Most Stablecoins are pegged to the US dollar. They close the gap between the advantages of Cryptocurrencies and the more stable fiat currencies. The first and largest of these is Tether (USDT), with a market capitalization of nearly $40 billion.
Stability to currency can come in a variety of ways. In early times, Tether was created 1:1 with the equivalent of deposited dollars. Users have left the fiat system with exchanges to digital units. These, in turn, can be booked faster and used promptly on various trading platforms.
The capital tied up in fiat can be profitably invested, or lent by issuers in the traditional financial world. To attract further capital, interest is often paid on the digital assets as well. Thus, it’s the same mechanism that banks used in early times – before they switched to book money.
Parity to fiat collateralized
This is a simple method, but it requires regular auditing and a financial manager. The latter must monitor that the token remains fully collateralized. This is usually a disadvantage as the token is centrally managed by one party. Tether (USDT) is considered one of the most successful Stablecoins on Cryptocurrency exchanges, where direct USD transactions are not possible.
The direct competitor for Tether is Circle’s stablecoin – the USD Coin (USDC). USDC has managed to build a reputation in transparency. Regular audits, fully backed collateral, and regulatory compliance have made this possible. One of their partners is credit card giant Visa.
TrueUSD is another competitor, however it has a much smaller market capitalization. They hold partnerships with numerous banks and trusts to avoid centralized status. Thanks to smart contracts, TrueUSD has no way to access the deposited funds – ensuring complete decentralization.
Centralized Stablecoins take up the majority of the market right now, and have the best liquidity on a wide variety of exchanges.
In the same way that a fiat-backed Stablecoin has fiat tenders as collateral, Crypto-backed Stablecoins have a Cryptocurrency as collateral. To compensate for the volatility of the collateralized Cryptocurrency, the Stablecoin must pledge collateral. This means that the coin will not have a 1:1 ratio against the collateral value. The industry leader in this regard is the stablecoin “DAI” from MakerDAO.
Crypto-backed Stablecoins function more like pawn shops. They allow Crypto assets to be used as debt collateral. They serve to stabilize the system and balance volatility. Credit collateral is provided in a decentralized manner via a smart contract. These Stablecoins counteract price volatility by ensuring that each coin is fully collateralized with this reserve.
On-chain issuance allows for full transparency and auditability of these reserves. The collateral is held in a smart contract and can only be accessed by clearing the Stablecoin debt. Alternatively, the smart contract can be closed and the collateral sold through the Stablecoin system if the deposited collateral falls below a certain pre-determined level.
The biggest risk with this Stablecoin model is the volatility of the underlying collateral. If the collateral loses too much value, the system becomes under-collateralized and fallback procedures could be activated, such as Stablecoin liquidation. Ultimately, the volatility of the collateral portfolio determines the stability of Cryptocurrencies.
Non-collateralized / Algorithmic Stablecoins
There are Stablecoins that use a seigniorage share system. The money creation profit (seigniorage) is the difference between the value of the money and the cost of printing the money. Non-collateralized Stablecoins rely on a mechanical algorithm that changes the supply quantity as needed to maintain the price.
Through the use of smart contracts, the Stablecoin is sold when the price falls below the fixed currency. In turn, more tokens are added to the market when the value rises above the fixed currency. Central banks typically control the money supply by buying and selling securities. When a central bank wants to increase the amount of money in circulation, it buys securities from banks and other financial institutions. It does not create its own securities.
Algorithmic Stablecoins are currently rarely used, because they often have high volatility.
Leading banking institutions are looking into creating their own digital Stablecoins. One example is JP Morgan’s JPM Coin and Facebook’s Diem. Libra, as the initiative was called when it was launched in 2019, will be linked to a basket of fiat currencies and some other assets. In Christine Lagarde’s view, they pose a greater risk to the EU’s financial stability and monetary sovereignty than Bitcoin.
Even governments and central banks have begun to ponder the idea of Stablecoins (CBDC). The former chairman of the U.S. Commodity Futures Trading Commission (CFTC) led an initiative to create a “digital dollar.” A draft document from the European Union indicated that they are also considering the creation of a “digital euro.” It would possibly be an upgrade for the Eurodollar system.
Even Stablecoins have two sides
Proponents argue that Stablecoins act as a perfect model to fulfil the key elements of a currency. They act as a medium of exchange and store of value, and also serve as a unit of account. Moreover, Stablecoins offer the benefits of Blockchain-based payment while avoiding the inherent volatility of Cryptocurrencies.
On the other hand, it is argued that currencies like the U.S. dollar are not good collateral due to their own inflationary nature. For this reason, Stablecoins are not a sustainable solution to the problem that Bitcoin is trying to solve. Furthermore, it could be argued that because the fiat ratio is so blatantly derived from a national currency, Stablecoins are very much governed by the nation’s legal financial laws.
The transparency of a public Blockchain can quickly be abused as a surveillance tool in the case of a private (JPM, Facebook, etc.) or government-issued digital currency. Stablecoins are good for digital commerce, but may not be good as a payment system for everyday spending.
*Originally posted at CVJ.CH