A “stablecoin” is a type of cryptocurrency whose value is tied to another asset class such as fiat currency or gold in order to stabilize its price.
Cryptocurrencies like Bitcoin and Ether offer a number of advantages, and one of the most basic is that it does not require trust in an intermediary institution to send payments, which opens up their use to anyone around the world. A major disadvantage, however, is that the prices of cryptocurrencies are unpredictable and tend to fluctuate widely.
This makes them difficult for ordinary people to use. In general, people expect to know how much their money is worth in a week, both for their safety and for a living.
The unpredictability of the cryptocurrency contrasts with the generally stable prices of fiat money like US dollars or other assets like gold. The values of currencies such as the dollar change gradually over time, but the daily changes are often more drastic for cryptocurrencies, which are regularly rising and falling in value.
The graph below shows the price of Bitcoin versus the US dollar (USD) versus another fiat currency, the Canadian dollar (CAD), to see how much each currency fluctuates in relation to each other.
Stablecoins in brief
Stablecoins attempt to counter fluctuations in price by pegging the value of cryptocurrencies to other more stable assets – usually fiat currencies. Fiat is the government issued currency that we all use in everyday life, like dollars or euros.
Typically, the unit behind a stablecoin sets up a “reserve” in which it securely stores the asset or basket of assets that the stablecoin supports – for example, $ 1 million in an old-fashioned bank (the type with branches and counters and ATMs in the lobby) to secure one million units of a stablecoin.
This is one way digital stablecoins are tied to real assets. The money in the reserve serves as security for the stablecoin – that is, when a stablecoin holder wants to cash out his tokens, an equal amount of the respective asset is withdrawn from the reserve.
There is a more complex type of stablecoin that is backed by other cryptocurrencies rather than fiat, but is nonetheless designed to track a mainstream asset like the dollar.
Maker, perhaps the most famous stablecoin issuer to use this mechanism, accomplishes this through a service called “Vault” (formerly known as Collateralized Debt Position), which locks down a user’s cryptocurrency collateral. Once the smart contract knows that the collateral is secured, a user can use it to borrow freshly minted dai, the stablecoin.
A third variety of stablecoin, known as algorithmic stablecoin, is not collateralized at all; Instead, coins are either burned or created to match the value of the coin with the target price. Let’s say the stablecoin falls from the target price of $ 1 to $ 0.75. The algorithm automatically burns a tranche of coins to increase the scarcity and increase the price of the stablecoin. This type of stablecoin protocol is difficult to get right and has been tried and failed multiple times over the past few years. But entrepreneurs keep trying.
One of the few working examples using this model to date is known as UST, which was created by the Terra blockchain project.
Types of stablecoin collateral
Using this framework, stablecoins come in a number of flavors, and the secured stablecoins use a variety of types of assets as support:
- Fiat: Fiat is the most common security for stablecoins. The US dollar is the most popular among fiat currencies, but companies are also researching stablecoins that are pegged to other fiat currencies, such as BiLira, which is pegged to the Turkish lira.
- Precious metals: Some cryptocurrencies are tied to the value of precious metals such as gold or silver.
- Cryptocurrencies: Some stablecoins even use other cryptocurrencies such as ether, the native token of the Ethereum network, as security.
- Other Investments: Tether’s USDT was once supposed to be dollar-backed 1-to-1, but its collateral mix has shifted over time, and in a breakdown in 2021, the company stated that nearly half of its reserves were in commercial paper, Some form of short, fixed-term corporate debt exists. It did not disclose the issuers of this paper, but claims that it has all been rated A-2 or higher (A-2 is the second highest rating available to a corporate borrower from rating agencies such as Standard & Poor’s). Similarly, Circle’s USDC lists unspecified “approved investments” in its monthly disclosures alongside accounts with government-insured banks (specifically, it does not specify whether the accounts are themselves insured).
What are the most popular stablecoins?
To give you a taste of the experiments in stablecoin land, let’s go over some of the most popular stablecoins.
Diem (formerly known as Libra) is a stablecoin in the works that was originally conceived by the powerful, global social media platform Facebook. While Libra has not yet been introduced, it has had more psychological effects than any other stablecoin.
Governments, especially China’s, are now researching their own crypto-inspired digital currencies, in part because they fear it could pose a competitive threat as Facebook is a multinational with billions of users from around the world.
The Diem Association, the consortium founded by Facebook, initially said Diem was backed by a “basket” of currencies, including the US dollar and the euro. However, due to global regulatory concerns, the association has pulled back from its ambitious original vision. Instead, it now plans to focus on developing multiple stablecoins, each backed by its own local currency.
Its first stablecoin, the Diem dollar, should hit the market as early as January 2021.
Tether (USDT) is one of the oldest stablecoins, launched in 2014 and remains the most popular to this day. It is one of the most valuable cryptocurrencies overall by market capitalization.
The main use case for USDT is to move money quickly between exchanges to take advantage of arbitrage opportunities when the price of cryptocurrencies is different on two exchanges. Traders can make money from this discrepancy. But it has found other uses as well: Chinese importers stationed in Russia have also used USDT to send millions of dollars worth of money across the border while bypassing tight capital controls in China.
Tether Ltd., the company that issues USDT, was embroiled in a 22-month lawsuit with the New York attorney general over allegations that Bitfinex (a sister company of Tether) attempted to recover a shortfall of $ 850 million with funds from Tether cover up.
Eventually, the case was settled on February 23, 2021, forcing Tether and Bitfinex to pay $ 18.5 million and produce quarterly reports showing Tether’s stablecoin reserves for the next two years.
USD Coin was launched in 2018 and is a stablecoin that is jointly managed by the cryptocurrency companies Circle and Coinbase through the Center Consortium.
Like Tether before its shift to a mix of collateral, USD Coin is pegged to the US dollar with nearly $ 26 billion in circulation. By 2023, Circle said in a recent investor presentation that the offering is expected to reach $ 190 billion.
On July 8, 2021, Circle announced a $ 4.5 billion SpaC merger agreement with Concord Acquisition Corp. IPO (parent company of CoinDesk) and Fidelity Management and Research Company.
Dai runs on the MakerDAO protocol and is a stablecoin on the Ethereum blockchain. Founded in 2015, Dai is pegged to the US dollar and backed by Ether, the token behind Ethereum.
Unlike other stablecoins, MakerDAO intends for dai to be decentralized, which means that no central authority is trusted with control over the system. Instead, Ethereum smart contracts – which encode rules that cannot be changed – do that job.
However, there are still problems with this innovative model; for example, when the smart contracts on which MakerDAO is based do not work exactly as expected. In fact, they were played in 2020, resulting in losses of $ 8 million.
Do stablecoins have any disadvantages?
There are a few drawbacks to stablecoins that you should be aware of. Because of the way stablecoins are usually set up, they have different vulnerabilities than other cryptocurrencies.
If the reserves are held with a bank or other third party, there is an additional exposure to counterparty risk. This boils down to the question: does the company really have the collateral that it claims to have? This is a question that Tether has been asked a lot of times, for example, whether it maintains true 1: 1 support between USDT tokens and US dollars.
In the worst case scenario, it is possible that the reserves that support a stablecoin will not be sufficient to redeem each unit, potentially shaking confidence in the coin.
Cryptocurrencies were created to replace intermediate businesses that are normally entrusted with a user’s money. Intermediaries naturally have control over this money; for example, they are usually able to prevent a transaction. Some stablecoins add the ability to put transactions back into the mix.
USD coins have a back door open to stop payments when coins are used in illegal ways. Circle, one of the firms behind USDC, confirmed in July 2020 that it has frozen $ 100,000 of the stablecoin at the behest of law enforcement agencies.