Stablecoins: Everything You Need to Know in 2020
Stablecoins are cryptocurrencies whose price is pegged to another asset, which reduces price volatility and makes them suitable for everyday use. They’re not all created equal, though.
Bitcoin started a digital currency revolution when it went live on January 3, 2009. Now there are over 5,000 cryptocurrencies on the market!
The vast majority of these cryptocurrencies have extremely volatile prices that can pop or plummet 50% or more any given day. While this makes them suitable for very exciting (and risky) investments, they are unfit for everyday spending.
That’s where stablecoins come in.
In this article, we’ll review the following topics and learn more about the massive impact stablecoins can have on the economy:
- What is a Stablecoin?
- The History of Stablecoins
- What Can Stablecoins Be Used For?
- Types of Stablecoins (and their pros and cons)
What is a Stablecoin?
Stablecoins are cryptocurrencies whose value is pegged to another asset, whether a fiat currency like the US Dollar or a commodity like gold or oil.
Compared to other cryptocurrencies, stablecoins are designed to be more practical to be used to purchase goods and services (i.e. as a medium of exchange) because they avoid wild price fluctuations and volatility that traditional cryptocurrencies experience.
If cryptocurrencies’ prices are like riding a huge, looping, up-and-down roller coaster at your local theme park, stablecoins are akin to riding the Thomas the Tank Engine train ride in the kids area.
Everyone knows about the Bitcoin Pizza Guy, Laszlo Hanyecz, who spent 10,000 Bitcoins on 2 pizzas on May 22, 2010. Back then, those Bitcoins were only worth $30. At today’s price of about $5,000 per Bitcoin, they’re now worth over $50,000,000! Stablecoins aim to avoid this kind of price volatility so they can be used for everyday purchases like pizza.
Many stablecoins are also collateralized, meaning they are backed by another asset held in reserve. For instance, if there are 1 million of Euro-pegged stablecoins in circulation, there should be at least 1 million Euros held in a bank to back those coins.
In short, you can think of stablecoins as the digital equivalent of fiat currency that you can spend everyday. There’s a lot more nuance to this though, as you’ll learn throughout this article.
The History of Stablecoins
Though stablecoins have recently seen gains in popularity and adoption, the idea of a stable digital currency is actually pretty old.
E-gold was a digital gold currency operated by Gold & Silver Reserve Inc. that launched in 1996. Users’ accounts were denominated in grams of gold (or other precious metals) and they could easily and instantly transfer value (“spends”) to other E-gold accounts. The company grew to over five million accounts and processed more than $2 billion worth of spends per year at its peak. Transfers on E-gold were halted in 2009 due to legal issues.
Liberty Reserve is another stable digital currency that was launched in 2006 and based in Costa Rica. It was a centralized digital currency that allowed users to create an account and transfer money with only a name, email address, and date of birth. Deposits could be made via credit card or bank wire, and these funds were converted to Liberty Reserve Dollars or Liberty Reserve Euros, which were pegged to the US Dollar and Euro, respectively. The company was shut down in 2013 by the US Government for money laundering and operating an unlicensed money transmitting business.
In addition to E-gold and Liberty Reserve, there have been many other lesser-known stablecoins that were launched (and subsequently shut down).
As you can see, stablecoins have been around in some form for decades. But today’s stablecoins are in a much better position to succeed compared to their predecessors.
What Can Stablecoins Be Used For?
Stablecoins have the potential to integrate themselves into our everyday lives. Additionally, investors and institutions can benefit from their stability and durability.
While the list of possible uses of stablecoins below isn’t comprehensive, it gives us a glimpse into how transformative stablecoins can be.
Everyday purchases and payments
Stablecoins have the potential to replace Dollars, Euros, Rupees, or whatever your local fiat currency is as an everyday medium of exchange.
Eventually you’ll be able to buy coffee, pay your bills, and purchase groceries everywhere by using your mobile phone to transfer stablecoins to merchants. No more carrying cash or credit cards around.
Your employer may even pay your salary in stablecoins. They can set up recurring payments to pay you every two weeks and these payments will happen automatically and instantly with very little effort.
Stablecoins have the potential to change how we use money everyday.
Stablecoins are extremely beneficial for both consumers and corporations for making payments across international borders.
The World Bank reported that global remittances hit an all-time high in 2018, with $689 billion moving across borders. $529 billion of this total went to low- and middle-income countries, presumably by migrant workers sending money home.
Currently, these migrant workers have to use global money transfer services like MoneyGram and Western Union to send their money home. This process takes a long time and these companies take out huge fees for their services.
By using stablecoins, migrant workers can send money to their families’ crypto wallets with low fees, quickly, and without the price volatility of other cryptocurrencies.
Multinational companies can also use stablecoins to settle cross-border payments instead of using current solutions like SWIFT that take days to clear payments and cost an arm and a leg.
They can also use stablecoins to pay the salaries of international workers quickly and cheaply.
Stable trading asset
Retail and institutional traders can benefit from stablecoins in a number of ways.
Due to stringent local regulations, most crypto exchanges don’t currently support fiat currencies. Exchanges skirt this issue by offering crypto-fiat trading pairs by using stablecoins that are backed by US Dollars (or other fiat currencies) instead of actual fiat. This increases adoption of cryptocurrencies and lessens dependence on Bitcoin as the only on-ramp to crypto trading.
Stablecoins also offer traders a more stable option when crypto markets get very choppy and volatile. If you believe that the price of the cryptocurrencies in your portfolio are going to drop, you can trade them out for a stablecoin and maintain value until it’s time to buy the dip.
Stablecoins also allow you to enter and exit trading markets without the need to convert your assets into fiat. This avoids currency exchange fees and takes banks out of the equation, which is always a good thing.
Protection from fiat inflation
Venezuela is in a monetary and economic crisis right now.
The Central Bank of Venezuela estimated that the country’s inflation increased to 53,798,500% between 2016 and April 2019, essentially making the Bolivar (their fiat currency) absolutely worthless. Venezuelans can’t afford essentials like food and water. The country is in a tailspin.
Venezuelan citizens can transfer their Bolivars into stablecoins to protect themselves from losing more value.
Inflation is happening all over the world, and stablecoins may be the answer for citizens to break free from their central banks’ mismanagement of money.
Types of Stablecoins
There are three primary types of stablecoins:
Let’s review each of these categories and their pros and cons.
Asset-collateralized stablecoins are backed by another asset in reserve. This backing helps the stablecoin maintain its stable value and allows the user to redeem the value of their coins when desired.
Asset-collateralized stablecoins can be backed by three types of collateral:
Let’s dig into each of these.
For every one fiat-collateralized stablecoin issued, there should be one unit of fiat currency kept in a bank as backing.
For instance, if you have 10 million units of a stablecoin that is pegged to the US Dollar, there should be $10 million US Dollars sitting in a bank somewhere.
When you want to cash out your stablecoins, the managing entity should be able to easily take out the fiat from their reserves and pay you out. The equivalent amount of stablecoins will be taken out of circulation or destroyed.
Tether (USDT), the most prominent and widely-used stablecoin in existence today, is a fiat-collateralized stablecoin.
Tether is the 4th largest cryptocurrency by market capitalization and has the highest daily trading volume of any coin (even higher than Bitcoin).
The stablecoin is supposed to be backed 100% by the US dollar, but Bitfinex, the company behind Tether, revealed last year that only 74% of all Tether is backed by cash and securities. This highlights one of the concerns with fiat-backed stablecoins — trust in a central entity.
Other fiat-backed stablecoins include Circle and Coinbase’s USDC, Paxos Standard (PAX), Binance USD, HUSD, and many more.
Advantages of Fiat-Collateralized Stablecoins
The first advantage of fiat-backed stablecoins is that they are simple and easy to understand. People already understand how to use fiat currencies, so the transition to fiat-backed stablecoins is relatively easy. Because of this, fiat-backed stablecoins are the most common type of stablecoin and have the highest adoption.
And being backed by proven, widely-used fiat allows these stablecoins to maintain their peg relatively easily (assuming that the economy of the country the stablecoin is pegged to stays stable itself).
Disadvantages of Fiat-Collateralized Stablecoins
The primary drawback of fiat-collateralized stablecoins is that they are managed by a central entity. This causes a few issues:
- Single point of failure: This central entity is a potential single point of failure. If they go bankrupt, the value of the stablecoin goes to zero and you’re out of luck.
- Trust: You need to trust the central entity to do the right thing. You need to have confidence that they won’t issue too much of the stablecoin so that the value won’t drop, they have enough fiat collateral in reserve, and they will operate honestly and in good faith.
- Regulatory oversight: Increased oversight is needed for fiat-collateralized stablecoins. External audits are necessary to ensure there is enough fiat collateral in reserve, and because these coins deal with government fiat, they are more susceptible to governmental involvement.
- Inefficiency: Fiat-backed stablecoins rely on fiat currency payment systems and processes, which can be slow and expensive, thus making them less efficient.
Instead of being backed by a fiat currency, commodity-collateralized stablecoins are backed by other types of valuable assets such as gold, real estate, and oil.
In 2018, Venezuela introduced its national cryptocurrency called the “Petro.” A mentioned earlier, Venezuela’s fiat currency, the Bolivar, has had a history of massive inflation. President Nicolas Maduro created the Petro to hopefully solve the country’s financial woes.
Originally, Maduro claimed the Petro would be backed by 5 billion barrels of oil, only to lower that collateral to 30 million barrels. And as much as the Venezuelan government has tried to increase the use of the Petro, adoption has been slim to none.
Digix is a stablecoin built on the Ethereum network where one DGX is backed by one gram of gold. The physical gold is stored in a vault in Singapore and gets audited every three months to ensure that there is enough to back the amount of DGX in circulation. If you own DGX and want to cash out for physical gold, you can book a flight to Singapore to do so!
Advantages of Commodity-Collateralized Stablecoins
The first advantage of commodity-collateralized stablecoins is that they give you exposure to assets that you may not typically have access to. For instance, it’s pretty difficult to buy and store a fraction of a bar of gold. But if you own a gold-backed stablecoin like DGX, you theoretically own a piece of that precious metal.
When compared to fiat-backed stablecoins, commodity-backed stablecoins are less susceptible to inflation and typically hold their peg more easily. This is because it’s much more difficult to mine gold or create more real estate than it is for a central bank to print more fiat money.
Disadvantages of Commodity-Collateralized Stablecoins
Disadvantages of commodity-backed stablecoins are similar to those of fiat-backed coins:
- A central party still manages the coins.
- You have to trust that this central party will do the right thing.
- There is still regulatory oversight to ensure there is enough collateral.
- Commodity payment systems are even more inefficient than those for fiat, and it may take you a very long time to cash out.
The development of the Petro highlights many of the issues of commodity-backed stablecoins, namely it being managed by a central party, and citizens’ lack of trust in this party.
Finally, we have crypto-collateralized stablecoins — those that are backed by one or more cryptocurrencies.
These stablecoins are much more permissionless and decentralized because the assets that are backing them — cryptocurrencies — run on public blockchains and aren’t controlled by central parties like fiat currency and commodities are.
The most popular crypto-backed stablecoin is DAI, which is created by MakerDAO. This system is built on the Ethereum blockchain and allows Ethereum (ETH), Basic Attention Token (BAT), and now USDC as collateral to obtain DAI.
The platform had major issues when the price of ETH tanked on March 12, 2020, which led to mass liquidations, a loss of millions of dollars ( read our blog post about what led to the MakerDAO loss to learn more), and the addition of USDC as collateral.
Other crypto-backed stablecoins include EOSDT and Wrapped Bitcoin (wBTC).
Advantages of Crypto-Collateralized Stablecoins
The primary benefit of crypto-backed stablecoins is that they are much more decentralized than their fiat- and commodity-backed counterparts because everything is built on blockchains. No centralized entity controls your funds, which allows for increased trustlessness and transparency.
They also benefit from increased liquidity and thus can quickly be converted into the underlying asset when necessary.
Disadvantages of Crypto-Collateralized Stablecoins
MakerDAO highlights a few of the drawbacks of crypto-backed stablecoins.
Cryptocurrency prices can be extremely volatile. In order to absorb these price fluctuations and mitigate risk, MakerDAO forces you to overcollateralize to a 1.5:1 Collateralization Ratio (CR) — meaning that you’ll have to deposit $150 worth of collateral to acquire $100 worth of DAI. If the CR dips below 1.5:1, your stablecoins and collateral are at risk of getting completely liquidated.
There are a couple of issues that using crypto as collateral leads to.
First, by using volatile crypto as collateral, Maker is susceptible to the huge price drop of ETH that they saw on March 12, 2020. The protocol wasn’t built to account for this massive price decrease and millions of dollars was lost by users and the platform as a result.
Furthermore, if a very large percentage of a specific cryptocurrency is locked up as collateral in the system and its price tanks, the mass liquidations will likely cause that cryptocurrency’s price to further crash. This avalanche effect could cause instability across the greater cryptocurrency ecosystem.
Next, price oracles are necessary to ensure that the CR is being met by DAI borrowers. This oracle is a point of centralization. If the collateral price that comes from these oracles are inaccurate or manipulated, illegitimate liquidations can occur and the system can crumble.
Finally, putting up this much collateral isn’t accessible nor realistic for many users, putting DAI out of reach for much of the world.
While DAI is the most decentralized stablecoin, there is still one entity who maintains the stability and security of the system, and they can be a point of failure.
The complexity of these systems are also a big hurdle in adoption. The way DAI is minted is extremely complicated, and many avoid using MakerDAO because of this complexity.
Non-collateralized stablecoins are exactly what they sound like — they don’t use any collateral to back them.
The prevailing philosophy of this type of stablecoins is that the US Dollar, Euro, and many other fiat currencies are not backed by any tangible assets; rather, they are backed by the social belief that these currencies are worth something. Thus, this model can be applied to digital stable currencies as well.
The primary category of non-collateralized stablecoins is algorithmic stablecoins. Also known as the “Seigniorage Supply” or “Seigniorage Shares” model, these stablecoins use algorithms and smart contracts to balance supply and demand. These algorithms increase supply when the price of their stablecoin is getting too high, and buy coins in circulation when the price is too low, to maintain its peg.
Algorithmic stablecoins have been a difficult nut to crack. The most high-profile example is Basis. Positioned as a “stable cryptocurrency with an algorithmic central bank”, Basis maintains its stability by issuing and buying bonds in response to changes in demand for its coin. Basis acquired $133 million in funding by top-tier investors but shut down at the end of 2018.
Other examples of algorithmic stablecoins include Nubits, BitBay, and others, most of which either haven’t gained traction or shut down.
Meter is creating a new category of non-collateralized stablecoin that we call “ economic consenus-based “ stablecoins. Meter doesn’t rely on algorithms to maintain its stable value — it uses the profit-seeking behavior of Proof-of-Work miners instead — and is immune to many of the drawbacks of algorithmic stablecoins (which are mentioned below).
Advantages of Non-collateralized Stablecoins
The primary pro of non-collateralized stablecoins is that they are the most decentralized form of stablecoin.
Because they are completely built on the blockchain and run by code, they are trustless and free of human intervention.
They are independent of fiat or crypto market crashes because they don’t need collateral.
Finally, non-collateralized stablecoins theoretically should hold their peg more easily due to their independence from collateral.
Disadvantages of Non-collateralized Stablecoins
The first drawback is that algorithmic stablecoins rely on continual future demand in order to be successful.
For example, as mentioned earlier, Basis issues bonds to investors when demand for its coin is low (and thus price is below its peg). But these bonds are susceptible to getting priced lower and lower, as investors are motivated to wait for prices to decrease before they buy. This causes a downward price spiral that may cause the stablecoin’s value to plummet to 0. In short, there is no true consensus on the value of the stablecoin due to lack of fundamentals in token economics.
The algorithms behind these stablecoins are very complicated and difficult for average users and investors. This may hinder adoption.
The model used by algorithmic stablecoins to maintain their peg may be subject to regulatory scrutiny. This was the case for Basis, where the bond and share tokens they sold to maintain the Basis coin peg to the US Dollar were likely to be considered securities by financial authorities.
Finally, this model of stablecoin is extremely young and unproven, as evidenced by how many have failed.
Hybrid stablecoins combine two or more aspects of the aforementioned models — fiat-collateralized, commodity-collateralized, crypto-collateralized, and algorithmic — into a single token.
Facebook Libra, in its current plan, will be a hybrid stablecoin. As of now, the vision is for Libra to create multiple stablecoins backed by fiat, then another multi-collateral stablecoin backed by these stablecoins.
Another example is Reserve, which will use a combination of crypto-collateralization and algorithms to maintain its peg to the US Dollar. Initially, the Reserve token will be backed by a number of tokenized assets, but eventually the coin will algorithmically maintain its own peg.
Advantages of Hybrid Stablecoins
Hybrid stablecoins can combine the best characteristics of different stablecoin models. This combination can be very attractive to users and investors who seek certain traits not available in non-hybrid coins.
Disadvantages of Hybrid Stablecoins
Hybrid stablecoins can sometimes be even more complex than purely algorithmic stablecoins. Combining asset backing with complicated algorithms may scare off users and investors who don’t fully understand the technology, which in turn may hinder adoption.
Hybrid stablecoins may also be scrutinized by regulators if they involve any aspects that resemble securities.
Finally, like algorithmic stablecoins, hybrid tokens are young and unproven.
Stablecoins already come in many shapes and sizes. Yet the space continues to evolve quickly, as newer entrants attempt to solve the issues that face currently available tokens.
This is because the potential of stablecoins is clear — they can help transform the global economy by providing a steady medium of exchange suitable for many everyday uses.
What are your thoughts about the different types of stablecoins and their pros and cons? Do you have a favorite stablecoin that you currently use? We’d love to hear from you.
We hope you enjoyed this article! If you did, show us some love by 👏🏻 clapping 👏🏻 (up to 50x!) to help other people find this post.
To stay updated on all things Meter, visit our website and join us on Twitter, Telegram, Discord, and Facebook.
Originally published at https://www.meter.io