Crypto Education
What are Stablecoins?
An in depth article explaining all you need to know about cryptocurrency stablecoins.
Introduction: What are stablecoins ?
Stablecoins are a type of cryptocurrency created to grant stability, or one might say less volatility than other cryptocurrencies. The initial reason for this was to provide a means of exchange for trading assets. As the applications on decentralised networks have evolved they have become a means of participation in DeFi (decentralised finance) applications. These applications are similar to those of traditional finance but with many additional benefits. By using stable assets you can participate in DeFi without the exposure to the whims of the market faced by other crypto assets .
Some stables are backed by a reserve of the asset they are pegged to while others use algorithms to keep their value stable. A pegged cryptocurrency is a coin whose value is tied to that of some other medium of exchange, such as the currency of a given nation. Once the exchange rate is established between the currencies (usually 1:1), the value of the cryptocurrency fluctuates in the same direction and to the same degree as the currency to which it is pegged.
How do they work ?
Just like any other cryptocurrency, stablecoins are based on blockchain technology and are circulated on decentralised networks using cryptography and other measures to keep transactions secure. Most cryptocurrency, such as Bitcoin, has a current value which is decided based on what the market will bear and have become known for less predictable fluctuations than those of traditional markets.
Stablecoins often rely on stable assets as a basis for their value. The most commonly used forms of stablecoins are pegged to a fiat currency such as the U.S dollar or the Euro. They can also have their value pegged to real world assets, such as gold , or they can have their value pegged to other cryptocurrencies. When their value is pegged to a relatively stable external asset, they are less likely to fluctuate in value than a cryptocurrency whose value is decided based on factors such as supply and demand. Essentially these assets closely resemble the traditional centralised currency system.
The prevalent idea behind a stablecoin is that each coin is to be backed by whichever asset its value is tied to. These assets are held in reserve and act as collateral for the stablecoin. Stablecoins have become a fundamental part of DeFi, which allows financial transactions to be made without a middleman or intermediary party such as a bank. Stablecoins, such as USD Coin, Dai and Tether, have some of the highest market capitalisation in the crypto market. This is due in part to the fact that they have been shown to be reliable throughout the market events of the past years.
Types of stablecoins
There are a number of different types of stablecoins and they can have different structures.
- Fiat-Collateralised Stablecoins
Fiat-collateralised stablecoin issuers maintain a reserve of fiat currency such as the Euro or more commonly the U.S. dollar. This is used as collateral which assures the stablecoin’s value. At the time of writing one of the biggest stablecoins on the market is USD Coin (USDC), which was launched in September 2018 by Circle. All of the USDC in circulation is backed by its equivalent thus for every USDC there is $1 to back it.
2. Crypto-Collateralised Stablecoins
Overcollateralization is used to define a situation where an asset (or assets) value, that is to be used as collateral on a loan, exceeds the loans value. It is commonly used by borrowers to reduce credit risk for the creditor thus enhancing a loan’s credit rating.
In the cryptocurrency lending world, collateral refers to the asset that a borrower pledges as a guarantee that they will repay a loan. In traditional banking, a common example of collateral is mortgage. The house or apartment that is being financed is used as the collateral which ensures the buyer pays a loan and in the event of default can be sold to retrieve the cost.
Instead of being backed by a stable traditional currency such as the U.S dollar, these stablecoins are backed by other cryptocurrencies. So as not to lose their value to the fluctuations of the crypto market these stablecoins are over-collateralised. When done the right way this ensures the value of the reserved cryptocurrency is more than that of the stablecoin.
Dai is an example of a tried and tested overcollateralized stablecoin which is pegged to the dollar but backed to date primarily by Ethereum. Dai began as an Ethereum based stablecoin (ERC-20 token) that maintains a value equal to one U.S dollar. This is done through an automatic system of smart contracts on the Ethereum blockchain.
Dai is created when users borrow against locked collateral, and it is destroyed when loans are repaid. If you deposit Ethereum or other cryptocurrencies accepted as collateral, you will create new Dai. When you pay back the borrowed Dai, the locked collateral will be recovered.
Since cryptocurrencies are volatile, Dai can be used as a hedge against volatility, especially at times when traders believe the price of cryptocurrencies could crash. Dai token keeps the value of $1 since it is soft-pegged to the dollar.
3. Algorithmic Stablecoins
Algorithmic stablecoins do not need to be backed by reserve assets. Their value is kept stable through a supply control system, determined through an algorithm that is calculated by a computer program. It is similar to the system used by central banks, which do not rely on a reserve, such as gold, to keep the value of the currency stable. Some see this as the basis of what future currencies will be.
What are stablecoins used for?
The uses for this asset class have multiplied in recent times. They began life as a bridging system and safe ‘parking space’ for those who trade in crypto assets. The rise of decentralised finance (DeFi) applications has seen continued growth in their utility.
Stablecoins are often used by people to trade in cryptocurrencies more easily than if they were to use other traditional currencies. They are used as a bridge between an asset such as Bitcoin and traditional currency. Traders sell their asset for a stable asset and then convert this into a currency such as the dollar.
In the beginning stablecoins were not usually used for investments as there is not much increase in their value due to the fact they are usually pegged to assets such as the dollar. With the evolution of DeFi which typically offers greater returns on savings than traditional banking they continue to grow in popularity as more people access savings mechanisms and other forms of DeFi. Stablecoins provide most of the liquidity in DeFi applications such as decentralised exchanges and lending protocols
Trading in stablecoins allows you to keep all of your transactions within a decentralised network such as Avalanche rather than convert to traditional currency through a crypto exchanges and incur exchange fees.
For example, let’s say you own an asset which you want to sell now and in the future you want to buy Avax. Until recently because Avax and other assets are on different blockchains you could not exchange them without using a centralised exchange. As well as time spent you often end up paying some additional transaction fees. Now you can trade your asset for stablecoins, such as USDC which you can then use to buy Avax without the exchange rates and transaction fees applied by centralised exchanges. That said many crypto exchanges do not apply fees when exchanging between U.S dollars and stablecoins.
Stablecoins have just begun to become a practical means of payment for the real economy. Currently holders can spend their crypto assets, stable or otherwise, through the use of crypto linked credit and debit cards from providers such as Wirex. A continuing growth of developers working on ways to make use of stables coupled with the continued growth of adopters of this asset class makes it ever more likely that new ways of transacting with stablecoins are not far away.
Conclusion
Even though stablecoins are less volatile than other cryptocurrencies they still come with their own risks that arise from using new technology, such as unknown bugs in an unreliable smart contract or participation in a risky yield bearing platform. However, the biggest issues to face stablecoins will most likely come in the form of government regulation.
While regulation which serves the public is welcome, some entrenched lobbyists wish to undermine the benefits and democratic developments of the new DeFi market. It appears to threaten the control of the traditional centralised financial system but is that not what a free market represents, the ability for the individual to choose that which best serves their needs and interest?
Recent events in ecosystem collapse have shown that crypto collateralised stablecoins underpinned by risky design which mirror the worst aspects of traditional financial mechanisms should be avoided at all cost. You may have heard about how TerraUSD lost its peg to the US dollar on 9 May and crashed to a price below USD 10 cents after 16 May. This occurred through a process of debt creation rather than over collateralisation. If something seems too good to be true it usually is. For example the offer of receiving a 20% annual return for staking an asset without transparent explanation of how this is achieved should be viewed as extremely high risk.
Always do your own research, the idea of stable assets is to mitigate risk not expose yourself to it. There are many benefits to be had through taking part in decentralised networks, their applications and using the assets at hand but you should proceed with a firm understanding of what you are participating in.
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