What is a Stablecoin?

What is a Stablecoin?

Stablecoins are a kind of cryptocurrency whose price is pegged to a stable asset, like the U.S. dollar or gold.

One of the most fundamental advantages of cryptocurrencies such as bitcoin and ether is that they do not require trust in an intermediary institution to send payments, making them accessible worldwide. However, a significant disadvantage of cryptocurrencies is that their prices are unpredictable and tend to fluctuate wildly. This makes them difficult to use for the average person. People generally expect to be able to predict the value of their money a week from now for their security and livelihood.

Unlike fiat currencies, including the U.S. dollar, and other assets, such as gold, cryptocurrency prices are unpredictable. The value of fiat currencies, such as the dollar, fluctuates gradually over time, whereas the value of cryptocurrencies fluctuates dramatically daily.

The following graph compares the price of bitcoin versus the U.S. dollar (USD) and another fiat currency, the Canadian dollar (CAD), to illustrate the relative fluctuation of each currency.

Stablecoins

Stablecoins attempt to combat price volatility by tying the value of cryptocurrencies to more stable assets — typically fiat currencies. Fiat is the government-issued currency we are all accustomed to using, such as the dollar or euro.

Typically, the entity behind a stablecoin will set up a “reserve” where the asset or basket of assets backing the stablecoin will be securely stored – for example, $1 million in an old bank to support one million stablecoin units.

This is one approach to connecting digital stablecoins to physical assets. The reserve acts as collateral for the stablecoin, which means that whenever a stablecoin owner wishes to cash out his/her tokens, the reserve is depleted of an equivalent amount of the underlying asset.

A more complex type of stablecoin is collateralized by other cryptocurrencies rather than fiat, yet it still is designed to track a mainstream asset such as the dollar.

Maker, arguably the most well-known stablecoin issuer that uses this mechanism, accomplishes this with a service called “Vault,” which locks up a user’s cryptocurrency collateral. When the smart contract determines that the collateral has been secured, the user may use it to borrow newly issued Dai, the stablecoin.

The third type of stablecoin, known as an algorithmic stablecoin, is not collateralized at all; instead, coins are burned or created to maintain the target price of the coin. Suppose the target price of the stablecoin falls from $1 to $0.75. The algorithm will automatically burn a number of stablecoins to increase scarcity and drive up the price. This stablecoin type of protocol is difficult to perfect, and numerous attempts in recent years have failed. Yet, entrepreneurs keep trying.

Terra’s blockchain project has developed one of the few working examples of this model to date, UST.

Four varieties of Stablecoins

There are four distinct types of stablecoins, each with its method for fixing the tokens’ value to a constant amount:

• Fiat-backed
• Cryptocurrency-backed
• Commodity-backed
• Algorithmic Stablecoin

Fiat backed Stablecoins

On the market, the most popular stablecoins are those backed by fiat currency. For instance, the USD coin (USDC) is supported by fiat and pegged to the U.S. dollar (USD) at 1:1. Other stablecoins are pegged to the euro, British pound, Japanese yen, and Chinese renminbi.

Cryptocurrency-backed Stablecoins

Without getting to meta, crypto-backed stablecoins are cryptocurrencies whose value is pegged to that of a more well-established cryptocurrency. As an example, MakerDAO is one of the most well-known crypto-backed stablecoins. With the use of the Ethereum blockchain and a smart contract, it can gather enough ether (ETH) to serve as collateral for its stablecoin. A smart contract is a sort of code-based contract that operates automatically. Users may manufacture DAI, the MakerDAO stablecoin, after the collateral amount hits a set level in the smart contract.

Stablecoins supported by physical assets

Commodity-backed stablecoins, as their name implies, are pegged to the value of commodities such as precious metals, industrial metals, oil, or real estate. Commodity investors favor stablecoins backed by commodities since it lets them invest in gold without the problem of sourcing and storing it. For example, Tether gold (XAUT) is a stablecoin backed by a commodity. The currency is supported by a gold reserve stored in a vault in Switzerland. A single ounce of gold equals one XAUT.

Algorithmic Stablecoins

This category of stablecoins is not backed by any “real-world” commodities and instead uses algorithms to adjust supply based on market demand. Briefly, these algorithms automatically burn (remove from circulation permanently) or mint new coins based on the varying requests for the stablecoin at any time.

An algorithmic stablecoin can be compared to a bucket of water left outside with the water level marked on the inside. A mechanism that adds or removes water based on how far the water level has diverged from the mark is set up to maintain the same water level inside the bucket. This is controlled by a computer algorithm, which instructs the mechanism to release water from the bottom of bucket until the water level mark is reached if it rains and the bucket starts to fill. In contrast, if it is a hot day and water evaporates from the bucket, the computer algorithm instructs the mechanism to refill the bucket with water until the correct level is restored.

There has been a great deal of trial and error in introducing successful algorithmic stablecoins to the crypto ecosystem, and as an example, Terra’s UST stablecoin failure shows how things can go wrong if the algorithm is unable to keep up with dramatic price fluctuations.

What are the usages of Stablecoins?

Minimize volatility

The value of cryptocurrencies such as Bitcoin and Ether fluctuates significantly, sometimes minute-by-minute. An asset pegged to a more stable currency can assure buyers and sellers that their tokens’ values will not fluctuate erratically in the near future.

Invest or store assets

Stablecoins can be held without a bank account and are simple to transfer. The value of stablecoins can be easily transferred worldwide, including to regions where the U.S. dollar may be challenging to obtain or where the local currency is volatile.

Acquire interest on Stablecoin investments

Interest can be earned easily (usually higher than what a bank would offer).

Transfer funds affordably

One million dollar’s worth of USDC has been transferred with less than one dollar transfer fee.

Deliver internationally

Stablecoins, such as USDC, is a good choice for sending money anywhere in the world due to their rapid processing and low transaction fees.

What are the most widely utilized Stablecoins?

Let’s review some of the most popular stablecoins in the stablecoin space.

Tether (USDT)

Tether (USDT) is one of the earliest stablecoins, introduced in 2014, and is currently the most popular. According to market capitalization, it is among the most valuable cryptocurrencies overall. The primary use case for USDT is the rapid transfer of funds between exchanges to take advantage of arbitrage opportunities when the prices of cryptocurrencies on two exchanges differ; traders can profit from this price difference. But it has also found other uses: Chinese importers in Russia have also used USDT to transfer millions of dollars across the border, circumventing China’s strict capital controls.

Tether Ltd., the company, was involved in a 22-month legal dispute with the New York Attorney General on claims that Bitfinex, a sister company of Tether, tried to use money taken from Tether to cover up an $850 million shortfall. On February 23, 2021, however, the case was finally resolved, and Tether and Bitfinex were ordered to pay $18.5 million and provide quarterly reports for the following two years outlining Tether’s stablecoin reserves.

USD Coin

USD Coin is a stablecoin introduced by cryptocurrency companies Circle and Coinbase through the Centre Consortium in 2018.

Similar to Tether, USD Coin was initially pegged to the US dollar before shifting to a variety of collateral assets. Since USDC is an open-source protocol, any person or business can use it to make their own products.

Circle announced going public through a $4.5 billion SPAC merger with Concord Acquisition Corporation on July 8, 2021. The announcement was made a month after Circle closed a $440 million funding round with industry heavyweights, including FTX, Digital Currency Group, and Fidelity Management and Research Company.

Dai

Dai is a stablecoin built on the MakerDAO protocol and based on the Ethereum network. The 2015-introduced Dai is backed by ether, an Ethereum-based currency, and is fixed to the US dollar.

In contrast to the other stablecoins, MakerDAO intends to make Dai decentralized, which means there will be no trusted central authority controlling the system. Instead, Ethereum smart contracts, which encode immutable rules, perform this function.

However, there are still issues with this innovative model, such as if the smart contracts underlying MakerDAO do not function as expected. Indeed, they were gamed in 2020, resulting in $8 million in losses.

Top Stablecoin Tokens by Market Cap

Source: binance.com on 25 October 2022

Do Stablecoins present any disadvantages?

There are a few disadvantages of stablecoins to consider. Because stablecoins are typically implemented differently than other cryptocurrencies, their pain points are distinct.

If the reserves are stored in a bank or other third party, there is also the risk of counterparty default. This boils down to the question of whether or not the entity actually possesses the collateral it claims to possess. Frequently, Tether has been asked whether an actual 1:1 ratio backs its USDT tokens and U.S. dollars.

In the worst-case scenario, it is possible that the reserves backing a stablecoin will not be sufficient to redeem every unit, thereby undermining the coin’s credibility.

Cryptocurrencies were designed to eliminate the need for intermediary companies, which are typically entrusted with a user’s funds. By definition, intermediaries have control over this money; for instance, they can typically halt a transaction. Some stablecoins reintroduce the ability to halt transactions.

The USD coin has a back door that can be used to stop payments if the coin is used illegally. In July 2020, Circle, one of the companies behind USDC, confirmed that it had frozen $100,000 worth of the stablecoin at the request of law enforcement.

Further Reading:

Coinmarketcap
Binance Academy
What is a Stablecoin (Video)

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