There has been some talk recently of the potential of stablecoins to replace the U.S. dollar as the world's reserve currency. Much of what has been proposed to date has been merely theoretical. To actually implement a stablecoin project as a reserve system would require some systemic changes in the way the world does business. It's not that it can't be done, it is just that we are not prepared to do it.

Stablecoins, like more traditional cryptocurrencies, have their strengths and weaknesses. Unfortunately, the weaknesses are more compelling at this point. But if we view those weaknesses as challenges to overcome, there may eventually be some solutions forthcoming.

This post will discuss some of the special challenges currently holding stablecoins back. We will begin with a brief overview explaining exactly what stablecoins are and how they work, then transition into a discussion of the challenges. It is possible that stablecoins could become a major financial player in the future if these challenges can be sufficiently overcome.

More about stablecoins

A stablecoin is a kind of digital currency that could easily be described as a cross between a pure cryptocurrency and a fiat. It is a hybrid currency that shares technological similarities with traditional platforms like Bitcoin and Litecoin, while enjoying the stability of fiat currencies and securities.

The main feature of the stablecoin is that it is backed by some other asset. Where Bitcoin is backed only by the value and demand of its tokens, a stablecoin enjoys the backing of something with an established value. Stablecoin creators sometimes choose fiat currencies for backing purposes. For example, Tether is ostensibly backed by the U.S. dollar.

The thing about stablecoins is that they can be backed by any tangible asset. Some are backed with fiat, others are backed by precious metals, and still others by securities like stocks and bonds. It is even possible to back a stablecoin with a basket of assets. That is the plan for Facebook's Libra, should it ever get off the ground.

The purpose of backing

If you are familiar with Bitcoin's monumental market dominance, you might wonder why anyone would want to back a cryptocurrency and potentially limit its value. The answer is found in a single word: stability. Indeed, that is where stablecoins get their name from.

At the time this post was written, Bitcoin was trading in excess of $10,000. Just a few days earlier it was struggling to stay at the $9,000 mark. But that is not the half of it. Bitcoin was in the $3,000 neighborhood at the start of 2019. At its peak in 2017, a single coin was trading at nearly $20,000.

Do you see the problem here? Bitcoin is not price stable. It is volatile enough that prices can swing drastically in mere minutes. You could walk into your favorite Bitcoin-accepting coffee shop planning to pay a certain amount in BTC only to discover that by the time you make it to the counter, the price of your morning cup has increased by 25%.

Volatility is one of the things that has kept Bitcoin from becoming a daily transactional currency. Stablecoins were invented to counter this problem. By tying a stablecoin to another tangible asset, you virtually guarantee stable pricing. Now your coin has value users can rely on.

Choice of assets

The knowledge of how stablecoins work bring us to the first of the challenges that will be discussed in this post. That challenge is the choice of assets. As good a stablecoins are in theory, no stablecoin is any better than the assets that back it. As such, project developers have to choose their assets wisely.

Pegging a stablecoin to a single fiat is considered the safest option. However, it is not the most investment friendly option. Exchange rates do not grow enough to make investing in a fiat-backed token worthwhile, so that leaves project developers wondering where they are going to get the financing to launch their projects.

A developer might not like the idea of fiat. Let us say he turns to precious metals instead. He needs access to those precious metals in order to protect the value of his tokens. Good luck with that. It is not as though he can go down to the bank and borrow gold or silver.

Securities are another option. Backing a stablecoin with securities is as simple as using the money raised by token sales to invest in stocks, bonds, mutual funds, etc. This sort of arrangement protects the project developer while also allowing growth in line with the assets. But just like those assets can gain, they can also lose.

The long and short of it is that none of the three backing options is ideal. Smart project developers combine at least two of them to create a basket of backing assets. Some utilize all three. Still, there are no guarantees.

Liquidity

The next challenge is liquidity. What is liquidity? It is the ability to convert assets to cash with immediate effect. This could be the biggest challenge facing stablecoin development. If you are going to sell stablecoins, you need to have significant liquidity to pay those who choose to sell.

To show just how challenging this is, we turn to Tether. The world's most successful stablecoin has a market value in the billions of dollars. What you need to know is that one coin is equal to one U.S. dollar. Knowing that, Tether needs to have access to billions of dollars in cash to cover all the coins in circulation.

Guess what? They don't have that kind of cash. The most recent estimates suggest they only have 75% of Tether's value in reserve. They have had to secure commercial loans and invest in Bitcoin to cover the remaining 25%. The problem with this arrangement is that Tether is no longer a stable token because it is relying on the promise of loans and Bitcoin to cover itself.

Transparency

You would think that stablecoin developers would be absolutely transparent about what they are doing in order to bolster the case for their tokens. It turns out they are not. Stablecoin developers are among the worst when it comes to transparency. Again, Tether is a notable example.

Tether has been under a great deal of scrutiny due to in its inability to cover its own market capitalization. When pressed on the issue, they have been less than forthcoming about how they do things. Even a supposed audit intended to uncover the truth behind the organization's assets proved unfruitful.

A lack of transparency is something that cannot exist for any stablecoin that hopes to be a replacement for fiat. If no one knows what is going on with a particular stablecoin, it is going to be awfully difficult to convince investors to buy. And where there is no investment, there is no stablecoin.

Lack of regulation

We normally consider the lack of regulation as a good thing in the cryptocurrency space. It is when you are talking projects like Bitcoin, Ethereum, and Monero. These are all projects that can get along just fine without government interference. The same is not true for stablecoins due to their backing.

Let us go back to Tether to prove this point. Remember that Tether is backed by the U.S. dollar. Who controls the U.S. dollar? The U.S. government and its Federal Reserve partner. This means that Tether is inexorably linked to government fiat control even if it had enough cash on hand to cover 100% of its coins. When you throw in the loans being used to help make up some of the shortfall in liquidity, you have a stablecoin that is intertwined with the banking system.

How can Tether properly interact with the traditional financial sector without following the same regulations? It cannot, except for the fact that any similar regulations directly controlling stablecoins are nonexistent. So Tether is more or less a stablecoin existing somewhere between the financial sector and the free world of cryptocurrency. That doesn't work.

A lack of regulatory control automatically results in the lack of a governance framework that stablecoins can use to self-govern. They have no foundation on which to come up with a form of governance because their interactions with the financial sector are subject to an entirely different set of rules.

Not ready for prime time

It is entirely possible that stablecoins will eventually become an option for replacing fiat. We may see one or two stablecoins emerge as reserve currencies to replace the U.S. dollar. But both of those possibilities are a long way off. Things would have to drastically change before that could realistically happen. Simply put, stablecoins are not ready for prime time.

For now, the best use of a stablecoin is as a safe haven. You make some profit on Bitcoin or Ethereum, then dump it into a stablecoin like the U.S. Dollar Coin (USTD) to protect its value. Meanwhile, you keep your principle in play in hopes of earning more profit.

Stablecoins work well as a safe haven right now. Maybe someday they will prove their usefulness in other ways. We will have to wait and see.