What is a stablecoin?

The crypto ecosystem is ever-evolving. And as the media increasingly covers the subject, many people are left wondering: What is stablecoin?

Stablecoins are an attempt to create a cryptocurrency token with a stable price. This stability is commonly achieved by pegging the token to an asset such as gold or fiat currency.

Crypto volatility, both long term and short term, has made coins largely considered a speculative investment. Stablecoins backed by more traditional investments give markets greater confidence in their price. For this reason, stablecoins are often the go-to option for financial decisions from both institutional and retail users of cryptocurrencies.

Price fluctuation makes Bitcoin too volatile for daily use. We need a digital asset that is decentralized but doesn’t change in value. The market needed an asset that can be used as a store of monetary value for entering and exiting (on and off ramps) decentralized finance ecosystems. The asset also needs to act as a medium of exchange — its value should remain stable over time. Ideally, a digital asset should have low inflation to maintain its purchasing power.

Stablecoins achieve stability by pegging themselves to a less volatile asset such as gold or fiat currency. It represents real money, which makes for its price stability.

In this article, we’ll dive into stablecoins and why we need them. We’ll also dive into their history and review the types of stablecoins available in the market.

What is stablecoin?

A stablecoin is a digital asset that remains stable in value against a pegged external traditional asset class. Stablecoin reduces price volatility by backing its value against a conventional asset. The backing asset could be a combination of currencies, a single fiat currency, or other valuable assets. Stablecoins aim to create a stable and reliable environment to increase cryptocurrency adoption and negate digital assets’ speculative nature. They offer the best of both worlds — security and decentralization of cryptocurrencies, with fiat currencies’ stability.

The need for stablecoins

Mainstream users consider traditional cryptocurrencies, which lack both long-term and short-term stability, to be extremely risky.

Adopting cryptocurrencies as a direct replacement for conventional fiat currency requires stability. A volatile currency can compromise the purchasing power of a holder.

Stablecoins are a digital currency where you don’t have to worry about volatility or instability of crypto prices. We have compiled a list of benefits the stablecoin market offers, such as:

Little to no volatility

To see the volatile nature of cryptocurrencies, look no further than the first cryptocurrency, Bitcoin. Since its inception, Bitcoin’s price has gone through significant highs and lows. For example, Bitcoin rose to a then-all-time high of $64,000 in early 2021, then fell below $30,000 by that summer. After rising back to $68,000 by November 2021, it dropped to about $35,000 in January 2022.

The mainstream public sees a fiat-backed stablecoin as a more acceptable class of digital currency. The market prices of stablecoins don’t fluctuate as frequently as popular cryptos like Bitcoin or Ether.

Global payment and remittance

Financial institutions like Wells Fargo and JP Morgan look at stablecoins as an efficient solution for settling international payments. Cross-border transactions with stablecoins are faster, cheaper, and more efficient than traditional SWIFT or Western Union methods.

The current methods are not only costly but also take days to clear a single international payment. That is a lot of unnecessary weight and fees for payments, which could be simplified using stablecoins.Recently, the stablecoin Tether was used in the transfer of millions of dollars of value across the China-Russia border.

South Korea’s leading bank, Shinhan Bank, for example, is collaborating with Hedera to leverage stablecoins and international remittances.

Meanwhile, Standard Bank Group, Africa’s largest bank by assets, also partnered with Hedera in 2021. Using Hedera’s distributed public ledger, cross-border trade is streamlined and gives full transparency to all parties.

“It has become increasingly clear that digitization of assets will impact all facets of our business,” said Ian Putter, Head of DLT/Blockchain at Standard Bank Group, in an interview with Hedera. “And we must strategically plan for these pieces to work seamlessly together.”

Protecting cryptocurrency traders

Stablecoins also can anchor crypto trading and protect investors during volatile markets. In a bear market, traders can flip their Bitcoin, Ethereum, or other crypto assets to stablecoin in a split second. Traders can also increase their crypto holdings by using comparison services, then entering or exiting markets using stablecoins without converting them to a fiat currency.

Types of stablecoins

In the cryptocurrency market, stablecoins are divided into four main categories:

Fiat-collateralized stablecoins

These are the most common types of stablecoins. Backed at a 1:1 ratio, meaning one stablecoin can be exchanged with one unit of currency. Fiat-backed stablecoins are backed, or collateralized, by fiat currencies like EUR, USD, or GBP. For each stablecoin that exists, there is fiat currency held in the treasury to back it up. The aim is to create a fixed-price stablecoin by real fiat in real bank accounts.

Though this stablecoin category is the simplest, it is the most centralized, too. A central entity acts as the fiat reserve custodian and manages issuance of fiat-backed tokens and receipt of new fiats.

Benefits

  • Fiat-backed stablecoins’ structure is simple.

  • Fiat is considered stable, which ensures low volatility.

Disadvantages

  • The centralized structure makes room for hacks and bankruptcy.

  • Comes with counterparty risk: You need to trust the issuer of coins and the centralized organization holding the reserves.

  • Need regulations and audits.

Crypto-backed stablecoins

Cryptocurrencies are also used to back stablecoins. A crypto-backed stablecoin operates just like a fiat-backed stablecoin. But instead of using the fiat as collateral, cryptocurrencies are locked up as collateral that backs up the crypto-backed stablecoin.

The token used to back the stablecoin uses a “security pledge” to compensate for the price fluctuation. Since the token can’t hold its peg, it doesn’t have a 1:1 ratio for the underlying crypto collateral. For instance, a crypto-backed token pegged to the US dollar will have approximately $2 peg for each stablecoin issued.

Benefits

  • It’s decentralized, as it’s based on blockchain.

  • Doesn’t require a custodian.

  • No regulations or audits required.

Disadvantages

  • Crypto backed stablecoin’s structure is more complex.

  • Too much dependency on the collateralized crypto.

Non-collateralized stablecoins

This category uses Seigniorage-style stablecoins to maintain the price stability of a token pegged to an asset. The asset could be U.S. dollars or a real asset like gold. These are algorithmic stablecoins that are non-collateralized. Seigniorage style stablecoins rely on algorithm-generated smart contracts to supply or sell tokens if the price fluctuates from pegged assets.

Benefits

  • Decentralized, because no collateral is required.

  • Smart contracts to create a trustworthy system.

  • Offers interactive tools through coin shares and bonds.

Disadvantages

  • More complex mechanism than any other type of stablecoin.

  • Meeting high demand is not always guaranteed.

  • Historically failed pegging mechanisms (ie Terra UST)

Commodity backed stablecoins

Unlike an algorithmic stablecoin, commodity-backed stablecoins are collateralized by interchangeable assets, like precious metals. The most common commodity used to back these stablecoins is gold. Some issuers, like Daxos Gold and Kitco Gold, design their stablecoin to work by cashing out coins with gold bars. But, in other cases, stablecoins are backed by real estate, oil, or other precious metals. The underlying asset is often stored in a vault of a trusted third party. The stablecoins entitle a purchaser to redeem the coin with a commodity.

Benefits

  • Real assets back each commodity-collateralized stablecoin.

  • Commodities price is relatively stable.

  • Commodities tokenization brings more liquidity to the market.

Disadvantages

  • It is centralized, which increases the risks of potential hacks because of a single point of failure.

  • Have to undergo an audit process to ensure its authenticity.

History of stablecoins

Since the dawn of the internet, there has been a demand to take fiat digital and reduce its permissions. Entrepreneurs and institutions tried the idea of creating a digital dollar and initiated the journey by launching BitUSD.

The first Stablecoin: BitUSD

Launched in 2014, BitUSD was the first stablecoin issued as a token on the BitShare blockchain. The pioneering stablecoin was the brainchild of two prominent figures in the blockchain industry, Charles Hoskinson and Dan Larimer. The token was backed by the core token of BitShares, BTS, and was collateralized by a range of other cryptos — all locked in a smart contract to act as collateral.

The rise of Tether ($USDT)

Tether ($USDT), was launched in 2014 by Tether Limited and has become one of the most popular stablecoins in the market. The team introduced an easy concept for creating a cryptocurrency that maintained a stable price during market price falls.

For each USDT stablecoin issued, Tether kept 1 US dollar in reserve. The goal was to keep the USDT price stabilized at approximately $1. Each USDT token can be exchanged for one US dollar locked in the reserve. USDT started slowly but took off during the 2017 Bitcoin bull run, when its total supply reached almost 10M.

Protocol

USDT was initially developed to use the Bitcoin blockchain (Omni and Liquid Protocol) as its transport protocol, allowing transactions of tokenized fiat currencies. However, Tether tokens currently use multiple protocols, including Ethereum, Algorand, Bitcoin Cash, EOS, Tron, and OMG. Since the original Tether protocol uses the Bitcoin network, it inherits the security and stability of the Bitcoin blockchain.

Purpose

Tether allows individuals to quickly and efficiently transfer value from one exchange to another without using a volatile cryptocurrency. The fact that a US dollar backs Tether appealed to stock magnates and daily traders. As an alternative to fiat, it provides a place for investors to park their investments when the market is volatile.

Controversy

The crypto market’s most significant coins are also its most controversial. Tether critics have argued that the stablecoin isn’t backed by the real US dollar and USDT tokens are conjured out of thin air.

The criticism mounted after Tether hit a hurdle in 2018. Instead of undergoing an audit, the company parted ways with the audit firm. A year later, a New York Attorney General probed the currency, claiming that Tether did not have the resources to fully back the token. Tether and Bitfinex eventually paid $18.5 million to the State of New York and agreed to meet new transparency reporting requirements to settle the matter without admitting the charges.

However, Tether claims that it mints new coins in response to need. For example, if you give Tether $1, you’ll get 1 USDT in return. Tether’s excuse for not disclosing its audits is that it doesn’t want regulators to know how US dollars turn into Tether.

USD Coin (USDC), the next in line

Launched in September 2018 by Circle, USD Coin is a stablecoin pegged to 1:1 value with the US dollar. Tether was under heavy speculation, which led to a rise in other US dollar-backed stablecoins that are transparent and audited. USDC is both regulated and audited and works almost similarly to Tether.

The stablecoin isn’t created like other cryptocurrencies. Instead, it’s available as Solana SPL, ERC-20, and Algorand ASA tokens. A purchaser can buy USDC using US dollars on multiple exchanges.

USDC was created by Circle in collaboration with Coinbase; however, Circle issues the stablecoin tokens. The company behind Circle also owns Poloniex exchange and has investors from Goldman Sachs and Baidu.

Protocol

USDC is currently issued on multiple blockchains but was introduced on the Ethereum blockchain in 2018. Rising gas fees on the Ethereum network pushed the need to launch the token on other networks with a relatively smaller fee. Therefore, the coin was issued on several networks, including Algorand, Solana, and Stellar.

Purpose

USDC is traded on Coinbase, Poloniex, Binance, and other major exchanges like Huobi and Serum Dex. The stablecoin can also be used in several decentralized finance protocols. For example, you can deposit it in BlockFi and earn interest. Traders find it useful to hold USDC as a stable asset that avoids market volatility.

TrueUSD

TrueUSD is a fully collateralized, transparently verified, and legally protected ERC-20 token pegged to the US dollar. The stablecoin was launched in 2018 as part of the TrustToken asset tokenization platform. TrueUSD holds collateral in bank accounts of fiduciary partners that have signed escrow agreements. These bank accounts are subject to monthly audits to ensure trust in TrueUSD.

Protocol

TrueUSD tokens are issued on the Bitcoin network via the Omni Protocol so that no one oversees the issuance of tokens. However, the tokens are based on the Ethereum network advanced issuance framework.

Purpose

The TrueUSD stablecoin is created with different use cases in mind, including:

Hedging against market volatility for traders and exchanges.

Taking advantage of blockchain networks without exposure to massive price volatility.

Developing economies.

Maker DAI

Launched in 2017, Dai is an Ethereum-based stablecoin that has the fixed price of one US dollar. The ERC-20 stable token is also prominent in the MakerDAO lending system. A Dai is created every time someone takes out a loan on MakerDAO. The price of each stablecoin is kept in check using self-executing smart contracts. If the price increases or decreases, the Dai stablecoins are created or burned to stabilize the price at one dollar.

Protocol

The protocol behind stablecoin Dai is an open-source platform that anyone can use to create Dai tokens against crypto collateral assets. Dai is generated by users of Maker Vault who can deposit crypto collateral using the Oasis.app. Initially, DAI was launched with the support of only Pooled Ether (PETH), obtained by depositing ETH into a smart contract.

Purpose

Dai is a stable hedge against popular digital currencies like Bitcoin or Ethereum. Since Dai is stable, businesses can rely on it to accept and send stable money on the crypto networks. DAI can also be spent in Europe using the Monolith Visa Debit Card.

The future of stablecoins

The purpose of a stablecoin goes beyond being just a financial contract. It is the evolution of both conventional payment systems and traditional, volatile cryptocurrencies.

It is a new form of digital money. Controlled algorithmically instead of by a central authority, and offers similar monetary benefits as fiat currencies. As inherently stable assets, stablecoins could open new doors to the mainstream adoption of digital assets in day-to-day life.

But because of the dangers inherent to stablecoins, governments are exploring new forms of regulation. The Biden administration announced earlier in 2022 that they hope to regulate stablecoin issuers similarly to banks.

In doing so, issuers would need to insure their stablecoin reserves like traditional depository institutions. It’d be like a crypto version of FDIC insurance. It would give traders some protection not just from price fluctuations, but also from theft or issuer bankruptcy. Issuers would also be subject to federal oversight and auditing. And they’d need to comply with restrictions on commercial entity affiliation and promote interoperability among stablecoins.

Though the kinks are still being ironed out, Stablecoins have a huge potential to change the global payment landscape. As stablecoins continue to “stabilize” and gain public trust, the way the financial sector uses digital assets will keep evolving. Time will tell how they shape the future of finance.