This article provides a deep exploration into what stablecoins are, how they work, what makes them stable, and the unique solution they bring to the crypto space.
Stablecoins are cryptocurrencies designed to have a fixed value by pegging it to a fiat currency or physical asset.
Pegging: Tying the value of one currency to another so they both have the same value.
Fiat currency: A nationally sanctioned currency (e.g. USD, GBP, Euro)
In practice, $USD is the most common asset used for both backing their value (collateral) and for pegging. Stablecoins were born out of the need for a crypto asset immune to volatility.
Unlike bitcoin and its sibling altcoins characterised by price upsurges and crashes, stablecoins maintain a fixed price irrespective of crypto market sentiments.
As the name suggests, stablecoins are stable, making them useful for everyday transactions since their value does not change. While crypto traders can find perks in the volatility of classic cryptocurrencies by strategically trading them to turn profits, stablecoins have several applications in the DeFi space.
Stablecoins are classified according to their collateral structure. Collateral is what is held in reserve to secure the value of the stablecoin.
There are four types of stablecoin:
Fiat-Collateralised backing is the most common model used for creating stablecoins.
$USD Stablecoins are the most popularly used fiat-backed tokens. One unit of a stablecoin is equivalent to one unit of a dedicated fiat currency such as USD, EURO or GBP.
In this case, high-value physical items (like gold, precious metals, e.t.c) back stable tokens. Gold is the most used collateral in Stablecoin projects.
In this practice, stablecoins can match the value of other digital tokens in the blockchain space. But how about the problem of volatility? How does a stablecoin maintain a steady price when linked to a volatile asset?
Crypto-Backed Stablecoins accomplish stability by overcompensating for the reference crypto's volatility. Unlike the Fiat-Collateralised stablecoins, one unit of a Crypto-Backed token is worth more than two units of the reference crypto.
They are the only stablecoins unbound to any virtual or real-life asset. For algorithmic stablecoins, a software program stabilizes prices by controlling supply. Often they are paired with a reserve coin (a completely different cryptocurrency).
In short, reserve coins are tokens that maintain the algorithmic peg of their partner stablecoin.
As users trade (swap) the reserve coin, they help provide the liquidity required to maintain its stablecoin partner’s peg ratio.
If the value of the stablecoin climbs above its peg of $1USD (e.g. $1.02), the algorithm uses the stablecoin to buy the reserve coin, which results in the stablecoin returning to its $1USD peg.
If the value of the stablecoin falls below its $1USD peg, (e.g. $0.99), the algorithm buys the stablecoin from the open market with the reserve coin to raise the stablecoin price back up to the peg value of $1USD
Reserve coin holders get a share of the transaction fees generated by the stablecoin.
Decentralised finance (DeFi) is a catch-all term used to describe blockchain-based financial services.
In the same way that you make use of your bank to manage your money, buy insurance or trade assets, DeFi platforms allow you to do the same.
However, because it all takes place on public blockchains, it is faster, there’s less red tape and perhaps most importantly, as it is a peer-to-peer system, no banker or broker is taking a large chunk of your cash!
DeFi is designed to be global and open to everyone, whether you are in Zurich or Zambia everyone can use DeFi services, especially useful for the millions of people around the world who do not have access to traditional finance institutions.
A wide variety of stablecoins exist, although the market leaders at the moment in terms of market cap are Tether (USDT) and USD Coin (USDC). Based on data from CoinMarketCap, USDT has a market cap of over 80 billion dollars. USDC has a market cap of over 52 billion dollars.
Stablecoins are a big deal!
Users can trade between traditional cryptocurrencies and stablecoins, depending on their objectives. Recently, the use of stablecoins has extended into the DeFi space. They can be used to ease on and off ramping of fiat currencies, used to add liquidity to DEXs (decentralised exchanges) or used on DeFi lending and saving platforms; often with much higher interest rewards than traditional savings accounts.
On and Off Ramping: The process by which a user moves their assets between traditional finance and the cryptocurrency ecosystem.
At the moment, there are no regulations for stablecoins. Up until recently, Regulators have not paid much attention to stablecoins.
As a non-volatile asset, regulators did not pry much into stablecoins, unlike crypto, which aroused economic concerns due to its price spike. Regulators are hot on the tail of cryptocurrency projects. The government intends to curb the harmful effects of its volatility on the economy through regulations. On the other hand, stable tokens are receiving a much friendlier reception.
In November 2021, President Joe Biden and his administration proposed to congress asking for regulatory oversight over stablecoins. The proposal implies that only central banks will have the power to issue stablecoin tokens. So far, this proposal is the closest thing to a regulation stablecoins have faced.
Even still, Biden's plans for stablecoins are to bolster its use case. According to Bidens Working Group, regulating stablecoins will improve its ability to facilitate everyday transactions. In effect, paying for goods and services via stablecoins will become faster and cheaper.
With more and more DeFi platforms coming to market all the time, stable coins can provide a much better interest rate than a traditional savings account. Whilst you don’t get the large upswings in value that you may get from standard cryptocurrencies (BTC, ADA, etc), you do get the benefits of less risk and better interest.
This isn’t financial advice and you should always do your own research into any platforms that you are considering using.