What Are Stablecoins?

Crypto 101

What are Stablecoins?

Bitcoin was originally conceived by Satoshi Nakomoto as a system of payment. The original Bitcoin white paper described it as a “purely peer-to-peer version of electronic cash that would allow electronic payments to be sent directly from one party to another without going through a financial institution.” A decade — and significantly higher price point — later, Nakamoto’s vision seems a distant dream. Volatile price swings, a complicated interface and low mainstream adoption rates have ensured that Bitcoin remains on the margins of the current financial ecosystem. But all is not lost for the early dreamers; a new class of cryptocurrencies known as stablecoins has emerged to fulfill Bitcoin’s original promise.

As their name denotes, stablecoins are meant to be stable with respect to their price action. This stability is achieved by pegging the coin’s value to a tradeable basket of goods. The contents of the basket can be a diverse array, from fiat currencies to assets like gold, or even other cryptocurrencies.

Stablecoins are a counter to the volatile price swings of cryptocurrencies on exchanges, and their prices rarely diverge from their pegs. A stablecoin pegged to the US dollar, for instance, will trade at parity with the dollar most of the time. The only time it will diverge is during times of crisis in the markets, when fearful investors convert their funds from standard coins to stablecoins.

Within the context of the cryptocurrency ecosystem, stablecoins serve a number of functions.

First, stablecoins are a medium of exchange between different cryptocurrencies. Each cryptocurrency functions on a separate blockchain, making it difficult to directly exchange one for another, let alone for fiat currency.

Stablecoins are the rail mechanism between different cryptocurrencies and fiat currencies, meaning investors can move funds between different fiat and cryptocurrencies using stablecoins. Thus, an investor seeking to move funds from Ether to Dash at a cryptocurrency exchange will have to convert the former to a stablecoin and, subsequently, convert the stablecoin to Dash.   

The ultimate goal of most stablecoins is to become a medium for daily transactions. A stable price means that the coin’s value does not constantly fluctuate, and transactions are therefore not subject to price volatility. Stablecoins can also be used in financial markets for sophisticated trading activities.

The Evolution of Stablecoins

Tether, the world’s most popular stablecoin, is pegged to the US dollar and was launched in 2014. In a press release announcing Tether’s launch, Reeve Collins, cofounder and CEO of Tether described it as “bridging the gap [between the blockchain and fiat currencies] by bringing familiar currencies to the blockchain.” Collins also told journalists that Tether was “digitizing the dollar and giving that digital dollar access to the bitcoin blockchain.”

Tether initially partnered with exchanges and online wallets to encourage its adoption across the cryptocurrency ecosystem, but a majority of those partners did not survive the market. Hong Kong-based exchange Bitfinex, reportedly the largest cryptocurrency exchange in the world by trading volume, currently accounts for the bulk of Tether’s transaction volume. Tether is the third-most traded cryptocurrency in the world and has a market capitalization of $7.6 billion, as of this writing.

However, Tether has recently become engulfed in controversy. Bitfinex claims that there is an equivalent amount of US dollars in bank accounts as there are Tethers trading in cryptocurrency markets. However, critics are skeptical and point to the absence of an audit and Tether’s growing list of banking problems as proof that the coin is not adequately capitalized.

Tether’s troubles provided an opening for other stablecoins on the market, which resulted in a veritable explosion of stablecoins in 2018. And it’s not just startups issuing stablecoins; established organizations are also getting in on the action. Crypto exchanges — like Circle and Coinbase — have issued stablecoins, as have banking institutions like JP Morgan.

Even Facebook is reportedly developing a stablecoin. “It’s good that they [private organizations] are coming in,” says Nithin Eapen, founder of consulting firm Chance River and stablecoin investor. “That means they see the potential of making money or saving costs.” However, Eapen pointed out that these coins are still “government-controlled fiat banking” — in other words, stablecoins issued by JP Morgan and Facebook will not be available outside their respective firms.

What are the types of stablecoins?

There are four broad types of stablecoin as outlined below:

Fiat-backed stablecoins

As the name indicates, fiat-backed stablecoins are cryptocurrencies which are pegged to fiat currencies in a 1:1 ratio. This means that stablecoins claim to hold as much in fiat currency as the coin’s trading volume. The US dollar is the most popular fiat currency for backing stablecoins, with the Euro a distant second. Tether and USDC are stablecoins pegged to the US dollar. EURS, a stablecoin launched by cryptocurrency startup Stasis, is backed by the Euro.

Asset-backed stablecoins

Gold is the most popular asset for backing stablecoins. In this type of backing, each stablecoin is backed by an equivalent or fractional amount of the asset. The advantage of this approach is that stablecoins are backed by a tangible asset that can be redeemed in adverse circumstances. Asset-backed stablecoins are being built on a variety of platforms.

Digix Gold ($DGX) is an ERC-20 token backed by 1 gram of bullion from the London Bullion Market Association-approved refiners. The company behind the token calls it a “digital representation of physical gold” and says that its reserves will be audited every three months. Another example of an asset-backed stablecoin is the Tiberius coin, which is backed by a combination of seven precious metals used in technology products. The company’s contention is that the coin’s price will rise in tandem with an increase in usage of these metals in technology products.

Crypto-collateralized stablecoins

As the name indicates, this is a class of stablecoins backed by cryptocurrencies. Crypto-collateralized stablecoins are essentially smart contracts which enable investors to leverage their cryptocurrencies for stablecoins. But, the leverage is not a simple 1:1 ratio as in the case of fiat-backed stablecoins because cryptocurrencies are volatile assets prone to wild price swings.

Crypto-collateralized stablecoins have implemented a number of measures in order to maintain parity. With crypto-collateralized coins, a multiple of the pegged cryptocurrency is deposited for a single stablecoin which will ensure that the peg is maintained, even if the underlying cryptocurrency crashes or drops by a significant amount. Stablecoin holdings are also automatically liquidated if the peg drops below a specified threshold.

DAI, a stablecoin issued by MakerDAO, is the most popular among this taxonomy of stablecoins. MakerDAO uses the concept of smart contracts called Collateralized Debt Positions (CDP) which are used to deposit pooled Ether to maintain a 1:1 soft peg against the US dollar. An equivalency between the amounts of pooled Ether and US dollars does not exist. So, it may be possible that MakerDAO holds 100 Ether for every single dollar that it holds.

Algorithmic stablecoins

Algorithmic are the newest iteration of stablecoins, in which critical tasks, such as issuance of coins and price monitoring to maintain pegs, are performed by algorithms instead of humans. A high-profile startup called Basis, backed by some of the biggest names in venture capital, issued the most well-known algorithmic stablecoin, which it styled after the Federal Reserve’s economic system.

Basis’s stablecoin project consisted of three parts — the stablecoin, bond tokens and share tokens — and the algorithm functioned as a central bank, disbursing and burning (or eliminating) tokens depending on the economic situation. Despite its sterling credentials and backing, the project ran afoul of federal regulators and went under in 2018. No other algorithmic stablecoins are presently in circulation.

Should you invest in stablecoins?

The answer, as always, is: It’s complicated. Unlike other cryptocurrencies, stablecoins do not appreciate in value or have volatile daily price swings. Thus, the potential for investors to profit off basic trading operations is limited.

On the other hand, during a market crash, stablecoins could serve as a safe haven because they allow traders to remain within a complex and highly technical cryptocurrency market rather than cash out into fiat currency losses.

In an interview, Rune Christensen, MakerDAO cofounder, posited that stablecoins could become an indirect method for investing in the underlying peg (i.e. an investment in a stablecoin pegged to the US dollar is akin to putting money into the greenback). Similarly, gold-backed stablecoins represent investments in the precious metals while crypto-collateralized coins are indirect investments in the cryptocurrencies that hold the peg.

However, Christensen’s  assessment may not be completely accurate as certain stablecoins do not have a 1:1 exchange ratio with their peg. As we know, crypto-collateralized stablecoins are especially susceptible to volatility since they are backed by instruments that have proven to be unstable.

Eapen, from Chance River, makes the case that an investment in entities issuing stablecoins is a fixed income investment, similar to dividend distribution by publicly listed companies. Investors step in to fulfill capital requirements for stablecoin startups and companies. These companies earn interest and fees from transactions involving their coins, such as redemption or purchase. Those fees are distributed back to investors periodically.  

And, as previously described, stablecoins are used as rails to move funds between different cryptocurrencies. Having a stash of stablecoins makes transactions smoother overall and ensures that crypto traders lose less time in reacting to the market, or, as Eapen explains: “They are keeping the gunpowder dry and ready.”

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