A “stable coin” is a type of cryptocurrency whose value is tied to an external asset such as the US dollar or gold in order to stabilize the price.
Cryptocurrencies like Bitcoin and Ethereum offer a number of advantages, and one of the most basic is that it does not require trust in an intermediary institution to send payments, which opens their use to anyone around the world. A major drawback, however, is that cryptocurrency prices are unpredictable and tend to fluctuate a lot at times.
This makes them difficult for everyday people to use. Generally, people expect to know how much their money will be worth in a week, both for their safety and for a living.
The unpredictability of cryptocurrency contrasts with the generally stable prices of fiat money like US dollars or other assets like gold. Currency values like the dollar change gradually over time, but the daily changes are often more drastic for cryptocurrencies, where the value bounces up and down regularly.
The graph below shows the price of Bitcoin versus the US dollar (USD) versus another fiat currency, the Canadian dollar (CAD), to see how much each currency fluctuates in relation to each other.
Price fluctuations for Bitcoin (black line) tend to be much larger than for the US dollar (orange line). (Both are normalized to the Canadian dollar or CAD for this comparison.)
Source: CoinMarketCap, CoinDesk Research
Stablecoins were valued at more than $ 10 billion as of May 2020. In countries like Brazil, many people are turning to stable coins as an alternative to their national currencies in uncertain economic conditions. In Hong Kong, some people are using stablecoins to avoid new internet censorship in a turbulent political climate.
Stable coins in a nutshell
Stable coins try to counter price fluctuations by pegging the value of cryptocurrencies to other more stable assets – usually fiat. Fiat is the government issued currency that we all use on a daily basis, e.g. B. Dollars and Euros, and it tends to remain stable over time.
Typically, the company sets up a “reserve” behind the stablecoin, where it securely stores the asset that backs the stablecoin – say, $ 1 million in an old-fashioned bank (the kind with branches and cashiers and ATMs in the lobby ) to secure one million units of the stable coin.
In this way, a digital stablecoin and a real asset are linked together. The money in the reserve serves as “security” for the stable coin. A user can theoretically redeem one unit of stable coin for one unit of the asset that secures it.
There is a more complex type of stable coin that is backed by other cryptocurrencies rather than fiat, yet is designed to mimic a mainstream asset like the dollar.
Maker, perhaps the most famous stablecoin issuer to use this mechanism, accomplishes this by using CDPs (Collateralized Debt Positions), which lock in a user’s cryptocurrency collateral. Once the smart contract knows that the collateral is secured, a user can use it to borrow freshly minted dai, the stablecoin.
A third variety of stablecoin, called algorithmic stablecoin, is not collateralized at all. Instead, coins are either burned or created to keep the value of the coin in line with the target price. Suppose the coin falls from its target price of $ 1 to $ 0.75. The algorithm automatically destroys part of the coins to create more scarcity and increase the stable coin price.
This type of stablecoin has been much less popular so far. One of the most popular stablecoins based on this model was closed in 2018 due to regulatory concerns.
Types of stablecoin collateral
Using this framework, stablecoins come in several flavors, and the secured stablecoins use a variety of types of assets as the background:
- Fiat: Fiat is the most common security for stablecoin. The US dollar is the most popular among fiat currencies, but companies are researching stable coins that are also pegged to other fiat currencies, such as bilira, which is pegged to the Turkish lira.
- Precious metals: Some cryptocurrencies are linked to the value of precious metals such as gold or silver.
- Cryptocurrencies: Some stablecoins even use other cryptocurrencies such as ether, the native token of the Ethereum network, as security.
What are the most popular stablecoins?
To give you a taste of the experiments that take place in the stable coin land, let’s go over some of the most popular stable coins.
Diem (formerly known as Libra) is a stable coin in the works originally conceived by the powerful global social media platform Facebook. Although Libra hadn’t started yet, it had more psychological effects than any other stablecoin.
Governments, especially China’s, are currently investigating their own crypto-inspired digital currencies, partly because they fear that Diem would pose a competitive threat as Facebook is a multinational with billions of users from around the world.
The Diem Association, the consortium founded by Facebook, initially said Diem was backed by a “basket of currencies,” including the US dollar and the euro. Due to global regulatory concerns, the association has since pulled back from its ambitious original vision. Instead, there are now plans to focus on developing several stable coins, each supported by its own local currency.
The first stable coin, the Diem dollar, is expected to hit the market as early as January 2021.
Tether USDT is one of the oldest stablecoin, introduced in 2014 and remains the most popular to this day. It is currently one of the most valuable cryptocurrencies overall by market capitalization.
The main use case for USDT is to move money quickly between exchanges to take advantage of arbitrage opportunities when the price of cryptocurrencies is different on two exchanges. Traders can make money from this discrepancy. But it has found other uses: Chinese importers stationed in Russia have also used USDT to send millions of dollars worth of value across the border, circumventing tight capital controls in China.
Tether Ltd., the company that issues USDT, is involved in a lawsuit with the New York attorney general over the provision of financial documents that would shed light on its financial relationship with the Bitfinex cryptocurrency exchange.
Launched in 2018, USD Coin is a stable coin that is co-managed by cryptocurrency firms Circle and Coinbase through the Center Consortium.
Like Tether, USD Coin is pegged to the US dollar. It is the second largest stable coin by market capitalization.
Dai runs on the MakerDAO protocol and is a stable coin on the Ethereum blockchain. Founded in 2015, Dai is pegged to the US dollar and backed by Ether, the symbol behind Ethereum.
Unlike other stablecoins, MakerDAO intends to decentralize dei, which means there is no central authority that trusts control of the system. Instead, Ethereum smart contracts that encode rules that can’t be changed do this job instead.
However, there are still problems with this innovative model; For example, when the smart contracts MakerDAO is based on don’t work exactly as expected. In fact, they were played earlier this year, resulting in losses of $ 8 million.
Do stable coins have any disadvantages?
Stallcoins have some disadvantages to be aware of. Because of the way stablecoins are usually set up, they have different vulnerabilities than other cryptocurrencies.
For example, crypto publication The Capital argues that while stablecoins are labeled “stable,” they are only as stable as the asset the stablecoin is tied to. Traditionally, the price of the dollar has been very stable, but if this were to change, any fluctuations in the value of the dollar would be reflected in the stable coin.
If the reserves are stored with a bank or other third party, there is an additional security vulnerability in the form of counterparty risk. This boils down to the question: does the company really have the securities it claims to have? For example, this was a question that Tether was often asked with no clear answers. Tether has yet to conduct a full open review of its reserves.
Many stablecoin issuers do not offer transparency about where their reserves are held. This can help a user determine how risky it is to invest in stablecoin. Knowing where his money is being held, users can tell if a stablecoin is operating without a license in the region where the reserves are being held. For example, if the stablecoin operators are not licensed, a regulator could freeze the stablecoin’s underlying funds.
In addition, it is possible that the reserves for a stable coin will not be sufficient to redeem each unit, potentially shaking confidence in the coin.
Cryptocurrencies were created to replace intermediary companies that are normally entrusted with a user’s money. Intermediaries naturally have control over this money. For example, they can usually prevent a transaction from occurring. Some stablecoins offer the option of adding transactions back into the mix.
USD Coin has a back door open to stop payments when coins are used in illegal ways. Circle, one of the companies behind USD Coin, confirmed in July 2020 that it has frozen USD 100,000 in coin at the behest of law enforcement agencies.