Following the announcement of New York’s Department of Financial Services on the approval of the Gemini Dollar and the Paxos Standard as stablecoins, there is much hype over the role and benefits of stablecoins.
One of the most striking differences between cryptocurrency and fiat currencies is with volatility. Namely, cryptocurrencies experience huge price swings. These price swings are what make cryptocurrencies attractive for some as there is a lot of money to be made due to volatility. But these price swings also pose a huge risk for investors, as they may be surprised to find that the value of their crypto-portfolio slashed by 20% just overnight. This example highlights one key principle outlined by MakerDAO:
“For there to be a modern financial system on the blockchain, there needs to be a stable medium of exchange, a truly stable currency.”
This principle is what stablecoins try to adhere to. In effect, stablecoins aim to have a stable price. Their goal is to create a currency whereby prices would change little, or ideally none, over time in relation to a pegged asset.
The Design of Stablecoins
There are several approaches for stable-coin design, it can be simplified with this graphic as noted by Haseeb Qureshi:
This is the most straightforward way to create a stable currency. A certain amount of real world asset is deposited as a collateral and stablecoins are issued against this asset, usually at a pre-determined rate. Although this method is simple and robust, it requires a custodian which guarantees the issuance and redeemability of the stablecoin. Regular audits are needed to ensure that the stablecoin is indeed fully collateralized. This allows assets such as fiat currencies, gold, oil, and others to be used as collateral.
These are similar to their off-chain counterparts, but the collateral is another cryptocurrency. To account for the price-volatility of the underlying crypto-collateral, these stablecoins are often over-collateralized. This means that it takes $200 worth of ETH to receive $100 worth of stablecoins in return. In this case, even if the price of the underlying asset depreciates by 20%, the stablecoin can still keep its price stable as there are still $160 worth in ETH collateral backing the value of the stablecoin. However, in case of a black swan event, where the underlying asset becomes completely worthless, the stablecoin would collapse too. In this case the loss-exposure would even be amplified for the stablecoin owners because of the over-collateralization. This is also why some experts are strongly discouraging this approach.
With no collateral, these are not actually “backed” by anything other than the expectation that they will retain a certain value. One often-mentioned solution to non-collateralized stablecoins is the seigniorage shares approach. This concept builds on smart contracts that algorithmically expand and contract the supply of the price-stable currency much like a central bank does with fiat currencies, but in a decentralized manner.
3 Benefits of Stablecoins
- Serves as an on-ramp and off-ramp to crypto
- Offers better market liquidity
- Potential backbone of a blockchain-integrated economy
Having a stable cryptocurrency allows for some material benefits to the market. One of the most important benefits for stablecoins is it serves as an on-ramp and off-ramp to cryptocurrencies. Because of their stable price, these stablecoins can protect investors from rampant volatility in the crypto space. It is not uncommon to see an increase in the use of stablecoins whenever a huge price loss is expected to happen, or even in a bear market. One side-effect of stablecoins is that they allow traders to enter or exit the market despite a government ban. For example, despite China’s tightening control over cryptocurrency trading, there are reports of Chinese traders using VPNs and the stablecoin “Tether” to continue crypto-trading activities.
Stablecoins also allow for better market liquidity, especially when making an intra-exchange trade. This is possible because stablecoins are essentially digitized versions of fiat value, allowing exchanges to quickly settle balances using stablecoins.
But more than that, stablecoins hold great promise in the future of a blockchain-integrated economy. Much like how the US Dollar maintains a degree of stability and is used for daily transactions, stablecoins hope to become a medium of exchange that can be used for daily transactions. A stable stablecoin can even serve as the backbone of a blockchain-based lending system, once the system supports it. All in all, there are currently some major developments on stablecoins, with focus on the seigniorage shares category of stablecoins.