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Stablecoins: Why Does The Ecosystem Needs Them

It won’t be an exaggeration to say that Stablecoins may just become the saviour of the entire crypto space Though the need for this tech is felt since last few years, it is not until last year that it has emerged. Since then, in a very short period, it has grown into a very promising cryptocurrency tech, thus rekindling the original aim of cryptocurrency.

Tether was the first stablecoin to come into the market and generated the interest that stablecin enjoys today, much like what bitcoin did with the whole crypto world. Now there are about 60 stablecoins that have already been introduced or in the development stage.

Before we discuss what is the importance stablecoin bring to the cryptoshpere, first let us explain what stablecoin is and what general idea represents.

What is Stable Coin?

If the name can be of any hints, Stablecoins are cryptocoins that offer stability. And the stability it offers is in its price or value.

A stablecoin is a digital currency whose value or price is linked to a real-world asset.

Well theoretically speaking, Stablecoins can be linked to anything that gives them a stable value. It can be real-world currencies, or gold – just like our paper currency are dependent on – or oil or it can even be dependent on another cryptocurrency as well. Generally, though, stablecoins are pegged to fiat currencies like USD, Euro or Chinese Yuan.

Now, this does not mean that stablecoins are linked to a central bank or a state or a nation for that matter who can control its supply. They are reliant on their cryptograph and stringent audits to make sure the underlying asset is indeed present and is where it needs to be.

Why do we need them in the first place?

We know that cryptocurrency prices vary wildly throughout the day and it poses a challenge to do business with it. Let’s look at two scenarios first to make the point clear.

Say you own an eatery and you accept cryptocurrencies as payment. Now you have received cryptocoin for the lunch from one of your customers, say he gave you 1 litecoin which at the time of the writing valued at $53.46 – cost for your lunch service. The next day you check and the value of a litecoin now is $47, so the value of the coin has depreciated the very next day and now you are facing loss.

In another scenario, you have gone for that lunch and have paid in litecoin. The value at that time was $53.47 but the next day it went up and now that litecoin is worth $58. So it is a loss for you but definitely a gain for the eatery owner. How do you feel?

This volatility of cryptocurrencies are ever present, and though this characteristic of price volatility is very much suited for investors and traders, this is not something you as a consumer, buyer, seller or businessman would appreciate. The price or value of our general cryptocurrencies vary so much, ranging from 5% to 10% within 24 hours, and often even a 20%-30% change in price is not impossible. This huge swings in price have led critics to consider cryptocurrencies more of a speculative investment than fiat currencies.

It is clear that the general cryptocurrencies are not fit for business. We need something which is worth the same every time, every day, and that is where the stablecoin comes in – a price-stable cryptocurrency which can be reliably used as a medium of exchange just like the fiat peers yet benefitting from the blockchain technology.

Types of Stable Coin

Before we discuss any further on the importance of stablecoin in the crypto ecosystem, we think it would be apt for you to check the three types of stablecoins and consider their merits and demerits.

As mentioned earlier, stablecoin is not tied to any central authority and that is because it should be global in nature so that no one can control its supply. There are generally two popular models that stablecoin follows based on their asses-backing choices, i.e. on what and how the stablecoins are dependent on. Below we have discussed three distinctive types.

Fiat-collateralized stablecoins

 

 

Fiat-collateralized stablecoins are those stablecoins whose value is dependent on fiat currencies.

In its simplest form, you can issue stablecoin in a 1-to-1 ratio with any asset in your bank account. Thus 1 unit of your stablecoin can represent 1 USD or 1 Euro or a single unit of gold or silver – i.e. based on whatever physical reserve you have in your bank account. This model is called IoU. Now you may choose to represent 1 stablecoin for $2 or 2mg of Gold as well.

So a user has to deposit that asset and get the stablecoin. The asset stays in the bank and whenever he or she feels like liquidating his or her stablecoin, you destroy the stablecoin and wire the equivalent USD (or other assets) of original purchase value to that user.

AS you may have noticed it has one big issue. This method requires centralization and making sure that the asset (dollar) is really there in the issuing company’s bank account. So let’s jot down the pros and cons of this method.

Pros

  1. Offer 100% stability in price since the reserve is in fiat or other real assets
  2. Very simple method
  3. Since no collateral is held in the blockchain, it is very unlikely to get affected by hacking

Cons

  1. It is regulated
  2. It requires centralization, meaning a trusted custodian
  3. Requires regular audits to ensure transparency
  4. Slow and expensive liquidation

Example:

Tether, is definitely the most important and well-known stablecoin and it is fiat-collateralized stablecoin. It has a huge market cap of $2,676,149,512 USD. Tether is not totally a success story, as it has been in the constant news with allegations of insolvency and previous audit issues.

As for other examples, Digix Golda and TrueUSD are other important stablecoins of this type. TrustToken’s TrueUSD has come out as next best stablecoin. Both Tether and TrustUSD have a varying degree of transparency and only keep fractional reserves. Both Tether and TrueUSD are dollar-based, but another stablecoin Digix Gold is a gold-based stablecoin.

Crypto-collateralized stablecoins

To remove that centralization quite naturally you can say that what if the asset is another cryptocurrency. We can issue stablecoins based on a company’s crypto asset. The problem is now that we need to tackle the price volatility of that cryptocoin now so that the price of the stablecoin remain unchanged. The only way to address this is to over-collateralize. Let us explain.

Say you have deposited $1000 worth of Litecoin and made 500 stablecoins each of $1 worth available. This means the rest $500 is over-collateralized. Now if the price of the litecoin depreciates by 30%, the stablecoins can still be valued at $1 with an over-collateralization of $200. So you have to liquidate the stablecoin before the depreciation crosses 50% in this case.

Here is an interesting question you can ask – why would I want to lock that extra $500? Well, there are two advantages – first, you can get interests from it obviously and the second, which most crypto-collateralized stablecoins use, is to create a leverage tree by buying another $500 worth of litecoin using that 500 stablecoins, therefore having a leverage of $1500 of Litecoin.

These crypto-collateralized coins are much more vulnerable to price instability than their fiat-collateralized peers. Here, for example, if Litecoin crashes here hard enough, then all your stablecoin will automatically be liquidated into Litecoin. At this point, you’ll be exposed to normal currency risk but now the exchanges have to deal with stablecoin balances and trading pairs suddenly mutating into the underlying crypto assets.

Pros:

  1. More decentralized than fiat-based
  2. This method is very transparent, anyone can inspect the collateralization ratio of the stablecoin
  3. Require blockchain transaction only therefore liquidating is cheap and quick
  4. Leverage can be created.

Cons:

  1. Less price stable than fiat-collateral
  2. Auto-liquidated into underlying collateral during a price crash
  3. Tied to the health of that cryptocurrency or a basket of it
  4. Very much complex process
  5. Inefficient use of fund

Example:

Dan Larimer’s BitUSD, collateralized with BitShares, was the first one of this type.

But MakerDAO’s Dai (collateralized by Ether) is now the most promising crypto-collateralized stablecoin out there. DAI holds smart contract reserves of Ether in a 3:1 ratio i.e. 3 Ether for every dollar. Additionally, its another token, called MKR, is used for governance purposes.

Non-Collateralized Stablecoins

 

As the name suggests, there is no collateral for this type of stablecoin. This stablecoins either use an algorithm to do that or have a system where the coin supply is increased or decreased depending on the price of the coin.

Here you are modeling a smart contract as a central agency, which is in charge of setting the price at a fixed rate. Suppose the price of a stablecoin is should be $1, and if the value increases to $2, the smart contract can issue new coins, auctioning them in open market to bring the price down to $1. Now if the price fell to $0.8 then obviously it can not take out already issued stablecoins out of the market. In this scenario, the smart contract issue shares where it will pay out in future when the price will again go up. So the reliance here is totally on when and if the price goes up.

Pros:

  1. No collateral is required
  2. It is independent of any fiat or cryptocurrency and decentralized in nature

Cons:

  1. Thrives on continual growth – a mandatory criteria
  2. If crypto prices fall or experience crash it can not recover and also cannot be liquidated during a crash
  3. It has some level of complexity
  4. Difficult to analyze safety bounds or health

Example:

Let’s take the example of Basecoin, a stablecoin backed by some of the prominent names in the crypto industry, including Metastable Capital and Andreessen Horowitz. Basecoin has recently been rebranded as Basis.  It utilizes a system similar to an algorithmic central bank and incorporates that using three token systems – basecoin, base bonds, and base shares.

Let’s check a part of Basis’s incentive structure. When the supply is needed to be reduced, the Basis system offers bonds valued at $1 to the token holders at a subsidized rate. This pays for the principal of $1 along with the interest in the future and the coins used to buy these bonds are subsequently destroyed, thus contracting supply. Now in future when the demand for the coins increases, the system automatically increases the coin supply, first paying the bondholders.

There is another way Basis system tackles this issue. If all the base bond tokens are distributed and if the demand for new coins still exists, holders of base share tokens receive dividends in the form of newly generated basecoins. Base share has a fixed supply and is created at the genesis block.

So Which Type of Stablecoin is Best?

It is very difficult to answer this question, well at least now. Let’s check what each of three offers.

Types Decentralized Crash-proof Collateral Efficient
Fiat-Collateralized No Yes Yes
Crypto-Collateralized Yes Can withstand but not fully No
Non-Collateralized Yes No Yes

So it is evident that there is not a single one which fulfills all the required criteria. There is a trade-off involved in each of them. We need to observe more which type turns out to be better than the other two practically.

Features of an Ideal Stablecoin

The three types show the pros and cons they offer, and therefore it all depends on for what purpose you want to use that stablecoin, specifically the market or scenario matters the most.

Though there is no such thing, we here would like to express what should be the characteristics of an ideal stablecoin. If any stablecoin can follow these characteristics as closely as possible they will gain real-world stability.

  • It should be very stable i.e. can withstand a great level of market volatility
  • It should be cheap to maintain, as cheap as possible
  • It should have very easy-to-analyze stability parameters
  • It should be transparent to traders, investors and general users

Why Stablecoin holds a special place in Cryptoverse?

Now back to addressing the elephant in the room: why it is so important for the crypto ecosystem.

Though just started as the mainstream product only since last year, stablecoin has come up a long way in this short period (about 19 months). There are a few reasons for this rise and popularity of stablecoins.

The first and foremost is the obvious stability it brings to the volatile crypto ecosystem.   Let’s check what this transcends into.

Other general Cryptocurrencies have a limited supply of coins and those are distributed in various segments. Stablecoins, on the other hand, is not capped by a limited supply of coins or have a fixed schedule either. Instead, these coins are disbursed based on market conditions and coin economics – If values more, increase coin supply to dilute value, if less take actions to increase the value.

The most important thing that steers the majority of potential and even regular crypto users from using cryptocoins is there is no way to check that volatility frequency. Stablecoins are backed by collateral to safeguard users and investors in case a crash occurs – well to a certain extent. Take the example of Tether in this regard. Tether claims to have an equal amount of dollars (in an unspecified bank account) as Tether coins, allowing them to trade at parity with fiat currencies.

The price stability allows stablecoins to be used in purchasing items as well as exchanging with other cryptocurrencies or fiat currencies. In exchanges like Bitfinex a beginner investor can use Tether as a token to do just that. First, you have to purchase Tether, that trades at parity with US dollar i.e. on 1:1 ratio, and then you can use the stablecoin to buy other cryptocurrencies.

One of the main objective or dream of cryptocurrency creators is that one day it will be used as a daily driver for our every transactional need and will replace the fiat currency. Given how it has turned up, stablecoin is the only cryptocurrency that is still keeping our hopes up, though it has a long way to go.

Though the fixed value nature of the stablecoin i.e. aims for price stability should discourage investors and venture capitalists from pouring their money into the development of stablecoins, but with growing introduction of new business models in the ecosystem offers them a  prospect for making profits. Thus stablecoin projects are receiving more and more money.

What Stablecoins can do for us?

Stablecoins are linked to fiat currencies, but many fiat currencies have not been able to achieve true stability – for example, the price volatility between USD and CNY. Therefore fiat-dependent Stablecoins can’t achieve that perfect stability either. But since the level of this fiat volatility is much less compared to that of cryptocurrencies, its additional crypto benefit makes it mainstream payment choice.

If you are making overseas transactions, then you have to face various issues like transaction time, the high cost of remittance and then the hassle of choosing the best way to do that to avoid the remittance fee. Now doing that over a blockchain network with other cryptocurrencies will solve the transaction time issue but the hassle and high fee issues remain given the high volatility. Stablecoin can easily tackle all three issues with instant transaction, stable value leading to lower remittance fee and lesser hassle.

Stablecoin follows the mechanism of the peer-to-peer transaction, and therefore as a medium of exchange can wave off the additional taxes paid to the governing body, and instead, only a minimal transaction fee can be charged.

The lack of so much price fluctuation of stablecoin ensures it retains its purchasing value, therefore it should experience a minimum inflation. This will definitely push more users to use stablecoin for spending or transacting rather than storing or hoarding them for long-term investments only like many do with other cryptocurrencies.

Once stablecoin gets widely accepted as the main form of currency, It will reduce the need for converting cryptos into fiat, and vice-versa. Therefore neither you nor companies operating in blockchain network would need to convert their cryptocurrencies to their fiat peers to pay for business and other services, thus keeping most of the world money in the crypto realm.

Ultimately stablecoin can eventually replace most if not all form of transaction, storing and investing where fiat currencies are used – be it paying salaries to insurance to doing big businesses.

Challenges for Stablecoins

Though the potential of stablecoin is very promising, how effective it is in real-world economics is questionable. Except for Tether, there is no other stablecoin which has been tested in real-world economic scenarios, therefore, raising a  question mark regarding their practical implementation.

According to Barry Eichengreen, an economist at UC Berkeley, there are some design problems associated with stablecoins. Recently, in a Guardian post, he has pointed out two major issues regarding this.

The first one is the possibility of a bank run on low-priced bonds. If Basecoin’s network does not achieve sufficient growth it needs in near future, then the price of its bonds will go down for sure. And as the price keeps falling further, the bond will be soon worth nothing due to lack of buyers.

The second problem is associated with those multi-asset collateral-backed stablecoins. It may happen that when the value of one of its assets (for example a dip in the value of ether or litecoin) is falling, to tackle that issue the company has to take the route of increasing the value of its holdings in another asset to compensate and keep the value of the coin stable. Such a strategy may eventually lead to a situation where investors may flee from an asset that is declining in value.

Then there is the challenge of scaling – probably one of the biggest issues with any cryptocurrency. As mentioned earlier the price-stability nature of the stablecoin should dissuade investors from putting their money into it. But to make use of stablecoins technology in various innovative applications, it needs investments in millions, even billions. Therefore the stablecoins need to reach a level where liquidity is deep enough to support that. This can put a cap on how fast stablecoin can grow.

Other stablecoins looking to replace Tether as a liquid proxy may run into problems, as Tether had a good head start, and it has held its peg to US dollars quite reliably so far.

Another challenge stablecoin is likely to run into is regulatory scrutiny. Stablecoin closely resembles fiat currencies and therefore likely to have quite some effect on monetary policies worldwide. Therefore central banks are likely to take necessary measures on it, unlike other cryptocurrencies.

Conclusion

With all the amazing benefits cryptocurrencies offer, the only problem that has deterred cryptocurrencies from becoming the mainstream currency is its unpredictable price swings. Stablecoin, addressing that exact issue is the right step forward.

Stablecoin has all the right ingredients to become that desired crypto coin that we dream about. But the technology is still in its infancy. You may say that Tether has come up a long way, so much so that it has laddered itself up into top 10 cryptocurrency. But even Tether has a lot of issues to resolve before it truly becomes what it has set to become. As for the other stablecoins, they can learn their way up by observing the example of Tether, and make the market competitive enough to quicken the innovation.

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