The emergence of Stablecoins

Stablecoins are highly topical in the digital investments and blockchain industry currently. Whether you are scrolling through LinkedIn or browsing articles on the internet, almost daily, there is an article or press release containing information regarding Stablecoins. Often highlighted by headlines about countries or communities investigating the potential use cases of and/or the investment into the development of Stablecoins. The reaction I have found most common is that these are often not read and rather avoided, stemming simply from the apprehension caused by the lack of confidence in the ability to understand the concept. This article aims to unpack the basics of what a Stablecoin is, how it works, the problems they aim to solve, and the opportunities that these present.

What is a Stablecoin?

These are a?class or type?of cryptocurrency (digital currency), which its value is?pegged?to another “stable” reserve asset or asset class. These are designed to reduce?volatility?relative to unpegged cryptocurrencies such as Bitcoin, by aiming to stabilise its price.

To put this into context, the difference between a physical US Dollar and a stable coin that is pegged to the US Dollar is that the stable coin lives in the crypto realm – meaning that the Stablecoins exist on public blockchains like Ethereum.

The principal reason for creating a Stablecoin is to protect investors in times of volatility. They bridge the world of cryptocurrency and everyday fiat currency because their prices are pegged to a reserve asset like the US Dollar or gold. This combination of traditional-asset stability with digital asset flexibility has proven to be a popular way to store and trade value in the crypto ecosystem. The demand for Stablecoins was driven by traders who wished to “lock in” profits by shifting value from volatile assets into stable ones?without?the need to interact with the traditional financial system.

Understanding Stablecoins and what you can do with them:

Stablecoins are open, global, and accessible to anyone with an internet connection (24/7). They are fast, cheap, and secure to transmit as well as being digitally native to the internet and are programmable.

These allow you to:

1. Minimize volatility: for means of exchange, people can trade in cryptocurrencies such as Bitcoin and hold profits in Stablecoins which reduces the purchase price risk associated with transacting in unpegged cryptocurrencies.
2. Trade or save assets: without the need for a bank account to hold these Stablecoins, they are easy to transfer around the globe, including places where that specific pegged currency may be difficult to obtain. In addition to this, these can be used as an alternative store of value where the local currency may be unstable.
3. Transfer internationally at low costs: fast processing and low transactions fees allow for Stablecoins to be a good choice for sending money anywhere in the world at a fraction of the cost of a traditional system.

What are the types of Stablecoins?

Stablecoins are distinguished into two groups. The first is collateralised (centralised) and then secondly those that are non-collateralised (decentralised).

Firstly, Collateralised (“backed”) Stablecoins that are tied to an external value which could be in the form of fiat currency, another cryptocurrency, or an asset. Inherently, as it is pegged to an external form of value, in theory, it provides stability.

Under this group of Stablecoins, there are three categories of collateralised Stablecoins

-?Fiat backed:?these are centralised as a result of them being launched and governed by a central organisation, which could be either a company, a bank or even a government. Fiat-backed Stablecoins are backed 1:1 by fiat currencies which are stored in bank accounts. The risk here is that trust is required that there are sufficient fiat reserves that act as a deposit guarantee.??

-?Cryptocurrency backed:?these are arguably the most controversial type of collateralised Stablecoins as they use other cryptocurrencies to keep their value stable. These are a relatively new type of Stablecoin that don’t have a central operator but are governed by a consensus of the users who take part in the network. An example of this is Maker DAO’s Stablecoin – DAI, where users lock up a certain amount of cryptocurrencies, such as Ethereum, as collateral (often over collateralised) for borrowing DAI – which is pegged to the US Dollar. These are over-collateralised through a larger amount of cryptocurrency tokens being maintained as a reserve for issuing a lower number of Stablecoins, due to the reserve cryptocurrency also being prone to volatility.

-?Asset-backed:?these cryptocurrencies peg their value to an external good, like gold, to keep their value stable. (G Coin | A new way to own gold | Responsible Gold?– is an example of an asset-backed stable coin)

Secondly, Decentralised or non-collateralised algorithmic Stablecoins:

- These do not use any reserve but include a working mechanism, as they are not linked to any external value and rather use algorithms to avoid price fluctuations. In these models, the blockchain itself controls the currency’s volatility by using algorithms and smart contracts. These are also a relatively new type of Stablecoin, an example being USDX (?USDX Wallet | Quick no-fee transfers in stablecoin) which uses algorithms to keep the price of the token pegged to the dollar to control its stability. These are recognised as being decentralised as they are governed by smart contracts.

Central Banks Digital Currencies (CBDCs) vs Cryptocurrency:

What are CBDCs?

Central bank digital currencies are digital tokens, similar to cryptocurrency, issued by a central bank. They are pegged to the value of that country's fiat currency. Many countries are developing CBDCs, and some have even implemented them. Because so many countries are researching ways to transition to digital currencies, it's important to understand what they are.

A central bank digital currency (CBDC) is a digital extension of a central bank’s medium of exchange, able to permanently settle transactions between parties. The central bank can remove credit risk and ensure stability by guaranteeing the value of the CBDC, exactly like paper money. And any person tied to any central bank on the network can instantaneously transfer value between any other person tied to any other central bank on the network. (IE: Peer-to-peer capability)

The introduction and evolution of cryptocurrency and blockchain technology have created further interest in cashless societies and digital currencies. Thus, governments and central banks worldwide are?exploring the possibility?of using government-backed digital currencies. When they are implemented, these currencies will have the full faith and backing of the government that issued them, just like fiat money.

The following are important attributes of a CBDC:

• A central bank or central monetary authority issues CBDCs
• The central bank or issuing monetary authority backs the CBDC
• CBDCs are easily transferrable through peer-to-peer formats
• They are practically programmable for any use case
• CBDCs are considered the legal tender
• Central bank digital currency is pegged against a fiat currency

What are the benefits of CBDCs?

CBDCs offer notable benefits to central governments. They will be significantly more efficient than the current clearing and settlement systems, and there’s an opportunity to reduce the costs of minting physical money. CBDCs will also ease the process of allocating payments to citizens.

They could also lower the cost of interbank and cross-border remittances and even help to promote financial inclusion. It may be easier for an individual to acquire a CBDC account on a blockchain than a traditional bank account.

What are the drawbacks of CBDCs?

Banks will want to ensure that any CBDC is resilient enough to withstand cyberattacks. The idea that hackers could launch a 51% attack and start double-spending digital versions of fiat currencies would be unthinkable. Similarly, governments will want assurances that CBDCs don’t introduce any new risks of digital cash being used in money laundering or other illicit activities.

However, these security and crime prevention measures need to be balanced against legitimate privacy concerns. If all of an individual’s financial transactions can be tied back to their account on a blockchain, then CBDCs will severely degrade the relative anonymity with which an individual can transact in physical cash. In turn, these privacy concerns may hamper adoption. This can be seen as both a benefit and drawback, depending on the audience. And inevitably, the use of cash is slowly being phased out as means of payment. However, privacy concerns are still something to bear in mind.

How do these differ from Cryptocurrencies?

Though the idea for central bank digital currencies stems from cryptocurrencies and blockchain technology, CBDCs are not cryptocurrencies. CBDCs are controlled by a central bank, whereas cryptocurrencies are almost always decentralized, meaning they cannot be regulated by a single authority.

Despite a long-standing association with cryptocurrencies, CBDCs don’t share many characteristics with?Bitcoin. Bitcoin is based on?blockchain technology. New bitcoins are created as a reward for miners, to incentivize them to continue confirming blocks of transactions. The network of bitcoin miners is decentralized and public, so anyone can join and start?mining bitcoins, providing they have the right equipment.

Bitcoin is also a deflationary currency. The issuance of new bitcoins is programmed to decrease over time, which helps to drive the value through scarcity.

In contrast, a?CBDC?simply refers to a digital currency issued by a central bank. It doesn’t need to be based on a blockchain or any kind of distributed ledger, although it may be in some cases.

CBDCs are foreseen to act as a complement to, or replace, physical cash with digital equivalents. Therefore, their issuance will be subject to the control of central banks in the same way as fiat currencies. It inevitably follows that their value will be determined by the value of the national currency.?Research?into CBDCs has examined one of the possibilities of them being used purely as a form of a means of settlement between central banks, without issuing the currency for public use. However, we are only at the beginning stages of the development of these CBDCs, and the use cases and possibilities are constantly evolving. There is undoubtedly a long road ahead, with plenty of work and many more developments to come.

Despite the risks and concerns, the increasing likelihood of CBDCs is undoubtedly bullish for the broader cryptocurrency markets. Central banks adopting?digital assets?is a ringing endorsement of the technology, indicating that it’s here to stay for the long term.

Furthermore, the very fact that CBDCs may mean some compromises on privacy is likely to create even more value for?BTC, given that it will remain decentralized and pseudonymous. Overall, it seems likely that we’ll see a future where CBDCs and established cryptocurrencies can exist side-by-side, each contributing to a financial system that’s greater than the sum of its parts.

Keep following on our journey of unpacking the digital investments and blockchain space as we close the understanding gap.