Stablecoins: An Introduction

With Facebook’s proposed cryptocurrency Libra having been at the center of many conversations in the crypto world and beyond in the last couple of months of so, another term which you may have heard is stablecoin. Indeed, Libra is one itself, but what does the term actually mean? Let’s take a look.

What is a stablecoin?

A stablecoin is essentially a cryptocurrency that has been created with the purpose of having price stability, in contrast to many cryptocurrencies which are renowned for their volatility. This is done by pegging its price to a stable asset, or group of assets. Most are pegged to fiat – i.e. real currency. However, some may be pegged to the price of commodities such as gold, or even other cryptocurrencies. Stablecoins are becoming increasingly popular, with their trading volumes increasing four-fold year-by-year in the 12 months up to April 2019. The below chart demonstrates how stable the prices some of the major stablecoins are against the US dollar.

Source: Coin Codex

They are often used to exchange from a cryptocurrency. This can be useful when someone is concerned about the risk of the price of Bitcoin falling against the US dollar for example. They could be exchanged to a stablecoin pegged to the price of the US dollar, and this risk is then taken away. They are also being increasingly used for transactions, with some individuals and merchants perhaps understandably resistant to transact in a cryptocurrency which may fluctuate in price massively in a short period of time – another risk the stablecoin takes away.

Fiat pegged stablecoins

Most stablecoins are pegged to fiat currency, such as USD, EUR or GBP. This is done at, or very near to, a 1:1 ratio. This essentially means that for every stablecoin, there is a unit of fiat currency stored in a bank account too.

This is done in the eventuality that somebody wants to convert their stablecoins into cash. The institution storing the stablecoins will send the fiat currency being stored to the individual’s bank account, and the amount of stablecoins equating to the amount of fiat circulation will be removed from circulation.

Fiat pegged stablecoins, as well as being the most common, are the simplest type of stablecoins to possess and understand in terms of their mechanisms and the way they work. Indeed, these two factors are undoubtedly interconnected.

Types of fiat pegged stablecoins

By far the most popular stablecoin is Tether (USDT). This is, at the time of writing (August 2019) the 7th most largest cryptocurrency in terms of market cap and has the highest 24 hour trading volume of all the cryptocurrencies, even more than Bitcoin.

Source: Coin Market Cap

Despite Tether having an astronomical trading volume, thanks largely due to the fact it was the first stablecoin on the market, it hasn’t been without its controversy. There has been doubts about the amount of fiat currency in their reserves, which in turn sent the price of Tether tumbling against the US dollar, at one point reaching a price of $0.85 in October 2018. However, the price soon after recovered towards parity after Tether’s banking partner confirmed that they have over $2 billion in reserve the following month.

Another popular stablecoin is TrueUSD (TUSD). This has grown in popularity in the light of the controversy surrounding Tether, which in March 2019 drew further scrutiny after it emerged that Tether’s developers had deleted previous claims that it was fully backed by US dollars. TrueUSD however has not had the same controversy.

An audit released in April 2019 revealed that TrustToken, the company behind the stabecoin, has the US dollar reserves in full to back up the currency. Some of the most other notable stablecoins include, LBXPeg, pegged to the GBP, and Gemini Dollar, which is regulated by the New York financial authorities and built on the Ethereum network.

Commodity pegged stablecoins

Some stablecoins are pegged to commodity assets, such as gold, oil, or even real estate. The advantage of holding these stablecoins is that they are holding a tangible asset, and their value has the potential to appreciate over time. Although investments in assets such as gold have traditionally been for the rich, these type of stablecoins have opened them up to potentially to a whole new demographic of people.

The most famous example of a commodity pegged stablecoin is Digix Gold Tokens (DGX). This is pegged to gold, with one unit of the currency equal to one gram of gold. The gold is stored in a Singapore vault, and holders of the currency may redeem gold bars if they visit the vault themselves. The gold is audited every three months to ensure the full amount is still being held.

Cryptocurrencypegged stablecoins

Some stablecoins are pegged to cryptocurrencies. The advantage of this is that they can be significantly more decentralized than ones that are fiat-pegged, because transactions take place on blockchains. This also allows for complete security and transparency. They will also often have higher amounts of liquidity, meaning they can be converted quickly and at a low cost.

However, despite these advantages, their operating mechanisms are quite complex, meaning they haven’t caught on in popularity like some other types of stablecoins, at least not yet.

Dai is the most popular stablecoin pegged to a cryptocurrency. Like others, it is also built on the Ethereum blockchain. The price is pegged to the value of the US dollar by the smart contract mechanisms, and will work to bring the price down when it is above, and up and when it is below.

Non pegged stablecoins

This may seem confusing, but believe it or not, they do exist! This can be explained by the fact that there is long-held confidence in the value of the US dollar. Historically, the US dollar was pegged to the value of gold, but this hasn’t been the case for several decades now. The supply of these stablecoins is controlled by an algorirthm-based model known as seignorage shares.

Supply and demand drives the prices of these stablecoins. If the demand increases, more stablecoins are made to bring down their price. As they aren’t centralized to any asset at all, they are in essence the most decentralized stablecoin. This makes them seemingly immune to any crashes the crypto or financial markets may suffer. Or does it? In reality, these stablecoins need growth to flourish. If there was a crash, there would be no collateral for the liquidity of the coins, so everyone would lose their money.