A stablecoin is a cryptocurrency that is designed as a medium of exchange. The goal is to have stability in market pricing so as to provide consistency for commerce. This is unlike other cryptocurrency coins and tokens which tend to attract speculation, thus inserting volatility into the equation.
Price stability is often sought by having a peg in value to something else.
All stablecoins are considered altcoins. These are any coins or tokens that are not Bitcoin.
Types of Stablecoins
The first type of stablecoin is one that is asset backed.
Here the currency is backed by holdings of other assets called a reserve. The most popular is to use the U.S. dollar by having cash and/or cash equivalents in reserve. The latter is often in the form of treasuries, specifically T-Bills.
This is usually accomplished by having an entity that holds the assets. For example, we see Circle and the Tether Foundation who hold the reserve for USDC and Tether. As regulation forms, these organizations will be responsible for being in compliance.
The second type are algorithmic stablecoins.
These are not directly backed by a basket of assets. Instead, it is tied to another cryptocurrency. The backing is created by conversion the other digital asset. Here we see some ratio set which the non-stable asset will have a floating exchange rate. The stablecoin is them converted to a certain amount of the other asset, reducing the amount of the former while increasing the circulating supply of the latter.
An example of this is the Hive Backed Dollar (HBD) on the Hive blockchain.
A third type is one that is backed by assets other than government debt. This could be tied to gold or another cryptocurrency such as Bitcoin.
Volatility
The enemy of a stablecoin is volatility. Thus, we see the goal to reduce it. Not only is this necessary as a medium of exchange but for other aspects within finance.
Obviously payments become questionable if a currency will have a large degree of volatility, especially in a short period of time.
In addition to commercial transactions, stability is required for collateralization. When lenders accept collateral on a loan, they want to know the value will hold. So in addition to liquidity, the asset has to maintain its pricing within the market. This is especially true for short term lending.
Bitcoin, as an example, can drop 10% in price in a few hours. If we were to utilize this for overnight lending, the borrower might realize a profit simply be defaulting on the loan. In this situation, the lender will seek to reduce the risk associated by having a higher over collateralization rate, requiring more Bitcoin be posted to counter the volatility. As we can see, it makes it more expensive to operate in this manner, reducing the balance sheet capacity for such transactions.
Finally, when dealing with the crypto version of FOREX, having two sides of a currency pair being extremely volatile results in difficulty when managing multi-currency transactions. The reason the USD tends to reign supreme by making up the bulk of the pairs in FOREX is because of the stability it brings.
This is often offset by the use of derivatives. Here the FOREX risk is hedged through the use of a foreign exchange derivative.
Stablecoins could seek to address these factors as the industry builds more financial tools. By having stablecoins pegged to a dollar, the swapping is basically a 1:1 relationship. Basically, one USDC could be exchanged for 1 Tether.
Utility
Stablecoins started to be incorporated into the fixed income market. This differs from the typical approach to cryptocurrency which is purely speculation. Also, since the stability offers the potential for commercial transactions, it can take on the role of fiat currency.
In this regard, we can look at stablecoins as currency. When it comes to the traditional characteristics of money, we see how it fits:
- medium of exchange
- store of value - due to the peg
- unit of account - mostly using the USD
Obviously, stablecoins are outside the control of the commercial banks. Also, there are no central banks involved in the process. While the Fed does have some input since it is responsible for the monetary policy regarding the US dollar, the allotment of coins is completely out of their reach.
Some believe that stablecoins offer a solution to the deficit in US dollar in both the domestic economy and the Eurodollar system. As the value of the USD rose, it has a negative impact on many economies as their currencies were obliterated. Stablecoins offer a way for individuals to get access to USD without actually having to get a hold of the currency itself. It is also in digital form, unlike banknotes which is how most foreigners acquire the USD. This means they can store it in a wallet on a smartphone.
Ultimately, a stablecoin can piggyback on commercial bank and central bank money yet is something completely different.
Stablecoins are not to be confused with Central Bank Digital Currencies (CBDC). The former is established by private, non-bank institutions whereas CBDCs are being set up by central banks or governments.
Value From Utility
A stablecoin, like any currency, will ultimately derive its value form the use cases. When a currency has massive utility, both in commerce and finance, there is incentive for people to hold it. This means demand will naturally ensure.
One of the key components is the unit of account. This can be thought like a common language. When a currency is global and a unit of account used for not only transactions but also record keeping like with financial statements, then its value only grows.
Central bank personnel tend to disregard stablecoins, claiming these derive their price stability from the actions of the central bank. While the main point is not really up to debate, what is questionable is whether currencies get their stability from central bank policy. There is a growing amount of evidence that it ultimately comes down to the network effect.
This is a benefit to stablecoins being pegged to a major fiat currency like the US dollar.
To start, it is a known unit of account in many places. It also provides stability to stablecoins while they are small and growing. Eventually, if adopted on a widespread scale, the network effect will come to these tokens through the utility people require.
Counterparty Risk
There is a major drawback to most stablecoins.
Counterparty risk is something present with most stablecoins. This stems from the fact that most of them are run by some foundation or company. Here is a point of vulnerability since use of the token requires trust in the entity behind it.
Another factor is the reserve which is help by some financial institutions. Now we are dealing with trust in the custodian, another layer that asset backed stablecoins introduce.
Algorithmic stablecoins do not present this issue since the trust level is moved to the blockchain. Here we see the base layer operating as the counterparty.
Protection Against Governments
Stablecoins are able to provide a benefit to people in high inflation countries. When the local currency is out of control, stablecoins can provide a defense.
Most currencies are tied to unstable economies and overtly corrupt governments.
Cryptocurrency operates on global networks. This means impact on the currency is much broader than a single location or economy. Here is where resiliency arises simply through design. Since it was created on the Internet, it is accessible by anyone with a connection.
Digital access makes things a lot harder to control, offering another layer of defense that most typically do not have.