Cryptocurrencies like bitcoin are quite volatile. This price volatility limits how well cryptocurrencies can function as money. After all, why would you want to be paid in bitcoin, for example, when its price could drop at any moment? Enter, stablecoins.
Stablecoins are a type of cryptocurrency. They’re designed to maintain a stable value. The value of most stablecoins are pegged to a collateralising asset or basket of assets. Because of this peg, the price stability of stablecoins is far better than bitcoin and many other cryptocurrencies.
How Stablecoins Are Used
- Safety exit for crypto investors. Stablecoins usually rises when the crypto market is performing poorly. That’s because crypto investors use stablecoins as a safe harbour. When markets turn sour, they sell into stablecoins. This is usually cheaper and faster than selling into fiat.
- Faster and cheaper remittance. Because stablecoins maintain parity, they’re better at functioning as a medium of exchange than other cryptocurrencies. Being built on blockchain technology means stablecoins are a lot faster and cheaper to send than a bank wire.
- Stablecoins and dApps. Pairing smart contract technology with price-stable cryptocurrencies allows dApp developers to build better solutions. The decentralised finance (DeFi) space, for example, wouldn’t be where it is today had it not been for stablecoins.
- Financial inclusivity. Censorship-resistant stablecoins offer a much-needed alternative for those living in countries with bad monetary systems and tight capital controls.
Are stable-value assets necessary? Given the high level of interest in “blockchain technology” coupled with disinterest in “Bitcoin the currency” that we see among so many in the mainstream world, perhaps the time is ripe for stable-currency or multi-currency systems to take over. — Vitalik Buterin (The Search for a Stable Cryptocurrency; November 11, 2014)
Types of Stablecoins
There are many types of stablecoin cryptocurrencies. Despite each of them offering the same utility, the form and function of stablecoins vary a lot. Broadly speaking, stablecoins can fall into one of the five categories described below.
By far the most popular type, fiat-collateralised stablecoins essentially function as an IOU. That is, a centralised third party will mint and issue stablecoins in exchange for a fiat currency (e.g., the U.S. dollar (USD)) at a fixed one-to-one exchange rate. When the stablecoins are redeemed, that same centralised party will return the equivalent fiat currency and destroy the redeemed stablecoin.
Fiat-collateralised stablecoins require interaction with and trust of a centralised entity. This introduces an uncomfortable amount of counterparty risk. (Counterparty risk is the likelihood that one or more parties to a transaction fails to meet their obligations.) Indeed, issuers of these price-stable cryptocurrencies are, to varying degrees, vulnerable to losing banking relationships, injunctive actions, and regulatory enforcement.
Some well-known USD-collateralised stablecoins are tether (USD₮), TrueUSD (TUSD), USD Coin (USDC), Paxos Standard (PAX), Binance USD (BUSD), and Gemini Dollar (GUSD).
Stablecoins pegged to the value of the Australian dollar (AUD) include Synthetix-based sAUD, TrueAUD (TAUD), Sparkdex-supported Sparkdex.AUD, and AUD Ramp (AUDR).
USD₮ has long been the most widely used stablecoin (Source: Coin Metrics)
Many stablecoins are fully backed by commodities. Like their fiat-collateralised equivalent, commodity-collateralised stablecoins involve a trusted third party. To build and maintain trust, credible issuers will routinely have their corresponding precious metal holdings verified by an auditor.
Precious metals—typically gold or silver—are the most common form of commodity-collateralised stablecoin. Australia-based Ainslie Wealth’s Gold Standard (AUS) and Silver Standard (AGS) tokens are two examples of this type of price-stable cryptocurrency.
Note, calling these stablecoins is perhaps a slight misnomer. That’s because commodities are typically more volatile than major fiat currencies.
A stablecoin that is collateralised by another cryptocurrency—or a basket of cryptocurrencies—offers a solution that’s more censorship-resistant than a fiat-pegged stablecoin.
That’s because the collateral type (i.e., cryptocurrency) is held by a smart contract that runs on a decentralised blockchain, such as Ethereum. This contrasts to other stablecoins, where the collateral is held by a bank or another off-chain entity.
Because these stablecoins are collateralised with cryptocurrencies, they require over-collateralisation to absorb fluctuations in the collateral’s value. This is very capital inefficient and can be a difficult concept for prospective users to grasp.
The most well-known example of a cryptocurrency-collateralised stablecoin is Dai (DAI). DAI is pegged one-to-one to the USD through a system of smart contracts, over-collateralisation, dynamic feedback mechanisms, and incentive structures on Maker (MKR).
Seignorage-style stablecoins are arguably the most decentralised of any stablecoin type. They’re sometimes called ‘algorithmic stablecoins’ because they function by algorithmically expanding or contracting circulating supply to meet demand. The smart contract-based models enabling these stablecoins mimic a central bank seigniorage system.
Unlike those described above, seigniorage-style stablecoins aren’t collateralised. They do, however, require continual network growth and capital inflows, with investors earning a proportional amount of seigniorage. This exposes seigniorage-style stablecoins to a considerable amount of regulatory risk.
Seigniorage-style stablecoins are very difficult to build and maintain. Many, such as NuBits (USNBT), have tried and failed to maintain parity. Whilst others like Basis (formerly Basecoin) never even went live.
Time to go meta. Indeed, stablecoin-collateralised stablecoins are a thing. Developers of such solutions argue that the propagation of fiat-pegged stablecoins confuses prospective users and has fragmented the stablecoin market.
mStable’s mUSD is one such stablecoin-collateralised stablecoin. mUSD an Ethereum-based ERC-20 token that’s pegged to a basket of constituent stablecoins including USDC, TUSD, USDC, and DAI.
How Stable Are They?
It’s all well and good describing how different stablecoins function. But it’s just as important to scrutinise how effectively they maintain parity with their collateralising asset—or basket of assets.
Basically every single collateralised stablecoin is currently failing to sustain parity. They spend a lot of time trading on exchanges for a value that’s one or two percentage points either side of parity.
The average crypto investor or trader will likely tolerate this discrepancy. But if stablecoins are to ever serve as the backbone of the dApp ecosystem, improvements are needed. For dApps in finance, insurance, remittance, and prediction markets, a one- and two-percentage-point deviation from a stablecoin’s pegged value would hurt mass adoption.
Stablecoins play a major role in the crypto ecosystem. Compared to other cryptocurrencies, stablecoins are far better at functioning as a medium of exchange. What’s more, they serve as an invaluable bridge between the worlds of fiat and crypto.
Looking ahead, expect fully collateralised, fiat-pegged stablecoins to dominate the stablecoin market. Meanwhile, skilled developers continue in their efforts to build a decentralised stablecoin that’s permissionless, censorship-resistant, and trustless. Should they succeed, trustless dApps will become a lot more powerful.