What Are Stablecoins

Stablecoins have been growing in popularity over the past couple of years. The pandemic has further increased the demand for them. It’s natural as these coins address the issue of high volatility, common for all cryptocurrencies. Today, we will talk about what stablecoins are, and who will benefit from their widespread adoption.

What Are Stablecoins: Basic Explanation

Stablecoins are cryptocurrencies with their value pegged to a traditional or a digital asset. It may be

  • well-established fiat currencies
  • commodities like gold, oil, etc.
  • other cryptocurrencies

Besides, the value of some coins isn’t linked to any asset at all. We will deal with this classification a bit later.

Stablecoins are getting popular as they promise to make digital currencies more stable and thus more usable for the average person or business. At the same time, they retain the benefits of typical cryptos: transparency, reduced operational costs, speed, borderlessness.

Ideally, stablecoins seamlessly integrate tradition with innovation.

Types of Stablecoins

At the most general level, there are 2 basic classes of stablecoins: asset-collateralized and non-collateralized. “Collateralized” means “backed”. For instance, USD backs USDT coin.

Also, the first category falls into 3 types, depending on the asset class used. They are fiat-collateralized, commodity-collateralized, and crypto-collateralized stablecoins.

Non-collateralized (algorithmic) stablecoins stand apart from the rest.

To summarize, we have 4 types, each serving a specific purpose. As we promised, we are going to explore them in more detail below.

Fiat-backed Stablecoins

Some popular representatives of this class are Tether, USD Coin, TrueUSD, BitUSD, and some others. The underlying fiat currency (USD, EURO, GBP, etc.) backs such a stablecoin in the ratio of 1:1.
It means that 1 USD Coin = 1 USD.

Example:
You deposit $10,000 at a centralized institution like a bank or a crypto exchange. This institution issues 1 USDT for every dollar it receives from you. Therefore, the value of your holdings doesn’t change. (Of course, the underlying fiat currency may suffer some volatility, but it’s another story).

When you decide to withdraw your funds, this bank or exchange makes a transfer and then “burns” the stablecoins. In this context, burning means the issuer sends your coins to a public address where they will stay forever because the private keys of this address are impossible to obtain. In other words, they make your coins unusable.

Commodity-backed Stablecoins

Stablecoins of this category build on some interchangeable asset. In a way, they resemble fiat currencies, when they were backed by gold.

This metal is the most popular (but not the only) underlying commodity. For instance, TCX coin represents a basket of seven demandable metals that are likely to grow in price in the future. This basket includes nickel, cobalt, platinum, and copper necessary for some industries with great potential.

The advantages of this coin type are obvious: your “digital gold” is as good as the real one. Cryptocurrency finally becomes tangible: there’s a certain amount of precious metal or a part of the real estate portfolio behind it.

Among other things, it gives new investment opportunities to middle-class people. Commodity-collateralized stablecoins may help to balance their investment risks.

Example:
A commodity-backed stablecoin Digix Gold (DGH) is an ERC-20 token worth 1 g of pure gold. This is literal: all this gold exists and the third-party auditors check on it every 90 days. Moreover, this gold is physically deliverable. Any DGH holder can convert their stablecoins into bright heavy bars, If they take a flight to Singapore and visit the storage.

Crypto-backed Stablecoins

As the name suggests, crypto-collateralized stablecoins use another cryptocurrency as a backing asset. Therefore, these coins differ from their “colleagues” in one important way — they rely on a blockchain and are decentralized. For example, you have probably heard about a crypto-backed stablecoin DAI, the brainchild of the MakerDAO project team. Sometimes they call it a “digital dollar”. However, though the value of DAI is pegged to the U.S. dollar, it uses ETH as collateral.

The question is, why would you use a cryptocurrency as collateral for another crypto if both are inherently volatile? Counterintuitively, you do it to smooth out the negative effects of this very volatility.

It sounds baffling, indeed. To make things clearer, let’s see how DAI works in real life.

Example:
Decentralized DAI coins are not issued by any central body. Instead, a special decentralized protocol is responsible for their creation. This protocol makes it possible for a user to lock some amount of collateral crypto (ETH or other acceptable coins) in the system and receive a loan in DAO tokens. One DAO token is worth 1 USD, with minor price fluctuations.

To guarantee this level of price stability, the developers use “overcollaterization”. It means that the dollar value of your ETH deposit is bigger than the dollar value of the coins you receive in return. For instance, to receive the amount of DAI worth $100, a user has to deposit the amount of ETH worth twice as much ($200). Due to this cushion the system can resist considerable price drops.

When you want your ETH funds back, you return the same amount of DAI you borrowed + a fee. Then the system returns your collateral and destroys the tokens.

Non-collateralized (Algorithmic) Stable Coins

Finally, some stablecoins are not backed by any asset. The stability of their price is due to a special algorithm that regulates their supply. Accordingly, it determines the demand for the coins and their price.

When more people want to buy a non-collateralized stablecoin, the algorithm issues new coins to satisfy the need. In the opposite case, the smart contract reduces the number of coins in circulation. Due to this flexible approach, the price remains at the same level.

In fact, the absence of collaterals has its pros and cons. On the bright side, non-collateralized stablecoins are independent as they don’t use any centralized asset as a reference. However, if something goes wrong, there’s no collateral you can convert your coins into.

A typical example of this type was Basis, an ambitious stablecoin project. Unfortunately, the developers announced its termination as they were unable to comply with the U.S. securities regulation. The investors got their money back.

The Biggest Stablecoins

At the time of writing, the most popular stablecoins in terms of market capitalization are:

The Main Advantages of Stablecoins

Here are 4 main reasons why stablecoins can change our life for the better.

  • Stablecoins look more familiar and friendly for the average user, who finds regular cryptos rather difficult to understand. For example, you can always explain a coin like Tether as a “digital dollar”.
  • They make transactions faster, cheaper, secure, and friction-free. These benefits are common for all cryptocurrencies.
  • Stablecoins have a low level of volatility since they reflect the stability of the centralized assets that back them.
  • The developers can design or improve stablecoins to adapt them to changing needs. It applies to branded stablecoins big corporations issue, that have built-in features like loyalty programs.

Of course, every type of stablecoins has its distinctive pros and cons that you should consider separately.

Who Can Benefit From Stablecoins

First of all, everyone can win if stablecoins go mainstream because we all want our money transfers to be speedy, convenient, and affordable.

More specifically, the list of potential beneficiaries include:

  • Traders
    In fact, the cryptos like Tether are already widely used on the major exchanges including Binance. It’s a convenient way to lock in gains or transfer funds between crypto exchanges, as many of them don’t support fiat withdrawals and deposits.
  • Investors
    Also, stablecoins may be seen as a safe-haven asset as they stay stable over a long period of time. It gives them an advantage over other cryptos, the price of which can change dramatically within a day. So, stablecoins may be perfect for countries with unstable economies, where citizens have no trust in the currencies their government issues.
  • Unbanked people
    For un unbanked person, it would be enough to have a smartphone with the internet connection to get access to alternative financial services, using stablecoins.
  • Businesses
    Like unbanked individuals, unbanked businesses could benefit from having an alternative. For example, companies could accept payments in stablecoins to save money on transaction fees. Also, they could use stablecoins to pay their employees and contractors living abroad.
  • Freelancers
    On the other hand, stable cryptos could become a “key to freedom” for freelance workers and global nomads. They allow you to get paid in a safe manner and at a lower cost. Also, you have your global money protected from frequent price drops.
  • Migrant workers
    Stablecoins, like any crypto, make cross-border transfers easier and faster. At the same time, you can be sure its price won’t change overnight. Therefore, overseas workers (and it’s a huge community!) could avoid high fees the payment systems and banks charge.

Stablecoins: Challenges

Like any coin, stablecoins have the other side. Here are some challenges they currently face.

  • Fiat-backed stablecoins (see the list above) are centralized. If something goes wrong with an issuer, their stablecoin suffers, too.
  • Centralized (fiat- and commodity-backed) stablecoins need regular audits by a third party. If you issue a commodity-collateralized stablecoin, you must have enough physical gold or other precious stuff to support it.
  • Like other cryptos, stablecoins are facing intense political and regulatory resistance. We all remember Libra, the infamous coin by Facebook, that was stifled by politicians and now has an uncertain future. The list of recent victims also includes Basis coin that failed to comply with the US securities laws.
  • Despite their name, stablecoins are no more stable than the asset behind them. If the demand for this asset reduces for some reason, the stablecoin will lose its value, too.
  • Crypto-backed stablecoins are more vulnerable than fiat-backed ones, though they enjoy a greater degree of decentralization. Besides, a mainstream user may have difficulty understanding them. So far, most people have no idea how blockchain and cryptos work.

Stablecoins: Regulation and Prospects

As we have mentioned, one of the major challenges all stablecoins face is strong regulatory resistance. The biggest concern of the regulators is that this type of asset may undermine financial stability and become a money-laundering tool. In the case of Libra, the regulators assumed that the rapid adoption of this coin could be a serious threat to the weak economies of under-developed states. Probably, we would never know if Libra was capable of doing this. But this fear itself demonstrates that similar stablecoins have great appeal for the citizens of poorer countries.

Despite this cautious attitude, many industry experts believe that stablecoins have a bright future. If properly regulated, they may greatly contribute to the stability of the global economy and improve the financial situation of many people.

In April 2020, G20 has developed 10 rules for stablecoins regulation. Long story short, this high-level regulatory body makes a strong accent on law-enforcement, supervision, and accountability.

What Are Stablecoins: Conclusion

As you have noticed, stablecoins have a lot of use-cases and arouse different sentiments. Currently, it’s rather hard to predict what lies ahead. It’s a relatively new technology that is still under construction.

But the promise of stability matched with convenience of use is attractive for many people.

Originally published at Exscudo Blog. Check it out for more articles on crypto, blockchain, finance, trading, and technology.

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