We discussed some Defi concepts last week, and you might notice that the terms “coins” and “tokens” were presented several times. What are the differences between them? Can they be used interchangeably? What are stablecoins? In today’s post, we will discuss them in detail:
- Coins vs Tokens
- Centralised stablecoins
- Decentralised stablecoins
Coins vs Tokens
TL;DR: A coin has its blockchain, whereas a token “borrows” a coin’s blockchain infrastructure and run the network on top of it.
Let’s say a team has a fantastic idea about a product or service they want to provide that requires some level of “currency” concept in the ecosystem. Still, they do not want to build the blockchain infrastructure from scratch due to a lack of resources or time constraints. This is when the tokens come into play. Instead of creating a brand-new network and worrying about the safety or stability of the blockchain, the team can focus on the quality of the service by introducing tokens, which still offers the capability that a coin can deliver. Most of the tokens follow the ERC20 standard, and you can find out more here: https://ethereum.org/en/developers/docs/standards/tokens/erc-20/
Note that it is possible to migrate the token to coin when the ecosystem matures. For example, it often happens at the later stage of a project when the foundation has built up, and the platform requires a more independent network. Or it could simply be the team identifies some optimisation opportunity on the existing blockchain(they are borrowing) and want to build a better one. This means that the new native blockchain is now responsible for validating all transactions and storing information.
Tokens can be on multiple blockchains. A typical example is stablecoins. According to ethereum.org — “Stablecoins are Ethereum tokens designed to stay at a fixed value, even when the price of ETH changes.” [1] So stablecoins are just tokens on different blockchains, which makes sense as each blockchain needs some representation of fiat currencies.
Even coins can be on other networks as tokens! For example, there is a “Binance-peg Ethereum Token” on the Binance Smart Chain(BSC) network. It is just a representation of ETH on the BSC network. Why do we need that? If you have traded with ETH before, you might have noticed the high gas(transaction) fee on the ETH blockchain, which can range from $10-$100 for each transaction, depending on the network activity level. However, it only costs about 50 cents on BSC per transaction! Therefore, traders can save tons of transaction fees by trading with the Binance-peg Ethereum Token.
There are several types of tokens, but I am just going to discuss the three main types briefly in the crypto market at the moment:
Utility tokens
Users can trade utility tokens within the ecosystem. They serve single or multiple functions on the blockchain they are built on. It’s similar to the coins for the arcade game machines. You need to pay cash(fiat currencies) for exchanging some coins(crypto tokens) at the reception(CEX or DEX, of course, you will need to use stablecoins at DEX), and use it to play games on the machines(use the product/service/protocol on the platform). For example, the AAVE tokens for the AAVE Defi protocol.
Security tokens
A real-world asset backs the security tokens. That means for each token on the blockchain, there is a one-to-one mapping to a physical asset, such as gold. Why do we need this? Well, it is indeed harder to hack a crypto wallet than break into a house and steal the gold. PAX Gold (PAXG) is an example of security tokens: “Every PAX Gold token is backed by an ounce of allocated gold.” [2]
Governance tokens
Some DEXes have tokens for governance purposes. Governance tokens hold power to vote for a change in the platform, such as increasing the profit rate from transaction fees for liquidity providers. The more tokens you own, the more voting power you have. However, this introduces the centralisation problem: if a person holds 51% of the token’s total supply, they effectively control the entire decision-making power for the platform. An example of governance tokens is the UNI token for Uniswap DEX.
Stablecoins
As explained above, stablecoins are typically backed by a fiat currency without volatility, meaning the price does not fluctuate like other cryptocurrencies.
But do you know there are differences between stablecoins? Let’s discuss.
Centralized stablecoins
Centralised stablecoins are created by companies and regulated by the government. They are fiat collateralised, meaning that one stablecoin is pegged to one unit of a fiat currency. This unit is primarily dollars($), not cents. It’s also straightforward to purchase centralised stablecoins at CEXes. Examples of them are USDC and USDT.
However, centralised stablecoins are not as safe as you think. The reasons are the following:
- Because the government regulates them, the company that developed the coins can freeze all the stablecoins in your crypto wallet. For example, this happened during the recent Russia-Ukraine war.
- They may not be backed by the asset the company claimed. Tether created USDT, and the company declared that each USDT minted is backed by one US dollar. Many people raised concerns regarding the validity of this statement because Tether has not been transparent about its reserves. It turns out that concerns became the truth: Tether recently revealed their reserves breakdown due to audit requirements. Let’s take a look:
Only 3.89% out of the 75.85% “Cash Equivalents” are cash! As you can see, people believe that 1 USDT = 1 USD if it is pegged to the US dollar, so what will happen if this is not the case? Is it still safe to hold USDT? We shall see.
Decentralized stablecoins
Decentralised stablecoins are maintained by communities, meaning they are not regulated by the government. So how do the communities ensure that the price of decentralised stablecoins is pegged to fiat currencies? This is achieved by utilising smart contracts to manipulate the price. While some decentralised stablecoins, such as DAI use collateral mechanisms in the smart contract, I want to explain how the Terra ecosystem works in this blog. When writing this blog, UST — a stablecoin developed by Terra, has the largest market cap under the decentralised stablecoins category.
Terra is a POS blockchain and it aims to be the VISA of the crypto market. It has two main types of coins:
- decentralised stablecoins that are pegged with fiat currencies. These include UST for USD, KRT for KRW, EUT for EUD.
- the native coin LUNA for utility purposes, such as paying transaction fees.
So how does Terra maintain the price of UST, for example? When the value of UST mismatches the value of USD, the ecosystem incentives people to do certain things to stabilise the price of UST. These include burning(destroying) or minting(creating) UST to keep the price consistent due to supply and demand. Let me elaborate using some examples:
- if 1 UST > 1 USD, that means we need more UST to reduce the price. It incentivises people to burn LUNA for minting more UST to achieve this. For example, let’s say you have 10 UST and 1 LUNA, and the price for 1 UST is $1.5, whereas for 1 LUNA is $10. Because the ecosystem assumes that 1 UST = 1 USD, so 1 LUNA = 10 USD = 10 USTs, you can burn 1 LUNA for 10 USTs. But since the price for 1 UST is $1.5, LUNA holders who burn 1 LUNA(-$10) to mint 10 USTs will gain 50% profit by selling them at $15(+$15). From doing so, more USTs are minted, meaning the price of UST will drop back to $1 until LUNA holders cannot generate more profit.
- If 1 UST < 1 USD, that means we need less UST to increase the price. People are incentivised to burn UST and receive LUNA as rewards. For example, if 1 UST is only worth $0.5 and you have 10 USTs, you can burn all 10 USTs(-$5) to earn 1 LUNA(+$10), so you get a 2X return. Since the amount of USTs has reduced from the burning, the price will go up until it reaches $1 again.
However, because the algorithm calculates the price of UST, this does mean that it is more volatile.
Outro
That’s all I have for today. I hope you enjoy the content and see you next week!
Reference
[1] — https://ethereum.org/en/stablecoins/
[2] — https://paxos.com/paxgold/
