What is A Stablecoin?

What is A Stablecoin?

One of the main arguments raised by cryptocurrencies skeptics is that they are way too volatile to fulfil what we have learned is a key function of money. Acting as a medium of exchange to buy and sell things, and a unit of account - a benchmark for pricing. That’s exactly where Stablecoins come in.

Stablecoins combine the best of both worlds. The stability of fiat with the borderless, peer-to-peer nature of cryptocurrencies and full transparency over their supply.This combination puts Stablecoins in the unique position of creating a bridge between cryptocurrencies and the traditional economy.

They do this by tracking the value of a given fiat currency on a 1:1 ratio, and can be denominated in any national currency. This means that a stablecoin is only as stable as the underlying currency it represents and the mechanism used to maintain the relationship.

By far the most common denomination of stablecoin is the US Dollar. The first and still the biggest stablecoin by market cap today is Tether (USDT) launched in 2014.

Why Are Stablecoins Useful?

Money deposited with a bank is no longer in your control, your card can be frozen, your account blocked. If you want to send money to your family in another country you may have to pay hefty sums and delays of several days. If you live in a country suffering from hyperinflation. you might not have access to a solid fiat currency.

The boiling frog problem means your savings are gradually eroded because Fiat isn't a good store of value. That’s where Stablecoins come in. By combining the stability of fiat denominations with the decentralised, global nature of cryptocurrencies, Stablecoins can be immensely useful for integrating and expanding the reach of the global economy.

How Do Stablecoins Work?

Most Stablecoins don’t run their own networks. Instead, they run on top of established blockchains, such as Ethereum or Binance Chain. This enables Stablecoins to be launched without the complexity of starting a network from scratch.

Trading an Ethereum-based Stablecoin, for example, is no different than trading Ether itself. But the key property of a Stablecoin is, of course, stability. Different stablecoins use different approaches to achieve stability, falling into the following broad categories.

Fiat Collateral-Based Stablecoins

This is the most intuitive and straightforward way to achieve stability. It was the first model to be used, and it’s by far and large the most prevalent today. Fiat collateral-based stablecoins are issued by companies on-chain against corresponding bank deposits in fiat currency (collateral) - usually redeemable on a 1:1 basis at the issuing company.

It’s worth noting that this type of relationship can be extended to collateral other than money - commodities (like gold or silver) and even more complex financial products can (and have started to) be tokenised this way - that is, kept as collateral and released as a token on a blockchain.

The pros of this type of stablecoins are reliability, high liquidity and scalability. Meanwhile the cons are high trust required on the issuing company to honour redemption. There are some transparency issues surrounding existing deposits. Also financial regulations may change, leading to freezing of funds.

Crypto Collateral-Based Stablecoins

This approach tries to reduce the reliance on companies and human behaviour, instead using smart contracts to manage stability in the system, This allows for purely on-chain stablecoins based on the value of the underlying cryptocurrency (or cryptocurrencies).

These stablecoins always require over-collateralised deposits in order to ensure that fluctuations in value of the underlying collateral won’t break the peg. Coins like these are crypto-native, transparent and decentralised by default. Howevere, the dangers are novelty, cost and catastrophic drop.

Algorithmic-Based Seigniorage Stablecoins

This type of stablecoin tries to mirror the mechanism behind the traditional central bank model, but with smart contracts instead of humans in charge. These smart contracts aim to adjust the circulating supply based on demand for the currency.

Price levels are kept by issuing more tokens when demand is high (via interest-bearing shares), and removing tokens as demand drops via a system of redeemable bonds and automated buybacks. Unlike collateralised models, there is no underlying asset which can be redeemed or traded. Value derives from the expectation that the system will be able to keep the stablecoin stable.

Their advantages are the solid concept, transparency and being native to crypto. On the other hand these stablecoins provide a borad attack surface, the legality is also questionable.

Central Bank Digital Currencies

CBDCs are not cryptocurrencies, nor are they Stablecoins - but they include elements of both. They are stable, since a CBDC is nothing more than a reengineered form of a national currency that incorporates some of the features that make cryptocurrencies so powerful.

In many ways, it’s useful to think of CBDCs as a hybrid between Bitcoin and a fiat currency. The main feature used by most CBDC proposals is the use of a blockchain or other distributed ledger system (DLT) to keep a single ledger of payments and transactions.

Even if each country exploring a CBDC has its own approach, one thing that most governments aren’t particularly known for is for their being keen on giving up control. Therefore, it’s very likely that most - if not all - CBDCs will be permissioned networks, as opposed to Bitcoin’s open nature.

Transaction validation will probably remain under the control of regulated entities, although it’s unsure if these will include the private sector as well as government. Finally, also unlike Bitcoin, both money supply and monetary rules will probably remain under full control of the currency’s national - much like fiat currencies today, but allowing for more direct control by the central bank.