Everything You Need to Know About Stablecoins

The cryptocurrency markets frequently come under fire for their speculative nature. The price of Bitcoin is notoriously volatile. In January 2017, it was valued at around $1,000, rising to nearly $20,000 in December 2017, and falling again to $3,500 in January 2019. There are many reasons attributed to this volatility, from uneven wealth distribution to the laws of supply and demand. Regardless of the explanation, stablecoins emerged as cryptocurrency’s response to market instability.

A stablecoin is simply a digital asset which has its value pegged to another asset. In most cases, stablecoins are collateralized by the pegged asset in one way or another. Put simply, if there are one million USD-pegged cryptocurrency coins in circulation, there should be $1m USD held in reserve to back up the value of the cryptocurrency.

The Utility of Stablecoins

Stablecoins have become popular because they serve as both a store of value and as a medium of exchange within the volatile cryptocurrency markets. Trading fiat currencies is a regulated business, so cryptocurrency exchanges that accept fiat are rarer than those exchanges operating crypto-to-crypto trades.

For the average cryptocurrency day trader, denominating trades in Bitcoin or other major cryptocurrency comes with significant risk. After all, Bitcoin can quickly go up or down, negating any profits from a trade in different coins.

Stablecoins overcome this risk. They allow traders and investors to denominate their trades in a currency pegged to the US dollar. This means they can easily convert their profits back to fiat without incurring losses due to cryptocurrency market swings. Furthermore, stablecoins are in a digital value that are pegged to currencies, such as pegged to US Dollar, Traders use stablecoins in their balance sheets. So they have no profits or losses from currency conversion at the end of the year when they do their tax filings.

However, since the emergence of the first US dollar-backed stablecoins, the market has evolved. Stablecoins are now central to the growing decentralized finance (DeFi) movement, which consists of distributed applications covering lending, insurance, exchanges, and derivatives trading, among others.

Furthermore, several different types of stablecoins have emerged. These include cryptocurrency-backed stablecoins, commodity-backed stablecoins, and even coins backed by a basket of different assets.

Fiat-Backed Stablecoins

These are the first and most popular type of stablecoins. Tether (USDT) was the first to emerge in 2014. For years, Tether maintained that the USDT was 100% backed by reserves of US dollars. They published information to support their claim that Tether had been 100% backed. During 2019, Tether updated its terms to reflect that some reserves now consist of collateralized loans as well as fiat currencies.

The incident caused other stablecoins, such as TrueUSD, to publish audit reports verifying the existence of their own reserves. Regardless, Tether has maintained its market dominance. At the time of writing, it has a market cap of around $4bn. The closest competitor is USD Coin (USDC) issued by Coinbase, which has a market cap around one-tenth that of Tether.

Although US dollar-backed stablecoins are the most popular, other fiat-backed coins exist. TrustToken has issued several stablecoins backed by British pounds, Australian dollars, and Hong Kong dollars, among others.

In the eyes of decentralization advocates, the major disadvantage of fiat-backed cryptocurrencies is that they maintain dependence on banks. Reserved funds can be subject to inflation or even confiscated. Therefore, cryptocurrency-backed assets were developed to combat these shortcomings.

Cryptocurrency-Backed Stablecoins

The very idea of a stablecoin backed by cryptocurrencies seems almost absurd. After all, cryptos are volatile by nature, so any stablecoin backed by a cryptocurrency asset isn’t going to be stable. However, smart contracts can manage the volatility to ensure that these coins remain stable even despite the fluctuations in the cryptocurrency markets.

Dai, the stablecoin issued by Maker, is the most well-known of the crypto-backed stablecoins. Dai is kept stable through a system of smart contracts called collateralized debt positions (CDPs). These are backed by ether (ETH) and automatically regulate the value of Dai, so it’s kept equivalent to the US dollar. The underlying mechanisms are somewhat complicated , but there are many helpful explainers available for those who are interested.

Asset-Backed Stablecoins

For those who prefer to put their trust into assets other than fiat or cryptocurrencies, asset-backed stablecoins provide a further alternative. Digix is an example of a coin backed by gold. Venezuela has previously issued its own national cryptocurrency backed by oil, called the Petro. The principle is that the stablecoin is backed by an underlying asset which has a relatively stable value. The asset could be almost any type of commodity, providing people are willing to trade it.

Asset-backed currencies offer vast potential to bring new value to governments, institutions, and individuals. We have covered asset-backed currencies in detail in a previous blog post.

Takeaway

At their core, stablecoins represent just one way of tokenizing assets. Stablecoins proved able to weather the prolonged bear market in cryptocurrencies remarkably well, leading to some predictions that they will outlive Bitcoin. Regardless of whether or not that happens, their popularity within the cryptocurrency community demonstrates a promising outlook for the adoption of asset tokenization in mainstream society.

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