In my opinion, stablecoins are one of the most interesting and promising aspects of cryptocurrency. They combine the benefits of cryptocurrency, such as decentralization and permissionless peer to peer exchange with the relative stability of fiat currencies.....or do they? Over the past month, even highly regarded stablecoins have experienced rapid swings in price. What do these price swings tell us about stablecoins, and is it possible to build a better stablecoin? The thesis of this article is that the concept of "stability" is a myth; a stablecoin that remains pegged to fiat will inherently be unstable with regards to purchasing power, and one that remains pegged to tangible assets will remain unstable with regards to fiat.
The Search for Stability
Throughout history, people have been looking for a medium of exchange that is also a stable store of value. In fact, if you look in any economics textbook, you will find that the most important definitions of money include "medium of exchange" and "store of value." The advantages of a stable medium of exchange go without saying. If the value of the currency is fluctuating up and down, long-term business planning, personal saving and even investing become exceptionally difficult because people have to take into account the profitability of their investments and business ventures and also whether the fluctuations in the value of the currency will negate the profits from their activities.
The need for a stable store of value is even more pronounced when we're talking about cryptocurrencies. At least in the US, cryptocurrency is treated as property. This means that every transaction made with cryptocurrency must be reported as either a gain or a loss on the underlying cryptocurrency asset. For example, let's suppose I received 1/100th of a Bitcoin at $60. A month later, I use that 1/100th of a Bitcoin to purchase a watch. Because the price of Bitcoin fluctuates (in relation to USD), I can't simply exchange my Bitcoin for the watch. Even if the merchant accepts Bitcoin as payment, I still have to calculate the change in value from the time I received the Bitcoin to the time that I sell the Bitcoin for the watch.
Even though I am directly trading 1/100 BTC for the watch, the IRS looks at as if I am selling my BTC for cash, and then using the cash to make the purchase. Suppose that my Bitcoin was worth $60 and now it is worth $65. I can't simply exchange that Bitcoin for the watch. I also have to pay tax on that $5 gain. That's just one simple transaction. Suppose that someone earns most of their income from crypto and also spends most of their income on cryptocurrency transactions. That's a lot of gains and losses to be reporting and figuring out, and it makes using traditional cryptos especially cumbersome for numerous day-to-day transactions. Trust me, I completely understand that none of this is Bitcoin's fault. It's a consequence of the tax code that I wish was different, but we still have to be aware that this burdensome reporting requirement discourages many people from using crypto.
Current Crypto Stablecoins
To an extent, stablecoins help solve this issue. If I am paid in USDC (collateralized by $1 USD) and then spend that USDC, I won't have a capital gain or loss as long as USDC remains perfectly pegged to the dollar. As a result, truly stable stable coins encourage mass adoption of crypto by (legally) reducing the compliance and tax requirements imposed by the government. However, maintaining a clear peg to the dollar may not always be feasible or desirable (more on that later). During the market meltdown earlier this month, the Dai stablecoin demonstrated erratic trading activity, consistently broke its $1 USD peg, and briefly touched $1.20 due to liquidations (Balakrishnan,2020).
On the surface, a difference of $0.20 might not seem like a big deal however, realize that this is over 20% of its value. Further, even the change of a few cents means that a stablecoin is no longer "stable" and will now trigger a taxable event just the same as if you were paying in ETH or BTC. Remember, the IRS considers the value of the cryptocurrency at the instant that you receive and spend it. So, even if DAI has a nominal $1 value, but you sell (or use in exchange) at $1.02 you have now incurred a capital gain and therefore have a taxable event. I don't mean to belabor the point, but it's critical that we understand that stablecoins lose many of their advantages if they don't maintain that stable peg to the fiat currency.
There are many different stable coins on the market today, but they differ in how they maintain their fiat peg. Dai, for example, uses a decentralized system of financial incentives (stability fees, DSR, arbitration) to gently guide the price towards one US dollar. By contrast, USDC is fully collateralized by actual US Dollars on a 1 to 1 basis. Each system has advantages and disadvantages. Dai is more decentralized and censorship resistant, but USDC, by way of its actual collateralization, seems to do a better job of holding the one to one peg with the US dollar.
The core the primary thesis of this paper is that we are asking stablecoins to simultaneously fulfill two different and yet incompatible roles. One one hand, stablecoins can more or less approximate the value of any fiat currency by using either a system of market-based incentives (Dai) or full fiat collateralization and one-to-one redeemability (USDC). From a tax perspective, this is understandable, but we have to remember that the added convenience of a fiat peg also means the added risk that inflation will devalue our purchasing power. Ironically, the more stable a crypto is in relation to fiat, the more unstable it could become with regards to actual purchasing power.
Purchasing Power Stability
I'm sure many of you have seen a graph similar to the one below in which the decline in purchasing power of the USD is charted from some period in the past to the present. Given that existing stable coins are pegged to the USD, it is almost inevitable that existing stablecoins will lose purchasing power.
So then, what is the solution? Is it possible to develop a truly stable stablecoin? Historically, gold has been one of the most stable assets and many fans of gold will point to the gold-to-suit ratio which shows that since Roman times, an ounce of gold has held its purchasing power and that an ounce of gold in Roman times could buy a nice suit while an ounce of gold today could still buy a nice suit. One of the most promising aspects of blockchain technology and cryptocurrency is the ability to tokenize physical assets.
Tokenizing physical gold would allow us to tie the value of a cryptocurrency to a relatively stable asset, and it would also eliminate many of the problems with physical gold such as either transport, divisibility, and security. The cryptocurrency Digix (DGX) he is currently doing just that. Each DGX token is backed by one gram of .9999 fine gold.
Commodity Backed Stable Coins
This shows great initiative, and is a modern solution to a modern problem, but it doesn't completely solve the problem either. Although gold has retained purchasing power over a longer time horizon, it still exhibits significant volatility in the short run. For example, gold reached a price of $1,876 back in 2011 and has still yet to rebound to that price. Although we may get longer-term stability by using a gold-backed crypto, we do have to accept more volatility in the short term.
One other consideration about using a tokenized form of commodity money is that the supply of and demand for commodities is in a constant state of flux. For now, gold remains scarce because of its limited supply and its difficulty of mining and refining, but we have no assurance that "space mining" or planetary exploration might someday make gold a fairly plentiful commodity. An oil-backed crypto could collapse in value as the world moves towards more renewable forms of energy.
How about a basket based cryptocurrency that is backed by many different forms of collateral such as oil, wheat, gold, BTC, USD, JPY, etc. The notion of a "commodity basket" form of money has been around for quite a while but faces the same drawback as the gold-backed money. Some commodities become cheaper to produce with time (think automated farming) while others become more scarce and valuable (depletion of natural resources). The more commodities that are included in a commodity basket, the more complex it becomes to manage the basket, and it also exposes the basket to more potential fluctuation in price.
So where does that leave us? Fiat pegged stable coins are tied to depreciating government-managed currencies. Gold-backed stablecoins are better in the long run (as long as gold isn't found on the moon), but have short-run volatility. Basket type currencies are unnecessarily complex and usually break down as the ratios between the prices of the underlying assets change.
The world is complex. Technology is constantly making some products cheaper while scarcity, disaster, and war make some products more expensive. Prices are not static in a dynamic economy. Even things such as changing consumer preferences increase or reduce demand for products and necessitate that businesses adjust their prices.
So, what is the point of this article? My point is that there are two mutually exclusive kinds of stability that can be applied to "stable coins". USDC and Dai have proven that we can develop a stablecoin that maintains a relatively close value in terms of its fiat counterpart, but we also have to accept that the underlying purchasing power of that peg is declining. On the flip side, forward-thinking cryptos, such as Digix, may have more stable purchasing power in the long run, but, due to government money printing and inflation, the cryptos that actually retain stable purchasing power will seem to be more unstable compared to fiat. Crypto can give us the best of both worlds, but it can't give us them both at the same time.
Balakrishnan, A. (2020, March 18). Community Bailouts in DeFi: Restoring the DAI Peg. Retrieved from https://cryptobriefing.com/community-bailouts-defi-restoring-dai-peg/
Circle. (n.d.). What is Circle USDC? Retrieved from https://support.usdc.circle.com/hc/en-us/articles/360015478051-What-is-Circle-USDC-
Digix. (n.d.). Owning Smart Gold Now. Retrieved from https://digix.global/#/ecosystem
Dollar Purchasing Power Graph: https://bmg-group.com/usd-purchasing-power-currency-in-circulation/