What Are Stablecoins?
And why you should care about them
Stablecoins are digital tokens that are designed to maintain a designated price peg. Unlike tokens such as ETH or BTC, which are considered highly volatile, stablecoins have minimum fluctuations in price. If you’re new to the crypto space, you’ve probably heard of tokens such as USDC, DAI, or Tether. These are some of the most popular stablecoins on the market.
Most of us enter the crypto space with expectations of wild price movements and high risk investments. Stablecoins, however, are meant to provide a safe haven from the rocky crypto markets.
But isn’t crypto meant to be a financial casino where anyone can become a millionaire overnight?
Not quite.
What’s the point of stablecoins?
To answer that question, we need to have a brief look at different types of money. When we think money, we’re often thinking about fiat currency such as the US Dollar or the Euro. But, in today’s complex economies, money serves many different purposes and isn’t necessarily just fiat currencies. There are many different types of money in an efficient economy. For the purposes of this section, however, we’re going to look at two main types of money. There’s debt money and there’s collateral money. Both are equally important in a thriving economy.
Debt Money
This is a type of money that’s really useful for things like loans, such as USD. Why is that? Many reasons. But the primary reason is because it’s inflationary. Yes you read that right. Inflation is useful. It makes money worth less overtime which makes it easier to pay back on a long-term loan. This means more people can take loans, spend more, and keep the economy growing. Imagine if the value of a loan increased at a similar rate to the stock market. It would be crippling for all of society.
Debt money is also handy for things such as purchasing pizza and ice cream because it maintains a relatively stable value over time. You wouldn’t want to purchase (or sell) pizza with a type of money that had potentially rapid price movements up or down. It doesn’t work for either party.
Collateral Money
Collateral money, on the other hand, can be easier to think of as assets. When people take loans or engage in financial contracts, they need assets as collateral. A bank won’t give you a loan unless you provide them with an insurance policy in the form of valuable collateral. Real estate is one of the most common forms of collateral and serves this purpose well. Historically it increases in value, which means a lender will feel comfortable accepting it as collateral against a loan. Stock and bonds can also be considered collateral money.
In the context of the Ethereum economy, the ETH token is best placed as collateral money (the asset), and stablecoins are debt money. In the early days of crypto, people envisaged that BTC and ETH would become a new type of money that could replace fiat currency. As the space as matured and evolved, however, it became evident that this wasn’t feasible. The rapid increase in value of these assets made it impossible to consider them a replacement for money. This is why stablecoins were born. Without stablecoins, we’d never be able to create an efficiency economy on crypto rails.
So How Do They Work?
There are a few different kinds of stablecoins on the market, depending on the type of mechanism used to build and secure the designated price peg. The 3 most common types of stablecoins are collateralised, algorithmic, and fractional. Let’s have a look at what this means.
1. Collateralised
As mentioned earlier, stablecoins are designed to maintain a designated price peg, most often the US Dollar. Collateralized stablecoins are able to achieve this by holding US dollars as collateral at a 1:1 ratio with the issued token supply. So, if there’s a circulating supply of 10 million collateralized stablecoins, it means a cash reserve of 10 million US dollars is held in a bank account to backup this price. Every token is redeemable for 1 USD. Examples of collateralised stablecoins are USDC, USDT (Tether), and DAI, from MakerDAO.
2. Algorithmic
Algorithmic stablecoins take a completely different approach. They hold zero collateral of the designated fiat currency. Instead, they’re collateralized by a ‘sister’ cryptocurrency and rely on an algorithm to stabilize the price of the token towards the designated price peg. The algorithm regulates supply and demand of the stablecoin based on the price of the crypto collateral.
Algorithmic stablecoins help make the project more decentralized but can lead to increased risks to the token holders in unstable market conditions. Due to the violent collapse of the UST token earlier this year, algorithmic stablecoins have garnered a bad name from financial regulators and the crypto community alike.
3. Fractional
Finally, there are projects that take a hybrid approach. They rely on both fiat currency collateral and algorithms to stabilize and secure the token peg. This typically means they don’t have a 1:1 ratio of fiat collateral backing the token. The actual ratio depends on the project and the approach they’ve chosen to adopt. The first fractional stablecoin is FRAX from Frax Finance. This project holds collateral of 93% against total supply and the rest is algorithmically managed. Some say the fractional approach is the future of stablecoins. Time will tell.
Now that you know what stablecoins are and have a baseline understanding of how they work, you’re probably wondering…
When would you need to use stablecoins?
For a well functioning economy to flourish, you need to have people who are spending money. To do that, they need the right kind of money. People need to be able to easily exchange their money for things like pizza and ice cream, or pay other people for their services. Using a token like ETH or BTC for these types of transactions isn’t very efficient and will lead to a stalling economy, because most people believe these tokens will appreciate over time and would rather hold on to them. This is where stablecoins play a big role in the crypto economy and allow cryptocurrency to be used in traditional economies and markets as well. Let’s look at a few use cases.
Paying for services
Let’s say you own a business in the United States, and want to pay an invoice to a contractor based in Japan, who also has subcontractors in Europe. You’ll need to exchange your US Dollars for Euros and Yen before sending it to each respective bank account in their country. This currency exchange costs money and takes time. Furthermore, you’ll need to understand the requirements for wiring money to each country, using each of these currencies, following each party’s specific banking procedures. It’s a mess, it takes time, and it’s expensive. Stablecoins solve this by allowing you to send money to anyone in the world within minutes. All you need is their public wallet address.
If you’re looking to build a new tool in web3 and you need a smart contract developer, you’ll want to use stablecoins. It makes the exchange of goods and services way easier in this crypto economy and massively increases the efficiency compared to our traditional economies.
Engage in DeFi
Need to loan money quickly but you’re not happy with the terms from your bank? Jump into the world of DeFi and you can check out the going rates for a USDC loan on Binance or Aave. It’s permissionless and allows you to take a loan within minutes. No approval or processing time needed.
Savings
If you want quick access to crypto assets, but market conditions are prohibiting you from taking a position right now, stablecoins are your safe haven. They keep you in the crypto economy without having to take on the risk of fluctuating prices in crypto assets. I keep cash in USDC anytime I’m looking to rebalance or re-evaluate my crypto positions. However, your assets don’t need to sit statically in a wallet gathering dust. Why not jump into DeFi and provide liquidity for people who are looking to borrow money? You’ll get paid some interest on your stablecoins and can easily swap them into other crypto assets when you’re ready to take a new position without having to wait for people to repay you (the beauty of liquidity pools). Another great way to earn some higher interest (although it’s not guaranteed) is by depositing your stablecoins into PoolTogether.
The final question on most people’s mind is…
Why not just use regular money?
The answer to this lies in the entire crypto thesis. Regular money comes with strings. Lots of them. First off, you need approval to send or transact with fiat money from your bank and the recipient bank. This can be massively prohibitive for transactions that are time sensitive. Furthermore, it’s far from private. Not only does your bank and government know exactly what you’re paying for and to who, private companies do too. Your financial data is traded amongst companies, eroding your right to privacy by the day. There are so many reasons why stablecoins are a better way to do business and transact compared to fiat money. This would warrant an entire article all by itself so I’ll leave you here.
Stablecoins are the basis of our future economy and have brought us one step closer to decentralized finance in the mainstream.
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