Several broad categories of solutions to this problem have appeared.
Many merchants prefer to exchange the cryptocurrency they receive into fiat currencies. The exchange results in a position that is often more stable than cryptocurrencies, as well as being liquid and familiar. Examples include BitPay, local underwriting as in North Queensland, Australia, and other exchange deposit based solutions.
Fiat exchange suffers from the friction inherent to interfacing with a centrally controlled currency. It is subject to onerous regulations and processing that incur costs similar to traditional payment gateways, erode censorship-resistance and eliminate the inherent efficiency of cryptocurrencies.
Fiat-backed stablecoins emerged as a response to fiat exchange issues and attempt to offer the best of both worlds. They are created and sent digitally much like cryptocurrencies. However instead of having their value determined only by the market, they peg their value to fiat currency backing held under custody of a central entity. Holders of stablecoins can, with certain conditions, exchange them for the fiat currency that backs them. Having roots in enterprises that predate modern cryptocurrencies such as Liberty Reserve, there are multiple stablecoins today that have seen various degrees of adoption such as Tether (USDT), USD Coin (USDC), TrueUSD (TUSD) and HonestCoin (USDH).
Fiat-backed stablecoins take advantage of the current regulation landscape where use of fiat-backed instruments tends to be less regulated than direct interfaces with fiat currencies. The creation and redemption of stablecoins incurs as much or more burden as direct fiat exchange, but that complexity is managed by the issuer. The sending and receiving of stablecoins themselves receive less scrutiny, restoring some of the cryptocurrency-like properties. Furthermore, as stablecoins have a stable, liquid and familiar user experience similar to fiat currencies, they are easier to understand, trust and adopt.
Stablecoins do have some inherent limitations. Their value depends on their fiat currency reserve, and that reserve establishes a large custodial risk. The custodian can steal, falsify or otherwise manipulate the reserve and trigger a catastrophic loss of value throughout the stablecoin’s ecosystem. The simple presence of such a risk marks a key difference between fiat-backed stablecoins and permissionless cryptocurrencies: they have clear central points of vulnerability and failure.
The regulatory advantage of stablecoins is also fragile and subject to change. Their central issuing authorities can easily be pressured into extending heavy handed scrutiny beyond redemption and creation. We have already seen an incident of direct, protocol-level blacklisting and it is reasonable to expect regulatory pressure for such measures to increase on stablecoin custodians.
To address the above shortcomings of fiat-backed stablecoins, a relatively recent development is algorithmic stablecoins such as MakerDAO’s DAI and Reserve Protocol’s RSV. While they differ in exact mechanisms, these algorithmic coins are typically over-collateralized by volatile crypto-assets instead of directly backed by fiat. As a result, they can be programmed to exist purely on a decentralized blockchain. There is no need for a centralized redemption gateway that forms the basis of the entire system. This mitigates the censorship and regulatory risks of fiat-backed stablecoins to a certain extent, while retaining the pleasant user experience of an easy-to-understand token representing fiat value.
Algorithmic stablecoins, however, have two primary risks associated with them. The first is the inherent risk with using volatile, illiquid assets to back “stable” value. As the underlying asset depreciates, the entire system will need to be downsized in a controlled manner. A catastrophic market downturn may result in systemic problems, such as Global Settlement in DAI, that lead to political intervention or other unexpected edge cases. This risk does not exist in fiat-backed stablecoins with a proper reserve where they simply draw down toward zero when demand falls.
Unintuitively, another risk of algorithmic stablecoins is centralization of control. Due to the need to adjust collateral policies over time, algorithmic stablecoins typically have a second layer of governance tokens, as seen in MKR of MakerDAO and RSR of the Reserve protocol. Necessity of these governance tokens reintroduces the risk of centralized capture and control. In the worst case, poorly designed incentives can lead to apathetic holders of the governance coin, and vulnerability to sabotage by a minority of stakeholders.
Finally, all software has the potential for bugs and vulnerabilities. Any bug or vulnerability in the complex central smart contracts that control algorithmic stablecoins will have a systemic, potentially existential impact.
There is a fourth type of volatility mitigation that is not directly tied to fiat currencies or fiat-backed currencies. Many major cryptocurrency exchanges, even those without a fiat interface, have markets for fiat-denominated futures. These markets match bearish actors who seek stability with bullish actors who seek additional risk-taking, and use a variety of derivatives to satisfy both sides on a contractual basis. The derivatives may include futures, forwards, options, leveraged longs and shorts, lending and borrowing among others. They are available on a wide variety of well-known platforms, ranging from purely fiat-denominated exchanges such as Chicago Mercantile Exchange (CME), to custodial cryptocurrency-only exchanges such as BitMEX, to fiat-crypto spot markets such as Binance, Bitfinex and Huobi.
While derivatives generally have custodians that can and have abused trust, they are typically transactional and are not exposed to the same systemic risks. That transactional nature also introduces unique strengths and weaknesses compared to other stability solutions. They have more flexibility in configuration at contract creation that is only limited by the availability of counterparties. That flexibility can also work against derivatives where a variety of parameter sets reduces fungibility and divides derivatives into smaller pools of liquidity, leading to a generally worse user experience than stablecoins. The custodial nature of derivatives also exposes users to the well known custodial risks of censorability and central points of failure.
We take the reliability of our protocols very seriously, so we had a third party do a mathematical analysis of the AnyHedge protocol.