Stablecoins are a newer breed of crypto coins that are gaining popularity as they aim to tackle the problem of cryptocurrency volatility.
First introduced in 2014 with Tether, by 2021 the list of stablecoins included DAI, USD Coin, True USD, Digix Gold, Havven's Nomin, Paxos Standard, and Binance USD.
Another name, Basecoin, introduced in 2018 and later renamed Basis, was shut down at the end of that year after the intervention of the Securities and Exchange Commission.
- The world of cryptocurrencies is known for its extreme volatility and its attractiveness to speculators.
- Stablecoins aim to eliminate price volatility.
- A stablecoin, if successful, would be effective as a store of value and a medium of exchange, just like a fiat currency, while retaining the qualities of a cryptocurrency.
What are Stablecoins?
Whether it's a U.S. dollar or a Dogecoin, a currency is a medium of exchange and a mode of storing wealth. In the real world, stability is the essential quality of a currency.
Not so in the world of cryptocurrency. The world’s most popular cryptocurrency, Bitcoin, shot from $5,940 to above $19,190 between mid-November and mid-December of 2017, then fell to about $6,900 by early February. More recently, it moved from under $12,000 in August 2020 to over $44,000 in August 2021.
Even on an intraday basis, it is not uncommon to see cryptocurrencies jump or fall by 10% in a 24-hour period.
Swings of this magnitude are not characteristics of a stable currency. They have more in common with speculative trading instruments like derivatives, which are attractive to speculators but impractical for mainstream use.
This has led to serious questions about the viability of the popular cryptocurrencies as a reliable store of value or medium of exchange.
The Stablecoin Model
Enter a new class of cryptocurrencies, called stablecoins, which aim to provide price stability and a steady valuation.
To be used as a medium of exchange or a store of value, a model cryptocoin should retain its purchasing power and experience minimal inflation, just enough to encourage spending the coins instead of storing them.
Stablecoins attempt to achieve this ideal behavior.
Since a cryptocurrency operates on a global level and is not controlled by a central authority (like a central bank), it theoretically offers the best of both worlds. It has the security, anonymity, and decentralized features of a cryptocurrency and the low volatility of a fiat currency.
How Stablecoins Maintain Valuations
Historically, the most stable currencies were pegged to an underlying asset, namely gold. None are today. Great Britain went off the gold standard in 1931 and the U.S. followed two years later.
Today's substitute for the gold standard is the U.S. dollar. At least 14 currencies are pegged to the dollar. The nations that issue them rely on the value of the dollar to prevent their own currencies from undergoing a level of volatility that would disrupt their economies.
Similarly, stablecoins attempt to achieve little or no volatility as they are tied to price-stable assets like the U.S. dollar or gold. Different stablecoins use different methods to achieve price stability. They can be broadly categorized into three groups:
Fiat-collateralized stablecoins: These stablecoins use a specific amount of a standard fiat currency, like the U.S. dollar, as collateral to issue crypto coins. Other forms of collateral can include precious metals like gold and silver and commodities like oil.
With the number of cryptocoins issued in a 1:1 ratio against the pegged fiat currency, this method is one of the simplest ways to create and operate a stable cryptocurrency. It is viewed as a possible solution that can be adopted by central banks to issue their own versions of cryptocurrencies.
However, this method requires a custodian to hold the fiat currency or commodity collateral, and guarantee the issuance as well the redemption of the stablecoin tokens. It also requires operational processes, including frequent audits, to ensure that the collateral is being maintained up to the mark.
Tether (USDT) and TrueUSD are popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits.
Crypto-collateralized stablecoins: Crypto-collateralized stablecoins are similar to fiat-collateralized stablecoins, except that their underlying collateral is another cryptocurrency instead of a tangible commodity or a fiat currency.
To accommodate the adverse impact of the collateral cryptocurrency's volatility, the stablecoins are “over-collateralized.” That is, a higher valued cryptocurrency is used to issue lesser valued-stablecoins.
For instance, $1,000 worth of bitcoins may be required to issue $500 worth of stablecoins. Even if bitcoin loses 30% of its value, the stablecoins will be covered. More frequent audits and regular top-ups for any shortfalls in collateral value can keep the stablecoins covered.
DAO’s DAI uses a basket of crypto assets as collateral. It is pegged against the U.S. dollar and is backed by ethereum.
It's not a perfect system. If the collateral cryptocurrency goes completely bust, or there are procedural issues with the audit process, or demands for additional top-ups of collateral are not met in time, the stablecoin valuation will plummet, defeating the whole purpose of a stablecoin.
Such scenarios are the reasons that this approach is discouraged by many stablecoin proponents.
Non-collateralized stablecoins: These stablecoins are not backed by any collateral but operate in such a way that they are expected to retain a stable value.
For example, a non-collateralized stablecoin can incorporate a rule that ensures adjusting the quantity of the coin supply in proportion to changes in the value of the coin. This is akin to the actions performed by a central bank that increases or reduces the printing of banknotes to keep the fiat currency stable.
It can be achieved by implementing a smart contract on a decentralized platform that can run in an autonomous manner.
The Stablecoin Potential
The increasing adoption of stablecoins will act as an important catalyst to popularize the use of cryptocurrencies as a mainstream medium of everyday transactions, as well as for other applications.
Such applications may include using them for trading goods and services over blockchain networks, decentralized insurance solutions, derivatives contracts, financial applications like consumer loans, and prediction markets.
Such transactions are not possible if the transacting currency remains volatile, which brings the inherent risk of one of the transacting parties losing monetary value due to price volatility.
The Bottom Line
Stablecoins potentially offer the best of both worlds – a decentralized, anonymous, and global payment mechanism like a cryptocurrency, and steady valuations like a stable fiat currency.
While stablecoins continue to gain popularity, the increasing number of new launches and the variety of customized collateral methods to achieve the objective of price stability may lead to different outcomes and varying levels of success.
Despite all claims of a foolproof working mechanism, extreme events may still have an impact, as they have in the real world on fiat currencies including the Saudi Arabian riyal, the Venezuelan bolivar, and the Zimbabwean dollar.
Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.