Updated 21 March 2020

What are stablecoins?

A stablecoin’s goal is to provide a currency that is stable, which is done by pegging the value of a stablecoin to another asset, be it precious metals (e.g. gold) or another currency (usually US dollar). The stablecoin has a fixed exchange rate with the underlying asset, something that’s not particularly new as there are numerous examples of fixed exchange rates currencies.

You can also back a stablecoin with another cryptocurrency. There are even algorithmic stablecoins that don’t rely on any underlying asset. Major stablecoin models will be explained later in the article.

To understand stablecoins you have to know what money is. And there are several qualities of money you should be aware of, namely medium of exchange, unit of account, and store of value.

Medium of exchange

All parties involved in a transaction need to agree that the instrument you pay with (money) has value, which makes it a medium of exchange. This solves the issue of a barter system (exchanging one good for another, e.g. apples for oranges), which requires both people to need the exact goods that are being exchanged. For example, if you want to sell apples for oranges, you need to find not only someone who wants to get rid of oranges, but also someone who wants apples – such situation is not always a given.

Unit of account

One should be able to use money to measure value, that is the money should be able to be used as a unit of account. This feature requires the instrument to have a stable value. Can you imagine, for example, comparing two items in a restaurant menu when the prices have changed three times before you could make a choice?

Store of value

Money should retain its value (purchasing power) over a longer period of time. That means that it has to be a reliable store of value. You want to be able to spend your money or exchange it in the future without the fear that your money changed in value.

There a few other characteristics of “ideal” money: the quality of being interchangeable (so-called fungibility), divisibility into smaller units, portability (easy to move), durability (paper money is very easily destroyed). Finally, in order to maintain the value of money, its supply should be limited.

Cryptocurrency vs fiat money

Let’s take a look at cryptocurrencies in the context of these money features. Overall, cryptocurrencies do quite well as money. They can definitely be used as a medium of exchange, often with some advantages over traditional fiat money (e.g. lower or no fees). They also fulfil the characteristics of portability, uniformity, and durability. Fungibility is interesting, as it depends on the specific cryptocurrency. The more private the coin is, the more fungible it is. For example, Monero could be considered fungible, but not Bitcoin (as you are able to trace Bitcoin transactions). Cryptocurrencies definitely win in the limited supply and divisibility category, as they can be divided up to 18 points after the decimal point, compared to fiat’s 2 points (down to $0.01, or whatever currency you use).

Perfect joke exemplifying the volatility of cryptocurrencies

One of the few areas where cryptocurrencies lose to fiat currencies is also the reason why the former is not mainstream yet – volatility. Often changing prices means that cryptocurrencies are difficult to be used as a unit of account, as the joke shows. Additionally, they can be tricky as store of value, since the volatility works both ways. The price can “go to the moon”. Or quite the opposite, as the people who bought Bitcoin at the height of the 2017 hype can now tell you.

The opinion of the writer is their own and do not constitute financial advice in any way whatsoever. Edited by Sean Vanian, contributor for The Coin Radar.

Stablecoin advantages

In order for cryptocurrencies to be widely used, they have to be better that contemporary money. Which means that cryptos need to be at least as good as the money we have today, that is one that can be used as a medium of exchange, unit of account, and store of value.

Stablecoins may become a catalyst for widespread cryptocurrency adoption. As their value does not fluctuate (for the most part, but we’ll get to that), they are better suited as a store of value and a unit of account. This means that they can enjoy all the traditional advantages of cryptocurrencies, mentioned earlier, as well as solve the volatility issue currently present in the crypto market. Furthermore, depending on who you ask, stablecoins include several other advantages.

Traders can utilise stablecoins to protect against market corrections (price-drops of at least 10% after a temporary increase in price, e.g. due to hype). In general, if the cryptocurrencies are in a bear market, if the prices are going down due to a market correction, or if you simply believe that an asset’s price will go down, you can exchange it for stablecoins. If the price of the asset does go down, your value will be locked in stablecoins. Let’s take an example. Let’s say you exchange 1 BTC at the current price of $6.600 for stablecoins, and the price of Bitcoin goes down to $6.000, you still hold $6.600 worth of BTC, just in another coin.

But day traders are not the only ones who benefit from keeping the value of their trades. Investors can retain value against market volatility by holding stablecoins. The ability to keep the value of your money stable is especially useful if you live in a country in a dire economic situation, for example one where inflation is out of control (Venezuela comes to mind, but it certainly is not the only country with inflationary problems). Stablecoins might also aid innocent citizens in countries suffering under sanctions, or simply those who don’t want to trust banks or other centralised (and possibly corrupted) institutions.

Retail adoption of cryptocurrencies can still be considered small. But the stability of these coins may be attractive to both retailers and consumers, as it solves the unit of account issue mentioned earlier. And if retailers decide to add some stablecoins to the cryptocurrencies they accept, day-to-day purchases with cryptos may rise significantly.

Individuals often want to deal in dollars (or other major fiat currencies), as during times of high volatility the actual price at which a trade is executed may be higher than expected (so-called slippage). However, regulatory issues can make it difficult for crypto exchanges to allow fiat currencies. Stablecoins neatly solve this issue. Additionally, people exchanging their funds for fiat-equivalents (or as close as stablecoins can get to it) leads to a higher liquidity on exchanges, something that these platforms surely appreciate.

Issues

So far, everything sounds great. There is certainly a demand for stablecoins, and their potential can be clearly seen. However, there are still a few issues to be solved.

Instability

Why is it so hard to keep a currency stable? Simple: saying that a coin will cost $1 is simply not how financial markets work. Under normal market conditions, the value of any item, be it an asset, commodity, or a token, is determined by supply and demand. And every previous and current pegged asset has struggled with this very problem.

One of the most dramatic histories belongs to NuBits. In October, 2016, the price jumped to $1.22, in March, 2017, dropped to $0.72. And in September and December, 2017, the price reached $1.52 and $1.49 respectively. In March, 2018, NuBits’ peg crashed again. The team did not have enough in reserve to withstand a drop in demand. A reserve, by the way, which was held in Bitcoin. So when the value of Bitcoin went down, so did the value of NuBits reserves. And although in April the price saw some recovery, the price suffered a death spiral soon after (due to panic, selling off, and insufficient reserves). NuBits is by far not the only stablecoin with price volatility issues. Every stablecoin on the market has experienced price jumps, which only speaks to the fact that stability is more of a goal of stablecoins, rather than an inherent characteristic.

Centralisation

Within stablecoin environment, fiat-collateralized ones (pegging a stablecoin to a fiat currency such as USD) are especially vulnerable to centralisation, as the reserves of the coin are usually held with a centralised entity that has to ensure that the token is redeemable for fiat money. The stablecoin Tether, backed by USD, is considered heavily centralised due to its close ties to the Bitfinex exchange – during the Paradise papers data leak in November 2017 it was revealed that Bitfinex leadership, Potter and Devasini, set up the company Tether Limited in 2014 (but kept quiet about this close relationship). Despite the centralisation and other criticisms, including not being able to conclusively prove that they have enough reserves to back USDT (Tether’s token), Tether is currently the most popular stablecoin.

Vulnerability to a black swan event

A black swan event is a random, unexpected crash. Crypto-collateralized stablecoins are especially at risk here, as they have to deal not only with the volatility of their own coin, but also the volatility of the underlying cryptocurrency. Additionally, as these coins may require overcollateralization, the loss would be even worse in case of a crash. It should also be mentioned that while fiat-currencies are more stable than cryptocurrencies, they cannot be considered crash-proof (e.g. the 2001 dot-com bubble, the 2008 crash, etc.).

Scaling

Scaling is especially tricky for reserve-backed stablecoins, as it is difficult to scale while achieving a 1:1 reserve at all times. In order to achieve enough liquidity, significant investment has to be poured into the project.

Regulatory challenges

The whole cryptocurrency market faces regulatory issues. But with stablecoins, the situations may be even more precarious. They are more closely related to actual (fiat) money, and therefore regulators may have an easier time cracking down on them. The recently released Gemini stablecoin aims to be the first regulated stablecoin.

In short, stablecoins still face a number of challenges; none of them can be described as perfectly stable, as stability seems to be more of a goal rather than an inherent feature. Other challenges include a possible centralisation, threat of a black swan event, scaling, and possibly regulatory issues.

Types of stablecoins

There are several models of a stablecoin. They can be pegged to an asset: fiat currency, an asset (gold or precious metals), or another cryptocurrency. There are also algorithmic stablecoins, requiring no peg.

Asset-backed

Backing a stablecoin with fiat is also called IOU issuance. This stems from the nature of how these coins work. A (centralised) entity issues tokens that can be redeemed for fiat currency. They are digital representations of fiat money (for example, the US dollar). When you buy these tokens, the entity issues an equal number of IOUs to be stored in its (centralised) reserves. When you redeem (sell) fiat-backed tokens for its pegged currency, you receive an equal value in dollars, and the tokens you redeemed are destroyed.

Advantages of the IOU model

It’s easy to understand, which is an advantage in and of itself. Moreover, as the reserves are held in fiat (or another “traditional” asset, such as gold), this model can withstand volatility in the crypto market. It should also be said that this makes it the most stable model currently on the market.

Issues of the IOU model

Counterparty risk in asset-backed stablecoins relates to the risk the company does not hold as much in its reserves as it should (see, for example, Tether controversy – explained below). As the model requires users to trust an entity and a bank that stores the currency reserves, centralisation is one of its main drawbacks. Additionally, in order to foster trust, the model calls for frequent audits, which may be expensive and time-consuming.

Regulation can be considered either an advantage or an issue, depending what kind of investor you are. Because of the strong relationship to traditional assets (fiat, precious metals), this type of stablecoin is often highly regulated.

Examples of asset backed stablecoins are Tether (USDT) and TrueUSD (TUSD), both backed by the US dollar (1:1). DigixDAO should also be mentioned, as it is one of the few stablecoins backed by precious metals, in this case gold (1 DGX is redeemable for 1 gram of gold).

Crypto-collateralized

Stablecoins don’t have to be backed by fiat currency or physical assets, some of the current applications utilise other cryptocurrencies as collateral. This allows both the stablecoins and the reserve to be on the Blockchain. On the other hand, in order to compensate for the volatility of the underlying asset (crypto), the stablecoins in this model are overcollateralized. That is, the value of the crypto collateral you put up is higher than the value of the stablecoins you get in return.

Advantages of the model

This model exists fully on the Blockchain, which makes it more decentralised. Since all that is required to switch between collateral and the stablecoin is a blockchain transaction, users can quickly liquidatetheir holdings into the crypto collateral. Furthermore, it allows more experienced traders to trade with leverage.

Issues of the model

One of the main challenges is its vulnerability to black swan events (when the price of the underlying asset suddenly crashes) and relative instability. The model is also quite complicated to understand. This model may also have issues with scalability, as (depending on the level of overcollateralization) the demand for stablecoins may some day exceed the demand for the underlying cryptocurrency asset.

Overcollaterization is an inherent requirement of the crypto-backed model. Some users believe overcollaterization to be worth the other advantages, while others may consider it as an inefficient use of capital.

Examples of crypto-collateralized stablecoins are MakerDAO (backed by Ethereum, and in the near future they will become the first multi-asset backed stablecoin), and Synthetix (until very recently Havven), which is backed by their native SNX token (formerly Havven token).

Non-collateralized

This type of a stablecoin model is also called seigniorage shares. Instead of putting up collateral, users are promised future profits of the company, so the model is in fact backed by future dividends. The model works much like a central bank, contracting and expanding as needed. However, this functionality is fulfilled algorithmically. Smart contracts, with a single goal of keeping the price stable at $1, automatically take action when the price deviates. Should the price rise, more stablecoins are minted and offered in an auction, increasing the supply and eventually bringing the price to the desired level. When the price falls, new shares (bonds) are created that users buy with stablecoins (believing that the demand, and hence supply, will increase in the future).

Advantages of the model

The model is fully decentralised, and does not rely on any other asset (self-contained). Even if fiat or cryptocurrency would crash, the non-collateralized coin would remain. Although the model is still experimental, it holds much potential for the future.

Issues of the model

Such models may be vulnerable to death spirals (if demand falls significantly, not enough people may be inlined to buy shares in exchange for tokens, as the chances of the demand for the tokens rising and the shares being paid out are slim), which is a challenge especially in the early stages of the project when the adoption and faith in the system are low. Other criticisms of the model include its resemblance to a pyramid scheme, as the success of the coin depends on new entrants to the system and a perpetual growth in demand (while many fiat currencies have had a steady rise in demand for cash, the same is not given for crypto project).

Basis (formerly Basecoin) has in June introduced a stablecoin with an algorithmic central bank. It is the most popular stablecoin of its kind. Or rather was, as their CEO recently stated that the Basis project is shutting down due to regulatory concerns.

Which is the best stablecoin?

There is no one ideal stablecoin model. Rather, the investors and users need to decide for themselves which features they value more, and which model they consider to be most sustainable and scalable in the future. Would you rather be sure that the coin is fully backed, and at the same time not care about decentralisation that much? Choose the regulated, fiat-backed projects. Do you trust in crypto and are unafraid of black swan events? Then crypto-backed stablecoins, such as Dai from MakerDAO, may be your solution.

The opinion of the writer is their own and do not constitute financial advice in any way whatsoever. Edited by Sean Vanian, contributor for The Coin Radar.

The article was originally posted on Coinisseur.