A beginner’s guide to stablecoins

Stablecoins are a contemporary class of cryptocurrency whereby the value is pegged to either one external, relatively “stable” asset such as the US dollar or gold. They can even be pegged to a ‘basket’ of stable assets.

Unlike traditional cryptocurrencies, their price is not set by supply and demand. Rather, they employ a range of different mechanisms to ensure the price remains pegged to that asset. For example, in the case of USD Coin (USDC), for every token that’s created, one US dollar is held in reserve as collateral. This guarantees that every USDC token is backed by a US dollar and it’s redeemable on a 1:1 basis.

Stablecoins first arrived on the scene in 2014. The first was BitUSD, a crypto-backed stablecoin that was issued on the BitShares blockchain. BitUSD was founded by, among others, Charles Hoskinson of Cardano fame. BitUSD was collateralized by crypto and backed by the BitShares core token BTS, which was locked in a smart contract to act as collateral.

Since then, a number of stablecoins have been created – including USDC and, perhaps more famously, Tether (USDT). These have gained a great deal of traction in recent months and now have market caps in the billions. This is the result of a number of factors, with commentators crediting their rise to the current economic climate, the DeFi craze, and headlines around Facebook’s Libra project, among other things.

How do they work?

There are three main types of stablecoins: fiat-collateralised, crypto-collateralised, and non-collateralised (algorithmic).

Fiat-collateralised stablecoins maintain a fiat currency reserve, like the US dollar, as collateral to issue a suitable number of coins. There are also those backed by a commodity, like gold, silver or oil, but most present-day fiat-collateralised stablecoins use dollar reserves.

These reserves are maintained by independent custodians and are regularly audited to ensure the necessary compliance measures are being followed.

Crypto-collateralised stablecoins are backed by other cryptocurrencies. Since the reserve currency may also fall prey to high volatility, these types of stablecoins are typically over-collateralised. This means a larger number of cryptocurrency tokens are reserved for issuing a lower number of stablecoins.

For example, $200 worth of ether may be held as reserves for issuing $100 worth of crypto-backed stablecoins, accomodating for up to 50% of swings in the reserve currency.

Non-collateralised (algorithmic) stablecoins don’t use any reserves but employ a working mechanism, similar to central banks, to retain a stable price. These tokens rely on a mechanically-generated algorithm to adjust the supply if needs be, so as to maintain the token’s pegged-asset price.

This class of stablecoins typically uses smart contracts to sell tokens if the price falls below the peg or to supply tokens to the market if the value increases.

Benefits and use cases

The value proposition is simple. Stablecoins combine the instant processing capabilities, functionality, adaptability, and security of cryptocurrencies with the stability and trust enjoyed by fiat currencies.

Fighting currency devaluation and democratising money

Stablecoins’ inherent stability is a serious attraction for those living in countries where currencies are extremely unstable and volatile – even more so than regular cryptocurrencies. High levels of inflation are destructive, often leaving people struggling to pay for basic necessities like food and medicine.

In theory, stablecoins offer an escape from the effects of unstable local currencies, without people having to resort to illegal or unsustainable methods like using currencies from other countries or bartering. A currency is generally only as stable as the government that issues it, and this offers those living under unstable political regimes usable money. This is subject to the laws of a specific country, so although this may seem like a great solution to a serious issue, it’s unproven whether or not it would be viable in each specific context.

Payments and remittances

Ever tried sending someone money from a different country? It can be an incredibly slow and expensive process, and it typically affects the people who can least afford to deal with exorbitant third-party fees, never mind the paperwork or the significant wait-time.

In 2018, annual global remittance flows to low- and middle-income countries reached $529 billion, an increase of 9.6% from the previous year. However, the global cost of sending money home is unjustifiably high. For example, sending $200 costs around 6.8%. Sub-Saharan Africa continues to have the highest average cost at around 9% despite the fact intra-regional migrants in Sub-Saharan Africa comprise over two-thirds of all international migration from the region.

By sending stablecoins from one wallet to another, users have the opportunity to bypass banks which typically charge high fees. Stablecoin’s value can also be sent to regions where US dollars are hard to obtain or where there is instability in local currency.

Trading

One of the primary functions of a stablecoin is to facilitate trades on crypto exchanges. Instead of buying cryptocurrency with fiat currency, traders will exchange fiat for a stablecoin, and then perform a trade for another cryptocurrency like Bitcoin or Ether.  While trading beginners use stablecoins to mitigate trading fees, more advanced traders will also use stablecoins for a variety of purposes, such as staking and lending.

At the moment, temporary hedging is a big motivator for individuals to use stablecoins. For example, a cryptocurrency investor might split their portfolio between stablecoins and regular cryptocurrencies, so they have a hedge against volatility and won’t lose as much during market dips.

Decentralised apps

2020 has seen the rise of easy-to-use DApps and intuitive interfaces. Ethereum-based stablecoins, which constitute roughly half of all stablecoins in existence and have a total value of over $11.3 billion, are performing even better than traditional finance applications like PayPal due to DeFi apps that use them to facilitate value transfers.

Minimise Volatility

Just like the name suggests, these tokens are considered ‘stable’ because their value is stable relative to the currency they are pegged to. So, the intention of a stablecoin is to minimise volatility. This gives buyers and sellers more certainty that the value of their stablecoin shouldn’t be subject to drastic price changes in short time periods.

Keeping up with the technological revolution

The existing financial system has its fair share of inefficiencies – notably its reliance on third parties to facilitate transfers. And everyone takes their cut. Stablecoins, and blockchain technology, in particular, allow payments to occur directly between buyers and sellers, thereby reducing the costs for both parties. Automating the transaction verification process will also result in much faster settlement times.

As the cryptocurrency industry matures, we can expect to see a significant increase in stablecoin usage. Continued adoption from traditional finance entities will also undoubtedly bolster and normalise stablecoins’ place in our everyday lives.