What's the Point of a Stablecoin? (A Simple Explanation)
Whether you’re brand new or a veteran to the cryptocurrency world, navigating the new technologies that are popping up can be a full-time job. Since the beginning, cryptocurrencies like Bitcoin, Ethereum, and Litecoin have allowed anyone to take an active role in the growth of the cryptocurrency market. However, the massive waves of volatility have pushed a lot of would-be participants away. That’s, of course, until stablecoins came onto the scene.
So, what is the point of a stablecoin? A stablecoin is a cryptocurrency that attempts to peg its value to the value of another asset, including fiat currencies, commodities, and cryptocurrencies. The most popular types of stablecoins track the value of fiat currencies, including US dollars (USD) and Euros (EUR).
With the cryptocurrency market being as volatile and chaotic as it is, stablecoins have certainly tapped into a market of those wanting to take part without enduring wild market swings. By having a cryptocurrency that acts like USD, EUR, or any other relatively safe asset, market participants have a place to breath when market waves start to appear.
Why We Need Stablecoins
Cryptocurrencies are the most well-known application of the innovate blockchain technology. While fiat currencies, like USD or EUR, are backed by the confidence the market has in the issuing governments, stablecoins can be backed by actual assets. By also keeping the value of stablecoins pegged, they offer a level of stability in a shaky market.
Stablecoins provide the same value to cryptocurrency investors, traders, and exchanges as fiat money provides to the participants in the non-cryptocurrency financial markets; stability. While non-cryptocurrency investors will allocate portions of their portfolios to cash, Treasury bonds, or money market funds when volatility is on the rise, cryptocurrency investors move to stablecoins.
There are several reasons cryptocurrency market participants move to stablecoins as opposed to traditional ‘risk-off’ assets. For one, staying in the cryptocurrency market allows them to move faster between trades without having to wait days to transfer to fiat money. It’s also true that not all cryptocurrency exchanges support the use of fiat currencies, leaving stablecoin as the only solution.
Now that stablecoins have provided a way to find safety in the cryptocurrency market, market participation in terms of volume and market capitalization has steadily grown. Due to increased confidence in the cryptocurrency marketplace, more people are choosing to engage in the market.
As stablecoins bring more confidence into the market by allowing participants a ‘safe space,’ more movement, or volume, has occurred. This volume has had a proportional effect on liquidity, making the cryptocurrency market quicker to maneuver as well as making it more efficient. Increased efficiency also brings more accurate asset pricing, resulting in fairer asset prices and tighter bid and ask spreads.
The benefits of stablecoins are immense and have given a massive gift to the entire cryptocurrency market. By providing a ‘risk-off’ instrument, the market has instilled greater confidence, it’s grown, and it’s become more efficient. However, not all stablecoins are created equally, so getting to know the way they work can help you choose one over the other when the time comes.
How Stablecoins Work
As you know, a stablecoin’s value is pegged to the value of another asset, but it might not be clear on why the market believes they’re actually valued at that pegged price. The solution most stablecoins came up with is to keep collateral equal to the value they claim their cryptocurrency is pegged to.
Now, collateral can take several forms when it comes to stablecoins, including fiat money, commodities, and cryptocurrencies. By far the most common form of collateral is fiat money, especially USD and EUR. However, other assets are also used as collateral, including gold and baskets of cryptocurrencies. Some stablecoins are backed by nothing but an algorithm, but these are rather uncommon.
The most popular stablecoins are those that can provide the most stability, thus the most predictable, risk-free asset in the cryptocurrency market. The stablecoins that are the most stable are also the best at keeping their collateral frequently up-to-date while providing a certain level of transparency and market confidence.
Keeping collateral on hand can be tricky depending on the type of asset being tracked. Fiat money is the easiest and generally works like this:
- You buy $1 worth of a stablecoin, the company managing the stablecoin mints one stablecoin.
- You sell $1 worth of a stablecoin, the company managing the stablecoin destroys one stablecoin.
There’s a lot of handwaving going on here, but this is generally how it works for all types of stablecoins. The challenge for the managing company is providing enough liquidity while keeping their books properly balanced to ensure market confidence in their stablecoin.
This brings us to every stablecoins biggest challenge; trustworthiness. Blockchain has trust baked into it by offering a decentralized platform that isn’t controlled by any single user and views every user as an equal in the network. However, stablecoins don’t have that luxury as they must keep a tight ship when it comes to controlling the supply of their stablecoins while at the same time managing a portfolio of assets (collateral). Therefore, they are intrinsically centralized.
In this sense, stablecoins have their work cut out for them and they know it. That’s why the best stablecoins are those that are as transparent as possible by issuing audits (ideally from third-parties) regularly and keeping their users up-to-date on their technology’s continuous development.
While Bitcoin (BTC) is the largest cryptocurrency in terms of market capitalization (unit value multiplied by circulating supply), the most popular stablecoin, Tether (USDT), is the largest in terms of trade volume as well as circulating supply. This shouldn’t come as a surprise as one of the biggest reasons to use stablecoins in the first place is to move in and out of them when market risk reaches an uncomfortable level or when settling trades.
The number of stablecoins is increasing as requirements demanded by the market for improved liquidity, speed, and transparency increases. While the most popular stablecoins are pegged to USD, they carry with them distinct features that should be highlighted.
Tether (USDT) is the most popular stablecoin on the market boasting the highest trade volume and market capitalization of any other stablecoin. Backed by USD, they’re able to keep one of the steadiest stablecoins that’s pegged extremely close to its target price of $1.
While the most popular stablecoin, Tether is rather controversial due to their lack of transparency regarding asset reserves. Nonetheless, the market has continued to support them over other stablecoins by huge margins resulting in them dominating the stablecoin market.
USD Coin (USDC) comes in at a distant second, but is quite popular and becoming more so as the cryptocurrency market matures. It’s also backed by USD and is built on top of the popular Etherum (ERC20) protocol. USDC is managed by Circle and Coinbase, which are some of the most well-trusted cryptocurrency companies in the world.
Not only is USDC trustworthy based on their managing companies, but they also publish regular reports using results from third-party audits by a top accounting service. All transactions through USDC are fully compliant with US money transmission laws and occur through established financial firms.
Paxos Standard Token
Paxos Standard Token (PAX) is a USD-backed stablecoin that’s fully managed by Paxos Trust Company and regulated by the New York State Department of Financial Services (NYDFS). Similar to most other stablecoins, it’s also built on the ERC20 protocol.
PAX was first issued shortly after major controversy spread that Tether was ‘printing’ Tethers out of thin air back in 2018, which caused a major trust issue within the market. Based on their audited smart contract technology, PAX has a fully decentralized accounting solution to their stablecoin making it quite revolutionary. They’re also regularly audited by several accounting firms, so their reserves are constantly being verified.
TrueUSD (TUSD) is another USD-back stablecoin that came about during the Tether controversy when there were allegations of them using fractional reserve banking. Since TUSD has taken the stage, they’ve proven to be a well-trusted stablecoin that’s benefited greatly from the cryptocurrency market growth.
Apart from publishing their collateralized holdings every day and conducting monthly third-party audits, they’re unique in that they’ve been built on the TrustToken platform. TrustToken has a mission to tokenize all types of assets, including real-estate, commodities, patents, trademarks, businesses, and more, so everyone can participate in ‘fractional ownership’ of all kinds of assets on a global scale.
MakerDAO (DAI) is a very popular stablecoin because while one DAI equals $1, the assets backing that value is a basket of select cryptocurrencies. DAI was also created in response to the Tether controversies and has built a stablecoin that’s 100% decentralized and trustworthy.
One of the unique characteristics of DAI, apart from being a cryptocurrency-backed stablecoin, is that it’s always over-collateralized. What this means is that instead of having a 1-to-1 ratio with the underlying assets, the ratio is slightly greater resulting in having more reserves than is necessary. In technical terms, this results in what is known as a collateralized debt position (CDP), which allows them to keep their reserves safe when their basket of cryptocurrencies enters a volatile period.
Stablecoins and Beyond
Stablecoins come in all shapes and sizes, but they all serve a single purpose; to provide stability. By providing stability in the cryptocurrency market, they’ve effectively invited those market participants who were once too shakey to enter the market due to excessive volatility. It’s also given investors, traders, and exchanges opportunities to have a ‘risk-off’ allocation within their cryptocurrency portfolio.
While there are already a number of popular stablecoins on the market, there are likely more to come that serve specific purposes for target users. USD-backed stablecoins are the most popular, but the world of fiat money extends far beyond USD. On top of that, some people miss having a good old-fashioned commodity-backed currency back when the gold standard existed.
Stable coins also bring about the idea of backing cryptocurrencies to all kinds of assets. In this sense, stablecoins are really just a way to accurately price an asset through a decentralized marketplace, which may be the most efficient and trustworthy way to value any asset. That’s one powerful idea and shows a possible path stablecoins may take as well as their future siblings.