Whenever we talk about money or a currency, we all agree it should serve three main purposes – a medium of exchange, a store of value, and a unit of account. Bitcoin, as the world’s first truly digital currency, checks all three purposes and sets itself apart from all fiat currencies as better and sound money.
However, cryptocurrencies such as Bitcoin, Ethereum, and all rest of them suffer from high volatility when priced against fiat. As cryptocurrencies are not tied to any real-world assets resulting in speculations and the lack of price stability makes it almost impossible for common folks to see cryptocurrencies as a medium of exchange.
The fluctuations in digital currencies’ value have rendered them speculative assets rather than an ideal payment mode. The exponentially high volatility among cryptocurrencies has made retail users skeptical to accept or pay in crypto as currency value can fluctuate 10-15% on either side by the time a transaction settles.
That’s why they need for stablecoins emerged. So, let’s understand the concept of stablecoins and how stablecoins will open the door for cryptocurrencies in retail.
What are Stablecoins?
Stablecoins are a type of cryptocurrency that is designed to mimic the value of a fiat currency. As the name suggests, stablecoins’ key characteristic is to maintain price stability, thus showing negligible price movements and emulating the value of the underlying asset.
With the exponential growth of stablecoins in the past few years, the world has started looking at them as an alternative to central-bank digital currencies. The stablecoin market has already surpassed over $100 Billion in valuation and is transforming the face of payments and financial services as we speak.
The concept of stablecoin emerged from the need of safely parking crypto assets, especially during a highly volatile market, but now they are finding more utility in payments, remittances, as a safe-haven asset, and as crypto-fiat gateways.
Now let’s have a look at the type of stablecoins and how they stabilize their value.
Types of Stablecoins
If we look at the types of stablecoins, there are two distinct types of stablecoins –
- Collateralized stablecoins
- Non-collateralized stablecoins
The term collateral refers to an asset that a lender accepts as security for a loan. For example, when you borrow money from a bank against your gold, the gold acts as a collateral or security for your loan. Similarly, a collateralized stablecoin is directly backed by a fiat or cryptocurrency.
As of now, collateralized stablecoins are the most popular form of stablecoins. However, if we look closely at collateralized stablecoins, there are two distinct categories:
Fiat-Collateralized Stablecoins (USDT, USDC)
As the name suggests, fiat-collateralized stablecoins are backed by fiat currencies such as USD, Euro, INR, etc. These stablecoins are backed by fiat currency at a 1:1 ratio, meaning one unit of stablecoin is valued the same as one unit of fiat currency.
For example, stablecoins (USDT) launched by the company Tether are fiat-backed stablecoins deriving their value from the US dollar. For every token of USDT minted, the company must hold one US dollar in a bank account to back it up. Thus, the USDT stablecoin has its value pegged at the US dollar.
So how does it work?
Well, if a user wants to receive stablecoins, the user will transfer an amount of US dollars from her bank account to the entity’s bank account and in exchange will receive the same amount of stablecoins in her crypto wallet. If vice versa, the user then redeems the cash against their stablecoins by transferring the tokens back to the entity, which are then destroyed or taken out of circulation.
However, there’s a catch. For every stablecoin token circulating in the market, we must trust the entity that it holds the same amount of fiat currency to back it up. Furthermore, it goes against the ethos of decentralization and an open system for which blockchain tech stands. Also, fiat-backed stablecoins rely on the traditional banking system that negates the whole point of removing such rent-seeking central entities.
Crypto-collateralized Stablecoins (DAI)
Now, let’s have a look at the crypto-backed stablecoins. Unlike fiat-based stablecoins, crypto-backed stablecoins follow the ethos of decentralized and open systems, as every user can independently verify the amount of collateral with on-chain data.
DAI stablecoin from MakerDAO is one such example of crypto-backed stablecoin. It is backed by Ether (Ethereum’s native token) and requires a 150% collateral ratio. Meaning, if one Ether is valued at $15 for any given moment, you can borrow 10 DAI (worth $10 USD) using one Ether as your collateral. In case the value of Ether goes down, the user must provide additional collateral or get her position liquidated.
However, it is worth noting that DAI is a multi-crypto collateralized stablecoin, meaning it’s not only backed by Ether but a bunch of other crypto assets as well. Recently, it came to light that around 20% of the total supply of DAI is backed by USDC, a fiat-backed stablecoin. Thus making DAI as a crypto-backed stablecoin but also indirectly backed by a fiat currency.
Non-collateralized Algorithmic Stablecoins
Non-collateralized or algorithmic stablecoins can be said to be the most innovative and complex kind of stablecoins. These stablecoins are not backed by any asset but leverage an algorithmic governance model to stabilize the price by contracting or expanding the supply.
If the demand for such stablecoins increases, the supply is automatically expanded by minting new stablecoins to reduce the price back to the stable level. Similarly, if the demand falls under, the supply is automatically contracted by buying back the coins and burning (destroying) them to bounce the price back.
Algorithmic stablecoins can be said to be the most decentralized, open, and independent for stablecoins resonating with the core ethos of blockchain technology. Terra stablecoin (UST) is one such example of algorithmic stablecoin, with its value pegged to the US dollar without any collateral.
Hopefully, we’ll see more innovation in the stablecoin market with an influx of new algorithmic stablecoins while keeping away from central intermediaries.