The volatility of Bitcoin limits its transactional utility so the current consensus is that Bitcoin is most useful as a store of value, a more easily-transferred version of gold. In order for a digital currency to be more ideally suited to daily use, its value needs to be stable over time. Enter Stablecoins.
It's a story that is now part of BitCoin folklore: In 2010, Laszlo Hanyecz paid 10,000 BTC for two Domino's pizzas. At the time, each BitCoin token was worth a fraction of a penny, so the transaction made sense...but at today's prices, Laszlo paid almost $100 million dollars for two subpar pizzas.
The story is an extreme example, but it illustrates why the volatility of Bitcoin limits its transactional utility. The current consensus is that Bitcoin is most useful as a store of value, a more easily-transferred version of gold.
In order for a digital currency to be more ideally suited to daily use, its value needs to be stable over time. Enter Stablecoins.
A Stablecoin limits volatility in one of two ways: by backing the currency with a more stable asset or through centralized controls on the monetary supply.
Stablecoins are commonly backed by government currency. Tether and USDC (an offering from Coinbase) are backed by the US Dollar. Since both currencies maintain a 1:1 peg to the dollar, they are essentially digital representations of the US Dollar that leverage the blockchain. This may sound familiar to readers of my previous posts. Stablecoins share a lot in common with Central Bank Digital Currency, and I encourage you to read my piece about current efforts around the world to produce digital versions of government currency. Crypto startups are not the only ones experimenting with these kinds of coins; JP Morgan recently released their own version, the JPM Coin.
It is also possible to back Stablecoins with other forms of cryptocurrency. MakerDao leverages the Ethereum blockchain to allow users to effectively borrow Ether from themselves, in the form of a Stablecoin called Dai. This has the advantage of keeping the currency more ‘crypto-native’, since both the Stablecoin and its backing asset live on the blockchain. However, it also means that the Stablecoin is backed by a much more volatile asset than the US Dollar. To deal with the additional volatility, the system requires that $1 of the Dai Stablecoin is backed by more than $1 of Ether, which means that users of this coin may not be as liquid as they’d like. .The need to over-collateralize hasn't seemed to prevent the success of the coin; 2.3 million Ether tokens have been locked into Dai tokens, representing about 2% of the overall supply.
Stablecoins are a compromise. In order to limit volatility, some of the inherent benefits of cryptocurrency get sacrificed. By tying a token to a government currency, the token is now subject to inflation when more of that currency gets printed. Stablecoins backed by cryptocurrency must be over-collateralized, which ties up equity and limits transactional power. Other forms of Stablecoins, such as those with a flexible monetary supply, place a lot of power in the hands of a centralized authority that has much less accountability than the central government. Finally, asset-backed stablecoins require that the user trusts a central authority (like Coinbase or Tether) to actually own the dollars, crypto, gold, or other asset they need to stabilize their currency.