For many users, stablecoins have carried with them a long promised function of utility to the digital currency world. This is a magical key that has ultimately unlocked virtual assets, bringing in numerous new users and also billions of dollars. While this idea was true in 2020, there are also many stablecoins risks involved in transferring all your money into stablecoins. As with all the issues in life, there isn’t a cure to solve all risks and worries, especially when it is about a new form of financial instrument, despite the fact of how stable the coin is.
Stablecoins Risks That Can’t Be Ignored
After all, the idea of stablecoin is not technically a new phenomenon. While the digital features that they hold are a breath of fresh air for the languishing world of finance, most of them are nothing but a currency that is backed up by fiat and is held on digital wallets or mobile phones. It is in this respect that we will be highlighting some of the stablecoins risks that cannot be ignored if you are in the digital currency world. Here is a list of stablecoin risks.
The Issue With Centralization
This is possibly among the highest stablecoins risks that is presently associated with the use of these cryptos, and something that goes wholly against the common ethos of what the technology of blockchain is supposed to be. As the saying goes, blockchain was created to fully decentralize the data age so that no single party has full dominance or control over any dimension of our technological space. It was presumed to bring with it a section of immutability and transparency that technology similar to the internet simply does not offer. For the most section, this has held real. Transactions are completely immutable and transparent on public blockchains. And so, they are not restrained, and cannot be changed by a single party.
Sadly, for stablecoins, this is not true, as often there is a single body that operates and controls the stablecoin with off-chain deals and transactions. Take USDT for instance, the most broadly traded and best stablecoin in the industry. In reality, USDT is dominated by a company known as Tether which functions just as any other profit maximizing entity does, in its own best interest.
Tether dominates both the distribution and supply rate of USDT and is not answerable to outsiders for how they wish to manipulate the supply in the market. Being a centrally backed asset it interferes with the essence of blockchain technology, even though not technically. This scarcity in decentralization poses evident risks to anyone who is holding USDT since a fall of Tether for any reason also then implies a collapse in USDT, probably sending the price of your digital USD crashing to zero. The best way to fight this is probably the same way most investment managers would suggest you do, via assets diversification. By diversifying your range of stablecoins, at the very least you can safeguard yourself against a single collapse of an entity that is in charge of the asset.
Lack Of Transparency
While on the topic of Tether and USDT, we need to discuss transparency, or rather the scarcity thereof. While Tether is not the only entity that has faced issues on auditing in the past, it is possibly the most renowned example as it was charged with using more than $800 million of its funds to hide a big Bitfinex Loss. Further inquiries unveiled that Tether at one point only had nearly 75% of its issued funds backed by USD and with the rest being collateralized by a series of assets that included Bitcoin. This urged a strong rebuke by governing agencies, demanding why Tether would use a fluctuating currency like Bitcoin as collateral when the complete point of designing USDT was to safeguard against the fluctuations of digital currencies like BTC.
Now if you wonder is Bitcoin a stablecoin, the answer is clearly no. It is a decentralized network and is not backed by any kind of fiat currency. Not only is this matter fair, but it is also incredibly crucial. As we spoke about above, Tether does not owe anyone decentralization or transparency, but the price of its token, 1 USDT is only backed to 1 USD as people think Tether really holds the fiat currency locked away somewhere safe. But, if Tether really only has 76 cents among 1 USD stored up in a vault, then the coin is not really pegged to 1 USD and the holders of this token will quickly pull out all their USDT transferring its liquidity down a cliff and possibly collapsing its value.
For the average user, this is not really something they themselves can safeguard via diversification. Rather, the only way to fight this is via a system wide protocols and audits that push any stablecoin entity to prove their protected assets genuinely match the portion of supply they have released to the market. Sadly, this is something much more difficult in practice than in theory.
Economic Inflation And Instability Issues
This is another very important stablecoins risk that should be considered. Here is the concept of being pegged to fiat currencies. You are at the urge of fiat currencies and therefore the central governing entities behind them. As we have witnessed throughout history, that the governing entities are not always the most financially well-informed individuals when making any financial decisions, often creating huge national inflation and crashing the local currency.
Simply placed, there is a cause why most stablecoins are backed to high performing and stable currencies like the EUR or the USD as condemned to the Argentinian Peso. This is because the USD, and by expansion the US Treasury, has an aura of stability that has resisted at least the last half-century. If stablecoins were offered in a much worse operated economic fiat currency, no one would exchange their cash for it, which implies that the stablecoin would carry no liquidity and hence no value. However, this also keeps your stablecoins at risk from global black swan incidents, or sudden economic decline which can lead to inflation in that economy.
Is the USD likely to abruptly crash drastically? No, odds are that is highly improbable. But is it impossible? No, it certainly is possible. In a substitute reality where the US-China trade war heightens, and the pandemic prevails to ravage its economy, we might have witnessed a very original scenario of hyper-inflation in the U.S. So while this wouldn’t impact the portion of stablecoins that you carry in your wallet, it would affect the real buying potential you have with them, which implies finally, it impacts your wealth. This idea is one of the main reasons why people have shifted their fiat currencies to digital variants like stablecoins, but it doesn’t completely safeguard them from larger, more macroeconomic issues resulting in economic inflation and instability. To be frank, there is not really much that the users can do about this, other than coming back to a life of trading more useful, tangible assets like chickens or sheep or.
It’s Difficult To Maintain A Perfect Peg Algorithmically
Let us talk about rare stablecoins risks. A lesser renowned type of stablecoin is the one that is backed algorithmically, also termed as seigniorage. These types of stablecoins are not pegged by any form of collateral, whether that is a bowl of digital ones like the DAI stablecoin or traditional fiat like USDT. In place of that, they depend on an algorithm that purchases up supply or manufactures is based on the fluctuations in the market. How it operates is as follows.
Let us assumethe value of our coin declines to $0.80, implying that supply in the industry is more than demand. The algorithm would estimate just precisely how much more supply is ideal, and purchase up that amount to get the price back up to $1 precisely. This sounds good in theory, having an algorithm that is powered by AI to always make sure stability in a wink of an eye, but there are underlying problems also.
For beginners, this does not work at the time of black swan like events when there is an abrupt decline in demand. Let us say that some dramatic event took place, and more than 80% of users pull their cash from this stablecoin. The algorithm would then be informed to purchase up enough supply to get the price back up to $1, but what takes place if there is not any future demand for this stablecoin anymore because of the drastic event? Algorithmically pegged stablecoins mainly depend on the future demand of their asset to continuously increase and decrease in supply to stay ideal, but if there is not a future demand, the model collapses. Above that, these algorithms are often incredibly complicated and tough to execute along with being a brand spanking latest technology, making them far too undependable to gain the broad trust of the public at this moment.
It is tough to debate with the astronomical increase witnessed by stablecoins in the last 12 months, and in no way are we recommending that this is just a bubble or flash in the pan. However, it is crucial to remain even rigid in these situations and evaluate that there are stablecoins risks that are involved with anything, especially digital coins even if they are highly stable. This vital space is only going to develop, rise, and piece into new areas at the speed of light. This is thrilling, and for many, this is just what the blockchain space requires. The US recently made stablecoin regulations, and other nations dealing with digital currencies should also consider it.