Understanding Stablecoins

With stablecoins like Tether and Gemini making news recently, it is worth exploring what the term “stablecoin” means, and how it might impact businesses and consumers in the coming years.

For starters, a stablecoin is a type of cryptocurrency that is designed to mitigate the short-term volatility that most cryptocurrencies are known for. Stablecoins are typically pegged to and collateralized by fiat currencies in a fixed ratio, and the most popular currencies are the U.S. dollar, euro, and Swiss franc. Stablecoins can also be pegged to and backed by exchange-traded commodities like gold, other cryptocurrencies, or decentralized autonomous organizations (DAOs, which are not collateralized), but these alternatives are not necessarily as effective at combatting volatility.

There are well over a dozen stablecoins in existence, and the list continues to grow. It includes:  Basis, BitUSD, Dai, Digix, Gemini Dollar, Paxos Standard, RockZ, Steem, Tether, TrueUSD, and USD//Coin. In late 2018, CoinMarketCap reported that Tether had over 87% of the stablecoin market capitalization, and over 98% of the total volume of all stablecoins traded within the 24 hours before the data was published. See below for a deeper dive on Tether, which was originally issued under the name “Realcoin” in October 2014.           

So why exactly are stablecoins noteworthy? And why is volatility a “problem” that needs to be solved? (Many investors would say that high volatility is desirable – more risk, more reward). The answer lies in cryptocurrency’s role as a currency. So long as cryptocurrency prices are fluctuating on a daily or even hourly basis, those cryptocurrencies will have a number of impediments to adoption as a traditional currency substitute.

Think about it: if a business wants to accept payment in cryptocurrency, what happens when a customer wants to return a product? If the customer paid the equivalent of $1000 in Bitcoin for the product, but the value of the same amount of Bitcoin has now increased to $1,500 or decreased to $500, what amount of Bitcoin should the customer receive upon returning the product? How should volatility risk be allocated? Should the business hold on to the Bitcoin payment as an investment and/or use it to pay employees and suppliers? Should the business exchange it for fiat currency immediately? These are the questions that arise (at least in part) because of the volatile nature of cryptocurrencies, that may be answered (at least in part) by the use of a stablecoin.

Stablecoins, because they (ostensibly) lack the volatility associated with typical cryptocurrencies, may be a more suitable medium of exchange and store of value for the general public. They operate (again, ostensibly) like traditional currencies, but with the benefits of a cryptocurrency: cryptographic security, immutability, accessibility, lower fees, and speedy transactions, among other things. Tyler Winklevoss, one of the founders and CEO of the company that issues Gemini Dollars, called stablecoins “the missing link between the traditional banking system and the crypto economy.” Sounds like a perfect method of payment for retailers, no?

Well, almost. Even if a stablecoin acts like a currency, it will still be treated as property for federal tax purposes, and as a commodity for purposes of regulation by the Commodity Futures Trading Commission (CFTC), unless Congress provides a legislative solution or one of the relevant agencies changes its regulations or guidance.

This means that stablecoins will not be able to solve certain cryptocurrency “problems” – including onerous IRS reporting and recordkeeping requirements, and capital gains taxes for any proceeds gained upon the exchange of a stablecoin for traditional currency (though in theory there should be no capital gains or losses if a stablecoin is exchanged for the currency to which it is pegged).

And about that peg – exactly how accurate is it? Take Tether, for example. The most popular and earliest stablecoin is designed to always be worth $1.00, and yet it dipped to $0.88 in October of last year. Although not entirely clear, it appears that investors panicked about the accuracy of Tether’s purported U.S. dollar reserves and access to banking services, and exchanged Tether in droves for Bitcoin, which then drove up the price of Bitcoin and raised price manipulation concerns that were then investigated by the CFTC. Despite Tether’s lack of parity with the dollar, its 2016 white paper states that Tether holders can redeem their stablecoin holdings for U.S. dollars directly with the company, which (supposedly) maintains one U.S. dollar for each one Tether. It is unclear whether Tether will retain its market share, particularly in light of these concerns and the market being flooded with new types of stablecoins.

What do you think – will the advent of stablecoins lead more businesses to accept cryptocurrency payments? Will Tether maintain its market lead? In my opinion: this is an area to watch closely in 2019. I expect stablecoin usage to become more and more prevalent, particularly as businesses weigh their payment options.

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