How Stable Are Stablecoins?

Matt Branton, CTO and Co-founder of Neutral

The dizzying price highs of December 2017 and subsequent sharp downturn in the crypto market in 2018 have painted a picture of a digital asset realm in a state of flux, with sudden jolts in market activity followed by protracted periods of price drops. The sensationalism that defined the crypto landscape for the better part of 12 months has somewhat subsided, largely due to an extended phase of maturity that has seen quality projects take the fore, and illegitimate ones petering out.

This phase of maturation has given rise to a new financial instrument, stablecoins which serve as a better unit of account for transaction. This has led to a greater calm and cohesion in a space that has often had a hype-filled rhetoric without the mature tools needed to reduce the volatility of crypto exposure, and steady the ecosystem. The emergence of the stablecoin hasn’t always delivered on its advertised promise, however, and volatility issues still linger, albeit to a much smaller degree.

The diverse types of stablecoins: what is their appeal?

When it comes to stablecoins, the dominant players in the field have been fiat-backed, meaning that stablecoins have become synonymous with the idea of pegging digital assets to fiat currency. This is not the only form of stablecoin, and the status quo is being challenged, with alternative stablecoin projects receiving over $350m in funding to date.

Explained simply, stablecoins are digital tokens designed to hold a reliable and balanced price. The most well known stablecoins are pegged to fiat (eg. USD, EUR) or other reliable, low risk assets, where a certain amount of fiat currency is deposited as a collateral and coins are issued 1:1 against this fiat money.

There are crypto-backed stablecoins , in which another cryptocurrency is used as collateral rather than fiat or other assets.

There are also non-collateralized stablecoins which are not collateralized by anything other than the expectation that they will retain a particular value, or are collateralized by algorithmically set smart contracts.

Increasingly, large institutions such as banks are making moves towards creating their own stablecoins, backed by the assets they themselves already hold. While it is encouraging to see institutions like Central Banks explore the benefits of stablecoins, it is important to note that volatility issues can persist, regardless of the status of financial institutions.  

The volatility issue

For each type of stablecoin, stability of price is essential to their value proposition, and when evaluating their prices, we expect coins to remain directly pegged to one price marker. Instead, an analysis post by Coinmonks shows that the value of these coins varies over time. This change in price can be caused by a number of factors, and with fluctuating degrees of deviation, stablecoins don’t always match their peg 1:1.

There are idiosyncrasies such as credit risk, inflows/outflows, redemption qualities, and counterparty behavior that distinguish stablecoins from one another. With this in mind, what does this instability look like in markets?

The Coinmonks analysis, examining the deviation of six prominent stablecoins over a 60-day period at the end of 2018, showed results which undermine the general consensus that stablecoins are indeed stable. Each of the stablecoins showed deviating tendencies, shedding light on this increasingly prominent issue in the market. Although this is a short-period, and deviations are not overly significant, when we take a broader view of the stablecoin market, it becomes clear that volatility is ever-present.

As such, new and seasoned investors in the crypto market must decide wisely. They must consider whether the stability of their stablecoins is actually reliable and whether it can persist during turbulent times — a time when stability is highly valued. Where a stablecoin can remain relatively stable in a calm market, this is not a given when there is market turbulence, leading to volatility even in stablecoins.

A new era of stability

How can this be addressed? In a market that has fluctuated wildly over the past 18 months, it is high time for new stability standards, both to encourage market growth and to protect investors and the reputation of the space.

The new era of stability comes in the form of diversification through a basket-backed stablecoin. This is a system where the aggregation of different stablecoins would naturally adjust the basket composition in response to price fluctuations, thus maintaining the stability of the overarching basket coin.

It is this stability, in the face of inherent market price shifts, that makes the basket model more reliable than others. Such a coin representing several stablecoins means that volatility can be minimized, and a more stable stablecoin is created and maintained.

Ultimately, stablecoins will have an increasingly important role to play in widening the pool of crypto market participants. There are undeniable benefits to many stablecoin projects, though price stability is an issue that continues to hinder the sustained growth of the market. In order to support stablecoin adoption, the highest standards for it must be promoted. As such, providing a next generation stablecoin, that boasts lower volatility, is essential to entice institutional investors to the space.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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