Why Are Digital Dollars Useful?
TLDR:
A volatility-minimizing asset is useful as a medium of exchange and unit of account for those who can’t stomach the volatility of bitcoin, and the dollar is the best volatility-minimizing asset available today.
Digital dollars solve problems people face in using bank or physical dollars. They can be accessed by anyone with the internet, and they are a fast, secure, and reliable way to use dollars. They can also be used in cryptographic applications like the Lava Loans protocol, enabling financial contracts that are more trustless and easier to use.
1:1 backed digital dollars are more secure and easier to use than algorithmic “dollars”.
Importance of Volatility-Minimizing Assets (ex. Dollars):
Having a volatility-minimizing asset whose price one can rely on to remain relatively stable is crucial for those living paycheck to paycheck, for credit, for long-term business contracts, and for many other economic use-cases.
For a volatility-minimizing asset to exist, it must be volatility-minimizing through periods of deflation and inflation, and the only way for this to happen is if the asset supply can expand or contract based on certain conditions.
Today, most people resort to using the dollar, the world’s standard volatility-minimizing asset. The Federal Reserve attempts to keep prices stable relative to the dollar, at ~2% annualized increase.
But, the shortcomings of using bank dollars (as discussed in prior posts here and here) which include but aren’t limited to lack of privacy, programmability, security, and accessibility detriment the dollar’s success. Digital dollars solve the problems people face when using bank dollars.
Why are Digital Dollars Useful?
Digital dollars are becoming a popular means of transacting with dollars, and they are the most secure means by which to hold and use dollars. This is because digital dollars live on blockchains, and these blockchains:
Enable fast, private, and censorship-resistant transactions.
Enable programmatically-executed, trust-minimized financial contracts that are thus more secure and reliable.
An example of such a financial contract is the Lava Loans Protocol. The Lava Loans Protocol enables users to borrow against native-bitcoin securely, and it is only possible with the existence of digital dollars. Digital dollars in the Lava Loans Protocol enable trustless loan initiation (borrowers and lenders can can send their BTC collateral to a smart contract only after they have accepted their digital dollar loan) or trustless loan repayment (BTC can only be reclaimed by the borrower when the borrower repays their digital dollar loan). This is only possible with digital dollars because by definition digital dollars live on blockchains, and these blockchains make available to us access to cryptographic primitives that we can then use to build novel financial applications that are more secure and reliable.
As discussed more in-depth here, digital dollars are useful for the same reasons physical dollars are (sovereignty, privacy, accessibility), but they also provide added benefits since they live in the digital space: faster and cheaper to use, accessible to anyone with internet access, and can be used in financial contracts without introducing a central intermediary.
What Digital Dollar Should I Use?
There are 1:1 backed digital dollars and algorithmic/minted dollars:
Algorithmic/minted dollars such as LUSD rely on collective demand as a medium of exchange. These dollars have a hard time building payments demand due to being more capital inefficient (they require more collateral than their value to mint them) and having higher costs (minting and redemption fees). They also have collateral risk, and many algorithmic dollars have collapsed in value because the underlying collateral backing them has lost value (see Terra Luna) or the underlying collateral backing them was hacked. Additionally, almost every algorithmic/minted dollar is supported by token emissions, which isn’t sustainable.
On the other hand, 1:1 backed digital dollars, such as USDC, are significantly more successful due to widespread confidence in their ability to hold their value since they are all backed 1:1. Digital dollars are completely capital efficient.
What Chain Should Digital Dollars Live On?
When deciding on which blockchain to use for digital dollar transactions, it's important to consider user-experience (speed, cost, and privacy), network security, and also if the network is compatible with the other people you want to pay. Vaults like Lava abstract all of this away, but if you’re using an app that doesn’t, this is a bigger consideration.
FAQ:
Can bitcoin be the volatility-minimizing asset?
Since bitcoin’s supply is fixed, it can’t be the best theoretical solution for a volatility-minimizing asset.
Are there any risks of using a 1:1 backed digital dollar?
As discussed more here, digital dollars can protect you from banks, but because they are issued, an issuer could compromise its users. Doing so however, if digital dollars are being used privately, would mean they wouldn’t be able to single you out, and so, they’d have to rug the entire asset base. Choose your issuer carefully, and realize that bitcoin provides you a way to hedge against this risk.
Contributors:
This article was written by Shehzan Maredia.