The Complete Beginner’s Guide to Stablecoins
Last updated: 1/8/19
Most cryptocurrencies 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.
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.
If you want a deeper explanation about Stablecoins keep on reading. Here’s what I’ll cover:
- Volatility in cryptocurrencies
- What are stablecoins good for?
- Creating a stablecoin peg
- Which pegging method is best?
- Stablecoin business models
- Popular stablecoins
- Stablecoin criticism
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Usually, the smaller a market cap an asset has, the more volatile its price will be. Imagine throwing a rock into a small pond. Now take the same rock and throw it into the ocean. Clearly, the rock will have much more of an effect on the pond than on the ocean. In the same manner, the cryptocurrency market cap is a small pond for now, and is more affected by everyday buy and sell orders than, say for example, the US Dollar.
This creates a major issue since you can’t enjoy the benefits of cryptocurrencies 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. Just think what it feels like to be the guy who bought 2 pizzas for 10K Bitcoins 8 years ago…
That’s exactly where stablecoins come in.
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. 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, I can just exchange my Bitcoins for USDT and retain my dollar value.
Once I want to “get back in the game” and hold Bitcoins, 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.
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. But 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.
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.
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. Let me explain.
Imagine we have a stablecoin that is pegged to the US dollar through an algorithmic peg. Assuming a lot of people were 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. 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. 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.
USDT (USD Tether) – 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 – TrueUSD 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 (Gemini USD) – 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 (USD Coin) – A fiat collateralized stablecoin issued by Circle and Coinbase.
DAI – A stablecoin created by MakerDAO that is crypto collateralized.
There’s a lot of criticism going on about the creation of stablecoins. The most common one is related to the inability of actually maintaining the peg in the long run. This could be due to any one of the reasons I’ve mentioned before.
On top of that, a quick look at history tells us that all pegged-currencies are doomed to fail due to the cost of maintaining them, especially when that peg comes under attack. Some well-known examples where pegs were broken are the Swiss Franc peg to the Euro in 2015, the Chinese Yuan to the US dollar in 2005, the Thai Bhat peg to the US dollar in 1997 and the most famous of them all, the gold standard – pegging the US dollar to gold in 1971.
But the bigger question here is the issue of governance. Stablecoins are considered by many to be centralized due to the fact that there is a company behind them that maintains the peg, whether it be algorithmic or collateralized. Therefore, stablecoins aren’t really cryptocurrencies in the sense that they aren’t decentralized.
Another issue is that stablecoins seem to be providing a solution to something that is just a growing pain and not a constant problem. Once cryptocurrencies achieve a higher market cap, their volatility will reduce dramatically and there will be no real use for stablecoins.
Stablecoins are trying to get the best of both worlds – the stability of an established currency with a large market AND the flexibility of a decentralized, free for all cryptocurrency. The problem is that they also get the worst of both worlds: A centralized coin with a sort of central bank controlling it and a questionable ability to maintain the public’s trust in it.
Finally there’s the question of regulation – Will regulators allow companies to create an asset that mimics legal tender without any oversight? One example for such an issue is Basis. An algorithmically pegged stablecoin that raised over $130m for its project, just to shut down due to regulatory issues not so long ago.
It seems like stablecoins are some sort of a temporary utility for exchanges, allowing traders a haven out of volatility, without needing to supply them with regulated fiat options. In the long run, it’s hard to be sure how, or whether, these coins will have a place in the crypto ecosystem, especially with so many question marks surrounding them.
Hopefully by now you understand what Stablecoins are and how they work – A type of cryptocurrency that is pegged to the value of a less volatile asset, usually the US dollar. You may still have some questions. If so, just leave them in the comment section below.