Stablecoins have gained more prominence in the cryptocurrency space, spurred particularly by the slump in digital asset prices after the 2017 bull run. This slump caused a fundamental shift in investors’ mindsets, as they started to look for cryptocurrencies with higher stability.
In This Article:
- What Are Stablecoins?
- The Need for Stablecoins
- The Advantages of Stablecoins
- Types of Stablecoin
- Why Are Stablecoins so Popular?
- The Best Stablecoins Available in 2021
What are Stablecoins?
In its simplest sense, a stablecoin is a form of digital currency that provides price stability via backing by a reserve asset.
Cryptocurrencies have become popular over the years. But, when most people talk about crypto, they are thinking about Bitcoin, ETH, XRP, and a select few others. The problem with this set of assets is that they are highly volatile.
There are several reasons why the market is so unpredictable. Chief of the reasons has to be the market size. Despite the media attention, the cryptocurrency market is still small compared to well-established markets like the U.S stock market or the gold market. With crypto, a small movement of funds could create a ripple effect on the market. You also have to look at the technology backing them. The blockchain is still a nascent tech that has room to grow. Many companies have started adopting the technology, but it would take a while for it to mature.
So, while it has proved itself to be a willing store of wealth, frequent price crashes, as witnessed in ‘crypto winter,’ would always affect its standing as an investment vehicle.
The Need for Stablecoins
Reducing volatility: This is the most pressing need for stablecoins. Traditional cryptocurrencies are volatile, and investors wanting to participate in the market need assets that can at least promise a considerable level of stability. Improved stability also helps with market predictions and institutional investment.
Cryptocurrency adoption: Whether for retail or institutional investors, digital assets that are highly volatile are just a hard sell. Their volatility hinders adoption by businesses and for making payments. Stablecoins can speed this up and attract more investment into the cryptocurrency sector. Also, users can convert many stablecoins into traditional cryptocurrencies. A popular trading pair, for example, is BTC/USDT.
Hedging: By virtue of their stability, stablecoins provide investors with the option to hedge their wealth against uncertainty. Even citizens in inflation-ridden economies can use stablecoins to preserve their wealth.
The Advantages of Stablecoins
- Stablecoins provide the same benefits of cryptocurrencies (low transaction fees, fast transactions, security) while still providing the stability that traditional digital assets lack
- Regulatory control
- They aid cryptocurrency adoption
- They’re perfect for different investors, regardless of their risk profile
- The inclusion of smart contracts protects all parties in a transaction
Types of Stablecoins
Stablecoins function in different ways. The way they’re setup also determines how they are characterized. The major types of stablecoins that we have are:
1. Fiat-collateralized stablecoins
Fiat-collateralized stablecoins are backed by fiat currencies. So, for every single fiat-collateralized stablecoin issued, a unit of the pegging fiat asset- say $1- is kept safely in a custodian (banks, etc.). This means that a fiat-collateralized stablecoin can be exchanged for its cash equivalent seamlessly and without any much money spent.
The company behind a fiat-collateralized stable coin can issue as many coins as are required, as long as they have the cash reserves to back this issuance up. Essentially, there needs to be a 1:1 ratio of the stablecoin and the reserve that the issuing company has in collateral (The coin can be pegged to US dollar for example).
The tokens in circulation are also audited to prevent issuing companies from sending out more coins than the cash in reserves.
There are also resource-collateralized stablecoins. Although these are less popular, they get their backing from the price of a specific resource. The Venezuelan government launched Petro, its official stablecoin, in 2018, announcing that the asset’s price will be tied to that of a barrel of oil. Resource-collateralized stablecoins follow the same rule as their fiat-collateralized counterparts and only differ in terms of the backing asset.
- They’re stable
- Their structure is simple to understand
- They’re centralized, which opens them up to attack
- You also need to trust the central entity, which negates the key principle of decentralization.
2. Crypto-collateralized stablecoins
Crypto-collateralized stablecoins are backed by cryptocurrencies, rather than fiat pegs. However, since the extended market volatility of cryptocurrencies is bigger than that of fiat currencies, crypto-collateralized stablecoins usually require more than a 1:1 ratio of coins to reserves- a phenomenon known as “over-collateralization.”
- They’re decentralized, so they comply with the tenets of cryptocurrencies
- They can be used to create leverage for trading, thanks to over-collateralization
- They do have public blockchains, so transactions are transparent
- Being backed by a cryptocurrency heightens volatility
- Their structures are more complex to understand
3. Uncollateralized stablecoins
The uncollateralized stablecoins essentially throw the concept of backing and collateral out. These assets work like reserve banks; they monitor demand and supply, and purchase circulating coins when prices are at rock bottom. When prices rise, they issue new coins. The objective of these coins is to keep their prices in tandem with those of the pegged asset. A prominent example is BASIS.
- They’re decentralized since all adjustments are made on-chain
- Values are adjusted based on market forces, so they’re rather stable
- Coins are minted or destroyed by an algorithm, so there’s no need for collateral
- They’re not backed by any asset, so their structures are also complex
Why Are Stablecoins So Popular?
Stablecoins’ raison d’etre is simple- they provide stability, thus eliminating uncertainty for both consumers and investors in the crypto market. Venezuela, for instance, has been dealing with uncertainty as far as its fiat currency- the bolivar- has been concerned due to the country’s economic woes. So, it elected to launch the aforementioned Petro to help.
Stablecoins provide safe asset storage, especially when the traditional crypto market becomes volatile. Customers who fear murky market conditions can easily swap their unbacked cryptos for stablecoins, thus eliminating the need to convert to fiat- an asset class that’s not immune to unfavourable at times too. Also, since conversions between stablecoins and other cryptocurrencies are crypto-to-crypto conversions themselves, transfers are still cheap since there are no fees given to third parties- payment processors, banks, etc.
The Best Stablecoins Available
1. Tether (USDT)
Tether is the most popular stablecoin in the world. It started back in 2015, and has now grown to become the 6th most valuable digital asset. Tether is an ERC-20, fiat-collateralized asset that’s backed by the dollar, and while the asset and its issuers (Tether Limited) are currently being investigated for possible financial crimes with cryptocurrency exchange Bitfinex, its popularity is still surging.
2. USDCoin (USDC)
USDC is a fiat-collateralized stablecoin that is pegged 1:1 with the dollar (obviously). It was developed by CENTRE- a joint venture between payment processor Circle and crypto exchange Coinbase. It’s also available on most popular crypto exchanges.
USDC is based on the Ethereum blockchain, and it is distributed as an Ethereum token. The issuers also maintain popular financial services company Grant Thornton as auditors for its reserves.
3. TrueUSD (TUSD)
As its name suggests, TrueUSD is another dollar-backed stablecoin based on the Ethereum blockchain. TrueUSD shares quite a lot of similarities with Tether, but the company makes a point to provide full transparency with investors and customers. All attestations by the company are made regularly, and they also publish financial reports on Twitter.
The token is managed by ex-workers from UC Berkeley, PwC, and Google. The issuers also plan to tokenize other real-world assets, such as TrueYen, TrueBond, and TrueEuro, to mitigate price fluctuations.
4. DAI (DAI)
DAI was developed in 2017 by MakerDAO, a decentralized, autonomous organization that is currently working on what it believes is a “new way of approaching stablecoins.”- whatever that means.
Unlike the tokens above, DAI is a crypto-collateralized stablecoin. While it has been criticized as being overly complex to be understood, the asset’s model is becoming popular and is an important aspect of DeFi.