Stablecoin: Everything to Know

By  Beluga Research October 27, 2023

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Summary

  • In cryptocurrency, a "stablecoin" is a digital asset designed to maintain a stable value, often pegged to a fiat currency to minimize price volatility
  • Stablecoins achieve stability through different mechanisms such as centralized control, collateralization and algorithmic interventions
  • Advantages of stablecoins include efficient transactions, global accessibility, borderless transactions, financial inclusion and programmability
  • Disadvantages of stablecoins include centralization risk, regulatory challenges, lack of transparency and limited adoption

Overview

In cryptocurrency, a "stablecoin" is a digital asset designed to maintain a stable value, often pegged to a fiat currency to minimize price volatility. They provide a means of reducing the price volatility commonly associated with cryptocurrencies like bitcoin. Stablecoins serve various purposes, including facilitating digital transactions, serving as a store of value and enabling users to access the benefits of blockchain technology without the risk of price fluctuations. They are widely used in the world of cryptocurrency trading, decentralized finance (DeFi) and as a means of transferring value across borders quickly and efficiently.

A Brief History

Stablecoins have been around since the early days of cryptocurrencies. In 2012, BitShares made the first major attempt at creating a stablecoin, but it was not until 2014 that Tether (USDT) became the first widely adopted stablecoin. Tether initially operated on the Bitcoin blockchain before expanding to other networks like Ethereum.

Stablecoin: Everything to Know

Different types of stablecoins exist, each with unique mechanisms for maintaining stability. These types are as follows:

  • Fiat-Collateralized Stablecoins - These stablecoins are backed by reserves of fiat currency held by a central entity. For example, Tether claims to be backed 1:1 by U.S. dollars held in reserve. Each token is redeemable for the underlying fiat currency, ensuring stability.
  • Crypto-Collateralized Stablecoins - These stablecoins are backed by other cryptocurrencies. They maintain stability through "overcollateralization," requiring users to deposit a larger value of cryptocurrency as collateral than the stablecoin they want to create. MakerDAO's DAI is an example, backed by ether and other crypto assets.
  • Algorithmic Stablecoins - Also known as "seigniorage-style stablecoins," these use algorithms to adjust the token supply and maintain price stability. They do not rely on reserves or collateral, but instead expand or contract the token supply based on market demand. Basis (formerly Basecoin) attempted to create an algorithmic stablecoin but shut down due to regulatory concerns.

Stablecoins use different mechanisms to achieve price stability based on the type. These mechanisms are as follows:

  • Centralized Control - Fiat-collateralized stablecoins rely on a central entity's control over reserves. They peg the stablecoin to the underlying fiat currency by ensuring sufficient reserves to redeem the circulating stablecoins.
  • Collateralization - Crypto-collateralized stablecoins maintain stability through collateralization. Users lock up a certain amount of cryptocurrency as collateral, which can be liquidated if the stablecoin's value deviates from the peg. This ensures full collateral backing.
  • Algorithmic Interventions - Algorithmic stablecoins use smart contracts and algorithms to maintain stability. When the stablecoin price exceeds the peg, the algorithm reduces the token supply to lower the price. If the price falls below the peg, the algorithm increases the token supply to stabilize the price. These interventions align the stablecoin's value with the pegged asset.

Getting Started

To understand stablecoins, it is important to grasp the concept of volatility in the cryptocurrency market. Traditional cryptocurrencies like bitcoin and ether can experience significant price fluctuations in short periods. While this volatility can present trading opportunities, it makes them less suitable for everyday transactions and as a store of value.

Stablecoins address this issue by introducing stability to the cryptocurrency ecosystem. They achieve this by pegging value to an external asset, such as a fiat currency like the U.S. dollar or a commodity like gold. This pegging mechanism helps stabilize the price of stablecoins, making them more reliable for everyday use.

There are different types of stablecoins, each with a different method for achieving stability. One common type is "fiat-collateralized" stablecoins. These stablecoins are backed by reserves of fiat currency held in bank accounts. For example, a stablecoin might be pegged to the U.S. dollar and backed by an equivalent amount of dollars held in a bank account. This ensures that the stablecoin's value remains close to that of the underlying fiat currency.

Another type of stablecoin is "crypto-collateralized" stablecoins, which are backed by other cryptocurrencies, usually held in smart contracts. To maintain stability, the value of the collateral must exceed the value of the stablecoin issued. If the price of the collateral drops significantly, mechanisms are in place to ensure the stability and solvency of the stablecoin.

Unique Aspects

Stablecoins offer several unique aspects that make them attractive to different users in the cryptocurrency ecosystem. One significant advantage is an ability to facilitate easier and faster transactions. Since stablecoins aim to maintain a stable value, users can transact with them without worrying about price volatility. This makes stablecoins a more practical option for everyday transactions, such as purchasing goods and services or sending remittances.

Moreover, stablecoins can also serve as a hedge against volatility in the broader cryptocurrency market. When the prices of other cryptocurrencies experience wild swings, stablecoins provide a relatively stable alternative for users to temporarily park funds. This allows users to mitigate exposure to market volatility while remaining within the cryptocurrency ecosystem.

Furthermore, stablecoins enable easier access to DeFi applications. DeFi platforms often require collateral in the form of cryptocurrencies for loans or participation in yield farming, but the volatility of many cryptocurrencies makes them risky as collateral. Stablecoins, due to a stable value, offer a safer option for users to engage in DeFi activities without the fear of sudden price fluctuations affecting positions.

Additionally, stablecoins act as a bridge between traditional financial systems and the world of cryptocurrencies. By pegging stablecoins to fiat currencies, they provide a familiar and accessible entry point for individuals and businesses to interact with cryptocurrencies. Stablecoins facilitate the seamless transfer of value between traditional banking systems and blockchain networks, opening up new possibilities for cross-border payments and international remittances.

Advantages

  • Stability - A stable value is provided by stablecoins, making them suitable for everyday transactions and financial planning compared to volatile cryptocurrencies. Users can trust that the value of stablecoin holdings will not experience drastic fluctuations over short periods.
  • Efficient Transactions - Quick and efficient transactions are enabled through stablecoins within the cryptocurrency ecosystem. Unlike traditional cryptocurrencies, stablecoins offer faster settlement times, making them more convenient for day-to-day transactions.
  • Global Accessibility - Stablecoins can be accessed and used by people worldwide, regardless of geographical location. This accessibility is particularly valuable in regions where access to stable fiat currencies is limited or unreliable, providing individuals with a stable and reliable alternative.
  • Borderless Transactions - Borderless transactions are facilitated through stablecoins without intermediaries like banks. These digital assets can be transferred across borders quickly and at a lower cost compared to traditional remittance methods, revolutionizing cross-border payments and making them more accessible and affordable.
  • Financial Inclusion - A crucial role is played by stablecoins in promoting financial inclusion. In many parts of the world, individuals lack access to traditional banking services. By using stablecoins, people can securely store and transfer value without a bank account, creating opportunities for the unbanked or underbanked to participate in the global economy.
  • Programmability - Some stablecoins are built on smart contract platforms like Ethereum, enabling programmability and the creation of decentralized applications (dapps). Stablecoins can be leveraged within applications to facilitate various financial activities, expanding utility and creating innovative financial ecosystems.

Disadvantages

  • Centralization Risk - Some stablecoins rely on centralized entities to maintain pegs to an external reference, introducing counterparty risk. Users must trust the custodian to hold the underlying assets and honor redemptions, so if the custodian operates opaquely or faces financial difficulties, the stability of the stablecoin could be compromised.
  • Regulatory Challenges - Stablecoins, especially those pegged to fiat currencies, may face regulatory hurdles. Governments and financial authorities are still navigating the regulatory landscape surrounding cryptocurrencies and stablecoins, and regulatory uncertainty can limit adoption and use in certain jurisdictions.
  • Lack of Transparency - Some stablecoins lack transparency regarding underlying assets and reserve holdings, raising concerns about sufficient reserves. Without proper audits and transparency, users may be exposed to risks such as fractional reserve practices or insufficient collateralization.
  • Counterparty Risk - Stablecoins relying on collateralized assets face counterparty risk. If the collateral's value drops significantly, it may not cover the stablecoin's outstanding supply. In such cases, the stablecoin issuer may be unable to maintain the peg, potentially leading to a loss in value for holders.
  • Limited Adoption - While stablecoins have gained popularity within the cryptocurrency space, adoption in traditional financial systems remains limited. Many businesses and individuals still prefer traditional fiat currencies, so widespread adoption of stablecoins would require education, regulatory clarity and infrastructure development.