4. Stablecoins

Core message: Stablecoins are digital tokens that are pegged to an underlying asset (such as US Dollars) in order to combine the stability of the underlying asset with the benefits of a digital currency.

Our 2-Cents: Very effective bridge between Fiat and Cryptocurrencies, at least in the short term. Smart contracts have given rise to the use of stablecoins in all kinds of decentralized finance, including lending, payments, insurance and prediction markets.

Let's break it down...

The stability of the underlying payment instruments in any transaction is crucial to ensure that neither the buyer nor seller lose out due to price fluctuations.

Cryptocurrencies, at present, experience high price volatility which causes this problem for buyers and sellers. This is where Stablecoins come into play.

Stablecoins are digital tokens that are pegged to an underlying asset (such as US Dollars) in order to combine the stability of the underlying asset with the benefits (speed, cost, ...) of a digital currency.

As well as facilitating domestic and international payments, stablecoins enable easier trade in and between cryptocurrencies on exchanges where fiat currency cannot be used due to regulations and provide a safe haven for crypto investors in times of high price volatility. (Cashing out to a fiat currency is a taxable event in many jurisdictions.)

There are now more than 200 stablecoins globally worth over USD180 billion in circulation (up from USD29 billion at the start of 2021).

Types of Stablecoins

There are 4 kinds of stablecoin:

Fiat Collateralised Stablecoin
Commodity Collateralised Stablecoin
Crypto Collateralised Stablecoin
Algorithmic Stablecoin

1. Fiat Collateralised Stablecoin

The most common type of stablecoin is collateralised by fiat currency, predominantly the US Dollar.

Fiat-backed stablecoins are backed at a 1:1 ratio, meaning 1 stablecoin is equal to 1 unit of currency. So, for each stablecoin that exists, there is theoretically real fiat currency being held in a bank account to back it up.

We say theoretically here as the ratio being maintained (1:1) is notoriously hard to verify and the two leading Stablecoins by Market Capitalisation, Tether (USDT) and USD Coin (USDC), have been under intense scrutiny for maintaining a ratio far below what they indicate to the market.

Two other USD-backed stablecoins, the Paxos Standard (PAX) and Gemini Dollar (GUSD), have been approved and regulated by the New York State Department of Financial Services. And both publish monthly reserve audits that are verified by independent accounting firms which goes to rectify this concern.

Financial services incumbents are also eyeing the opportunity — JPMorgan Chase, for example, has piloted and launched a stablecoin, JPM Coin, for its corporate clients.

2. Commodity Collateralised Stablecoin

Commodity-collateralised stablecoins are backed by gold/precious metals, oil, real estate, and the like.

Commodity-backed stablecoins are sometimes marketed as a way to open up certain asset classes, like real estate, to smaller investors.

3. Crypto Collateralised Stablecoin

These stablecoins are backed by other cryptocurrencies, such as Ethereum and Solana.

To reduce price volatility risks, these stablecoins are often over-collateralized so they can absorb price fluctuations in the collateral.

For example, to get $100 worth of stablecoins, you might need to deposit $200 worth of Ether (ETH). In this scenario, the stablecoins is 200% collateralized to take into account a potential downturn in price of the underlying cryptocurrency.

4. Algorithmic Stablecoin

Algorithmic stablecoins (also referred to as non-collateralized stablecoins) are completely new variants of cryptocurrency and do not have any associated collateral.

The working of an algorithm-based stablecoin depends profoundly on an algorithm that sets the rules for balancing the supply and demand of the stablecoin – put simply, when its price increases coins are sold and when the price falls coins are bought.

Tokens on a Smart Contract Blockchain

Stablecoins are tokens on a smart contract blockchain that represent redeemable claims on an asset (e.g., 1-for-1 by dollars).

Once stablecoins are issued, people can then use whichever blockchain they are issued on to send and receive stablecoin payments between themselves with no centralized third party.

From a user standpoint, stablecoins are a significant technological leap over existing bank payment systems, especially for international payments of any size, or large domestic payments. You can send someone a million dollars on another continent at 2am on a Sunday night and they can receive it in minutes, and you can verify the transaction on the blockchain.

Top 5 Stable Coins

The top 5 stablecoins by market capitalisation are (April 2022):

Tether (USDT)
USD Coin (USDC)
Binance USD (BUSD)
Terra USD (UST)
Dai (DAI)

As U.S. Dollar (USD) is the world's reserve currency, it's not surprising that USD-backed stablecoins are the

norm.

Currently, two stablecoins, USDT (Tether) and USDC (USD Coin) dominate the market. They have a combined share of over 80% of the total stablecoin supply. While USDT is still holding the lion’s share of over 50%, USDC is catching up, making up nearly 30% of the total stablecoin supply.

Binance USD (BUSD) is also a US Dollar backed stablecoin whilst Terra USD (UST) and Dai (DAI) are decentralized algorithmic stablecoins that try to avoid these regulatory/governance issues by maintaining their pegs through algorithms instead of through reserves of cash and debt.

The use of stablecoins has exploded in the last two years, coinciding with the rise of DeFi (decentralised finance). Large international banks are now showing interest in this area also with JP Morgan (US) and ANZ (AUS) now issuing and transacting in their own stable coins, the JPM Coin and the A$DC respectively.

Challenges for Stablecoins

Asset backed stablecoins are centralized. The custodian holds the actual money/asset; the collateral that backs all of those tokens. The custodians have the power to “blacklist” their tokens, which freezes them and basically makes them worthless. (Tether has blacklisted over 500 addresses and counting.)

The companies that own stablecoins have power of the public, smart contract blockchains on which they are minted. If there is a fork on the chain, the company will chose which fork retains their stablecoins. This is a serious concern in relation to the level of centralisation that exists on the smart contract blockchains (such as Ethereum and Solana).

The price and therefore stability of stablecoins is linked inextricably to the off-chain assets to which they are pegged.

The Algorithmic stablecoins, while undoubtedly clever, are inherently unstable in their attempt to increase or decrease the supply of stablecoins, and thereby control the price, in response to changes in demand.