Stablecoins as a crypto-fiat bridge: Would it work?

1 September, 2019

Not every cryptocurrency works exactly the same. There are different kinds of cryptos, including what are known as stablecoins. This post will discuss stablecoins, what they are, and what their real value appears to be. Some have suggested that their value lies in being a bridge between genuine cryptocurrency and fiat.

The bridge concept is an intriguing one. If cryptocurrency is supposed to exist separate from fiat, it should be able to carry its own weight. And yet we see that more than a decade after Bitcoin was first launched there are still far too many limits keeping it from being an everyday currency for the masses. The majority of global consumers still rely on fiat. So perhaps a bridge is necessary.

More about stablecoins

For those new to the stablecoin concept, a stablecoin is similar to a traditional cryptocurrency in some ways but drastically different in others. Let us start with the similarities.

A stablecoin is a digital asset rather than a tangible one. So like Bitcoin, you do not purchase physical coins and bills when you purchase a stablecoin. Rather, you purchase a digital asset represented by numbers on a blockchain. Stablecoins are traded on exchanges alongside other kinds of digital assets.

Stablecoins are also similar to traditional cryptocurrencies in that they are secured and maintained by blockchain ledgers. Transactions are verified, finalized, and added to the ledger. Once added, they cannot be modified in any way.

The biggest difference is that a stablecoin is backed by some other known asset. Where the value of Bitcoin is determined exclusively by supply and demand, the value of a stablecoin is determined by the value of its backing assets. We can use the USD Coin as an illustration.

Known as USDC on exchanges, this coin is backed by the U.S. dollar. Its value is directly tied to the dollar. One USDC equals one U.S. dollar. Pretty simple, right?

Stablecoins do not have to be backed by single fiat currencies. They could be back by multiple currencies or something entirely different. If Facebook's Libra ever gets off the ground, it will be a stablecoin backed by a basket of fiat and government securities.

The purpose of stablecoins

Stablecoins exist for one primary purpose: to afford investors an opportunity to put money into digital assets without subjecting themselves to extreme price volatility. That might sound complicated, but it is really not. An investor's biggest enemy is volatility. Investors want steady growth. They do not want huge growth today followed by a commensurate loss tomorrow.

Tying stablecoins to other assets provides the price stability investors are after. You might even say stablecoins are the cryptocurrency equivalent of government-issued bonds. Where securities investors might put money into bonds to protect themselves against stock market losses, digital asset investors sometimes steer money into stablecoins so as to protect against losses with other assets.

This understanding should make it a bit easier to grasp the bridge concept. Stablecoins can act as a bridge between cryptocurrency and fiat so as to afford a bit more stability to both investors and day-to-day crypto users.

Converting between currencies

If you already own some cryptocurrency, you know how easy it is to log on to an exchange and buy your favorite coins. If you use an exchange like Coinbase, or an electronic payment system like Skrill, you also know that you can swap between multiple currencies nearly instantly. It is all quite effortless. This is optimal for people who want to use a stablecoin as a bridge.

Let us go back to USDC again. We will use it as an example because Coinbase lists it on their exchange. Anyone with a Coinbase account can go in and either purchase or sell USDC on a whim. It takes less than a minute to do. USDC would make a particularly good bridge.

Converting fiat to USDC

Imagine you have set aside a certain amount from your monthly budget to purchase digital assets. Your favorite assets are Bitcoin and Bitcoin Cash. With your next paycheck, you are considering converting some of your fiat to either BTC or BCH. That's great.

Now let us say that you are not real comfortable with either coin's price direction on the day you decide to buy. There is no need to rush into a decision. Instead, you can use your fiat to purchase USDC. Then sit on that coin while you watch what happens with BTC and BCH. At whatever point you are ready to buy one of the other coins, just convert your USDC. It is not likely that your USDC will have changed all that much in terms of its value. After all, it is a stablecoin.

Converting BTC to USDC

Now let's look at the process in the other direction. Let us say BTC increases by 10% over the course of a couple of days. Such impressive price climbs are almost always followed by selloffs. So at whatever time you think BTC has reached its peak, you convert it to USDC. The value of your investment will remain stable even if BTC drops significantly.

Just as in our previous example, you can hold on to your USDC until you feel that BTC has bottomed out. Then you can convert back to BTC with the expectation that prices will start rising again.

This is all well and good, but it still doesn't explain the true value of having a stablecoin that acts as a crypto-fiat bridge. So to better explore that topic, let's talk about receiving your pay in cryptocurrency. There are currently a small number of companies that allow their employees to take their pay in Bitcoin.

Bitcoin salary payments

Receiving your weekly pay as Bitcoin is a rather novel idea. A company choosing to offer this to employees would pay them by pushing coin from their own wallet to employee wallets. They could do so fairly effortlessly once everything was set up. The question is one of what employees do once they have been paid.

If you were to accept your weekly pay in Bitcoin, would you simply leave it in your wallet until you wanted to buy something? If so, you would be taking a significant risk. Remember just how quickly cryptocurrency prices can change. Bitcoin's $10,000 price could easily drop to $9,000 by this time tomorrow.

Knowing that, you are taking the very real risk of losing money by parking BTC in your wallet until you need to buy something. Let's just say your weekly pay is $500. You receive the equivalent of $500 in BTC on payday. What if BTC's price drops by 10% overnight? You now have the equivalent of $450 in BTC.

That is not an enviable position to be in, is it? No, it's not. But there is a workaround. That workaround is using USDC has a bridge. You would do just what was described in the previous section of this post dealing with converting between currencies.

Convert and wait

You could protect the value of your weekly pay by immediately converting your BTC to USDC. That same $500 in BTC is worth $500 in USDC - if you make the conversion right away. Now you can sit on your USDC without worrying that its value will crash. Leave it in your wallet until you need to buy something.

Perhaps you need to pay your rent. Your landlord doesn't accept cryptocurrency, so you convert some of your USDC to fiat. Problem solved. The following day you decide to buy something online. The merchant you are dealing with accepts BTC, so you convert some of your USDC in order to make your purchase.

This example clearly shows that USDC, as a stablecoin, acts as a bridge between crypto and fiat. It essentially becomes a reserve currency that can be converted in either direction depending on your need. All the while, USDC remains stable enough that the value of your holdings is never in real jeopardy.

By the way, your employer could do the same thing. In order to pay you in BTC, your employer has to keep an adequate amount of cryptocurrency on hand. But they are just as subject to price volatility. They could hold their digital assets as USDC and only convert them to BTC when it is time to pay employees.

A theoretical bridge only

It should be clear that stablecoins can act as a bridge between cryptocurrency and fiat. However, such a bridge is theoretical only. No one is really doing it on a large enough scale to determine whether or not such a strategy is viable. There is good reason for that.

Converting between cryptocurrency and fiat is not free. You need an exchange to do so, and exchanges charge for the service. That is how they make their money. Anyone who wanted to use a stablecoin as a true bridge would have to consider the cost of conversion. Too many conversions would make the plan financially inviable.

Now you know a bit more about stablecoins and how they work. Can they work as a bridge between cryptocurrency and fiat? In theory, yes. Making it work practically is an entirely different matter. Perhaps someday we will see an organization successfully delve into that arena.