for them to provide traditional USD based services to the space. These constraints resulted in the creation of a blockchain native asset known as a stablecoin. The first type of stablecoin created was a fiat backed stablecoin for which every digital asset issued is supposed to represent a dollar in a bank account. These assets are widely used; but over time, the industry has begun to focus on the drawbacks to this system. As with every technology, innovation begets innovation; and next week’s topic will be discussion of how the digital asset industry has begun to innovate on the original stablecoin.