Solving the volatility issue in cryptocurrencies
Introduction to stable tokens
One of the most criticized aspects of cryptocurrencies is the fact that they change in value dramatically over short periods of time. Imagine you bought $100 worth of an ICO’s token last week, just to find out that this week your tokens are worth less than $50? If this token is unlinked to anything but the utility of a product, that means that you lost 2x the value in a week. As a speculator you may not care, but as a user, it is alarming. This problem can potentially be solved through stable tokens.
At its core, stable tokens are an incredibly simple concept. Take the value of a currency, say the US Dollar (USD), and build a token that always has the same value as that currency. For example 1 Tether token = $1 USD. Stable tokens are poised to become one of the most important types of cryptocurrencies due to their purely utilitarian aspect.
Sounds great in theory, but the reality is, stable tokens are some of the most difficult-to-implement cryptocurrencies. This week we’ll do a quick dive into stable tokens, looking at the applications and challenges of this form of cryptocurrency.
Fiats, Commodity Currency and Stability
The biggest problem for stable tokens is the fact that no currency, not even the US dollar, has a completely stable value. The biggest factors affecting currency’s value are: The health of the economy, import and export of goods and services, and, inflation. So where do government currencies derive their value from?
Existing currencies that countries use can be broken down into two types:
- A fiat currency is a monetary unit whose value is backed by the government that issued it.
- A commodity-backed currency gets its value from a commodity, typically gold or silver. The more money the currency is worth, the more silver or gold the issuing government buys. While this is a simplistic explanation, it is the core feature of a commodity backed currency.
The US dollar used to be backed by gold, which is held in the federal reserve. But in 1971 President Nixon moved the dollar from a commodity backed currency to a fiat currency, and completely separated the value of gold from the US dollar. The results were a much lower purchasing power of the dollar, but an economy independent of gold supply and demand. This allowed for the government to control the value of the currency much better as explained below.
The drawback of commodity backed currency is that the supply is manipulated without oversight from the government. The benefit of a fiat currency is that the controlling government body can control one of the factors influencing currency stability: the total supply.
One example of supply influencing currency stability is the USD. Using it as a case study, we have seen how a commodity backed currency can be vulnerable to large price shocks. The first is when new gold reserves were uncovered, the second is when people/organizations would hoard large amounts of gold. We can see from the graph that as the world moved to much more globalized trade (which involved trading with currencies NOT backed by gold/silver), gold prices rose sharply while stocks and bonds were relatively stable, giving evidence for the above thesis.
Stable tokens and stabilization
A stable token is very similar to a commodity backed currency, their value can be tied to multiple different assets. Some stable tokens are backed by gold, silver, or even the US dollar. Since the US dollar is not as volatile as any ordinary cryptocurrency, it offers some measure of stability. Some tokens are quite literally buying gold as a collateral.
The most exciting use of a stable token is to act as a reserve currency in case something drastic happens in a cryptocurrency ecosystem that requires a relatively non-volatile token. For example if one were to implement a loan in a smart contract in Ethereum, one could technically insure this loan with a stable token. The mechanism of insurance is as follows: if the loaner does not repay in time, the interest can still be calculated based off of a relatively stable store of value. This allows us to use the decentralized nature of Ethereum to automate transactions instead of it going through a bank while still maintaining the ability to insure such a loan.
Stable tokens in action
However, the implementation of stable tokens requires some unique technical considerations, centered around how to control their supply..
The considerations involve establishing two tokens, the stable token and a regular cryptocurrency with the stable token acting like a bond and the regular cryptocurrency acting like a share.
A bond is a very stable store of value, while a share is a very volatile store of value. Any time the value of the cryptocurrency varies too much, the supply can be controlled by exchanging them for a certain amount of stable tokens. If the value falls too rapidly, the issuer of the tokens can purchase the stable token for a fixed number of cryptocurrency and then destroy the excess cryptocurrency (therefore increasing the value of each existing cryptotoken). If the value rises too rapidly the reverse happens and more cryptocurrency is generated.
This way the value of the stable token can be used to regulate the supply of another token to curtail heavy inflation or deflation. Since the stable token is fixed in value to a fiat currency, its is a simple matter to determine how much to exchange to keep a relatively fixed value.
Stable tokens offer a way to offset inherent volatility in today’s cryptocurrencies but as a trade-off do not allow for high investment returns like those of Ethereum and Bitcoin.
While some may argue this eventually needs to happen in order for cryptocurrencies to have widespread usage, they tend to lack some of the benefits from decentralization and are intrinsically tied to certain economies (like the US economy for US backed stable tokens).
There is no clear answer as to which approach is best, however there is hope that eventually a hybrid of stable tokens and regular cryptocurrencies can eventually have both the benefits of a decentralized currency and the stability of a regular fiat currency with appropriate financial controls.
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