Could Stablecoin Solve the Volatility Problem?

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Stablecoin is a type of crypto currency that has an underlying asset and is accepted by some central banks. Stablecoin, which has been brought to the agenda and has been the subject of controversy with the digital central bank money studies and Facebook’s Diem project, is seen as a solution to many problems with its various advantages. So what is stablecoin and what does it offer users?

Great price volatility is not generally attributed to stable and reliable currencies. Bitcoin and other cryptocurrencies have generally experienced high price fluctuations since their emergence. One of the biggest criticisms directed to bitcoin, which ranks first in terms of market value, is price volatility. Although retail and institutional investors continue to invest by ignoring this situation, central banks or governments are not very convinced of this.

At this point, Stablecoin emerged with the goal of rescuing every person and institution, including investors, from the volatility problem. There are many stablecoins in the market such as USD Tether (USDT), True USD (TUSD), Paxos Standard (PAX), USD Coin (USDC), Binance USD (BUSD). These stablecoins use the US dollar as the underlying asset at a 1: 1 ratio. So what exactly are stablecoins that have such an opportunity to rise and value in the cryptocurrency industry?

What is Stablecoin?

A currency must be stable, not detrimental to users’ purchasing power, and have an inflation rate that encourages spending. The main purpose of the emergence of Stablecoins is to bring these features together with users in the digital environment. When these goals are combined with decentralization, a secure, anonymous and transparent currency is created. Stablecoins wish price stability with these strongly accepted features.

There are three types of stablecoins:

Fiat / commodity-based stablecoins: Fiat coins such as the US dollar are stablecoins that are the underlying assets. In addition to fiat coins, there are also commodity-based stablecoins such as gold, silver and oil. Tether (USDT), which is fixed to the US dollar, is one of the most well-known examples of this category.

Crypto-based stablecoins: These coins use the cryptocurrencies in the market as the underlying asset, and high value cryptocurrencies are generally preferred to adapt to volatility. MakerDAO, which is Stablecoin, falls under this category.

Non-underlying -algorithmic- stablecoins: Although these coins are not traded on any reserve asset base, they operate under various rules. They are processed in line with a mechanism that acts as a central bank and the state of the money is shaped in line with the decision. An example is Basecoin.

Most fiat and crypto-based stablecoins are traded in the market.

Can Stablecoin solve the volatility problem?

Most Stablecoins provide price stability by being fixed to the underlying asset. For the volatility problem, fiat / commodity-based stablecoins are fixed to the prices of commodities such as currencies controlled by central banks or gold. The volatility that can be seen in the underlying asset will be reflected in the stablecoin. However, currencies such as the dollar and euro under the control of government and central banks see lower price volatility compared to cryptocurrencies. With this feature, it is believed that stablecoins will be a solution to the high volatility problem seen in the crypto money market.

Technological advances or innovations such as fintech are among the driving forces that accelerate the emergence of stablecoins today. These coins can be used to facilitate payment methods domestically and internationally. PwC researchers John Shipman and George Samman explain what it takes to stabilize stablecoins:

“Fiat-backed stablecoins must be able to relate to traditional banking services. Due to the risks of trust, regulation and compliance, there are still a few barriers to large multinational banks from being able to offer fiat-backed stablecoin services. In this case, regional banks or smaller financial institutions have a job.

The release of Stablecoins with millions of dollars of support will affect the solvency and reveal credit risks. For this reason, these coins should be shaped according to traditional banking services to ensure stability in stablecoins.

However, there are studies that have been conducted on the fact that stablecoins cannot provide full price stability, so they cannot be a complete solution for volatility. In the article by Lai T. Hoang and Dirk G. Baur, it is stated that stablecoins are less volatile than bitcoin, but have higher volatility than commodities such as fiat money and gold. At the same time, stablecoins, which are highly preferred in the crypto money market, are accepted by users, although they do not provide the stability provided by fiat money. In this case, it is stated that rather than whether stablecoins are a solution to volatility, it is necessary to discuss whether these coins can be trusted or not.

European Central Bank’s Fabio Panetta said that stablecoins to be used in international payments could be cheaper and faster. However, stable coins that do not work, such as financial assets traded in banks, may be problematic in ensuring financial stability due to their data-based and potential cyber security vulnerabilities.

Why are stablecoins used instead of fiat money on exchanges?

According to the article by Richard K. Lyons and Ganesh Viswanath-Natraj, trading with fiat currencies on cryptocurrency exchanges may be more costly and in some cases the cost may increase due to high transaction volume. In addition, delays may occur in exchange transactions made with fiat money due to the effect of bank transfers. When a user wants to transfer funds from their bank account to the exchange, they may experience a few minutes delay. This is especially true during periods of high transaction volume and high volatility. Users may lose money or miss opportunities to make a profit due to delays.

Stablecoins used in exchanges have advantages in transaction fees. The pricing mechanism of fiat-based stablecoins has been modeled so that users can seize arbitrage opportunities. Accordingly, the difference between stablecoin and fiat money must be greater than arbitrage. Thus, transactions with stablecoin are stable in transactions as well as in price.

Fiat-based stablecoins gain a foothold in stock exchanges with their lower cost and compliance with real market conditions. These coins can function as a hedge, ensuring that users are protected in volatile cryptocurrency transactions. Thanks to the arbitrage mechanism of these coins, the price of stablecoins is fixed. For example, a user can buy and sell Tether at a 1: 1 ratio.

According to the researchers, decentralized stablecoins can work well, although they depend on price stability and demand-driven arbitration. As stablecoins are used more and more widely, new mechanisms will inevitably emerge to stabilize the price around the fixed currency. The development of arbitrage systems by financial institutions in the future may allow more secure and stable stablecoins to circulate.

Can Stablecoin replace fiat money?

Stablecoins were created mainly to solve the volatility problem and are often backed by a stable financial asset such as gold and dollars. Stable coins can be used to solve two basic problems with fiat coins. Among these two problems, it is difficult to transfer large amounts of money in international transactions and the difficulty of splitting fiat money into small units.

  • Stablecoins can be transferred to anywhere in the world in seconds.
  • Stablecoins can be divided into very small units.

These two advantages make stablecoins more exclusive than fiat coins.

“The volatility seen in cryptocurrencies makes them attractive to speculators and traders rather than those who want to use them as a means of payment in daily life. If the value of a cryptocurrency suddenly and drastically drops, users can suffer huge losses, leading to currency risk. ”

Stability of a currency positively affects its purchasing power. A stable currency can be measured against any underlying asset or a basket of assets. In addition, these currencies enable consumers to purchase the same products and services on the same day or the next day for approximately the same value. This is reassuring for both users and economies.

Due to these characteristics of fiat coins, stablecoins should offer the opportunity to be used easily according to the underlying asset. A stablecoin, whose prices are determined by fiat currencies controlled by banks and shaped according to inflation in the country of affiliation, can replace fiat money.

Although there is no development that can radically solve the problems in the blockchain network or cryptocurrencies, these sectors will offer more benefits to users with the development of stablecoins and the emergence of new technologies.

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