A condensed Guide on Stablecoins — Kasuria

While the cryptocurrency industry has undergone an incredible bull run in the first months of 2021, with the market cap temporarily peaking at over $2.5 trillion just to plummet by nearly 50% in the subsequent months, it is exactly this circumstance that once again revealed a major issue standing in the way of mainstream adoption of crypto — the tremendous volatility. On the one hand, this volatility is precisely what makes the likes of Bitcoin, Ether and other tokens prone to speculation and literally forges overnight millionaires, however, on the other hand when it comes to actually replacing traditional financial services, this is an obstacle that can’t be neglected. Let’s elaborate why stablecoins are a good start into crypto and present plenty of new opportunities.

What’s the Problem?

An essential prerequisite in order to widely compete with the conventional finance and banking sector is price stability. Although pice stability is pretty much the opposite of gaining attractive returns in a short period of time, it is a necessity for seamless trade, commerce, forecasting, payments and the functioning of the entire economy in general.

How can businesses and individuals rely on cryptocurrencies to be their new way of transacting if their holdings could lose 20%, 30% or 40% of their value in a matter of days?

This is where an increasingly used and popular class of cryptocurrencies that revolves around solving this particular problem comes into play: Stablecoins. As their name suggests, stablecoins attempt to provide stable prices and seek to combine the best traits of traditional finance and digital money. They aim to merge decentralization, cheap and ultimately secure transactions, high accessibility and transparency with the volatility-free stable valuations of fiat currencies. However, as we will see in this article, stablecoins might not always achieve these ambitious objectives.

There are multiple ways of achieving the desired stability, either by collateralizing the coins with underlying reserve assets or by applying sophisticated algorithms. The majority of stablecoins is pegged at a 1:1 ratio to respective fiat currencies and can be traded on decentralized exchanges or centralized crypto-exchanges like Binance or Coinbase, just like any other token.

Types of Stablecoins

1. Fiat-backed Stablecoins

Fiat-backed stablecoins are based upon a fiat currency reserve, such as the Euro, Chinese Yuan or US-Dollar. The fiat money serves as collateral which allowing for the issuance of a certain quantity of tokens. Usually, for each unit of collateralized fiat currency, one unit of stablecoin is issued, e.g. 1 token is backed by an equivalent of USD 1,-.

An example for such a fiat-backed stablecoin is the TrueUSD (TUSD), an ERC20 token collateralized by legally protected US-Dollar reserves. The issuer has to comply with a number of rules and regulations and is audited for adherence to the respective standards on a regular basis.

2. Commodity-backed Stablecoins

These stablecoins, similar to the US gold standard (“ Bretton Woods System”) that existed from 1944 until 1971, rely on commodities instead of fiat currencies as reserves. They can either be collateralized by a single commodity, like gold or oil, or a basket of different commodities, like a selection of multiple precious metals. Especially for critics who deem the intangibility of cryptocurrencies as a fatal flaw (which today applies to the overwhelming majority of non-collateralized fiat currencies as well) this kind of coin might be the ideal solution as it provides, in principle, real physical value. Depending on the value of a single unit of the respective stablecoin, this might even be some sort of fragmentation of otherwise fairly pricey assets and therefore increase their affordability.

One good example of a commodity-backed stablecoin is Kinesis Money, which is backed by physical silver (KAG) or gold (KAU). Each token is equivalent to 1 gram of the underlying precious metal. The gold and silver are vaulted across various locations globally and audited regularly to guarantee transparency.

3. Cryptocurrency-backed Stablecoins

Collateralizing stablecoins using other cryptocurrencies is a viable option as well. As the crypto-reserve itself might fluctuate heavily in price, over-collateralizing these stablecoins is necessary and common practice. It means the collateral’s value exceeds the value of issued stablecoins.

A well-known example is MakerDAO’s stablecoin DAI: to issue DAI, collateral worth more than 150% of the desired amount of DAI is locked up in a DeFi smart contract called a vault. If the value of this collateral falls below a previously set threshold, it is being liquidated automatically.

4. Algorithmically adjusted Stablecoins (AAS)

Instead of relying on any assets to back them, these stablecoins, also called non-collateralized stablecoins or seigniorage shares, make use of algorithms to maintain price stability. In some sense, this resembles the interference of central banks when their currency is suffering from extreme price swings, exaggerated devaluations and speculative attacks. AAS reply to significant market events by applying respective measures that are hard-coded into smart contracts and aim at creating stability.

Unlike the previously mentioned alternatives which in one way or another ultimately rely on at least one entity, AAS, once launched, are fully decentralized and give rise to institution-independent monetary policy, something that has never really been accomplished in history before. Some projects working on this include Basis Cash, Frax and Terra Money with its leading token “UST” that is pegged to the US-Dollar.

A good example to illustrate the mechanism behind AAS is Ampleforth (in their own words: “an inflation-resistant, decentralized, stablecoin”), which simply responds to changes in supply and demand by increasing or decreasing the total amount of AMPL tokens. There are three different states that AMPL needs to adjust to:

a) Expansion

If for some reason the demand for AMPL spiked, and 1 AMPL would temporarily be priced at $1.5, the algorithm would automatically enlarge the total supply of AMPL by a factor of 1.5, so that each AMPL would be valued at $1 again.

b) Contraction

This describes the exact opposite scenario: Once the demand for AMPL token significantly drops and a temporary devaluation occurs, the circulating amount of AMPL is automatically decreased in order to artificially create additional scarcity.

c) Equilibrium

Lastly, there is the state of equilibrium where no intervention is required. This state exists as long as the price of 1 AMPL does not deviate more than 5% from the underlying US-Dollar.

The figure below shows the core principle behind AMPL. Once the 5%-threshold is violated either the expansion or contraction mechanism sets in and adjusts the AMPL supply.

Further Considerations

One aspect to bear in mind is that stablecoins are only as stable as their underlying asset — be it gold, silver, fiat currencies, real estate or cryptocurrencies. And all of these can — obviously to varying extents — fluctuate in relative value.

Besides that, there also is an issuer risk — that is if the issuer (or the protocol itself) is getting into trouble (e.g., when questions about the proper collateralization of the issued amount of coins arise). This has repeatedly been the case with Tether’s USDT token.

Furthermore, one can often observe deviations of stablecoins’ prices from their pegs, in many cases resulting from changes in trading volumes. A study by Santiment, a crypto analysis firm, gathered extensive data about the volatility of nine stablecoins:

Usually, whenever the price of these coins deviates from the peg (USD 1,-), arbitrageurs should step in, exploiting the “mispricing” and thus eliminating the price discrepancy. However, as with fiat currencies that are pegged to one another, there is no guarantee that this will always be the case.

The following graph shows the maximum all-time deviations of some of the most important stablecoins.

While there is no distinctive pattern identifiable as to when these extreme fluctuations occur, generally they tend to happen during turbulent market times. For example during the Corona-crash in 2020 or the crypto market crash in May 2021, stablecoins exhibited deviations from their pegs. Also in some instances, major price swings come along with the novelty of the projects — it might just take some time to gain long-term stability, identify potential concerns and eliminate other threats.

Final thoughts

Stablecoins appear to be a — if not the — key ingredient in making blockchain, cryptocurrencies and decentralized finance accessible for mainstream investors, as they act as a relatively secure “investment haven” in an otherwise turbulent space. In particular this is the case for more conservative, less crypto-enthusiastic investors like professional asset managers and institutional investors. Given the opportunities to earn very attractive yields (even in real terms) on stablecoins, it willl be a matter of time until institutions enter this space.

Furthermore, it is also worth reflecting upon the opportunities stablecoins offer in bringing financial services to the so far “unbanked” — a staggering number of 1.7 billion people globally. Stablecoins will be a necessity in that context, as they allow for the easy execution of everyday transactions (groceries, utility bills, etc.) in a digital and more and more decentralized financial system. Traditional cryptocurrencies are less suitable in this environment, due to their enormous volatility vs. fiat money.

In summary, stablecoins have a variety of use cases and benefits making them an ideal entry point for anyone who wants to benefit from DeFi, without having to bear the high volatility of “normal” cryptocurrencies.

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