What Are Stablecoins & How Do They Work?
Stablecoins are stable cryptocurrencies, meaning the market price of a stable coin is pegged to another stable asset like the US dollar. It also can be pegged to gold, digital assets, real estate, etc.
How are stable coins different from other cryptocurrencies?
Bitcoin and Ether are the dominant cryptocurrencies and there are many more coins, but their prices are volatile. Speculation can fuel its volatility, which can fuel further speculation, which in the long run hinders real-world adoption. Businesses and individuals don't want to be exposed to unnecessary risks when transacting in cryptocurrencies.
Users just want to store and use the money on a censorship-resistant ledger. Many cryptocurrencies' innovations and adoption have been bottle-necked around price stability. For this reason, building a stable coin has long been considered the Holy Grail of the cryptocurrency ecosystem.
Types of Stabelcoins
At a high level, there are three types of stable coins.
- Fiat-collateralized coins,
- Crypto-collateralized coins
- Non-collateralized coins.
A fiat-collateralized stable coin is a cryptocurrency that is backed by a real-world currency like the USD. It works by depositing dollars into a bank account and issuing stable coins in a one-to-one ratio against those dollars.
When a user wants to liquidate their stable coins back into USD, you destroy their stable coins and wire them the USD. This asset should definitely trade at one dollar. It is less a peg than just a digital representation of a dollar. Some examples of this type of stable coin are Tether, USDC, and True USD.
This is the simplest type of stable coin, which is a great advantage both in helping people to understand how it works and in implementing those solutions. It is also 100% price-stable because, for each coin, there is one dollar in reserve that can be redeemed at any time. And perhaps most importantly, it is less vulnerable to hacks because no collateral is actually held on the blockchain.
However, this safety and stability come at a price. Fiat-collateralized stable coins are inherently centralized because they need a trusted custodian to store the real money, otherwise, they will be vulnerable to theft.
Lastly, a fiat-backed stable coin is highly regulated and constrained by legacy payment rails. If you want to exit the stable coin and get your fiat back out, you'll need to wire money or mail checks, a slow and expensive process. If we move away from fiat, we can also remove the centralization from the stable coin.
Crypto-collateralized stable coins
This is where the idea of crypto-collateralized stable coins comes in. They operate in the same way as fiat-backed stable coins but are backed with another cryptocurrency. This way, the entire system can live on the blockchain and remain decentralized. MakerDao's Die is the most prominent example of a crypto-collateralized stable coin.
One major difference to note between fiat-backed stable coins and crypto-backed stable coins is the ratio between the collateral and the stable coin, also known as the collateralization ratio. Because fiat currency is generally stable, we can use a one-to-one collateralization ratio where for each coin, we have one dollar stored in reserve.
Using a one-to-one collateralization ratio for a crypto-backed stable coin, however, would make the stable coin just as volatile as the collateral backing it, which would defeat its purpose. For this reason, crypto-backed stable coins are over-collateralized, which means that for every dollar of the stable coin, there is more than one dollar of cryptocurrency in reserve.
To ensure that even if the price drops there will still be one dollar in reserve for every stable coin in circulation. So to solve these problems there are many solutions coming into the market like USDAO which aims to solve the problem and issues the 1 one stable coin for exactly one dollar. For more check out their documentation or stay tuned for the next articles for detailed information and working of crypto collateralized stable coin.
There are a lot of advantages to using a crypto-collateralized stable coin. First and foremost, it is fully decentralized and can benefit from the inherent virtues of the blockchain. Stablecoins can be liquidated quickly and cheaply into the underlying crypto collateral with a simple blockchain transaction.
The entire system is also very transparent. Everyone can easily inspect the history of transactions, the collateralization ratios of a particular crypto asset, and how many reserves actually exist in the system at a given time. Accounting for volatility means having to over-collateralize each coin, which ultimately makes for inefficient use of capital because for every dollar you put in, you can only take out some percentage less than that dollar.
Crypto-collateralized coins are also rather complex in design and have to resort to very intricate, and sometimes non-intuitive methods to ensure their stability, which makes their adoption and implementation more difficult.
The last type of stable coin is a non-collateralized stable coin. It aims to maintain stability without relying on collateral in reserve. Fiat currencies have been able to do this for decades by using central banks to control the money supply.
The value of a currency is determined through supply and demand. If there are more people who want a currency than there are units of that currency available, the price of that currency will go up, and vice versa. Central banks use this information to ensure a currency's price stays stable by printing new money when the price of a currency goes up and buying back and destroying money when the price of a currency goes down.
Non-collateralized stablecoins
Non-collateralized stable coins want to do the same thing. By coding logic into smart contracts, they can perform the functions of a central bank. These smart contracts will use oracles to monitor the price of the stable coin on exchanges and will create new coins when the price goes up, and buy back and destroy coins when the price goes down.
Even if the US dollar and Ether collapse, a non-collateralized coin could survive them as a stable store of value. Unlike the central banks of nation-states, a non-collateralized stable coin would not have perverse incentives to inflate or deflate the currency. Its algorithm would only have one global mandate, stability.
This is an exciting possibility. And if it succeeds, a non-collateralized stable coin could radically change the world. But if it fails, that failure could be even more catastrophic, as there would be no collateral to liquidate the coin back into, and the coin would almost certainly crash to zero. The system also has some inherent complexity and can be rather opaque and difficult to analyze.
Most importantly though, it relies on faith in its stability and continual growth, just like national fiat currency does, which makes it very difficult to adopt at this early stage when faith in cryptocurrencies themselves hasn't been solidified.
Thanks for reading this article.
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Hello Everyone, I am Shubham and I will be posting a series of articles on stable coins, the topics we will cover will be what are stable coins, how do they work, how stable coins can solve the volatility problem, current challenges, innovation, solutions, etc.
So stay tuned for the next articles to learn more about stable coins and the ecosystem around them.