What are Stablecoins and why do we need them?
ELI5 (explain like I’m 5) stablecoins and why they’re very much needed for crypto adoption.
One of the the latest developments, of 2018–2019, in the crypto world, is the rise of the so called Stablecoins.
Stablecoins are basically cryptocurrency coins pegged to the US dollar, meaning 1 stablecoin = $1 USD, in most cases. Some of the more better known stablecoins are Tether, Dai (by MakerDao), USDC and PAX.
Why do we need stablecoins in the first place?
Well, unless you’ve been sleeping under a rock for the past 2 years, you should be well aware of the extreme volatility in the crypto space.
Bitcoin went from around $700 US to $20,000 US in 2017, before coming back down to $2,800 US at the end of 2018. Same goes for Ether(Ethereum), which bounced between $10 US to around $1,300 US in the past 2 years.
Obviously, this is quite a wild ride for anyone that invested in crypto and it doesn’t do much in terms of using cryptocurrencies as a method of payment or enabling a truly decentralized financial system. You cannot guarantee the “real world” value(US dollar/Euro value) of any payment transaction sent in crypto, which is touted as one of the most common use cases for the technology in the first place.
For anyone holding BTC or ETH this could be cause for sleepless nights and periods of anxiety, considering the extremely wild swings of the past couple of years.
Stablecoins are supposed to remedy the volatility issues, by providing the much needed stability. Just as the the word says, “Stable”, is the name of the game here.
How are they stable?
Each of the stablecoin projects mentioned above, uses a different type of mechanism to keep its peg to the US dollar, basically its stability. I won’t go into much detail about that, as it’s not really the point of this post, but I will at least mention the basics.
The most common one is the US dollar-backed stablecoin, like Tether and PAX.
Another one is the asset-backed stablecoin, like in the case of DAI and a third would be the algorithmic stablecoins like Basis (a failed project as of this wiriting).
Tether
The Tether coin uses a 1 to 1 US dollar redeemable backed coin, by providing US currency liquidity, stored in a bank of its choosing. You can theoretically redeem 1 Tether for $1 US dollar at any point in time from the Tether bank.
This means, that they need to provide US currency liquidity, based on the market demand for Tether, to be able to keep the peg as close to $1 US as possible.
Obviously, this is a very centralized system, in which you need to trust the Tether org. for liquidity and funds stored. You can read more about Tether here, on their website. https://tether.to/
DAI by MakerDAO
Another very interesting project, which is a lot more decentralized and superior, in my opinion, is the DAI stablecoin system, by MakerDAO.
DAI is an asset-backed coin, which is generated by the creation of CDPs (Collateralized Debt Position), a system that locks in Ethereum as collateral and in turn, it generates DAI, as the value in US dollars of the locked Ethereum.
For example if 1 ETH = $150 US, then by locking 1 ETH in a CDP, you’ll receive 100 DAI. The reason you receive $100 and not $150, is because the CDP needs to be overcollateralized for it to work.
Currently Ethereum is the only collateral accepted, but they’re planning to role out a multi-collateral version this year.
The whole DAI stablecoin system has a very interesting and relatively complex mechanism to keep its peg to the dollar, which involves the MKR token and various triggers for auctioning CDPs, etc. You can read more about it here https://makerdao.com/en/dai
Conclusion
It’s easy to see why the development and rise of the crypto stable coins is an evolutionary must-have for the space. I see it as an essential part, one of the building blocks, on the long road to mass adoptions and a decentralized financial system.
Hope you found this post helpful.
If you’d like to learn more about Stablecoins and Maker DAI, check out the links below.
Stablecoins Overview, a more detailed write-up
Ciao!
