Investors seeking cryptocurrencies that remain stable in price pursue stablecoins. At present, bitcoin’s volatility discourages merchants from accepting them for payment. Stablecoins solve this problem, as they are often pegged against the US dollar, basket of fiat currencies, or even the consumer price index. Thus, a merchant paid $5000 in bitcoin can immediately trade it in for a stablecoin to protect themselves from loss. In essence, they serve as a hedge against general cryptocurrency volatility.
As a result, the stablecoin Tether (USDT), which is pegged to the US dollar, has the second highest trading volume outside of Bitcoin. Tether enables short-term crypto traders to forego the need for transferring funds into a bank account (saving significant time in the process). Investors can thus feel confident that their investment’s value will be preserved
Handling Black Swan Events
In The Black Swan: The Impact of The Highly Improbable, author Nassim Taleb notes that financial forecasters tend to underestimate both the frequency and effects of rare events. So how might how stablecoins react when faced with a sudden market crash? Will they hold up or collapse and drag the entire cryptocurrency industry down with them? In The Strengths & Weaknesses of Stablecoins, the MakerDao stablecoin team suggests that the answer lies in whether they exist as IOUs, Seignorage Shares, or On-Chain Collagorization.
In its most fundamental form, traditional
However, what happens when a black swan event occurs? What consequences follow if investors begin to have little confidence in the
In contrast, seigniorage share stablecoins rely upon keeping the price stable by matching supply with demand. Thus, as demand rises, a stablecoin can meet this demand by issuing new coins. If demand drops, the stablecoin supply must contract. Consequently, these stablecoins “use a bond issuance system to incentivize users to “turn in” their coins for a bond that might provide a return of stablecoins issued in the future” (Medium).
However, operating in this way is predicated on the belief that the coin will soon appreciate in value again (which may not be the case). More importantly, if a black swan event hits, no collateral exists to back up the
With on-chain collateralization, an on-chain system issues coins “relative to the value of the underlying collateral. As explained in the article above,
This process is similar to an escrow. Since the collateral backs the stablecoin, coin stability links to the total value of the underlying assets. If those assets, collectively as a portfolio, are stable, the ability for the portfolio to quickly change in value reduces, further increasing stability.
In a black swan event, these coins “generally rely on allowing flexibility in the price of the underlying asset, or exchanging the
A Closer Look
Do crypto-collateralized coins offer any protection against a future cryptocurrency death spiral? MakerDAO argues that its Dai token relies upon “a diverse array of supporting assets.” Though that only assumes that those assets won’t fall as well (which remains highly likely given their positive covariance).
Consider what might happen to MakerDA in such an event. As one Reddit observer notes,
when ETH prices go down, MakerDAO starts liquidating ETH collateral in anticipation so the value of Ether backing Dai doesn’t go below 1:1. In mild price
downturnsthis is fine. But black swan crashes happen fast and they don’t give you time to recover. In market meltdowns, selling ETH to liquidate Dai would actually contribute to driving the price down faster. MakerDAO has a contingency plan for this. The community of MakerDAO MKR token holders will bailout Dai as a buyer of last resort. Not to underestimate the MakerDAO community, but I really doubt any such community can stand against a torrent of sell-orders in a market crash.
An Alternative Route
The truth is, no coin – or even monetary system – will easily survive a worldwide black swan event (say, a limited nuclear war). While MakerDAO holders are currently able to bail out their Dai if its collateral crashes, that won’t be the case if such a model goes large scale. So, what might a plausible future where fiat still plays a viable role?
Colton Robtoy suggests that
However, my guess is that cryptocurrency investors won’t be willing to tie themselves so tightly to fiat in the near future. Unless a black swan event does occur, jolting investors back toward that direction is some new semblance.