“What is a stablecoin? What is it used for?” How are stablecoins created and are they really a good idea?

 

     “What is a stablecoin? What is it used for?” How are stablecoins created and are they really a good idea?

Today’s topic is stablecoins. Most crypto-currencies were meant to serve as a medium of exchange and not just a store of value. The problem is that due to their relatively small market cap, even popular cryptocurrencies like Bitcoin tend to experience wide fluctuations in price.

 

Usually, the smaller a market cap an asset has, the more volatile its price will be.

 

 

This creates a major issue since you can’t enjoy the benefits of crypto-currencies which include the decentralization of money and a “Free for all” payment system, without the value volatility that accompanies it. Imagine how hard it is to use Bitcoin or any other cryptocurrency for day to day transactions and trading purposes when one day it's worth X and the next day it’s worth half of that.

 

That’s exactly where stablecoins come in Simply put, stablecoins are an attempt to create a cryptocurrency that isn’t volatile. A stablecoin’s value is pegged to a real world currency,

also known as fiat currency. For example, the Stablecoin known as Tether, or USDT,

is worth 1 US dollar and is expected to maintain this peg no matter what.

 

Stablecoins allow for the convenience of cryptocurrency, which means fast settlement and fewer regulatory hurdles, along with the stability of fiat currencies. Like most coins, the most obvious use case would be to use them as a medium of exchange for day to day purchases.

But since these coins aren’t very popular at the moment, no one really accepts them as a payment method. So the main usage of stablecoins today is actually on cryptocurrency exchanges.

Volatile cryptocurrencies for stable cryptocurrencies

Using stablecoins, traders can trade volatile cryptocurrencies for stable cryptocurrencies when they want to lower their risk. For example, if I’m invested in Bitcoin and I don’t want to risk the price of Bitcoin falling against the US dollar,

Exchanging Bitcoins

Exchanging Bitcoins for USDT and retaining the dollar value. I can just exchange my USDT back to BTC.

 

This method is extremely popular with crypto-only exchanges that don’t supply their users with the option to exchange Bitcoin for fiat currencies due to regulation.

Advantage

Another great advantage of stablecoins is that you can move funds between exchanges relatively quickly,

since Crypto transactions are faster and cheaper than fiat transactions. The option for such a fast settlement between exchanges makes arbitraging more convenient and closes the price gaps that you  usually see between Bitcoin exchanges.

 

So for now, stablecoins are more of a utility coin for traders than an actual medium of exchange.

“How are they made possible? What keeps their price from the volatility that other cryptocurrencies experience?”

Well, there are several ways a company can try and maintain its stablecoin’s peg to a fiat currency.

The first way to maintain a peg is by creating trust that the coin is actually worth what it is pegged to.

For example, if the market doesn’t believe that one USDT is really worth one dollar, people will immediately dump all of their USDT and the price will crash.

In order to maintain this trust the company backs its coins with some sort of asset. This collateral is basically proof that the company is good for its word and that its coins should actually be worth the pegged amount. For example, in Tether’s case, each USDT is said to be backed by an actual US dollar that Tether holds as collateral.

A different example for collateral is the DGX token that is said to be backed by gold.

Backed by one or more cryptocurrencies

Another version of a collateralized stable coin is one that is backed by one or more cryptocurrencies.

This form of collateral is much easier to audit since a company’s balance can be viewed on the blockchain.

 

Way to maintain a peg

The second way to maintain a peg is by manipulating the coin supply on the market,

also known as an algorithmic peg. An algorithmic peg means the company writes a set of rules,

also known as a smart contract, that increases or decreases the amount of a stablecoin in circulation depending on the coin’s price.

Algorithmic peg

Imagine we have a stablecoin that is pegged to the US dollar through an algorithmic peg.

Assuming a lot of people was to start buying the coin, its price would rise and the peg will be broken.

To prevent this from happening new coins are issued.

This increase in supply alleviates the price pressure created by the demand and maintains the coin’s value. If, on the other hand, many people start selling the coin, coins are removed from the overall supply

in order to hold the price peg to one US dollar.

To be clear, algorithmically pegged stablecoins don’t hold any assets as collateral.

The smart contract that manages the coin acts as a central bank. It tries to manipulate the price back to the peg by changing the money supply.

 

 

There are pros and cons for each pegging method.

 

Fiat collateralized pegs transmit the highest degree of certainty to stablecoin holders that the coin is indeed worth the asset it is backed by. However, fiat collateralized pegs have some major cons.

For one, from the company’s standpoint, the asset is frozen and can’t be used for anything else.

Risk of embezzlement

Also, there’s always the risk of embezzlement or the closing of the company’s bank account, which can ruin the trust in the stablecoin.

Another issue with fiat collateralized stablecoins is that it’s hard to actually prove the company owns enough of the asset to really back the amount of coins in circulation.

Tether, for example, has suffered severe criticism and audit requests from skeptics claiming the company doesn’t have enough collateral to back the USDT in circulation.

Crypto collateralized coins, on the other hand, may have the benefit of viewing the collateral on the blockchain, but the collateral itself is extremely volatile. That’s why a premium is needed.

 

In many cases that company will hold 150% or even more of the collateral needed, to make up for possible drops in cryptocurrency prices. Algorithmic pegging benefits from the fact that the company doesn’t need to hold any asset on hand.

Algorithmic pegging theory

However, many will argue that algorithmic pegging theory doesn’t really work in real life, since manipulating the money supply isn’t a guarantee the peg will hold. With all of the complexities in maintaining a stablecoin’s peg, you might be wondering

“what’s the incentive to create a stablecoin in the first place? What’s the business model?”

Well, for each company there’s a different incentive. Some companies can charge a fee for trading their coin. Other companies use their stablecoin as a marketing channel to raise awareness to the company and other services it offers.

 

Houbi, Gemini, Coinbase and Circle are exchanges that have created their own stablecoins in order to attract more users to their trading platforms and allow easier transition of funds within and between exchanges. Let's take a moment to go over some examples of the more popular stablecoins in use today.

USDT or USD Tether, which I’ve already mentioned, is a fiat collateralized stablecoin that is pegged to the US dollar.

 

The coin was created by the company Tether and has remained relatively stable since its introduction in 2015. TUSD, not to be confused with USDT, stands for TrueUSD

 and is a relatively new fiat collateralized stablecoin that attempts to address the criticism directed at Tether. Collateral U.S Dollars are held in the bank accounts of multiple trust companies.

These bank accounts are published every day and are subject to monthly audits.

 

GUSD, also known as Gemini USD, is a fiat collateralized stablecoin issued by the popular crypto exchange Gemini, which was established by the Winklevoss brothers.

 

According to Gemini, GUSD is the first regulated stablecoin in the world. USDC, which stands for USD Coin, is a fiat collateralized stablecoin issued by Circle and Coinbase. And finally, DAI is a stablecoin created by MakerDAO that is crypto collateralized. There’s a lot of criticism going on about the creation of stablecoins.