What is a Stablecoin?
A stablecoin is a crypto asset that is designed to have a stable value over a long time. Most stablecoins have a $1 value.
The Long Definition
A stablecoin is a crypto token whose value remains stable over an extended period. This stability is achieved by tying the value of the token to that of another stable asset like fiat currency or a commodity like gold.
Stablecoins also maintain certain assets as reserves. These reserves serve as collateral to help with price stability. Others use algorithms that control the token’s supply to maintain the desired price range.
Stablecoins were invented to provide a less volatile alternative to popular cryptocurrencies like Bitcoin and Ethereum. They provide an avenue for people to use stablecoins in everyday settings.
The Need for Stablecoins
As cryptocurrencies become popular, people want to use crypto on an everyday basis. They want to be able to pay for goods and services using digital currencies. This is, after all, what Bitcoin’s inventor had in mind.
However, there is a problem. Existing crypto assets are a little too volatile. The value of Bitcoin (BTC), Ether (ETH), and other popular cryptocurrencies undergo sudden increases and decreases in value.
For example, 1 ETH was worth around $3700 at the start of 2022. By mid-2022, this value had dropped to around $1000. This volatility is good for traders who make a profit by speculating on the price of crypto assets. However, it makes cryptocurrencies unsuitable for performing everyday transactions.
Imagine selling a pair of headphones for 1 ETH. If its price drops as it did above, you’ll take a loss. The 1 ETH that you received is no longer able to buy one headphone. Its purchasing power has essentially dropped. Most merchants know this. Therefore, they are hesitant to accept cryptocurrency payments.
This is where stablecoins come in. By maintaining a steady value, they maintain their purchasing power over time.
History of StableCoins
The idea of stablecoins was born in the early days of cryptocurrencies.
Attempts at stable assets started in 2014. BitUSD was one of the earliest attempts. It was designed to be pegged to the dollar and run on the BitShares blockchain. Another early attempt was NuBits. Like BitUSD, it was tied to the dollar. It used a decentralized algorithmic mechanism to maintain its $1 value.
However, these didn’t really take off. The first stablecoin to gain widespread adoption would be launched a year later in 2015. This was Tether (USDT). It is pegged to the dollar and remains the most popular stablecoin to date. MakerDAO’s DAI was also born at around the same time.
Many more stablecoins have been launched in the years since then. These include Terra’s UST, USD Coin (USDC), and Binance USD (BUSD). The UST token, unfortunately, collapsed in May 2022. This is one of the events that plunged the crypto industry into a bear market.
Overall though, stablecoins have continued to grow. Today, they are a 153-billion-dollar market. They play an important role in the utility and adoption of cryptocurrencies. This growth has attracted a fair share of scrutiny from regulators.
How Do Stable Coins Work?
Most stablecoins are designed such that one token is worth one basic monetary unit of a certain currency. For example, one USDT is worth one dollar. Similarly, one Euro Tether (EURT) is worth one euro. This practice is called pegging, i.e., tying the value of one currency to another’s value.
Different stablecoins have different ways of achieving that. They are those that are backed by reserves. These reserves can be fiat, crypto, precious metals like gold or silver, or a combination of those. There are also those that use an algorithm.
In the past, central banks did something called backing. This involved holding reserves in a precious metal like gold to support the value of the currency. The value of the relevant currency was thus tied to that of the gold reserves held by the central bank.
The more reserves the central bank held relative to the supply of their currency the more valuable the currency was.
Some stablecoins have borrowed this concept to ensure stability. Fiat-backed stablecoins are the most common type. These stablecoins hold fiat currencies, like the US dollar, in their reserves. For integrity purposes, the reserves are maintained by an independent custodian. They are also regularly audited.
Tether (USDT) a fiat-collateralized stablecoin. The token is backed by a 1:1 ratio to the dollar. This means that for every USDT token in circulation, there is a dollar in reserve.
These stablecoins are backed by cryptocurrencies like bitcoin (BTC) and ether (ETH). But BTC and ETH are still prone to high volatility. So, how do these tokens ensure a healthy reserve-token ratio?
Crypto-backed stablecoins are overcollateralized. This means that the value of cryptocurrencies held in reserves is more than that of the stablecoins in circulation. For instance, if there are $1 million worth of stablecoins in circulation, crypto worth $2 million might be held in reserve.
That way, even if the value of the crypto assets drops, there will still be enough reserves to cover the tokens in circulation.
DAI is the most popular crypto-backed stablecoin. The token is minted by the Maker protocol on the Ethereum blockchain.
The stability of crypto and fiat-backed stablecoins is primarily determined by the reserves. With algorithmic stablecoins, things are different. The stablecoins may hold reserve assets. However, their stability is maintained by an algorithm.
This algorithm controls the supply of tokens using a preset formula. For example, if the token’s value exceeds the peg, the algorithm increases supply by minting more tokens. Minting is the act of creating new tokens.
The thinking here is that assuming the demand remains constant, increasing supply will reduce the price of the tokens to the desired level.
On the other hand, if the token’s value falls below the peg, the algorithm burns tokens. Burning is the act of removing tokens from circulation. It involves sending the tokens to an irretrievable wallet address.
The thinking here is that assuming the demand remains constant, decreasing supply will increase the price of the tokens to the desired level
Due to their stability, stablecoins can be comfortably used in place of fiat currency. They are the most likely to replace conventional means of payment. Therefore, they have attracted a good share of attention from regulatory bodies.