- What Is a Stablecoin?
- How Do Stablecoins Work?
- What Are Stablecoins Pegged To?
- The Future of Stablecoins
It has become obvious by now that the future of the economy lies with cryptocurrencies. They are characterized by being decentralized, anonymous and global, and these qualities are too valuable to ignore. Cryptocurrencies have various unique features: most notably, they are not tied to any country. They represent a truly international payment system. However, so far cryptocurrencies do not ensure stability.
There are two factors that prevent an economy-wide implementation of cryptocurrencies: their high volatility and the lack of security mechanisms. Cryptocurrency security is an issue that many governments have been struggling with for years, but it seems that a solution has been found for the volatility problem. As soon as we can ensure the stability of cryptocurrencies, the entire world will switch to using them.
Any currency is a medium of exchange and storage of value. In the past, people used to collect and store material items but in today’s world, the barter system has been replaced by money. One of the main advantages of the currency system is its stability.
An unstable national currency may cause turmoil, sometimes leading to a takeover, a coup, or a revolution. Such events are most often caused by financial problems.
Everything is different in the world of cryptocurrency. Nowadays, Bitcoin and other cryptocurrencies are mostly seen as a way to get rich quickly or, on the contrary, to go completely broke. It is a way to get your adrenaline going, to take your chances. Trading in Bitcoin resembles gambling, the difference being that the chances of winning are higher if a trader knows how to wait and analyze tendencies.
A three-day Bitcoin price chart (August 12–15, 2021), source: rbc.ru
Cryptocurrencies jump and fall by 10% in one day which indicates an extremely high instability, or volatility. Because of that Bitcoin is often regarded as a speculative trading mechanism rather than as a mode of storing wealth. Most people are afraid to invest most of their assets into Bitcoin because of its lack of stability. Therefore, Bitcoin still cannot compete for the title of a world currency.
A new type of cryptocurrency appeared in 2014 with the launch of Tether. The developers named it a stablecoin and said that the currency was backed by collaterals. By 2021, new stablecoins have been established, and their list now includes DAI, USD Coin, True USD, Digix Gold, Havven’s Nomin, Paxos Standard, and Binance USD.
In 2018, attempts were made to rename this type of cryptocurrency into Basecoin and Basis, but they had to be abandoned after the intervention of the Securities and Exchange Commission. A stablecoin kept its name.
The main aim of a stable cryptocurrency is to eliminate price volatility which will allow it to become a proper means of payment. Retaining the qualities of a cryptocurrency, a stablecoin can become an effective medium of exchange and storage of value.
All modern currencies are pegged to an underlying asset that has the maximum level of stability. It used to be gold but in the early 20th century many countries went off the gold standard and substituted it with the U.S. dollar. It is considered to have the lowest level of volatility.
To be used on the same level as national currencies, a cryptocurrency must retain a certain purchasing power and experience minimal inflation which encourages spending the coins instead of storing them.
Therefore a stablecoin can offer the best of both worlds – the stability of a fiat currency, and the decentralized and anonymous system of a cryptocurrency.
Stablecoins can be broadly classified into three categories:
- Fiat-collateralized stablecoins. Cryptocurrency developers usually use the U.S. dollar as collateral for cryptocoins, as exemplified by Tether. Others use oil, as well as gold and other precious metals. The cryptocoins are issued in a limited amount, in a 1:1 ratio against the collateral. This is a very simple method, and only an underlying fixed-asset is required to achieve a stable cryptosystem. This is the solution that will most likely be adopted by central banks that intend to issue their own stablecoins. In most cases, only market giants are able to become a custodian and guarantee the issuance and the redemption of cryptocoins.
- Crypto-collateralized stablecoins. The underlying collateral of such stablecoins is another cryptocurrency. The volatility is accommodated by “over-collateralizing” the stablecoins: lesser-valued stablecoins are issued based on a higher-valued cryptocurrency. For example, 100 U.S. dollars worth of the basic cryptocurrency may be required to issue 10 U.S. dollars worth of tokens. In this case, even a significant decrease in the value of the new currency is not critical because the price reduction is covered by the difference in their actual value. If Bitcoin is used as collateral this ratio may be lower, for example, 1:2.
- Some cryptocurrency developers use a basket of other crypto assets. This was the case with the DAI developers. They also pegged the new currency against the U.S. dollar and ethereum.
In this model, there is still a risk of losing everything if the collateral cryptocurrency goes completely bankrupt. Sometimes it gives rise to issues with the audit procedure, and there is also a high risk of not being able to top up the collateral in time. Therefore, this approach is not supported by many stablecoin advocates.
Non-collateralized stablecoins. The stability of these stablecoins is ensured by the mechanism of issuance and offer. The supply of cryptocoins is adjusted in proportion to changes in their price. This is similar to the actions of central banks which adjust the number of banknotes, in order to keep the fiat currency stable.
This can be achieved by using smart contracts on a decentralized autonomous platform.
Currently, financial experts regard stablecoins as the best way to combine the advantages of two worlds: the traditional fiat currencies and the rebellious cryptocurrencies. The stability will allow cryptocoins to be used for regular payments, trading, and payment for services. However, it will still be based on the decentralized blockchain. Thus, stablecoins will achieve their main objectives: anonymity, security and stability.