In 1971, President Richard Nixon officially stopped selling gold to foreign official holders of dollars, bringing about an end to the gold exchange standard in the US. Since then, the economy has handled strictly fiat money — money that must be accepted as a means of payment purely because the Government says so. The transition to fiat money was fiercely disputed and debating the merits and pitfalls of commodity-backed currencies continues today. In the booming fintech world, the age-old argument has resurfaced. Should our new and innovative cryptocurrencies, specifically stablecoins, be backed by a fixed rate of a commodity such as gold, or cold, hard cash? What are the advantages of both?
An Introduction to Stablecoins
Seen as a solution to volatility in markets, stablecoins aim to offer all the benefits of cryptocurrencies, coupled with reliability and a balanced price. Offering an on-ramp into the crypto world that a retail user can easily depend on and comprehend, stablecoins can break ground for wider acceptance and adoption of digital currency, and are already making this a reality. For example, in February, JP Morgan created and successfully tested a digital coin representing a fiat currency, the JPMCoin.
Some stablecoins are collateralized, while others are pegged. Some are redeemable, while others are not. What is interesting is how the wide range of coins achieve stability— this can vary widely — according to the State of Stablecoins Report 2019, there are over 50 different stablecoins on the market. In its simplest form, a stablecoin is a digital coin, which represents a physical coin. However, stablecoins are not limited to fiat-money collateralization. In reality, stablecoins can be backed by many types of assets and even commodities such as diamonds, oil, gold, silver and bananas!
The Fiat Solution
When the stablecoin is ‘fiat-backed’, every single stablecoin must be linked to one corresponding unit of fiat currency sitting in a bank account — one euro can equal one stablecoin, for example. Currently, fiat-backed stablecoins are the most common use of stablecoins for crypto traders to move between investments easily, without unnecessary instability.
The fiat-backed structure is easy to understand and straightforward. Fiat-coins are the most redeemable stablecoin in the marketplace. Off-ramping fiat backed stablecoins is easy and avoids the more arduous process of exchanging stablecoins to a commodity and back to fiat. The major fiat-backed stablecoins such as Tether offer this.
From an inflationary perspective, given that fiat currencies are legally backed by the government, in theory the underlying prices won’t fluctuate too much as the Government has control over monetary policy. However, one of the great arguments for the gold standard, where the economic unit of account is based on a fixed quantity of the commodity gold, is that trust is not given to central bankers — politics and monetary policy are divorced. Under the gold standard, the government cannot print more money than they have gold. Proponents of the gold standard continue to make this point today and it is particularly relevant while countries around the world continue to stagnate under government-imposed hyperinflation.
In addition to this, fiat backed stablecoins tend to be very centralized in nature. Problems have arisen in the past where centralized accounts have failed to reveal audits of their reserves which prove the backing of their stablecoins. Single points of failure and bankruptcy are issues of concern with centralized institutions holding collateral. This structure contradicts the decentralized nature of cryptocurrencies, which is a downfall of fiat stablecoins that has been highlighted.
Commodity-collateralized stablecoins are (wholly or partly) ‘backed’ by a commodity, such as gold, which acts as collateral. For commodity backed coins, one coin would be worth one predetermined unit — 1 gram of gold equals 1 coin, for example. Similarly, this commodity unit must be stored by some centralized party which is the guarantor should the token holder desire to redeem their coin. Precious metals such as gold have often been viewed as a good store of value since they retain value quite well relative to other assets. During recession times, investors pile into gold, while other assets tend to reduce more drastically in value.
Commodity-backed stablecoin holders essentially hold a tangible asset that has real value — something the majority of cryptocurrencies do not have. While commodities manage to offer this benefit, they are very susceptible to price shocks. While these commodities even have the potential to appreciate in value over time, which gives increased incentive for people to purchase these coins, they are unreliable in price in comparison to USD for example. For stablecoins, this is their main sell, and it’s hard to look past that attribute.
There can be redeemability issues with commodity-backed stablecoins. Commodities such as oil might be held in reserve to back the currency, holders might not actually have a claim to the commodity, but can only redeem at a fixed rate against the commodity. This redeemability issue is particularly worrying for investors when there are question marks over the reserves in an account, and when the market place is so centralized.
By utilizing distributed ledger technology, stablecoins can offer speed and ease in accessing other cryptocurrencies and settling payments. Depending on the redeemability and collateralization characteristics, fiat and commodity backed stablecoins can offer a unique safehaven against volatility, both with their respective advantages and setbacks. Fiat-backed cryptocurrencies such as Tether, despite claiming to have a 1:1 reserve ratio, have been criticized for lacking clarity, while a gold-backed stablecoin such as USDVault, is fully collateralized and their accounts are transparently audited to make sure the stated value of gold actually exists. Similarly, the CryptoFranc (XCHF) stablecoin is fully backed by physical Swiss Franc banknotes with a 1:1 ratio. It is very difficult to determine which is a better mechanism to achieve stability but what we do know is this — the race for a truly decentralized, stable and transparent cryptocurrency is alive and well, and this will be a welcome solution to many of the problems inherent in the market currently.