Crypto-currency pegs: stablecoins

What are stablecoins?

Stablecoins

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Stablecoins are an attempt to represent fiat money (dollars, euros, etc) on a blockchain. Converting between fiat and crypto is a time-consuming process. The major hurdles? Heavy regulation and banking systems that some estimate still to be using fifty-year-old technology.

Most fiat transfers still take anywhere between one to three days to clear locally and between five to eight days internationally. Compare this with Bitcoin, which takes between 10 and 20 minutes to clear. Quite something when you consider Bitcoin is one of the slower blockchains!

Crypto traders do not want to wait days to exchange between crypto and fiat. By exchanging say Bitcoin into a stablecoin like Tether they “cash out without cashing out”. However, currency pegs suffer from their own set of problems, and history has some interesting lessons to share with us.

Black Wednesday and other pegs gone wrong

On 16 September 1992, ‘Black Wednesday’, investor George Soros broke the Bank of England (BoE), the UK’s central bank. The UK had planned to join the euro and was required to keep its exchange rate stable in preparation for the euro. The pound depreciating forced the BoE to buy its currency in the market.

Soros predicted that the BoE would not have enough foreign reserves to defend its currency. He started selling pounds in massive quantities. Despite heavy buying from the BoE, eventually the pound moved sharply lower. Soros was reported to have made 1 B dollars that day.

This is not an isolated incident. The 1997 Asian financial crisis began when the Thailand baht broke its peg. And in more recent times, markets were in a frenzy for quite some time after the Swiss National Bank removed its peg to the euro in early 2015.

The Hong Kong Dollar

The Hong Kong dollar is a shining success compared to some of its Asian counterparts. It has been pegged to the US dollar for more than 30 years. With sound monetary policy and good governance, it is possible to have pegged exchange rates that actually work. For a long time, at least.

Stablecoin risks

Take Tether for example, which aims to maintain a currency peg of 1:1 with the US dollar. Just like the BoE, whenever Tether (USDT) falls against the dollar, the company and/ or investors need to buy back more of the token to maintain the peg. A sustained price drop would undermine the project.

Other stablecoin projects like Basis are using largely untested mathematical engineering to maintain their pegs. The theory goes that when prices increase too much they can just print more tokens and inflation will cause prices to drop. The same principle is applied in reverse too.

The most important element that just about all these projects are missing is that cryptocurrency markets, like any other, are a confidence game. Investors do not buy coins, they buy into ideas. In fact, many companies behind these projects want to be the central bankers of the new age.

Final thoughts

Not all currency pegs are doomed to fail. The true test of currency pegs often happens in times of financial crisis. And cryptocurrency is such a new asset class that we will not really be able to tell what will happen until we are in the middle of the next one.

Investors and stablecoin projects continue to point out the crazy volatility that exists in Bitcoin and altcoin trading. However, the more important element here is to get people to start thinking in terms of a new global currency, such as Bitcoin, instead of their local one.

There are signs that point to the eventual destruction of fiat based monetary systems. When that happens, will there still be a need for stablecoins?

This article is an abridged version of an article originally posted at Coincentral.com (a P27 Partner) under the headline “Stablecoins and Currency Pegs: What Can History Teach Us?”.

CoinCentral’s owners, writers, and/ or guest post authors may or may not have a vested interest in any of the above projects and businesses. None of the content on CoinCentral is investment advice nor is it a replacement for advice from a certified financial planner.