A stable coin is a cryptocurrency that is pegged to another stable asset. The stable asset could be the gold or US dollar. Normally, it is pegged to a global currency which is not tied to a central bank and has volatility. This stability feature allows the practical usage of using cryptocurrency as a medium of payment.
Why do we need a stablecoin?
An optimal cryptocurrency should have the following 4 traits: price stability, scalability, privacy and decentralization.
Stablecoin is designed to minimize price volatility. On the contrary, popular cryptocurrencies such as Bitcoin and Ethereum are highly volatile. On any given day, it is common to see huge price fluctuation as much as 10–20% (whether an increase or a decrease). This would make using cryptocurrencies as the mode of payment for daily transactions to be almost inconvenient and impossible. Imagine you pay $5 for your Americano today and find out tomorrow that the price becomes $3. This is because the cryptocurrencies such as Bitcoin and Ethereum do not have any inbuilt price stability mechanism. Price instability is one the major drawbacks why many institutions and individuals have remained on the cryptocurrency sidelines to date. This volatility also has led critics to say that cryptocurrencies are a highly speculative investment. Thus, stablecoin is developed to address this issue.
Short-term stability is important for transactions and long-term stability is important for holding.
What are they used for? (Use Cases of Stablecoin)
Stablecoins can be employed for many of the same use cases as other cryptocurrencies like bitcoin, with the added benefit of price-stability.
(A) Liquidity Tool for Cryptocurrency Exchanges
One of the challenges many exchanges have been dealing with is acceptance of fiat due to the shutout of banking accounting. This is because banks are wary of dealing with anything crypto-related for compliance reasons.
Users want to buy with dollars and to be able to trade out of cryptos into dollars at times of high volatility. Stablecoins offer an elegant solution to this problem.
(B) The Pavement for More Complex Financial Products
Some proponents of stablecoin think the technology could allow for more complex financial products to be built on crypto such as insurance, smart contract dividend payments and loans.
How does the stablecoin work?
There are two main types of stablecoins: reserve-backed and algorithmic.
1.0 Reserve-Backed Stablecoin
Reserve-backed stablecoin can be further divided into traditional collateral (off-chain) and crypto collateral (on-chain)
1.1 Traditional-Collateral (‘Off-Chain’) Backed
Traditional-collateral backed stablecoins are backed by gold and certain currencies. Thus, they function a little like paper money. Just as fiat money used to be ultimately backed by gold reserves in a central bank, reserve-backed stablecoins are backed one-for-one by reserves of the currencies they are pegged to.
Issuers of coins like USDC or Tether “tokenize” dollars by exchanging them for a stablecoin and depositing the dollars in a bank. Those dollars are then left untouched until somebody redeems the stablecoin for the dollars. It’s this confidence that the stablecoin can be redeemed that maintains the price peg.
1.2 Crypto-Collateral (‘On-Chain’) Backed
On-chain collateral-backed stablecoin designs, while ‘natively digital’, are similar to the above traditional asset-backed design in some ways. Some stablecoins are employing a hybrid on-chain/off-chain strategy to gain advantages from both designs.
The second type of stablecoin is one that is not backed by any reserves but instead controlled by an algorithm.
Most of the stablecoins designs were started with an asset-backed token due to the prioritization of creating trust in the stability mechanism over decentralization. This is because asset-backed tokens are arguably less complex and easier to bring to market with the assumption that a banking partner can be found. With the passage of time, it is being expected that the asset-backed tokens will likely evolve into a digital-native, fully-algorithmic design over time.
Algorithmic designs share many of the same pros and cons of on-chain collateral-backed stablecoins, with arguably the key difference the greater complexity of a non-asset backed stability mechanism.
Potential advantages possessed by algorithmic stablecoins:
- Greater scalability (due to obviating the need for additional assets to back additional coin issuance)
- Stronger network adoption incentives
- Opportunity to earn profits (53% of stablecoins offer some type of ‘dividend’ or incentive mechanism built into the design of the stablecoin system e.g., ‘seigniorage shares’ and transaction fee dividends)
Challenge faced by algorithmic stablecoins:
- As demand for an algorithmic stablecoin increases, supply also has to increase to make sure there’s not an appreciation in the value of the stablecoin. At the same time, as the value decreases, there needs to be a mechanism by which supply can be reduced again to try and bring the price of the stablecoin back to the peg. “It is much more challenging to design. They’re really unproven at this point,” by Garrick Hileman, the head of research at Blockchain.
Examples of algorithmic stablecoin are Basis, Terra, Carbon, and Fragments.
Why are so many appearing?
Based on a report by Mosaic.io, there is a total of 57 identified stablecoins, 39% of which are live. The number of active stablecoin projects has dramatically increased over the past 12–18 months and more than a dozen project teams have stated they plan to launch in the coming weeks/months.
Stablecoins are nothing new and have been actively used for the past four years. They also already form an important part of the digital assets ecosystem. The total market value of all stablecoins is approximately $3 billion, or 1.5% of the total market value of all cryptoassets.
One of the major reasons why stablecoins proliferate is the potential for stablecoins to be used in everything from crypto insurance to lending and savings means entrepreneurs also hope there can be room in the market for many successful stablecoins.
Another is the success story of Tether. Stablecoins are listed on over 50 different exchanges at present, with Tether featuring the greatest number of total individual exchange listings (at least on 46 exchanges globally). Tether is the second most actively traded cryptocurrency, equal to approximately 60% of BTC daily trading volume. Earlier this year Tether entered the top-10 cryptoasset rankings by market value and it currently comprises 93% of the total market value of all stablecoins.
Despite its popularity, Tether has been beset by criticism of its auditing standards, corporate opacity, and claims of manipulation. As a result, many in the industry feel there is an opportunity to provide a better solution. Even with the success of new entrants like TrueUSD in gaining listings on major exchanges, Tether continues to dominate and commands approximately 98–99% of all stablecoin trading volume.
There are several projects working on this problem and each one has their advantages and their disadvantages. Let’s explore how some of the more popular stable coins are working towards building the most optimal cryptocurrency in Tokenize’s Ultimate Guide to Stablecoin (Part 2/2). Stay tuned!
Now, you may trade stablecoins such as Gemini Dollar (GUSD) and USD Coin (USDC) on Tokenize Xchange. Check out more details here!