What is a stablecoin?

Stablecoins are an attempt to create a cryptocurrency token with a stable price—their stability commonly achieved by pegging the token to an asset such as gold or fiat. By being backed by more traditional investments, the market has greater confidence in their price. For this reason, stablecoins are often the go-to option for both institutional and retail users of cryptocurrencies.

after reading this, you'll understand:

• What a stablecoin is and why we need them

• The history of stablecoins in the defi space

• Examples and types of stablecoins

• What the future holds for stablecoins

after reading this, you'll understand:

• What a stablecoin is and why we need them

• The history of stablecoins in the defi space

• Examples and types of stablecoins

• What the future holds for stablecoins

Bitcoin is too volatile. The price fluctuation makes Bitcoin unsuitable for daily use. We need a digital asset that is as decentralized as Bitcoin but doesn't change its value hourly. The market needed an asset that can be used as a store of monetary value and can 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, and, for this reason, stablecoins are the go-to option for both institutional and retail users of cryptocurrencies.

Within this introduction, we'll dive into stablecoins and why we need them — we'll also dive into their history and understand the various 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. It reduces the price volatility by backing its value against a conventional asset, such as a combination of currencies, a single fiat currency, or other valuable assets. Stablecoins aim to create a stable and reliable environment to increase cryptocurrencies' 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

Without both long-term and short-term stability, mainstream users consider cryptocurrencies extremely risky — it makes for a great reason not to use cryptocurrencies as a direct replacement for traditional fiat currencies. Adopting cryptocurrencies as a direct replacement for conventional fiat currency requires stability. Else, 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 stablecoins offer, such as:

Little to no volatility

To show the volatile nature of cryptocurrencies, look no further than the first cryptocurrency, Bitcoin. Since its inception, Bitcoin's price has gone through significant corrections. For example, Bitcoin rose from about $6,000 in November 2017 to above $19,000 in December 2017 and then fell to $7,000 in February 2018.

The mainstream public sees a fiat-backed stablecoin as a more acceptable class of digital currencies, the price of which doesn'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 to settle 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.

Protecting cryptocurrency traders

Stablecoins also protects traders and investors during volatile markets. In a bear market, traders can protect their position by flipping their Bitcoin, Ethereum, or other cryptocurrencies to a stablecoin within a split second. Traders can also increase their crypto holdings by entering or exiting the market using stablecoins without converting them to a fiat currency.

History of Stablecoins

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

The first Stablecoin: BitUSD

Launched in the early days of cryptocurrencies, 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. The team introduced an easy concept for creating a cryptocurrency that maintained a stable price. 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 very slow but took off during the Bitcoin bull run in 2017 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, which allowed 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. Its relevance as an alternative to fiat provides an avenue 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 argue the stablecoin isn't backed by the real US dollar and instead prints USDT tokens out of thin air.

The criticism comes after Tether hit a hurdle in 2018. Instead of going under an audit, the company parted ways with the audit firm. A year later, a New York Attorney General probed the currency and conceded that US dollars don't entirely back the token. This raised enough suspicion about USDT, whether it has enough in reserves to back the token or not.

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.

USDC, the next in line

Launched in September 2018 by Circle, USDC is a stablecoin pegged to 1:1 value with the US dollar. Tether was certainly 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 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. The rising gas fee 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, SeurmDex. The stablecoin can also be used in several decentralized finance protocols; for example, you can deposit it in BlockFi and earn interest for depositing USDC. Traders mainly hold USDC as a stable asset during the volatile market.

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. Instead of keeping US dollars in one place, the TrueUSD system holds the collateral in bank accounts of different 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 to ensure no one is in charge of issuing 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:

  • A hedge against market volatility for traders and exchanges.
  • Take advantage of blockchain networks without exposure to massive price volatility.
  • To develop economies.


Maker DAI

Launched in 2017, DAI is an Ethereum-based stablecoin pegged to 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-executed 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 to create DAI. Initially, DAI was launched with the support of only Pooled Ether (PETH) that can be 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 countries like the UK or Europe using the Monolith Visa Debit Card.

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 treasury to back it up. The aim is to back a stablecoin by real fiat in real bank accounts. Though this stablecoin's category is most simple, it is the most centralized, too. A central entity acts as the fiat reserve custodian and manages the whole process of issuing fiat-backed tokens and receiving 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
  • Requires trust in the issuer
  • 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; however, 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 collateral crypto; 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.
  • Don'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 Stablecoin

This category of stablecoin uses a Seigniorage Shares system to maintain the price stability of a token pegged to an asset, which could be a real asset like gold or a fiat currency like the US dollar. The non-collateralized stablecoins rely on an algorithm-generated mechanism (or smart contracts) to supply or sell tokens if the price goes down or above the pegged assets.

Benefits

  • Decentralized as no collateral is required
  • Smart contracts to create a trustworthy system


Disadvantages

  • Complex mechanism than any other type of stablecoin
  • Meeting high demand is not always guaranteed


Commodity-backed stablecoins

Interchangeable assets, like precious metals, back commodity-backed stablecoins. The most common commodity used to back these stablecoins is gold-but, in some cases, they are also backed by real estate, oil, or other precious metals. The collateral is often stored in a vault of a trusted third party. The stablecoins entitle a purchase 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


The Future of Stablecoins

The purpose of a stablecoin goes beyond being just a financial contract. It is the evolution of the traditional payment system.

It is a new form of digital money controlled algorithmically instead of a central authority and offers similar monetary benefits as fiat currencies. Stablecoins have the potential to open new doors to the mainstream adoption of digital assets in day-to-day life.

Though they have a huge potential in changing the global payment landscape, stablecoins are still in their infancy, and it may take a while before we see them used in the digital space.