Stablecoins are an attempt to create a cryptocurrency that isn’t volatile. A stable coin’s value is pegged to the current world currency also known as Fiat money. For example, a StableCoin known as Tether or USDT is worth 1 USD and is expected to maintain it no matter what. They allow for the convenience of the cryptocurrency which means a fast settlement and fewer regulatory hurdles along with the stability of Fiat money. Like most coins, the most obvious use is to use them as the medium of exchange and for day-to-day purchases. But since they are not popular, no one accepts them as their payment method. Using these coins, traders can create volatile cryptocurrencies for stable cryptocurrencies when they want to lower their risk and increase their stability.
For example, if I’m invested in Bitcoin and don’t want to risk the value of Bitcoin falling again, I could just exchange it for equivalent USDT which is still valued as 1USD. So when I want to return to the game, then maybe I would have to exchange the USDT back to its equivalent value BTC. This method is very popular around cryptocurrency exchanges. Another advantage of Stablecoins is that you can move funds between exchanges relatively quickly since crypto transactions are faster and cheaper. The option for such a quick settlement sets the fundamentals for arbitraging that closes the price gaps between Bitcoin exchanges. For traders, a Stablecoin is more of a utility coin than a medium of exchange.
How to maintain a Stablecoin?
To peg a StableCoin, the first method to do this is, through creating Trust that the coin is actually worth what it is pegged to. For example, if the market doesn’t believe that 1USDT is not worth a dollar, people will immediately dump all their USDTs and the prices will crash. To maintain this trust, the company backs it up with some assets. These assets can be anything ranging from actual dollars to any commodity in the global market or an algorithm or any other cryptocurrencies too. When it comes to Tether, it is backed by an actual USD as collateral whereas DGX is backed by gold as collateral. Another way to collateralize is to back it up with more one or more cryptocurrencies.
The second method is to do by manipulating the coin supply on the market, also known as an Algorithmic peg. It means a company writes a set of rules also known as Spot Contract that increases or decreases the amount of StableCoin in circulation depending on the coin’s price. If the demand is more, there might be a case where the value may rise, in that case, the company introduces new coins to the market. Alternatively, in case of less demand, the company removes few coins from the market to stabilize its value. This method does not hold any collateral as such but an algorithm that manipulates the market of its coin, based on demand and supply.
The third method is Fiat Collateral Peg that has the highest degree of certainty to stablecoin holders. Because it’s been backed up heavily by the company’s assets. The disadvantage to the company would be, not to be able to use those assets elsewhere. In addition to it, there is always a risk of embezzlement or closing of the company’s bank account which can take a hit on the trust metric. Another issue with this method is it is very hard to prove the company owns enough assets to really back the number of coins in circulation. For example, Tether has suffered severe criticism and audit requests from skeptics claiming the company doesn’t have enough collateral to back the USDT circulation.
The last method is called the Crypto collateral peg which has the benefit of viewing the collateral directly on the blockchain that is also volatile. This is where the premium comes into the picture as the company will hold 150% or even more of the collateral needed to back it up. Because it is backed up by Ether or DAI or maybe both, it has transparency and integrity to its customers on the numbers related to the collateral. As a cherry on top, it is also decentralized yet stable and is usable in the crypto world.
What is the Business Model behind creating a StableCoin?
Most Stablecoins projects are designed to make a profit for their organization usually for the founders from the transaction fees. Each exchange charges a buying fee of 0.1% to buy any stablecoin and a conversion fee of 0.3% to 0.4% from stablecoin to fiat money. The transaction fee is charged between 0.13% to 0.15% and the demurrage fee annually at close to 0.6%. This might differ for different exchanges but there may not be a drastic difference.
Different companies have different ways to incentivize them for trading a stablecoin. Other companies may use it as a marketing channel and raise awareness about their company and their services. Gemini, coinBase and Circle are exchanges that have created their own stablecoin to attract more users to their trading platforms. Let’s go over the most popular stablecoins in use today,
- Tether USDT – Fiat collateralized in dollar
- TUSD True USD – Fiat collateralized in dollar
- Gemini USD – Fiat collateralized (first regulated)
- USD coin USDC – Fiat collateralized
- DAI (Dai) – Crypto collateralized
Downsides of StableCoin
Lots of criticism going on in the creation of StableCoins for their inability to actually maintain the peg, in the long run, this could be because of anyone one of the reasons we had discussed so far. On top of that, all pegged coins are doomed to fail based on history due to the cost of maintaining them especially when the peg comes under attack. Some examples of broken pegs are Swiss Franc UHF, Chinese wan CNY, That Bhat peg THB, Gold standard USD in the last 4 decades.
Some argue that StableCoins are not cryptocurrencies because a single company is managing their peg, therefore becomes centralized. Another issue is that they only cater to a growing pain and not a constant problem in the crypto world. Once cryptocurrencies achieve a higher market cap, their volatility will reduce and there will be no use of stablecoins whatsoever.