Sunday, July 12, 2020

Everything You Need To Know About Stablecoins And How They Work

stablecoin

Stablecoins in a nutshell: subverting fiat currency by relying on it.

 

By Monika Ghosh

 

Stablecoins aspire to achieve the functions of traditional money without relying on confidence in an issuer—such as a central bank—to stand behind the “money.” – Lael Brainard

 

A stablecoin is a cryptocurrency whose value is pegged to a real and stable asset like gold or fiat currencies, in order to combat the price volatility experienced by cryptocurrencies like Bitcoin or Ether.

 

A cryptocurrency is a decentralized, peer-to-peer digital currency that allows for instant and anonymous payments to anyone in the world. Cryptocurrencies use encryption keys, thereby protecting the identity of the traders.

 

In other words, a currency like Bitcoin works like electronic cash that uses peer-to-peer networks and eliminates the need for a financial institution. This means that unlike fiat currencies, which are governed by banks and government regulations, cryptocurrencies aren’t issued or controlled by any monetary authorities.

 

Like other cryptocurrencies, stablecoins are digital currencies with no physical existence, and can be traded in exchanges across the world.

 

Many stablecoins are collateralized at a 1:1 ratio with certain fiat currencies, such as the U.S. Dollar or the Euro, which can be traded on exchanges. Other stablecoins can be pegged to other kinds of assets, such as precious metals like gold, or even to groups of cryptocurrencies.

 

This means that if you buy a stablecoin that is pegged to the U.S. dollar at 1:1, meaning 1 stablecoin is equivalent to $1, you can sell your stablecoin and redeem your $1 at any time.

 

According to CB Insights, stablecoins leverage the benefits of cryptocurrencies — such as transparency, security, immutability, digital wallets, fast transactions, low fees, and privacy — without losing the guarantees of trust and stability that come with using fiat currencies.

 

 

Why are stablecoins important?

 

According to the global Findex data released by the World Bank in 2018, 1.7 billion adults were unbanked in 2017. Moreover, China was home to 225 million unbanked adults in 2017, and 190 million people in India. Even the United States isn’t exempt from this issue, with 25% of U.S. households found to be either unbanked or underbanked, according to a 2017 survey by the Federal Deposit Insurance Corporation (FDIC).

 

Stablecoins, as digital currency that can be used to make payments across the world, have the potential to serve this huge unbanked and underbanked population.

 

From migrant workers who want to send money home, to businesses who make payments to overseas suppliers or employees, stablecoins have the potential to replace traditional currency to facilitate faster, more secure, easier, and cheaper cross-border payments.

 

According to the Global Payment Report 2019 by McKinsey & Company, the estimated 2018 global cross-border payments revenue was $230 billion. Every year, more than 250 million people send over $500 billion in remittances.

 

In 2020, the average cost of sending remitting money across the world is around 7%. The World Bank aims to reduce remittance fees to 3% by 2030.

 

Henri Arslanian, Chairman, FinTech Association of Hong Kong, and PwC Global Crypto Leader, mentioned in a recent webinar that stablecoins have the potential to bring about a meaningful difference in the cross-border payments sector.

 

 

Why do we need stablecoins?

 

The biggest drawback of cryptocurrencies is the high volatility of their prices, which is why stablecoins, with stabler prices, have a powerful allure.

 

Since cryptocurrencies are not as popular as other assets, they have a relatively small market cap, which makes their prices highly volatile. Even the most popular cryptocurrency, Bitcoin, experiences wild fluctuations in price.

 

Just think of the man from Florida, who paid 10,000 Bitcoins for two pizzas in 2010. The approximate price of those pizzas today is over $60 million.

 

Generally, the smaller the market cap an asset has, the more volatile its price. Imagine throwing a rock into a small pond, and then imagine throwing the same rock into the sea. The rock will have a higher impact on the pond than the sea.

 

Similarly, the cryptocurrency market is a small pond and it is more susceptible to everyday buy and sell orders than other stable assets like the U.S. Dollar.

 

Speculation on a cryptocurrency can also fuel its volatility, which in the long run, hinders its real world adoption. If 1 Bitcoin can be used to buy 10 pizzas today, and anywhere between one pizza or 100 pizzas tomorrow, then it cannot be used for daily transactions.

 

For this same reason, businesses cannot use cryptocurrencies to pay salaries if their employees’ purchasing power is going to fluctuate every month. Businesses and consumers do not want to be exposed to unnecessary currency risks when transacting in cryptocurrency – one of the major reasons why cryptocurrency has not found its way into mainstream transactions.

 

Price volatility also hinders blockchain-based loans, derivatives, prediction markets, and other long-term smart contracts that require price stability. If people paid mortgages in cryptocurrency, they might see their mortgage payments triple from month to month, which is far from ideal.

 

Moreover, most people do not want to speculate. They want to use cryptocurrency as a store of value, or as a substitute for traditional money, on a ledger that is not controlled by the financial institutions. This is why stablecoins, which provide the best of both worlds, have long been considered to be the holy grail of cryptocurrencies.

 

 

What are the different types of stablecoins and how do they work?

 

Algorithmic Stablecoins

 

The first credible stablecoin proposal was made by Robert Sams in a 2014 paper entitled, ‘A Note on Cryptocurrency Stabilisation: Seigniorage Shares.’

 

The basic mechanism he described in his paper proposed creating a new coin, setting a peg, and then monitoring the price on the exchange. Sams’ proposal showed how all of this can be done algorithmically, in a decentralized way, with open source code that is visible and auditable by everyone.

 

To understand how the algorithm works, let’s look at a simple example. Let’s say you create a new currency and peg it to the U.S. dollar, which means 1 new coin is equal to $1.

 

If the price of your coin goes above $1, it indicates that the demand for your new coins is too high. The algorithm increases the supply of your new coin by printing more coins, until the demand meets the supply at the price peg.

 

If the price of your coin falls below $1, it indicates that there are too many coins in circulation and demand is lower than supply. The algorithm is programmed to contract the number of coins in circulation, until supply meets demand at the dollar price point.

 

Although Robert Sams never launched Seigniorage Shares, his influential paper built the foundation for a class of stablecoins called Algorithmic Stablecoins, also known as Non-Collateralized Stablecoins.

 

Because they are programmed with code that is openly auditable, this mechanism can generate a lot of trust in the currency. These are the most transparent, and decentralized stablecoins. The major drawback, however, is that handling a large contraction of coins can become difficult.

 

 

Fiat-collateralized Stablecoins

 

These are the most common type of stablecoins. They are pegged to fiat currencies like the U.S. dollar or the Euro, and usually backed at a 1:1 ratio, meaning that for each stablecoin in existence, there’s a fiat currency in a bank account.

 

Let’s look at the example of the most popular stablecoin, Tether, to understand fiat-backed coins. Tether is collateralized 1:1 with the U.S. Dollar, so 1 Tether is equal to $1.

 

The mechanism behind Tether is as follows: There’s a bank account for an exchange that trades in Tether, and for every Tether coin that is bought from the exchange, the exchange deposits $1 in the bank account. Traders can exchange their Tether coins and redeem their dollars directly from the exchange at any time.

 

The drawback of fiat-collateralized stablecoins is that they are not transparent or auditable by everyone. Therefore, users require trust in the operator to trade in these currencies, since there is no way to inspect whether the exchanges are following protocol or not.

 

One argument against fiat-backed stablecoins, although they are the simplest kind of stablecoins to understand, is that they limit the true potential of cryptocurrencies since they essentially act only as proxies for fiat currencies.

 

 

Crypto-collateralized stablecoins

 

These are stablecoins that are pegged to other cryptocurrencies. Since everything occurs on the blockchain, these currencies are much more transparent, have open source codes, and can be operated in a decentralized manner, unlike their fiat-backed counterparts. However, they are also more complex to understand, and therefore lack popularity.

 

Since cryptocurrency prices are subject to volatility, these stablecoins are often collateralized by a diversified reserve of cryptocurrencies that can sustain shocks and yet remain stable.

 

Another mechanism involves over-collateralization, which means the ratio of collateralization increases. For example, for a crypto-backed stablecoin that is pegged 1:2, for each stablecoin, cryptocurrency worth twice the value of stablecoins will be held in reserve. In other words, that stablecoin would be said to be collateralized at 200%.

 

This is done to ensure that the stablecoin prices remain stable. If the price of the collateral cryptocurrency falls by 25%, the stablecoins will still retain their original value, since the value of the collateral is still more than the value of the stablecoins.

 

If the prices of the collateral cryptocurrencies fall below a certain point, the stablecoins are programmed to automatically be liquidated to protect their value, thereby reducing risk for traders.

 

The most popular crypto-backed stablecoin is Dai, created by MakerDAO, whose face value is pegged to the U.S. dollar, but is collateralized by Ethereum.

 

 

Commodity-collateralized Stablecoins

 

These are stablecoins that are backed by stable assets, like precious metals, gold, real estate, and oil. This theoretically indicates to investors that these stablecoins have the potential to appreciate in value concurrent with the increase in value of their underlying assets, thereby providing an increased incentive to hold and use these coins.

 

Digix Gold (DGX), for example, is a stablecoin backed by physical gold, where 1 DGX represents 1 gram of gold. This gold is stored in a vault in Singapore and gets audited every three months to ensure transparency. The creators of DGX claim they have “democratized access to gold.” DGX holders can even redeem the physical bars of gold from the vault in Singapore.

 

 

How are stablecoins used?

 

1. Stablecoins are most popularly used to quickly switch between a volatile cryptocurrency and a stablecoin, while trading, to protect the value of holdings. For example, if a trader holds Bitcoins and expects its price to fall, they can almost instantly trade their Bitcoins for a stablecoin to protect their holdings.

 

Think of it this way: when markets are volatile, traders prefer to invest in stable assets like gold, or park them in treasuries. Stablecoins provide traders with a safe harbor, much like gold, which allows them to reduce their risk to crypto-assets without the need to leave the crypto ecosystem.

 

2. The main aim is for stablecoins to be widely used as currency for daily transactions in the future. As Lael Brainard, an American economist and member of the U.S. Federal Reserve’s Board of Governors, said last year, “Stablecoins aspire to achieve the functions of traditional money without relying on confidence in an issuer—such as a central bank—to stand behind the money.”

 

3. Stablecoins allow for the use of smart financial contracts that are enforceable over time. Smart contracts are self-executing contracts that exist on a blockchain network, and do not require any third party or central authority’s involvement.

 

These automatic transactions are traceable, transparent, and irreversible, making them ideal for salary and loan payments, rent payments, and subscriptions. For example, a business can set up a smart contract that automatically transfers stablecoins to its employees’ accounts at the end of each month.

 

4. In the event of a local fiat currency crashing, people can easily exchange their savings with USD-backed or Euro-backed or even gold-backed stablecoins, thereby preventing the further depreciation of their savings.

 

 

Limitations of stablecoins

 

1. In the case of fiat-backed stablecoins are centralized, which means that traders need to trust the exchange to ensure that the stablecoins are fully backed by fiat, even if they do not release audit results.

 

2. Fiat-backed stablecoins are constrained by the regulations of fiat currencies, which compromises the efficiency of their conversion.

 

3. If the economy fails, fiat-backed stablecoins will crash as well, since they’re pegged so closely together. This stands true for commodity-backed and crypto-backed stablecoins as well. Their values are dependent on their underlying assets.

 

Since cryptocurrency prices can fluctuate violently, crypto-backed stablecoins are more susceptible to price instability than other collateralized stablecoins.

 

4. Commodity-backed stablecoins are less liquid, meaning they are harder to redeem. If you want to exchange a stablecoin pegged to real estate in a different country, you have to go through a long and arduous process.

 

 

Future prospects

 

Over the last few months, the supply of stablecoins has been growing at an unprecedented rate, and the overall volume of stablecoins is expected to increase over the next few months, especially with new players like Libra entering the space.

 

There’s a strong expectation that stablecoins will pave the way for cryptocurrencies to become mainstream. Moreover, with a huge unbanked and underbanked population globally, and people and businesses looking for faster, easier, and cheaper ways of sending payments across borders, stablecoins have huge potential for growth.

 

Header Image by Michelle Henderson on Unsplash

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