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What are stablecoins?

The beginner’s guide to stablecoins

Stablecoins attempt to offer cryptocurrency users the best of both worlds: instant processing and security of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies.

Definition

“Stablecoins” refer to a class of cryptocurrencies which offer price stability and/or are backed by reserve asset(s). In recent times, stablecoins have gained enough traction as they attempt to offer cryptocurrency users and enthusiasts the best of both worlds: instant processing and security of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies.

Stablecoins were initially created by exchanges (Bitfinex’s Tether, Gemini’s Dollar) in order to provide traders with a stable currency as a placeholder to store value in-between trades.

Purpose of token

Types Backed by Examples

To be used as a non-volatile

cryptocurrency store of value

Centralised,

Decentralised

Fiat-Currency, Assets,

Cryptocurrency, Algorithm

Tether, TrueUSD,

Digitex Gold Token, MakerDAO

 

Types

Stablecoins, as any other cryptocurrency, have alternative models for governance. At the moment of writing, there are two major stablecoin types:

  1. Centralised stablecoins, like Tether, where the supply is controlled by a company or small group of people
  2. Decentralised stablecoins, like MakerDAO, where the supply is controlled by the market (users) and transactions

Both types of stablecoins have the same purposes:

  • To allow users to quickly change from one cryptocurrency to another without losing too much value due to volatility
  • To store cryptocurrency linked to a fiat-backed asset like the USD

However, each has different inner working mechanics. The first usually implies users must trust a central party to restrict and allow the flow of money going into the market. The second implies decentralised trust and governance, meaning there are smart-contracts (applications) operating in the background, making sure the supply is always bounded to a certain price.

 

Backed by?

There are alternative models that support a stablecoin, all quite valid, giving different options to cryptocurrency users. Stablecoins are usually backed by:

  1. Fiat-currencies such as the USD or Euro.
    Many cryptocurrency users and enthusiasts rely on mechanisms to store some of their value in a non-volatile cryptocurrency form, while they perform trades.
  2. Assets such as gold, oil, bonds or any other commodities deemed valuable, which can endow stablecoins with a certain degree of stability.
    Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin is equivalent to the cost of maintaining the backing reserve of the exchange-traded commodity and the cost of legal compliance, maintaining licenses, auditors and the business infrastructure required by the regulator.
  3. Cryptocurrencies, such as BTC and/or ETH
    This is usually in bulk since the reserve cryptocurrency may be prone to high volatility, such stablecoins are “over-collateralised” – that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins.
  4. Seniorage, or algorithms, representing a programmable solution to the supply, price and volatility metrics.
    These stablecoins are fully digitalised and non-reliant on any types of collateral, as their supply and target price are  controlled only by the program code, typically a smart-contract. These algorithms usually include a DAO, or Distributed Autonomous Organisation, as a way to allow token holders to vote on governance decisions.

Examples

To date, three proper stablecoin models have emerged. The first one is the fiat-backed model in which a coin is backed by reserves of fiat currency, such as Tether USD.

The second model is a modified expansion of the first one. In the multi-asset collateral model, multiple assets are used to back the cryptocurrency. Instead of relying on one single asset, like Tether, stablecoins can rely on commodities such as gold. A great example is the Digix Gold Tokens.

Thirdly, we have the algorithmic model, not backed by any asset. MakerDAO’s DAI stablecoin, which holds smart contract reserves of Ethereum’s ether in a 3:1 ratio (three ether for every dollar), is an example of this model. Another token, MKR, is used for governance purposes. According to its founders, the DAI token can be used in multiple markets, such as prediction markets and gambling. This will increase its velocity and make it more valuable. Investment in the DAI stablecoin also translates into an investment into the underlying assets used to stabilise its price. In turn, this could translate into profits.

Conclusion

Stablecoins are becoming a popular choice for investors as the offer the best of both worlds. It minimises the volatility that often sees other currencies plunge into bear markets, resulting in huge losses for investors. It’s yet to be seen whether stablecoins will take more market share than the original Bitcoin that looks to replace fiat currencies entirely, though.

To find out more about stablecoins and how the cryptocurrency market is evolving, read our definitive series.

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