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Understanding DeFi: stablecoins explained

The advent of cryptocurrencies has given rise to a new financial universe, but the technology has suffered from a lot of criticism. One of the key arguments used to discredit cryptocurrencies like Bitcoin and Ether is the price volatility the assets are often prone to.

While price volatility is common with cryptocurrencies still in their infancy, a number of solutions have been developed to combat the problem. Stablecoins limit price fluctuations by tracking the price of other assets. Their value is often pegged to traditional fiat currencies such as the US dollar, and they can be thought of as a type of synthetic asset. Stablecoins are designed to be worth the same as the asset they’re pegged to, and they’re not restricted to fiat currencies.

In recent years, stablecoins have grown to become one of the most fundamental components of the cryptocurrency landscape. Today they account for over $30 billion of value on the Ethereum network.

Stablecoins on Ethereum (Source: CoinMetrics)

Uses of stablecoins

Stablecoins have a number of uses. They’re often used for decentralised finance activities like liquidity mining, lending and borrowing. Stablecoins can also be used to earn yield — currencies like aDAI pay interest on DAI deposited in Aave (aDAI is available in Monolith, among others).

aDAI, available through Aave with Monolith

Moreover, stablecoins can be used as an alternative to fiat currencies. Transactions are settled on the blockchain, so they’re often faster and more affordable than fiat money. That’s something the payments giant Visa has doubled down on: in late 2020, it was announced that they would be partnering with Circle to facilitate USDC payments to 60 million merchants worldwide.

Stablecoins could also improve the lives of people in deprived countries around the world. In addition to their partnership with Visa, Circle recently helped provide medical workers with USDC amid Venezuela’s economic crisis. It’s the first example of stablecoins being used to fight hyperinflation.

Types of stablecoins

Stablecoins come in various forms, and each has their own advantages and disadvantages.

Fiat-backed

The most commonly used stablecoins are collateralised with fiat. That means the equivalent fiat value is always held in a reserve and can be issued in exchange for the stablecoin. They require a custodian, and are also subject to regular audits. This is to ensure that the custodian stays compliant and their reserves are sufficient.

Fiat-backed stablecoins rarely fluctuate in price, but they are centralised. Whatever happens, a provider has to issue the tokens.

Examples of fiat-backed stablecoins include GUSD, PAX, USDC and USDT, all of which are available in Monolith (other than PAX, they can all be used to top up the Monolith Visa debit card).

Crypto-backed

Crypto-backed stablecoins work differently to fiat-backed tokens: they’re backed by crypto assets, and they must be overcollateralised. That means that the underlying asset backing the stablecoin must exceed its value. For example, a $1 stablecoin might be backed by $2 worth of ETH collateral.

Crypto-backed stablecoins need to be overcollateralised because assets like ETH are volatile. If the price of ETH drops, more collateral needs to be added to maintain the peg.

Crypto-backed stablecoins have become a backbone of the DeFi ecosystem, but they’re also prone to risk. On “Black Thursday”, when crypto assets plummeted 50% in response to Coronavirus, many MakerDAO loans became undercollateralised, which resulted in DAI losing its $1 peg.

Examples of crypto-backed stablecoins include DAI, sUSD, SAI, aDAI, cDAI and CHAI, all of which are available in Monolith.

DAI is the base currency of Monolith

DAI is currently the most popular crypto-backed stablecoin. It gets minted when users lock up their funds in MakerDAO. It’s also the base currency of Monolith, used to swap between tokens and for spending on the Monolith Visa debit card.

Commodity-backed stablecoins

Some stablecoins are backed by commodities such as gold.

Though less common, they provide a hedge against crypto volatility, as well as fiat currencies. Like fiat-backed stablecoins, they require an issuer, so they’re not trustless. The most common type of commodity-backed stablecoin is gold, though it’s likely more will emerge in the coming years as the cryptocurrency space continues to grow.

An example of a gold-backed stablecoin is DGX, which is available in Monolith.

Algorithmic stablecoins

Algorithmic stablecoins don’t rely on collateral: they use algorithms and smart contracts to calculate what the supply should be to achieve a certain price. For example, if a token’s price increases to $1.20, the circulation of tokens will be increased to bring the price down to $1. Though that means the number of tokens you own changes, the percentage of the supply you own stays constant.

One advantage of algorithmic stablecoins is that no collateral is required. But there’s risk associated with relying on an algorithm. In a memorable DeFi drama, YAM Finance used a rebasing system for its token, but the project suffered a failure when a bug caused the currency to inflate the supply.

Examples of algorithmic stablecoins include AMPL, YAM, ESD and LUNA. You can find AMPL in Monolith.

Hybrid stablecoins

Hybrid stablecoins combine different features of other types of stablecoin. They often use reserves of both fiat and crypto tokens as collateral, as well as algorithms.

While hybrid stablecoins aim to combine the best features of different types of stablecoin, they are more complex for regular users to understand.

Reserve acts as a flexible pool of stablecoins, including DAI, USDC and more (Source: Reserve)

RSV (Reserve) is an example of a hybrid stablecoin. It uses a flexible pool of tokenised assets including USDC and DAI.

Conclusions

In summary, stablecoins have become a crucial component of the cryptocurrency ecosystem, and their usage is growing. More than only a useful form of collateral in DeFi, stablecoins have shown promise in solving issues such as the hyperinflation crisis affecting Venezuela.

Now that you’ve learned about the different types of stablecoin, which ones have you used? What do you think about the pros and cons of each? And will stablecoins see wider adoption around the world as DeFi grows?

For more on stablecoins, read our guide to mStable here.
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Monolith

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Monolith is the world’s first DeFi wallet and accompanying Visa debit card made for spending crypto assets anywhere.

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