Stablecoin Series Part 1 – A Stablecoin Manual

Stablecoins have been gaining popularity as of late.

Stablecoins are cryptocurrencies that are not very attractive purchases from a margin trading perspective, because they track the US dollar, gold or other values 1:1. Also, investors typically investing in crypto through crypto exchanges, where they use fiat currency to purchase cryptocurrencies such has Bitcoin and Ethereum.

If that is so, then why are stablecoins being created that claim parity with fiat currencies and why are they gaining attention?

Why use stablecoins?

One of the most often named traits of cryptocurrencies is high volatility. Hearing that someone became a millionaire overnight, just to lose most of their fortune again in a matter of weeks is no unusual story in the crypto market. This is where stablecoins come in.

Stablecoins are designed to have a much more fixed value than other cryptocurrencies by linking their value with US dollars, gold, etc. This also means that the advantages of cryptocurrencies such as transparency and security can be combined with value stability similar to fiat currencies.

For this reason, stablecoins are being used as a safe haven in the event of a market downturn or crash. For example, when the price of Bitcoin begins to fall sharply, Bitcoin holders can avoid potentially huge losses by converting their Bitcoins to stablecoins within minutes on a single platform.

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If there were no stablecoins, cryptocurrency holders would have to convert their assets back to fiat again. Since most crypto exchanges do not support fiat trading on their platform, funds first need to be moved to an exchange that supports fiat and then converted. This extra step has the disadvantage of incurring significant transfer fees.

Stablecoins’ function as a store of value also shines in international remittances and payments. The point of stablecoins is to run on a smart contract system within a blockchain network. Therefore, stablecoins can be used to transfer assets securely while also offering the advantages of cryptocurrency. This makes them attractive compared to SWIFT (the traditional remittance network system) and the complicated payment structure that connects merchants, Payment Gateway companies and credit card companies. At the same time, stablecoins are also a way to use DeFi (Decentralized Finance) services.

Fiat collateral-based stablecoins most common

The most common type of stablecoin is a coin whose value is backed by a fiat reserve. For the most part, fiat-backed stablecoins have a 1:1 value linkage. This allows stablecoin projects to say that they nominally hold fiat currency corresponding to the number of issued stablecoins. If an investor wants to exchange their coin for cash, the entity that manages the stablecoin will withdraw the fiat amount from the reserve and pay the cash equivalent. The corresponding stablecoin will be burned or permanently removed.

This is the method adopted by the top three stablecoin projects by market capitalization – Tether (USDT) at no. 1, followed by Circle (USDC) and Binance USD (BUSD).

Tether is a stablecoin first issued in 2014 by an affiliate of the Bitfinex exchange in Hong Kong and is considered to have pioneered the market. USDC is a latecomer to the market, but with investment by Goldman Sachs and interest from leading institutional investors, the project has been quickly catching up to Tether. Binance USD is a stablecoin issued by cryptocurrency exchange Binance to expand its DeFi ecosystem.

Crypto, algorithms, products, etc. – collateral types getting more diverse

There are also cryptocurrencies that seek to maintain value parity with other crypto.

To reduce the risk of price volatility, some cryptocurrency-backed stablecoins are even over-collateralized and designed to withstand the price fluctuations of the collateral. Let’s take an example in which to get $500 worth of stablecoins, you need to deposit $1000 worth of Ethereum. In this scenario, the stablecoin is currently 200% collateralized, and even if the price of the collateral drops by 25%, $500 worth of stablecoin will still come with $750 of ETH collateral.

In some cases, multiple cryptocurrencies are used as collateral to spread risk. With this structure, the stablecoin is automatically liquidated if the price of the collateralized cryptocurrency significantly decreases. Crypto-based stablecoins are more decentralized than fiat-based stablecoins because all processes are carried out with blockchain technology. A key example of a crypto-collateralized stablecoin is MakerDAO’s DAI.

Then there are also uncollateralized stablecoins that seek to guarantee their value using only algorithms and reserve assets. Terra’s Terra USD (UST) is an algorithmic stablecoin with Luna as a reserve asset. The algorithm is designed to keep UST at its target fixed price by burning an equivalent amount of Luna when UST is created and vice versa.

Commodity-backed stablecoins are collateralized with other types of exchangeable assets. The most commonly used collateral commodity is gold. However, there are also stablecoins backed by oil, real estate and various precious metals. Digix Gold (DGX) is attempting to link the value of 1 DGX with 1 gram of gold.

Meanwhile, a big competitor to stablecoins is central bank digital currency (CBDC). Here, central banks around the world issue a digitized version of their respective fiat currency. Since CBDCs are issued, controlled and regulated by a country’s central bank or monetary authority, they can be exchanged for their equivalent fiat at a 1:1 ratio and are likely to be considered fiat.

Although CBDCs are not generally classified as stablecoins, there is ongoing debate as to whether stablecoins and CBDCs can coexist in the future, since they can perform similar functions depending on the use case. An example of CBDC can be found in China, which has started testing the digital yuan (e-CNY) to increase the use of the yuan worldwide and lower the cost of international payments.

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