What are stablecoins?
You are probably asking yourself, “what in the world is a stablecoin anyway?” In essence, a stablecoin is a cryptocurrency that is pegged to another asset (e.g. gold, the U.S. dollar, another cryptocurrency, etc.). This currency is global and is not tied to a central bank. A stablecoin should have as low volatility as possible, as opposed to other cryptocurrencies that are often highly volatile in nature.
Stablecoins are a massive opportunity in the cryptocurrency market because it addresses such a large market. The ultimate goal of a stablecoin is to become a digital form of fiat-free cash that is incredibly stable in value.
What is sound money?
In order for a stablecoin to work, it must meet the requirements of sound money. Those requirements are the following:
- It must be a Medium of Exchange (a.k.a. MoE)
- It must be a Store of Value (a.k.a. SoV)
- It must be a Unit of Account (a.k.a. UoA)
- It must be fungible, easily divisible, and easily moved
What do each of these requirements mean?
For a stablecoin to be a medium of exchange, that means that the stablecoin can be used to facilitate the sale of goods without the need to barter. However, this is not the only requirement. Essentially all cryptocurrencies today can be used as a medium of exchange. However, that doesn’t mean they will be used to buy goods and services. That’s because…
Most cryptocurrencies aren’t a good store of value. A store of value is a form of wealth that maintains the current value that it has without depreciating in the future. As we saw in the beginning of 2018 in the cryptocurrency market, many cryptocurrencies declined significantly in value from its all time highs. That means that many cryptocurrencies, while useful for investing and speculation purposes, are not particularly useful as an actual form of money. As such, many people who accept cryptocurrency as payment must exchange it into a stable currency within a relatively short period of time.
Precious metals, such as gold and silver, have often been viewed as being solid stores of value. That is why when investors fear recessions and depressions in the economy, they buy gold (and occasionally silver) because they believe that these precious metals will at the very least maintain its current value.
So why aren’t gold and silver used today as forms of payment? e.g. Why can’t I ask a business to pay me in gold for a service that I do for them? While gold acts as a MoE and a SoV, it does not meet the requirement of being easily divisible or easily moved. According to APMEX, the price of an ounce of gold is $1,293. Let’s say I do a service for somebody and I only need $200. That’s the equivalent of 0.15468 ounces of gold. It’s very difficult to measure how much gold is actually needed unless you have precise measurements. Even then, it can become difficult to get the exact amount of gold the more precise the dollar amount becomes.
Cryptocurrencies, on the other hand, are very easily divisible and are often divisible to up to 18 decimal places. The idea of getting an exact amount of gold in ounces to 18 decimal places is ridiculous. On the other hand, the idea of getting an exact amount of a stablecoin to 18 decimal places is not only feasible but has been done before.
Precious silvers are also difficult to transport, as they can get heavy when transferring large amounts. With cryptocurrencies it is possible to transfer large amounts of wealth with only a computer and an internet connection.
All cryptocurrencies can serve as a unit of account. A unit of account simply means that it is able to provide a unit of measurement that can be used to define and compare value. For example, I can use Ethereum as a unit of account because I can define value in how much Ethereum it costs (e.g. “this car costs 10.5 Ethereum”). I could also use something like shares in a company as a unit of account (e.g. “this apartment will cost the same as 5 AAPL shares a month”), although shares aren’t used as money because they don’t meet many of the other requirements of sound money.
Why do stablecoins matter?
Stablecoins are important for several reasons:
- It is important to have a digital currency that remains stable in value (as opposed to Bitcoin, Ethereum, etc. that can be volatile), similar to well-known currencies that remain relatively stable in value (such as the U.S. Dollar).
- Stablecoins fulfill the “store of value” requirement of money — something that even real-world currencies don’t fulfill.
Let’s look at the second point. There have been numerous examples in history where the value of a currency collapsed due to hyperinflation, causing the wealth of people who hold that currency to plummet. Some examples include:
- Weimar Germany (1913 — 1923): The German “mark” currency plummeted in value after a severe hyperinflation that caused the collapse of Germany’s economy. Apocryphal accounts of Germany at the time show how much the “mark” currency declined in value: families were using money instead of wood to heat a stove because it was a cheaper alternative, and people had to shop with backpacks and wheelbarrows just to carry their money.
- Zimbabwe (1990s — 2010): Zimbabwe experienced extremely volatile currency prices in the late 1990s as a result of confiscating private farms of landowners. It’s estimated that in 2008, Zimbabwe experienced a monthly inflation rate of 79.6 billion perent.
- Venezuela (2009 — Present): The value of Venezuela’s “bolivar” currency has declined steadily and significantly against the U.S. dollar for over a decade now, and experienced hyperinflation.
As you can see, it’s not easy to create a stable currency (especially a digital one). If a global, digital stablecoin were to be successful it would be able to solve many problems in economically unstable environments. For that reason, stablecoins have been referred to as the “holy grail” of the cryptocurrency market.
What are the different types of stablecoins?
There are three main types of stablecoins:
- Non-collateralized (i.e. seigniorage shares)
What are each of these stablecoin types and what do they mean exactly?
Fiat-collateralization is the simplest method of creating a stablecoin, and is used by one of the top stablecoins today (Tether). Essentially, fiat-collateralized stablecoins are backed by a real-world asset. This real-world asset is controlled and owned by a central entity.
Fiat-collateralized stablecoins are the easiest to understand — they are essentially IOUs on some asset. Although this method is simple, there is the issue that it requires some degree of centralization. It requires a central entity which can guarantee the issuance and redeemability of the stablecoin into the asset the stablecoin is backed by. Audits from trustworthy parties are required to make sure that the stablecoin is actually fully-collateralized.
Crypto-collateralized stablecoins are similar in concept to fiat-collateralized stablecoins, except that crypto-collateralized stablecoins are backed by another cryptocurrency as opposed to being backed by a real-world asset.
In order to account for the price-volatility of the collateral backing the stablecoin, stablecoins using this method are over-collateralized. For example, a person needs $200 of ETH to receive $100 of a stablecoin in return. That way, even if ETH falls by 25% the stablecoin can still be stable in value as there is $150 of ETH backing the stablecoin.
There are some criticisms of using the crypto-collateralized method to create a stablecoin. Preston Byrne, for example, believes that these types of stablecoins are doomed to fail in the instance of a “black swan” event where the asset collateralizing the stablecoin declines in value significantly. This would cause the stablecoin to collapse also.
Non-collateralized (i.e. seigniorage shares)
Non-collateralized stablecoins are not backed by any real-world or cryptocurrency asset, and instead it maintains value by people expecting it will maintain a certain value. The main non-collateralized approach is the seigniorage shares method. The seigniorage shares method uses smart contracts that automatically expand and contract the supply of the non-collateralized stablecoin using algorithms to maintain its value.
This method is similar to what central banks do with fiat currencies, but non-collateralized stablecoins do this in a decentralized fashion.
Roadblocks stablecoins must overcome
There are several roadblocks and challenges that stablecoins must overcome before they can become viable currencies that people use.
The first roadblock is that of scalability. In order for digital cash to be viable, it must be able to make transactions quickly and make them cheaply. This is not an easy problem to solve; Bitcoin has faced some criticisms for high transaction fees that make it difficult to use Bitcoin as an actual currency. Stablecoins must be able to solve this issue before they can become widely adopted.
The other roadblock is that of privacy — having privacy when doing transactions is a driving component of why cryptocurrencies are so popular. However, there are still some issues with privacy with current cryptocurrencies. Athough Bitcoin addresses are anonymous (they’re simply a string of letters/numbers), transactions can be linked to a single bitcoin address easily. Or with Ethereum, if I know what your ETH wallet address is then I can easily lookup how much money you own, other ETH addresses that you’ve transacted with, and when you’ve transacted with those addresses. This is an issue for people who expect 100% privacy when dealing with cryptocurrencies, which is possible when dealing with physical cash. Stablecoins will have to solve the issue of creating complete privacy for its users when they want it.
List of stablecoin projects
Here’s a list of some stablecoin projects that exist today. Note that this is not meant to be an exhaustive list, but an overview of some big stablecoin projects that exist today.
Tether is an incredibly popular stablecoin that is allegedly backed by the U.S. Dollar. I state allegedly because there have been some doubts about whether or not Tether is 100% collateralized by the U.S. dollar, along with some other criticisms.
TrueUSD is also a U.S. dollar backed stablecoin. One of the main differences between TrueUSD and Tether is that TrueUSD attempts to be more transparent when it comes to the auditing of its funds that back the TrueUSD token. TrueUSD regularly undergoes third-party auditing to ensure best security practices.
Stably has the StableUSD, which is backed by the U.S. Dollar and designed to work across different blockchain protocols including Ethereum and Stellar. Similar to TrueUSD, Stably attempts to be as transparent as possible when it comes to the auditing of its funds.
Maker has the DAI token, which is always worth $1 each. The DAI token is collateralized with ETH — anybody can create DAI with a bit of technical knowledge. The process of creating DAI can be somewhat complex, and this article will skip over the exact steps of how to create it.
BitShares has the BitUSD. BitUSD is also valued at $1 each, and it has 100% or more of its value backed by the BitShares core currency BTS.
Havven has Nomin, which is a stablecoin backed by a distributed collateral pool. Nomins are collateralised by the value of havvens, and the value of havvens comes from transaction fees that are generated with all nomin transactions and paid to havven holders. The value of nomins is kept stable by havven holders, who are incentivised to manage its supply.
Non-collateralized (i.e. seigniorage shares)
Basis is designed to keep prices stable by algorithmically adjusting supply. When demand is rising, the blockchain will create more Basis. The expanded supply is designed to bring the Basis price back down. When demand is falling, the blockchain will buy back Basis. The contracted supply is designed to restore Basis price. It could also be thought of as an “algorithmic central bank” of sorts.
Carbon is conceptually similar in design to Basis. However, Carbon uses Hedera Hashgraph which could potentially provide it with significantly higher throughput and speed.