Crypto Dip-Toe – Part 7: Stable on the Label

“Flexibility is the key to stability.” – Coach John Wooden

Volatility is often cited as a significant challenge for cryptocurrencies – and rightly so! If crypto eventually plays a role as day-to-day money in the future (as one potential use case), it will need to be stable. Some would call the recent events in the crypto space a drawdown, and others may deem it a full-blown bloodbath. I’ll let you decide, but first, we need to understand some more crypto basics before making sense of what happened. As foreshadowed last time, today we’ll learn more about Stablecoins and how those fit into the ongoing crypto conversation. And – to Coach Wooden’s point – perhaps flexibility is a necessary means to that stability. Bend, don’t break. Here we go!

Blowing up

Rapid inflation is awesome when it comes to getting your pool raft or bike tires ready for summer, but it can also be bad for the economy and many parts of your portfolio. And, yes, these are entirely different types of inflation (airflow vs. purchasing power), but it doesn’t make either point untrue.

On Friday, June 10th, the 40-year-high consumer price index (CPI) data – indicating that prices increased year-over-year by 8.6% – put additional pressure on equity and bond markets. And, if you’ve been following markets this year, you may have also guessed that crypto was even more adversely affected by that headline. Bitcoin is now down about 70% from the November 2021 highs (from ~$70,000 to ~$21,000) and has thus far been in freefall since the recent CPI print (from ~$31k to ~$21k, or over 30% from 6/10 thru 6/14/22); other cryptocurrencies have fared even worse. Essentially, more inflation means the Fed will have to raise interest rates more quickly and more significantly than previously expected. And higher rates generally mean that more speculative assets are less valuable than they were in the lower-rate “easy money” environment of the recent past (or, perhaps more accurately, the “value” of these assets has been forced to adjust to reality).

Tech is tech

So, what about the limited supply of Bitcoin we learned about in Part 5 of this series? Is that helping with this inflation situation? In the words of Rocky Balboa, “I say absolutely no.” In fact, what is very clear is that – at least in the short term, as compared to where BTC has been valued during years of lower rates – it has been a very poor inflation hedge (declining in value while rates are rising). Could that change over the long term? Of course, but no one knows that now. Whatever the value ultimately is, I believe it will be more related to long-term supply and demand than the “inflation scare of 2022.”

Along those lines, this quote from Paul Brodsky, of PostModern Partners, is interesting: “The big thing crypto has going for it today, ironically, is that blockchains don’t yet work at scale. If they did, then investors would be able to value crypto assets based on internal fundamentals. Instead, crypto prices today are priced purely on speculation that they will someday gain market share from fiat currencies and from conventional businesses vulnerable to losing market share from decentralization (Source: PostModern Partners Monthly Report: May 2022).” The idea of deriving current valuation purely on speculation about future value sounds a lot like some of the tech-stock space, right? That shouldn’t be surprising, as crypto is, well, a new technology.

Stablecoins, anyone?

In light of the general rollercoaster that is crypto these days, it’s a perfect time for a quick tutorial on stablecoins – our intended topic du jour. How’s that for coincidence? According to Coinbase, “a stablecoin is a digital currency that is pegged to a ‘stable’ reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin.”

The idea is to have the best of both worlds: the flexibility and potential advancements of crypto/blockchain technology combined with the relative stability of existing fiat currencies (or other widely-accepted commodities). As long as such a coin can fulfill its promise of stability, then standard “money things” – like trading, saving, and global money transfers – can be easily done WITHOUT needing to involve a bank or even a bank account.

How do they work?

This Cryptopedia article will allow you to dive deeper into this subject (if desired), but let’s cover the basics. First, stablecoins need a mechanism that pegs them to their intended underlying currency or commodity. For example, if a given stablecoin is supposed to have the same value as a US dollar (aka “being pegged to the US dollar”), there must be a reliable way to accomplish this. What also may jump out at you is that stablecoins are inherently derivatives, as they derive their value from something else; thus, the method of deriving said value is of utmost importance.

The most straightforward way to achieve stable value is to back a stablecoin token directly with the desired underlying asset. Sticking with our US dollar example, if I hold one dollar in a safe place – like an insured account at a trusted financial institution – for each token issued (i.e., a 1:1 ratio), that should create a solid argument for each token having the same value as a dollar. And in fact, the article goes on to say that “the most popular stablecoins are backed 1:1 by fiat currency…fiat collateral remains in reserve with a central issuer or financial institution, and must remain proportionate to the number of stablecoin tokens in circulation.”

Okay. That makes sense, but how about these?

The above example is a fiat-backed token, but stablecoins can also be backed by crypto, commodities, or an algorithm. Here’s a summary of each type – in order of my perceived complexity – so that we can begin to appreciate some of the nuances (again, thanks to Cryptopedia on the below quotes):

  • Commodity-backed: here, you can have tokens backed by “physical assets like precious metals, oil, and real estate,” so it’s conceptually still pretty straightforward. Some may even allow redemption of stablecoins for the underlying physical commodity at certain thresholds (reminds me of certain ETFs or closed-end funds with similar features). As long as the operational elements are well-managed, then it would make sense that these types of tokens should trade in line with the property/commodities they represent (very similar idea to the US dollar token example).
  • Crypto-backed: here’s where things get fun. Now we’re exiting the world of direct representation for one that is genuinely derivative (this conversation is starting to feel a whole lot riskier). In this example, I have my same US dollar token, BUT – instead of being collateralized by actual US dollars – it’s backed by a highly volatile cryptocurrency in an arrangement called a collateralized debt position (CDP). [Aside: Yes, that’s only one word or letter different from the collateralized debt obligations (CDOs) of 2008-financial-crisis infamy.] Not to worry (that’s sarcasm, just so we’re clear), as “crypto-collateralized stablecoins are also over collateralized to buffer against price fluctuations in the required cryptocurrency collateral asset.” The arrangement works very much like borrowing on margin against a stock portfolio. If the value of underlying collateral declines enough, it will be sold to maintain the integrity of the stablecoin. I guess that process can work, as long as there’s enough liquidity to sell the crypto at prices needed to do so – but I could probably draw up a scenario where this may not work so well (did I mention there’s been a 30%+ crypto freefall over the past few days?).
  • Algorithmic: This is utterly fascinating because it’s where the collateral is abandoned altogether (yikes!). Instead, the “system will reduce the number of tokens in circulation when the market price falls below the price of the fiat currency it tracks. Alternatively, if the price of the token exceeds the price of the fiat currency it tracks, new tokens enter into circulation to adjust the stablecoin value downward.” Now, I’m probably more forgiving (or optimistic, or idiotic – your choice) than most, in that I do think crypto and blockchain will play a pretty substantial role in our future, but “algorithmic stablecoins” fall far outside my realm of reason. It makes my head hurt – not because it sounds overly complex, but because my brain is exploding with red flags. I’ll spare you the rant and leave it as: “umm, WHAT!?”

The story doesn’t end there…

…but you’ll have to wait until the next Alt Blend, as this one has already gone long. It will be fun, as I’ll reveal an interesting discovery I’ve made, and we get to cover a crypto blowup. In the meantime, I’ll leave you to guess which of the above stablecoin arrangements could have possibly had a problem.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York.