Satoshi Nakamoto revealed a future of trust through Bitcoin - questioning many of the traditional structures that we depend on. It’s paving the way for secure, efficient and decentralized platforms and technologies without corrupt intermediaries. However, bitcoin and cryptocurrencies prices are notoriously volatile, remaining as one of the biggest hurdles to widespread adoption and legitimacy of cryptocurrency. Although crypto’s volatility attracts speculators looking to profit from price fluctuations, many others are concerned about actually using cryptocurrency in regular day-to-day transactions of buying goods or services. For this to be possible, there needs to be a stable currency to facilitate the modern financial system envisioned by Nakamoto.
Introducing the stablecoin, a new approach towards the future of digital currencies.
What are Stablecoins?
Stablecoins are much like other cryptocurrencies, except it’s stable (hence its name). They are fixed-price digital currencies designed to provide stability and a wider range of usability in our daily lives. There are currently more than 50 stablecoin projects being developed worldwide. To achieve price stability, stablecoins peg their value on widely used currencies such as the US dollar or even gold.
How do they work?
Let’s look at the three different types of stablecoins and how they each have their own unique approach to minimizing price volatility.
1. Fiat-collateralised stablecoins
The first and simplest approach to creating a stablecoin is used by Tether (USDT), USD Coin (USDC), Gemini USD (GUSD) and so on. Also known as the ‘IOU Model’, these stablecoins are backed by real-world assets such as the fiat currencies like USD or commodities like gold. It is owned and held by a central entity, backed 1:1 by the corresponding unit of fiat currency or commodity. In short, stablecoin issuers transfer one unit of stablecoin for every dollar it receives. In the event you cash out on 1,000 units of stablecoin, the issuer transfers you $1,000 of your chosen fiat currency (in this case, USD) and ‘burns’ 1,000 stablecoins.
Of course, the main downside of this approach is that a high level of trust is put into the central entity that controls deposits and issues the stablecoin. Trust is almost seen as a commodity in the bitcoin community - accusations of Tether (USDT) propping up the price of bitcoin and not having enough reserves to back up their coins were rife in 2017-2018. However, in 2019 Tether says that its coins have been ‘fully backed’.
2. Crypto-collateralised stablecoins
The concept of crypto-collateralised stablecoins is similar to fiat-collateralised stablecoins, except that the stablecoin is backed by a digital currency (or a few of them at once). This method, however, requires them to take into account the volatility of the cryptocurrency that is provided as collateral. Thus, crypto-collateralised stablecoins have to hold crypto deposits of ratios higher than 1:1. For example, you may need to deposit $500 worth of Litecoin (LTC) to access $250 worth of stablecoins.
These crypto-backed stablecoins are managed on-chain, without the need for a third party. The biggest concern would be the volatility of the collateral backing the stablecoin, so the issuer must hold sufficient amounts of collateral to protect against price fluctuations.
3. Seigniorage shares
A newer approach out of the three types of stablecoins, seigniorage shares don’t have any collateral backing their stablecoin. They rely on algorithms that determine the price to maintain stability. In short, they can’t be traded for another asset and they are stable due to the expectation that they will remain at a certain value.
Some argue that creating an algorithm that decides issuance and contracting rules (while being resilient to manipulation) is difficult. It also requires one to believe that the demand will increase as time progresses.
Why are Stablecoins important?
If you need to transfer a large sum of money from Australia to the US through a wire transfer, you would need to fill out forms, go into the bank and pay a fee for the transaction and potentially wait a few days. This is how ineffective the traditional financial system can be. As the development of blockchain technology becomes more mature, people are starting to take a more innovative approach. Hence, the rise of crypto and stablecoins.
However, due to the fluctuating price of crypto, holding and using crypto in the same way you do Australian dollars, for example, isn’t as viable. And this is where the theory of stablecoins comes in. They don’t only offer all the benefits of cryptocurrency, including cryptographic security and the ability to transfer funds digitally, but also the low volatility of traditional currencies like the USD or Euro. The goal is to create a digital currency that can be used in our daily lives as a new medium of exchange.
Some other advantages include:
- Protection against price volatility
- Low fees
- Faster transactions
- Global access to a stable currency
- Borderless payments
Some disadvantages could include:
- Possible centralisation
- Dependence on traditional financial markets/structures
What are some use-cases?
Many use cases for stablecoin have been proposed worldwide: mobile app payments, alternative currencies in emerging markets and global payment systems have been introduced.
In 2018, 16 countries alone experienced more than 20% annual inflation year after year. Among the most affected countries was Venezuela, suffering through a devastating 2,000,000% inflation in that year. The Reserve Protocol, was a project designed to combat inflation and aimed to provide economic stability. It is a ‘flexible pool of stablecoins’, using a hybrid system to implement an automated exchange-rate peg between their token and USD - holding a basket of tokenised real-world assets to collateralise their stablecoin (a.k.a the Reserve token) with a 1:1 backing.
In the journey of mainstream adoption and legitimisation, the introduction of stablecoin is an exciting step towards mainstream acceptance - but there’s still a long way to go. Long-term reliability is still to be tested and researched to ensure the stability that many are looking for.