It is very exciting that the Federal Reserve has been thinking deeply about the idea of digital currency. A series of papers released by the Federal Reserve on Stablecoins, the idea of central digital currency this year backs this assertion and hence the excitement about writing this post.
In very simple terms Stablecoins are cryptocurrencies whose price is pegged to an external asset like the US Dollar or gold. Examples of such cryptocurrencies are USD Coin (USDC) or Tether USD (USD) that are pegged to the US Dollar and Digix Gold Token (DGX) that is tied to the value of gold. There is a third type of Stablecoin that is cryptocurrency backed, an example being DAI. To simplify how DAI works, it maintains its value through cryptocurrency which is used as collateral. Thinking of it, you may say that the price of cryptocurrencies is volatile and hence the collateral ratio between DAI and Ether is managed to maintain the price stability. This interestingly all happens through smart contracts which maintain the proper ratio of having adequate Ether to keep the value of DAI steady.
The two papers from the Federal Reserve that have been very exciting around central digital currency and Stablecoins are [1] and [2]. I recommend reading through the summary at least which would give you an idea of the optimism but cautious stance that the Fed is taking.
A number of large banks have already recognized the ease and pace of transactions you can achieve with digital currencies that use distributed ledger technologies (DLT) like cryptocurrencies. The usual bank transactions also known as Automated Clearing House (ACH) transactions take anywhere from 2-3 days whereas transactions using DLT could make it happen in a matter of seconds or minutes. A number of banks have already made strides like JP Morgan with its JPM Coin, Silvergate, Ripple partner network. I was an early adopter of XRP (Ripple Cryptocurrency) as I was excited about the idea of faster global transactions.
Now coming to the point on what's in it for me? Great question, to start off with is to make people aware that the market cap for Stablecoins has surpassed $150 Billion. That is huge and the Fed paper [1] states that there has been a roughly 500% increase from 2020. This basically means that a lot of people are getting on the idea of maintaining their savings in Stablecoins. There are some obvious pros and cons.
Pros -
- These Stablecoins offer a much higher rate of interest that can be anywhere from 4% to 8% depending on the Stablecoin that you buy. Just a reminder, interest rates are subject to changes and hence the exact percentage may vary. But they have so far remained higher than what's offered for putting your money in the largest banks.
- Faster transactions for buying cryptocurrencies and you do not need to wait for your ACH transactions which could take days to settle.
Cons -
- They are not insured by FDIC and the US Government cannot guarantee the value of your Stablecoins like the US Dollar and large banks.
- Given the number of cryptocurrency exchange platforms and online wallets that have got compromised, the safety of your money is not the same as in one of the largest banks. This is a highly debatable topic, but the one main reason I think is if someone compromises your wallets and drains your coins, there is a very small chance that you are going to get it back. With ACH transactions, I personally think bank has a little more power to stop these transactions and more reaction time as transactions are slower.
- The transparency around assets that back the cryptocurrency could be a concern. To explain further, the cryptocurrency may not be backed 1:1 with a US Dollar as an example. This was brought to light in recent investigations.
- They are still subject to volatility although strong measures are taken to react quickly. But any huge moves in the overall cryptocurrency market as we saw during early Covid times, could cause volatility across the price. (See below)
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| Source: CoinMarketCap - Tether to USD Price volatility |
Given the pros and cons, I believe this is still a good diversification vehicle, but always remember the golden rule to never put all your eggs in one basket. The approach I follow is to diversify across a few different well known Stablecoins and then further diversify my balances across different cryptocurrency exchange platforms. Here is a good list of different Stablecoins by market capitalization. I also covered some of the Stablecoin strategies in one of my previous articles and recommend giving it a read if you have not already.
Maintaining the balance across different exchange platforms reduces the risk if one gets hit with a security issue, a person may end up losing these coins. I still maintain an emergency fund in my online savings bank but have moved a large amount of my extra savings into these Stablecoins, thereby reaping monthly benefits that allow me to fight the dollar inflation.
As a user of these cryptocurrency exchange platforms, what you can do to ensure the safety of your account is to choose a strong password, enable multi-factor authentication, enable security notifications and in some of the platforms you may be able to setup an allow list where you can move your cryptocurrencies. I also make it a point to keep a closer eye on these balances, much more than I would look at my bank account. This is for two main reasons, its a nice feeling to see that interest earnings grow on a daily basis with the power of compounding and then it keeps my anxiety low that the balances are safe.