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What are stablecoins and why they are needed?

In Jan 2021, the stablecoin universe has reached nearly $40 billion in supply with monthly transaction volume exceeded $200 billion. Stablecoins present the best opportunity to allow digital assets to scale into everyday financial services.

Stablecoins are emerging as the private sector’s answer to central-bank digital currencies (CBDC), with the likes of PayPal, Facebook-backed Diem, and crypto-native stablecoins poised to use these tools to transform payments and other financial services. However, the transition is likely to be gradual.

What are Stablecoins?

As the definition goes –

“Stablecoins are digital assets designed to mimic the value of fiat currencies like the dollar or the euro. They allow users to cheaply and rapidly transfer value around the globe while maintaining price stability.”

Cryptocurrencies like Bitcoin and Ethereum are very volatile in nature when priced against fiat currencies. This is to be expected, as blockchain technology is still very new, and the cryptocurrency markets are relatively small. The fact that the value of a cryptocurrency isn’t tethered to any asset is interesting from a free-market perspective, but it can be cumbersome when it comes to usability.

From a point of view of technology, cryptocurrencies are excellent but when it comes to payments they are considered very risky because by the time a transaction settles, coins can be worth significantly more or less than they were at the time they were sent. This makes cryptocurrencies non-ideal for making payment or used in any financial service directly.

On the other hand, stablecoins have no such issue because these assets see negligible price movement and closely track the value of the underlying asset or fiat currency that they emulate. As such, they serve as reliable safe-haven assets amid highly volatile crypto markets.

Now to understand how stablecoins manage stable price movement, it is also important to understand how fiat currency does it. There are two primary reasons for the price stability of fiat currencies. First they are backed by some reserves and second the timely market actions by the controlling authorities, like central banks. Since fiat currencies are pegged to an underlying asset, such as gold or forex reserves which act as collateral, their valuations remain free from wild swings.

Even in certain extreme cases when a fiat currency’s valuations may move drastically, the controlling authorities jump in and manage the demand and supply of currency to maintain price stability. The bulk of cryptocurrencies lacks both these key features—they don’t have a reserve backing their valuations and they don’t have a central authority to control prices when required.

Stablecoins attempt to bridge this gap between fiat currencies and cryptocurrencies. There are three categories of stablecoins, all based on their working mechanism.

What are the different categories of stablecoins and how they work?

Below are some of the most common categories of stablecoin –

Fiat-backed stablecoins

Dollar backed stablecoins

This is the most popular kind of stablecoin that is directly backed by a fiat currency with a 1:1 ratio. It is also called fiat-collateralized stablecoins. A central issuer (or bank) holds an amount of fiat currency in reserve and issues a proportionate amount of tokens.

Fiat-collateralized stablecoins maintain a fiat currency reserve, like the U.S. dollar, as collateral to issue a suitable number of crypto coins. Other forms of collateral can include precious metals like gold or silver, as well as commodities like oil, but most of the present-day fiat-collateralized stablecoins use dollar reserves.

Tether (USDT) and TrueUSD are some very well known and popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits. Other popular stablecoins in this category includes BUSD, maintaining a peg with the US dollar, and BGBP, which tracks the British pound.

Crypto-backed stablecoins

Also known as crypto-collateralized stablecoins, mirror their fiat-backed counterparts, with the main difference being that cryptocurrency is used as collateral. But since cryptocurrency is digital, smart contracts handle the issuance of units. 

To simply put crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized”—that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins.

To acquire this kind of stablecoin, users lock their cryptocurrency into a contract, which issues the token. Later, to get their collateral back, they pay stablecoins back into the same contract (along with any interest).

For example, $2,000 worth of ether may be held as reserves for issuing $1,000 worth of crypto-backed stablecoins which accommodates for up to 50% of swings in reserve currency (ether). More frequent audits and monitoring add to price stability.

Example of crypto-backed stablecoins are MakerDAO’s DAI that backed by ethereum and is pegged against the U.S. dollar and allows for using a basket of crypto-assets as a reserve.

Crypto-backed stablecoins are trust-minimized, but it should be noted that monetary policy is determined by voters as part of their governance systems. This means that you’re not trusting a single issuer, but you’re trusting that all the network participants will always act in the users’ best interests.

Algorithmic stablecoins

Algorithmic stablecoins are also known as Non-Collateralized (algorithmic) Stablecoins aren’t backed by fiat or cryptocurrency. Instead, their peg is achieved entirely by algorithms and smart contracts that manage the supply of the tokens issued. Functionally, their monetary policy closely mirrors that used by central banks to manage national currencies.

In an algorithmic stablecoin system, if the price falls below the price of fiat currency it tracks, the token supply is reduced and if the price surpasses the tracked fiat currency, new tokens enter into circulation to reduce the value of the stablecoin.

One example of such a coin is the dollar-pegged base coin uses a consensus mechanism to increase or decrease the supply of tokens on a need basis.

Some of the most popular and used stablecoins are –

Tether

Tether or USDT is one of the oldest stablecoins, launched in 2014, and is the most popular to this day. It’s currently one of the most valuable cryptocurrencies overall by market capitalization. 

The primary use case for USDT is moving money between exchanges quickly to take advantage of arbitrage opportunities when the price of cryptocurrencies differs on two exchanges; traders can make money on this discrepancy. But it has found other applications: Chinese importers stationed in Russia have also used USDT to send millions of dollars worth of value across the border, bypassing strict capital controls in China.

Tether (USDT) price trend for 1 year, source: CoinMarketCap

USD Coin

USD Coin is a stablecoin that was launched in 2018. It is managed jointly by the cryptocurrency firms Circle and Coinbase through the center consortium. Like tether, USD Coin is pegged to the U.S. dollar. It is the second-largest stablecoin by market capitalization.

MakerDAO Dai

Dai is a stablecoin on the Ethereum blockchain that runs on the MakerDAO protocol. It was created in 2015 and pegged to the U.S. dollar and backed by ether Ethereum token ETH.

Diem

Diem (formerly known as Libra) is a stablecoin in the works, originally conceived by the powerful, worldwide social media platform Facebook. While libra did not see the light of the day, it had more psychological impact than any other stablecoin.

Governments, notably China’s, are now exploring their own crypto-inspired digital currencies, in part because they’re worried Diem would be a competitive threat since Facebook is a multinational company with billions of users from across the globe.

Initially, the Diem Association, the consortium set up by Facebook, said Diem would be backed by a “basket” of currencies, including the U.S. dollar and the euro. But due to global regulatory concerns, the association has since backed off from its ambitious original vision. Instead, it is now planning to focus on developing multiple stablecoins, each backed by a separate national currency.

Although stablecoins have some disadvantages primarily related to transparency (if issuers don’t provide transparency about where their reserves are held, which can help a user determine how risky the stablecoin is to invest in). Stablecoins are a critical component of the cryptocurrency markets. Through a variety of mechanisms, these digital currencies can remain more or less steady at set prices. This allows them to be used reliably not only as mediums of exchange but as a safe haven for traders and investors.

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