Have you noticed that on Binance and other major crypto asset exchanges there are no fiat currency pairs? How do they get away with that? The easy answer is with stablecoins.
Stablecoins are digital assets whose value is linked to an external asset - like fiat currencies or gold - to provide stability.
Cryptocurrency markets can be incredibly volatile. Stablecoins offer investors the option to quickly swap from a volatile crypto asset into a decidedly stable one without exiting the cryptocurrency ecosystem. This comes with its obvious perks, and of course, a few drawbacks.
Stablecoins can be classified based on how they maintain price stability. Some are pegged to and backed by the value of various fiat currencies, like the U.S. Dollar, while others are pegged to physical assets like gold or oil. Stablecoins might also not actually be backed at all! This last type is known as an algorithmic stablecoin, which we’ll cover as well.
Types Of Stablecoins
Fiat-backed stablecoins maintain a 1:1 ratio with a fiat currency. These coins, like USDC, hold their collateral in their centralized reserves. This means that companies who provide fiat-backed stablecoins are not decentralized, but their blockchain may be public. While the U.S. dollar is the most frequently-used currency, some others are starting to crop up - like the Turkish lira backing BiLira (TRYB) or Nigeria’s Naira-pegged stablecoin NGNT.
One of the earliest fiat-collateralized stablecoins was Tether (USDT), launched in 2014 as RealCoin. Although it is by far the most-used stablecoin on the market today, it was steeped in some controversy due to doubts surrounding the existence of its fiat reserves (made worse by a refusal to deliver an audit proving otherwise). Regardless, not only is it the most successful stablecoin so far, it regularly sits in the top 10 by market cap and 24hr trading volume of all cryptocurrency. Other notable fiat-backed stablecoins include USD Coin (USDC), the Gemini Dollar (GUSD), and Binance USD (BUSD).
Because of their relative simplicity, fiat-backed stablecoins are more accessible and better suited for widespread, mainstream adoption.
Crypto-collateralized stablecoins are built similar to their fiat-backed cousins, but are backed by other cryptocurrencies instead. This makes their reserves - you guessed it - on-chain! Rather than going through a central issuer like a bank, crypto-collateralized stablecoins use smart contracts to function. This works by locking crypto collateral into a smart contract to issue tokens to users. Users can then put stablecoins back into the same contract to release their collateral.
MakerDAO’s native stablecoin, DAI, is a notable example of this stablecoin type. MakerDAO is an open-source decentralized autonomous organization founded in 2014, managed by users holding the protocol’s governance token MKR. While DAI is soft-pegged to the U.S. dollar, it maintains its relative stability with a massive reserve of ETH and other cryptocurrency in the DAO vaults. As of May 2021, the DAO has 3.04 million ETH to use as collateral.
You can actually participate in the governance of MakerDAO if you hold MKR. This would allow you to vote on major issues such as how much ETH should be deployed as collateral, and what the APR on its CDP should be.
DAI has also become multi-collateral, allowing it to accept a number of different cryptos as collateral - not only ETH, but also BAT, USDC, WBTC and more!
Commodity-backed stablecoins refer to cryptos that are backed by assets such as gold or silver, or even real estate. Some examples include Digix (DGX) and Paxos Gold (PAXG), both of which are backed by varying amounts of gold. Not only does this democratize access to and ownership of gold, but it also provides less costly ways of storing it.
Meet the wild card of the group. Algorithmic stablecoins are not backed by fiat, cryptocurrencies, or commodities. Instead they rely on algorithms that adjust token supply based on demand in order to achieve stability. If the demand is too high, the algorithmic system will emit more stablecoins; if the supply is too high, the system reduces it. And while creating more coins is easy, reducing the supply is another matter altogether.
Take FEI. FEI is a partially collateralized algorithmic stablecoin that uses direct incentives to maintain stability. What does this mean? It means that when demand is low, users are either rewarded by earning Mint or penalized by paying Burn based on whether they buy or sell. This was meant to incentivize buying and discourage selling, but instead froze investors after the Genesis Launch because of high penalties. Long story short, FEI failed to maintain its peg.
FEI has since recovered, but has provided a questionable case for the success of algorithmic stablecoins.
Another notable example of algorithmic stablecoins is Ampleforth (AMPL). AMPL maintains its price stability through a daily “rebasing” system. Rebases occur once a day at 2:00 UTC, and automatically adjusted token numbers in user wallets based on supply and demand. Yet AMPL has nonetheless seen considerable volatility in market price with an ATH of $3.8 in July 2020, up from its ATL of $0.33 in the fall of 2019!
How stable are these, then? Well, they’re not - not exactly, anyway. To Ampleforth’s credit, the team does clarify it is not a stablecoin, but instead a non-correlated, price-stable asset.
Use Cases & Limitations
Stablecoins make up a crucial cornerstone of the DeFi ecosystem, especially as a bridge between the traditional finance sector and the crypto industry. Because of their generally low volatility, they therefore offer a distinct level of functionality and real-world use value. This involves their role as alternative currencies - facilitating payments as well as cross-border remittance. For individuals trying to push back against government control and surveillance - or simply survive in a flailing economy - stablecoins can provide a lifeline. They can also allow investors to build a more balanced and reliable portfolio.
That being said, in the case of fiat-collateralized stablecoins, they are only really as stable as the asset they are pegged to. And while cryptos like BTC or ETH are decentralized, many stablecoins must rely on a third party or central bank for collateral. Reliance on a third party to be transparent is a tall order for many. This degree of counterparty risk, for some, is the reason to leave TradFi for crypto.
In that sense, algorithmic stablecoins remain closest to the decentralized, censorship-resistant values set out by the OG cryptocurrency, Bitcoin. Yet, they also provide the trickiest use case when it comes to liability as well as stability. Regardless, stablecoins add a considerable and critical amount of value to the crypto space right now - and this is only the beginning.