Stablecoins, Explained

What are stablecoins?

Stablecoins are a new type of cryptocurrency that often have their value pegged to another asset.

These coins can be pegged to fiat currencies such as the United States dollar, other cryptocurrencies, precious metals or a combination of the three. Fiat seems to be the most popular option in the marketplace right now, meaning one unit of a stablecoin equals $1.

Stablecoins are designed to tackle the inherent volatility seen in cryptocurrency prices. They are normally collateralized, meaning that the total number of stablecoins in circulation is backed by assets held in reserve. Put simply, if there are 500,000 USD-pegged coins in circulation, there should be at least $500,000 sitting in a bank.

With bitcoin suffering abrupt crashes and sudden gains, advocates believe stablecoins help eliminate doubt about conversion rates — making cryptocurrencies more practical for buying goods and services.

Examples of the best-known stablecoins include tether (USDT), trueUSD (TUSD), gemini dollar (GUSD), and USD coin by Circle and Coinbase (USDC). Demand for such coins has been growing. In December, Cointelegraph reported claims that four major stablecoins had clocked up $5 billion in on-chain transactions within just three months — enjoying a 1,032% surge in November compared with two months earlier.

So, how do they work?

As the name suggests, stablecoins are designed to have a consistent price or value over time.

There are three different ways of achieving this — delivering a happy medium between offering the stability of fiat currencies and the decentralized benefits that virtual currencies provide. Without stablecoins, taking out a loan while using crypto as collateral can be risky, as the assets used to secure your borrowing can be rendered worthless in a short space of time. Likewise, imagine what getting your salary in crypto would be like if prices were to tumble unexpectedly. In the real world, it would be like suddenly finding out that milk has ballooned in price from $1 to $3, meaning your money goes a lot less further.

The first type of stablecoin is collateralized by fiat. For every single stablecoin issued, $1 is kept safely by a central custodian such as a bank. This means that, in theory, you should be able to exchange between the two effortlessly without great expense. In other cases, commodities have been touted as a way of collateralizing crypto, with Venezuela’s government unveiling plans to launch the petro — a coin that’s value was to be tied to one barrel of oil. Alas, the petro’s launch was long delayed and, as Cointelegraph reported, it faced mixed success.

Next, you have stablecoins collateralized by crypto. “But wait!” I hear you cry. “Doesn’t this mean that price volatility is still possible?!” To an extent, yes — but some providers try to tackle this issue by “overcollateralization,” meaning $2 worth of crypto is deposited with a custodian for every $1 of a stablecoin. This can help to keep decentralization alive, with crypto reserves absorbing the impact of any fluctuations, but a downside is that huge amounts of capital can be required to get them off the ground.

Last, there are noncollateralized stablecoins, which do away with the idea of having reserves altogether. These types of assets see smart contracts take on a role not too dissimilar to a reserve bank. They monitor supply and demand — buying circulating coins when prices are too low and issuing new ones when prices are becoming too high. The ultimate goal is to keep prices in line with that of a pegged asset such as the U.S. dollar.

No matter what type of method is used, it is worth noting that stability is more of an aim than an inseparable feature.

Why have they become so popular?

Because they eliminate uncertainty for consumers — especially around conversions.

They offer the type of predictability that many countries struggle to achieve with their national currencies — hence why Venezuela, battling hyperinflation and political instability, decided to launch its own cryptocurrency.

Stablecoins give owners a safe place to store their assets whenever there are choppy waters in the crypto world. Consumers can quickly and easily convert from unpegged cryptocurrencies to stablecoins when they are worried about where the markets are heading next, eliminating the need to return to a fiat currency. These conversions can also be less expensive than when switching between crypto and fiat, as it takes the transaction fees of payment processing providers and banks out of the equation.

At the start of April, tether achieved an all-time high of daily transactions — and according to CoinMarketCap, the stablecoin is even nipping at the heels of bitcoin, with reported trading volumes of $9.4 billion compared to BTC’s $10.2 billion.

Part of the stablecoin’s burgeoning popularity may also be down to how crypto exchanges, the main point of access for many consumers, are starting to get in on the action — raising awareness. It was recently announced that OKEx, the sixth-largest exchange, was planning to launch its own stablecoin. And Binance, the world’s largest exchange, has been aggressively expanding the trading pairs it offers. In November, it rebranded its Tether (USDT) Market to the Stablecoin Market — and subsequently announced it would list a broader range of stablecoins. Explaining its rationale in a January blog post, Binance said: “In the last few months, the stablecoin space has evolved very quickly.”

Are stablecoins without controversy?

No — and this in part is because of transparency issues that have emerged.

Tether is one of the best-known stablecoins that has attracted controversy for several reasons in recent years. A study by academics claimed that the coin was used to “manipulate cryptocurrency prices” during the boom of 2017, with researchers even claiming that half of bitcoin’s price in December of that year was attributable to the stablecoin.

There have also been questions raised about whether Tether has enough dollars in reserve to collateralize all of its stablecoins — however, an unofficial audit in June 2018 appeared to confirm that its reserves were in order. Alarm bells were also ringing for some crypto enthusiasts in March 2019, when Tether appeared to dilute claims that its stablecoin was fully backed by U.S. dollars.

Other stablecoin advocates — such as Jeremy Allaire of Circle, which launched USDC back in autumn 2018 — have called for an “open standard that many companies can implement.” He added that greater levels of self-governance would give peace of mind to users, help tokenize the global economy and result in a joined-up ecosystem for the crypto industry that would pose a more compelling alternative to fiat.

Other critics argue that the existence of stablecoins have the potential to undermine normal cryptocurrencies, which have been working hard to develop their own economy and accrue value for many years. And, although they are meant to act as a safe haven for crypto consumers, the fact that pegged stablecoins will offer little to no financial gain is likely to be regarded as a major downside by some.

Who else is issuing stablecoins?

Everyone — from banks to social networks — is getting in on the action.

Even though JPMorgan Chase’s CEO appeared to call bitcoin a “fraud,” the U.S. bank recently unveiled plans to launch a stablecoin to speed up settlement times when transactions are taking place internationally.

Although some crypto commentators regarded the financial giant’s step as a ringing endorsement of stablecoins’ potential, others — such as the CEO of Ripple — attacked the “JPM Coin” for a lack of interoperability, which means that other banks would be unlikely to embrace the technology. Anthony Pompliano, the founder of Morgan Creek Digital Capital, went one step further — using his podcast to warn that “we should do everything in our power to prevent” JPMorgan Chase from succeeding, as it would mean trusting a Wall Street bank “that was previously charged with a felony.”

Elsewhere, IBM has launched its blockchain-powered World Wire in collaboration with Stellar (issuer of XLM) — also with the goal of building a cross-border payments network. Here, international banks can create their own stablecoins backed by their local fiat currency — and institutions from Brazil, South Korea and the Philippines have reportedly registered their interest so far.

We couldn’t wrap up without mentioning Facebook, which has reportedly hired dozens of engineers to develop a fiat-pegged stablecoin that users could rely on for paying their friends and family around the world. This could help the social network send shockwaves through the remittance industry by enabling foreign workers to transfer money with lower fees. The “Facebook Coin” could be a blessing for the embattled company as it tries to shake off privacy scandals and find sources of revenue beyond advertising. According to CNBC, one analyst believes the stablecoin could deliver an additional $19 billion in revenue by 2021, if the plans are pulled off.

Can stablecoins achieve true decentralization?

Certain providers believe they have struck a compromise.

Some stablecoin advocates are concerned that pegging a cryptocurrency directly to the U.S. dollar means that it must inevitably have ties to the U.S. banking system. This means that they have to rely on a centralized infrastructure — something Satoshi Nakamoto wanted to avoid when he set out his vision more than a decade ago.

Equilibrium says it has managed to address this pitfall by ensuring that its stablecoin, EOSDT, is overcollateralized above 170 percent. This is achieved by ensuring that one unit of EOSDT is equal to $1. The company says its framework delivers “the world’s first decentralized collateral-backed stablecoin built on the EOS blockchain” and addresses concerns surrounding safety and scalability.

At present, only EOS can be used as collateral, but the platform hopes to evolve into a cross-chain solution and accept a basket of multiple cryptocurrencies as collateral in time.

With new stablecoins launching all the time, and trading volumes on the rise, this is a segment of the crypto industry that could grow further in the coming years. Undoubtedly, new use cases will emerge along the way — potentially offering a temptation to consumers who have been reluctant to use virtual currencies so far.