The high volatility in the price of bitcoin is often cited as an obstacle to its wider adoption in trade. “Yes, all very smart, this bitcoin thing, but who wants to use a currency that fluctuates in value with tens of percents overnight? The amount that buys me a pizza today might buy me just two slices tomorrow, or two pizzas, nobody knows.” What if it were possible to build a cryptocurrency with a stable price? That would solve all problems, wouldn’t it? And so began the quest for the stablecoin, the Holy Grail of Cryptoland in the eyes of some. Alas, a stablecoin is a bad idea on many levels.
First of all, there is not really a problem to be solved. A trader incurs a currency risk when he enters into a contract in which his costs are denominated in one currency and his benefits in another, and there is a time gap between the two. But there are almost no economic transactions today where either costs or benefits are denominated in bitcoin. The most noticeable exception being bitcoin mining. In other words: in trade, bitcoin is used as a medium of exchange, not as a unit of account. I can buy bitcoins with euros, pay my Chinese supplier with them, and he can sell them for yuan, all in a time frame of a couple of hours at most. All the currency risk in our transaction is euro vs yuan, and has nothing to do with bitcoin.
The problem that a naive stablecoin like Tether really solves is not currency risk, but liquidity. Our banks don’t let us buy or sell bitcoins easily, so for frequent traders it is much more convenient to hold a balance in bitcoins, either in a wallet or on an exchange. And then, of course, exchange rate fluctuations do pose a problem. Tether makes your normal dollars liquid (i.e. easily exchangeable for bitcoin), without the currency risk that is involved with holding actual bitcoin, because Tether is pegged to the dollar.
Reinventing the banknote
I call Tether a naive stablecoin because it is not really an independent currency. It is a token that is exchangeable for US dollars only because the tokens are fully backed by a stack of US dollars. In essence, this is a modern reinvention of the banknote. Banknotes used to be notes issued by banks, hence the name. Not real money, but a promise to pay the bearer the denomination of the note in real money.
This is the second problem I have with stablecoins. Executed in this way, essentially as a full reserve bank, getting rid of the currency risk introduces all sorts of other risks, starting with a counterparty risk (can I get my real dollars back when I want to?). Bitcoin was, of course, explicitly designed as digital money without the need for a trusted third party. Trust, in bitcoin, is not based on a governing body, a lender of last resort or arrangements between banks and states. Instead, it is based on code, mathematics, cryptography, and game theory. With tether, there is again a whole range of third parties that can censor my transactions or even seize my funds: the Tether-organization, the exchange where I trade my tether for bitcoin, the bank where Tether holds its stack of dollars, the central bank supervising that bank — I think most people will be better of just using the commercial banking system.
External versus internal stability
Of course I am not the first to spot this, and there have been attempts to build a more sophisticated stablecoin; one that is not dependent on banks and fiat money. This brand of stablecoins tries to algorithmically mimic a central bank. Basecoin is probably the best-known example. If the exchange rate starts to rise, the “central bank” will increase supply and sell extra stablecoins. Conversely, when the exchange rate starts to fall it will take stablecoins out of circulation by buying them back. The first part, printing money, is never a problem. The second part, shrinking the money supply, is more difficult. Basecoins solution is the introduction of another token, which is basically a Basecoin-denominated bond. When the demand for Basecoin falls and the price begins to slump, the algorithm forces Basecoin holders to exchange a fraction of their coins for bonds. This works in the short term. But the contraction is only temporary: the bond is after all a promise to expand the money supply in the future. A prolonged or very sharp decrease in demand will send the system into a “death spiral”.
The mistake here, and my third problem with stablecoins, is that selling bonds to decrease the money supply is an instrument real central banks use to safeguard the internal stability of a currency, i.e. the inflation rate. To provide external stability, i.e. fight fluctuations in the exchange rate, one needs to intervene in the foreign exchange markets — and for that, one needs a pile of foreign currency, not “domestic” bonds. Ask any Latin American government.
So there we are. When we are talking about stablecoins, we should be talking about internal, not external, stability. A stable bitcoin would mean a bitcoin that holds its value vis a vis a basket of goods and services that are typically bought with bitcoin. But there is, of course, no way of creating such a bitcoin consumer price index. Apart from the lack of data, bitcoin is not a national currency. There are hardly any bitcoin-denominated contracts around. As I said earlier: it is only a medium of exchange, not a unit of account. So fluctuations in the bitcoin value of a basket of goods and services would mainly reflect exchange rate fluctuations anyway.
If we ever get to a point where people have bitcoin-denominated employment contracts, mortgages and electricity bills, then it will make sense to start thinking about things like the rate of inflation and the optimal money supply. Before that, “stablecoin” means stable in terms of the world’s main fiat currencies. That cannot be achieved without making use of the very institutions bitcoin promised to liberate us from. In which case it is probably much, much easier and less risky to just use the traditional banking system.