What are Stablecoins?
Definition
A stablecoin is a type of hybrid cryptocurrency whose value is tied to a stable asset like USD or gold.
Understanding Stablecoins
Stablecoins attempt to bridge traditional finance with the world of cryptocurrency.
They are a type of cryptocurrency that is ‘pegged’ to a real-world asset like fiat currency, precious metals or even other cryptocurrencies. This adds stability to their value, reducing much of the uncertainty and volatility that deters people from investing in crypto.
Initially, stablecoins were created to mimic fiat currency and to be used by traders who operated on exchanges that did not offer direct fiat to crypto trading.
Why do we need stablecoins?
For trading cryptocurrency
The first major use of stablecoins was by crypto traders. Stablecoins like USDT and DAI provided an on-ramp to crypto on exchanges that didn’t provide direct fiat to crypto trading. Given that stablecoins are already on the Blockchain, they can also carry less fees and processing times when compared to trading with fiat currency.
On certain exchanges, stablecoins are a safe place to store your crypto in times of market volatility. If you have a lot of money in Bitcoin, and the market is dipping, you can easily switch your BTC to USDT while the crash occurs, protecting your capital from the dip and buying back in once the price starts to take off again.
For fast & cheap payments
One of Bitcoin & cryptocurrency’s major pain points is that their value fluctuates from day to day. This makes them a risky place to store money as it could be worth X one day and then half that the next.
A person might have some of their savings in crypto, or be paid by an employer in crypto, meaning the amount of spending power they have will be entirely dependent on the market at that time. Stablecoins solve this problem, offering a stable, virtual currency that can be used for fast, cheap & highly efficient cross-border and everyday payments.
How do stablecoins have value?
The company issuing the stablecoins needs to keep an equal amount (or more) of whatever the stablecoin is pegged to and ‘backed’ by in their reserve so people can easily switch back and forth between fiat currency and stable coins. Without this backing the stablecoin would lose its legitimacy.
A centralised cryptocurrency?
Stablecoins have gained traction by attempting to offer the best of both worlds – the instant processing, security & privacy of cryptocurrencies and the trust and stability of regular fiat currency.
However, because each stablecoin is issued by a single company, they are essentially centralised, meaning they are not actually a ‘pure’ cryptocurrency like Bitcoin or Ethereum. Stablecoins have their limitations and have not yet been created in a way that offers all the advantages of a fully decentralised currency.
There are 3 main types of stablecoins:
- Fiat backed stablecoins
- Crypto backed stablecoins
- Commodity backed stablecoins
What are the main advantages/uses of stablecoins?
- Stablecoins are suited for everyday transactions, removing the price fluctuations associated with other cryptocurrencies.
- Stablecoins are backed & collateralised by real assets, meaning you can invest in them without fear that the currency may drop in value at any time.
- For exchanges that don’t provide direct fiat to crypto trading, stablecoins provide an efficient on-ramp to trading cryptocurrency, as well as a place to store money in times of market volatility.
- Stablecoins don’t have to pass through the usual financial intermediaries, meaning lower transaction fees & shorter transfer times.
- Stablecoins could be particularly valuable as an alternative to cash in countries where there is hyperinflation & economic instability.
- Stablecoins pave the way for DeFi (decentralised finance) to revolutionise the way we do business, offering financial possibilities from loans to interest earning opportunities to a universally accessible peer-to-peer payment system.
Key Takeaways
- Stablecoins are a virtual currency whose value is tied to a stable asset like USD or gold, solving crypto’s volatility problem.
- The price of a stablecoin depends on the asset it is pegged to. There are fluctuations in the rate, but they are usually insignificant.
- Stablecoins enhance the efficiency of crypto trading but can also be used for payments in the real world.
- Stablecoins will aid in the mass adoption of cryptocurrencies, giving investors a safe way to access the opportunities offered by crypto technology.
- A company issuing a stablecoin must keep an equivalent amount (or more) of collateral in their reserves.
- Stablecoins bridge traditional finance and crypto, however, they are not fully decentralised like other cryptos.
- Stablecoins are a relatively new phenomena, but they could well play an integral role in the future of business & finance.
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What are some real-world applications of stablecoins?
Although still in their early stages, stablecoins have many potential real-world applications, such as:
Day-to-day payments
Stablecoins can be used like any other currency but with the added advantages of a digital currency that’s legally backed and secure. This is especially useful for cross-border payments as it eliminates the need to convert between different fiat currencies. As stablecoins exist on the Blockchain, this also removes the third party intermediary, meaning the potential for lower transaction costs across the board.
Streamlining recurring smart contract payments
Stablecoins are cryptocurrencies and thus allow the use of smart financial contracts. These can be automated to execute in any way desired and would be an ideal way to handle recurring payments like salary payments, rent, loans and subscriptions. Given the stability of stablecoins this makes them a far better option than using a volatile asset like Bitcoin as currency.
Settlements
Currently, settlements are unable to be delivered immediately because they are subject to normal bank hours. This is not an issue with crypto and stablecoins as they operate on a Blockchain network and are active 24/7.
Remittances for migrant workers
Around the world, many people send remittances (wages) through agencies like Western Union and MoneyGram to their families overseas. This is often a slow and costly process, and a chunk of the payment is lost in the transfer process due to high cross-border transfer fees. Stablecoins provide migrant workers a far more efficient method of sending money to their families, with lower fees and no significant price volatility.
Escrow
Escrow services can be completely automated through smart contracts that are coded to evaluate and enforce escrow conditions, without the need for a third party to be involved. The smart contract would also be publicly available for audit as they are stored transparently on the Blockchain.
Lending & interest earning
Mix stablecoins and DeFi together and you get a world of interest earning opportunities. Stablecoin lending is currently one of the most high-yield opportunities out there, offering double-digit interest rates that put regular savings accounts to shame.
Alternative banking
Billions of people worldwide do not have access to a bank account. In the world of digital currencies, all one needs to have a stablecoin ‘bank account’ is an internet connection.
Protection from local currency crashes
Stablecoins are perfectly suited for countries with precarious economies. Hyper-inflation is a very real threat in some countries and stablecoins would provide a place for citizens of these countries to store their money during times of economic instability. They could be a viable solution for people wanting to quickly exchange their dropping currency into a stable currency, thus protecting them from further drops in value. Check out Crypto Simple’s article on why the world NEEDS cryptocurrency to learn more.
What is pegging?
Pegging is the mechanism which stablecoins use to mimic fiat currencies. It is also widely used as a way of controlling a country’s currency rate by tying it to another country’s currency.
For example, many countries stabilise their currencies by pegging them to the U.S. Dollar, which is generally considered to be the most stable currency globally. Stablecoins do the same thing but they are completely digital and operate on the Blockchain.
How can you earn interest on stablecoins?
Another selling point of stablecoins is the ability to earn interest with them. There are many crypto loan platforms and DeFi platforms like Curve or Yearn Finance that allow you to earn an interest rate far beyond anything that your bank could offer.
For example, once you have purchased your stablecoins with fiat, you can deposit them into liquidity pools or lend them out using a variety of platforms – but beware, while stablecoins are designed to combat price volatility, the integrity of the platforms you deposit them on is important.
The world of crypto is filled with lucrative interest earning opportunities, however, stablecoins provide investors a way to earn interest without the risk of your deposited cryptocurrency fluctuating in price. For example, while there are many ways to earn a good rate on coins like Bitcoin and Ethereum (you are often paid out in a cryptocurrency), there is every chance that your chosen crypto could drop in value, losing you money in the long run.
When it comes to earning interest, most investors don’t want this kind of volatility. Which is why stablecoins will change the game. Stablecoins allow you to earn interest with the peace of mind that when you withdraw your funds, they will not have dropped in value due to a market crash.
How are stable assets/stablecoins kept stable?
The two primary reasons for the price stability of fiat currencies and stablecoins are the reserves that back them and the occasional market intervention by controlling authorities, like central banks.
For instance, when an asset like the US dollar sees unnatural fluctuations in value, the authorities will step in and manage and manipulate the demand and supply of currency to maintain price stability (thus also stabilising the value of stablecoins).
What are fiat-backed stablecoins?
The most common type of stablecoins are collateralised (or backed) by fiat currency like USD, AUD EUR, or GBP. Fiat-backed stablecoins have what is called a 1:1 ratio, meaning 1 stablecoin is equal to 1 unit of currency. Thus, for each stablecoin that exists, there needs to be one unit of a real fiat currency held in reserves so that people can easily switch between the two.
When someone wants to redeem cash with their stablecoins, the entity that manages the stablecoin will provide the fiat from the reserve. Then, the equivalent stablecoins returned by the person will be destroyed or taken out of circulation.
What are commodity-backed stablecoins?
Commodity-backed stablecoins are backed up by physical assets like precious metals, oil, and real estate. Commodity-backed stablecoins allow for investments in assets like Gold that may otherwise be out of reach, depending on where you live.
What are crypto-backed stablecoins?
Crypto-backed/collateralized stablecoins are backed by another cryptocurrency as collateral. While cryptocurrencies are volatile, these stablecoins use smart contracts and over-collateralisation (more than the equivalent amount is held in reserves) to ensure that the stablecoin remains relatively steady in value.
When investing in a crypto-backed stablecoin, you lock your cryptocurrency into a smart contract to obtain tokens of equal value. When you are ready, you can then put your stablecoin back into the same smart contract to withdraw your original amount.
What are the potential drawbacks of stablecoins?
These hybrid cryptocurrencies are a relatively new phenomenon and they have their drawbacks. Some of these include:
Centralisation
To access stablecoins, you generally have to pass through a third party intermediary (the company issuing the stablecoin). This requires trusting that entity and is therefore not fully aligned with the decentralised spirit of cryptocurrencies.
While stablecoins provide a bridge between crypto and traditional finance, given that crypto is primarily known for being a decentralised currency, centralisation is not ideal and removes many of the benefits of other cryptos. While not all stablecoins are centralised (DAI, for example), most of them involve a third party.
Dependence on traditional finance markets
Stablecoins are usually pegged to fiat currencies, meaning their value is entirely dependent on the condition of the economy. Like fiat, they are vulnerable to inflation and carry some of the downsides of fiat currency that crypto was invented to solve.
External Audits Needed
To ensure all the stablecoins are backed by real world assets and properly accounted for, external audits of the issuing companies will need to be done regularly. There have been instances of stablecoin companies being accused of not having a sufficient amount of collateral in their reserves.
Lack of regulation
This is a potential pro and con for the entire cryptocurrency space. Stablecoins might mimic fiat currency, but the regulators are still trying to figure out how to handle the past decades wave of digital currencies. While stablecoins could play a pivotal role in the future of business and finance, they have a long way to go in terms of being properly regulated.
Not as lucrative as other cryptocurrencies
While you can earn an interest rate with stablecoins that outdoes the rate offered by your bank, stablecoins are indeed ‘stable’ and there isn’t as much potential for growth when compared to holding other cryptocurrencies that see price volatility. Less risk, less reward.
Lack of a track record
Stablecoins are a new thing, and it is hard to predict which ones are truly reliable. While the whole idea is to maintain a similar value to a stable asset, it is possible for a stablecoin to lose its peg or be hacked/stolen. It is recommended that you do some solid research before putting your money in them.
What are some examples of popular stablecoins?
- USD Coin (USDC) - Many crypto exchanges and brokers (including Binance (BUSD)) have come out with their very own stablecoins in order to provide a native stablecoin for their platform which traders can use. USD Coin is a stablecoin backed by Coinbase, one of the world’s biggest crypto brokers. Exchanges and brokers incentivise traders to use their stablecoin by offering lower fees and frictionless transactions on their platform.
- True USD (TUSD) - True USD is similar to USDT but 100% backed by the U.S. dollar. It boasts itself as one of the most liquid stablecoins on the market. With lower transaction fees than wire transfers, TUSD is another popular choice for investors who want to earn a tidy interest rate on their assets. The issuers of True USD also issue other stablecoins pegged to the value of the dollar from countries like England and Australia.
- Paxos Standard (PAX) - Paxos Standard also aims to stay pegged to the U.S. dollar. It’s known for its transparency, addressing the fact that other stablecoins (namely Tether) have been criticised for not holding the sufficient amount of fiat currency in their reserves. PAX is regularly audited and is another popular choice. It was created as an answer to the Tether printing controversy, which saw Tether come under fire for an unverified claim that it held $1.8 billion with Deltec Bank & Trust Ltd to back its stablecoin.
- PAX Gold (PAXG) - Pax Gold (PAXG) is a gold-backed cryptocurrency, launched by the creators of Paxos Standard (PAX) in September 2019. As an ERC-20 token built on the Ethereum blockchain, Pax Gold is available on a number of exchanges and has become a way for traders to invest in gold. Each token is backed by one fine troy ounce (t oz) of a 400 oz London Good Delivery gold bar. If you own PAXG, you essentially own the underlying physical gold, held by Paxos Trust Company.
- USD Coin (USDC) - Many crypto exchanges and brokers (including Binance (BUSD)) have come out with their very own stablecoins in order to provide a native stablecoin for their platform which traders can use. USD Coin is a stablecoin backed by Coinbase, one of the world’s biggest crypto brokers. Exchanges and brokers incentivise traders to use their stablecoin by offering lower fees and frictionless transactions on their platform.
How can stablecoins help the developing world?
Considering there are literally billions of people in the world without a bank account, Blockchain, stablecoins and cryptocurrency have begun a fundamental shift in how developing countries operate. Some areas likely to see huge positive change include (but are not limited to):
– Efficient money transfers (without the fee-charging third party)
– Land title proof
– A safe place to store assets
– The ability to earn interest without a bank account
– More effective humanitarian aid
– Better access to loans, capital and real estate investments
– Micro loans and small business funding
– Access to insurance and other financial services
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