Stablecoins peg market value to an external reference, read on to find out how it works.
As of October, Tether, the largest stablecoin in the world, is the fifth largest cryptocurrency in the world. As of October 18, Tether has a market capitalization of over US$69 billion. However, to make sense of this development, let’s break down what a stablecoin is, and then look at the various kinds of stablecoins and what the future holds for them.
What is a stablecoin?
When one thinks of cryptocurrency, the concern of highly fluctuating prices follows suit. A stablecoin seeks to remove this concern by giving all the benefits of quick transaction speed, low transaction costs, and cybersecurity along with the relatively stable valuations of conventional currencies.
Stablecoins act as a bridge between “fiat” currencies (currencies issued by the government of a country) and cryptocurrencies. It does so by keeping a reserve of the asset that backs up the stablecoin. For example, if a stablecoin is worth US$1 per unit, it would keep the same amount of money in US dollar as a reserve. This would mean that the user of the stablecoin could theoretically exchange it for its value in US dollar.
There are drawbacks to the stablecoin system as well. These include requiring a reliable third-party who would shoulder the responsibility of being an independent custodian and keep the reserve of assets backing the stablecoin, such as fiat money or other cryptocurrencies. This third-party independent custodian needs to be transparent so that the users can confirm whether the stablecoin is operating without a license in the region where the reserve is held. This knowledge can help minimize financial losses to the user in case the reserve gets frozen in the future due to licensing issues.
Different kinds of stablecoins operate within different collateral systems. The main categories of stablecoins are fiat-collateralized coins, crypto collateralized coins, and non-collateralized algorithmic coins.
Fiat collateralized stablecoins
Fiat collateralized stablecoins are ones that value themselves in terms of conventional currencies. This method pegs the stablecoin at 1:1 against a fiat currency. The reserve of the fiat currency to which such stablecoins are pegged is regularly audited for compliance by independent custodians. This is done to ensure that the collateral valuation is being maintained as per the value of the stablecoin in circulation.
Examples of this include TrueUSD, Tether USD and TerraUSD. These currencies are valued to the US dollar. Each individual coin in these currencies is equivalent to US$1.
Crypto collateralized stablecoins
Crypto collateralized stablecoins use other cryptocurrencies as collateral or reserve. As previously mentioned, other cryptocurrencies have high volatility, thus crypto collateralized stablecoins are “over collateralized”. This means that a large reserve of the cryptocurrency is maintained for a small number of stablecoins. Therefore, even if the pegged cryptocurrency loses its value, the stablecoin will still be covered and its rate will not fluctuate drastically.
One such stablecoin is Maker Dao’s DAI. DAI maintains a stable value of US$1 and allows the use of a basket of crypto-assets as a reserve.
Non-Collateralized Algorithmic Stablecoins
These coins do not use any form of currency as collateral. Instead, their stability is maintained by a mechanism used by central banks. They rely on an algorithm that controls the supply volume of the token in order to retain its value. The stablecoin can be valued as a fiat currency.
One such stablecoin is FEI under Fei Protocol. It has attracted 639’000 ETH (US$1.3 billion) in seed capital but has not established a solid peg against a fiat currency. Another algorithmic stablecoin is CarbonUSD, which is a hybrid fiat-algorithmic currency. CarbonUSD’s co-founder Miles Albert says that the company is driven to be as transparent as possible, “CarbonUSD will undergo frequent third-party attestation to verify that each token is one-to-one [dollar to token] backed.”
Future prospects of Stablecoins
Stablecoins pose their own set of unique challenges along with the benefits of a stable value. Their stable value allows users to make transactions without being concerned about daily fluctuations before making a purchase. For example, this enhances the reach of e-commerce websites without the added expense of transaction charges. In the long run, this stability may allow Stablecoins to perform important financial functions such as loans and credit, as well as decentralized insurance solutions.
A stable and decentralized currency allows those who live in countries facing financial crises to invest their capital in a more structured source of value. It allows them to carry out transactions globally without using banks as mediators.
As stablecoins get adopted by both businesses and individuals, we may see growth. Initiated in 2019, the stablecoin Terra has been growing 35% month after month. With over a million users, who use it for online purchases ranging from groceries to hotel bookings, Terra is demonstrating the potential of stablecoins.
Header Image courtesy of Unsplash