A Quick Guide to Stablecoins

When Facebook has finally unveiled its cryptocurrency project called Libra, a lot of spotlight has been brought to stablecoins. In fact, we can argue (and this is stated in the whitepaper) that Libra is a stablecoin as well.

Yet, it appears that there is an educational gap here as many people don’t know what a stablecoin is, what’s the use case for it and why they have been introduced in the first place. More importantly, is Libra any different in the context of other (stable)coins available in the market right now?

About this and more – in this quick guide. 

So What is a Stablecoin?

A stablecoin is a type of cryptocurrency that is designed to maintain a stable market price, and hence mimic traditional, stable currencies (of course, we can always argue about their stability). 

In other words, a stablecoin is a cryptocurrency that is collateralized to the value of an underlying asset. Many stablecoins are pegged at a 1:1 ratio with certain fiat currencies, such as the USD or EUR, which can effectively be traded on exchanges. Other stablecoins can be pegged to other kinds of assets, such as precious metals like gold, or even to other cryptocurrencies. 

Why Stablecoins?

The main idea behind stablecoins is to provide some of the advantages of both fiat and cryptocurrency worlds. Currently, stablecoins are mostly used as a hedge against the high volatility of cryptocurrency markets, but depending on the context, they can also be used as a stable currency that provides increased transparency and decentralization. Also, when compared to traditional fiat currencies, they present faster transactions and lower fees - making them quite useful for everyday payments and international transfers.

Stablecoin is a type of cryptocurrency that is designed to maintain a stable market price, and hence mimic traditional, stable currencies.

Further, people in underbanked communities, for example, can transact using this form of digital currency, especially if they live in areas where economic uncertainty is a regular concern. This form of digital money allows for the use of a global currency that is, in theory, not subject to localized laws and conditions. 

Different Types of Stablecoins

There are 4 main types of stablecoins – fiat-collateralized, commodity-collateralized, crypto-collateralized and non-collateralized.

Let us quickly go through each of the type.

FIAT-COLLATERALIZED STABLECOINS 

This is the most common and simple type of stablecoins, which is backed by fiat currency such USD, EUR, or GBP. Fiat-backed stablecoins are backed at a 1-to-1 ratio, meaning that 1 stablecoin is/should (always) equal to 1 unit of currency (like a dollar). Effectively, for each stablecoin that exists, there is real fiat currency being held in a bank account to back it up (at least, in theory).

When someone wants to redeem cash with their coins, the entity that manages the stablecoin will take out the amount of fiat from their reserve and it will be sent to the person’s bank account. The equivalent stablecoins then have to be destroyed.

Most notable examples include Tether (USDT), TrueUSD (TUSD), Paxos Standard (PAX) & Gemini Dollar (GUSD) – the world’s first regulated cryptocurrencies.

COMMODITY-COLLATERALIZED STABLECOINS 

Commodity-collateralized stablecoins are backed by other interchangeable assets, such as precious metals. The most common commodity to be collateralized is gold — yet, there are also stablecoins backed by oil, real estate, and baskets of various precious metals. 

Holders of commodity-backed stablecoins essentially hold a tangible asset that has real value — something most cryptocurrencies do not have. These commodities even have the potential to appreciate in value over time, which gives increased incentive for people to hold and use these coins. 

Most notable examples include Digix Gold (DGX) and SwissRealCoin (SRC).

CRYPTO-COLLATERALIZED STABLECOINS 

These are the most complex forms of stablecoins, and as the name states they are backed by other cryptocurrencies. 

To reduce price volatility risks, these stablecoins are often over-collateralized so they can absorb price fluctuations in the collateral. Crypto-collateralized stablecoins are decentralized, allowing processes to be even more trustless, secure, and completely transparent. There is no single entity controlling your funds. Moreover, they are often backed by multiple cryptocurrencies in order to distribute risk.

The most popular and promising example of a crypto-collateralzed stablecoin is Dai. Created by MakerDAO, Dai is a stablecoin that has a face-value pegged to USD, but is actually backed by ETH that is locked up in smart contracts. 

NON-COLLATERALIZED STABLECOINS

Non-collateralized stablecoins are not backed by anything, which might (and should) sound counterintuitive. 

These types of coins use an algorithmically governed approach to control the stablecoin supply. This is a model known as seignorage shares.  As demand increases, new stablecoins are created to reduce the price back to the normal level. If the coin is trading too low, then coins on the market are bought up to reduce the circulating supply. In theory, prices of these stablecoins would remain stable as they are driven by market supply and demand. 

This is the most decentralized and independent form of stablecoin, as it isn’t collateralized to any other asset. This means even if the US dollar and the entire crypto market crashes, this form of stablecoin would survive and stay stable. 

However, non-collateralized stablecoins require continual growth to be successful. In the event of a crash, there is no collateral to liquidate the coin back into, and everyone’s money would be lost. 

One such example of a non-collatorialized stablecoin is Basis, which algorithmically adjusts supply in order to keep its prices stable. It refers to itself as “a stable cryptocurrency with an algorithmic central bank.” 

Basis was shut down in December 2018 due to regulatory constraints.

What are the Real-World Applications?

There are quite a few real-world applications of stablecoins, but these are argued to be the most promising ones:

• Everyday currency. It can be used as an everyday currency for your purchase online – just like fiat.
• P2P payments. Making peer-to-peer payments is easier with stablecoins. You can use them on smart contracts to make payments automatically.
• Affordable & fast remmitances. Sending remittances oversears is much simpler with these coins. They are extremely fast and will have the same value as the fiat money.
• More security from currency crashes. As they are stable, you won’t have to worry about currency crashes while investing. Unlike other cryptos, their value almost doesn’t have any fluctuations.
• More stable cryptocurrency exchanges. Stabilizing the market, these coins can improve the overall nature of the crypto exchanges. No added risk, no unnecessary regulations.

What About Limitations?

As almost anything in life, stablecoins obviously have their own set of limitations. Some of the most notable ones are as follows:

• Centralization. Stablecoins have a centralized nature, which goes against the initial nature of cryptocurrency and blockchain per se.
• Trust. As they have centralized nature, people can’t fully trust the system. Hint: Tether.
• Regulations. Most of the coins have the same regulations as the fiat money, hence, this effectively clashes with the purpose of cryptos.
• Stability. Crypto-backed or commodity-backed stablecoins could easily become unstable due the quick changes in value. It is still unclear how they will be backed up if the value of the underlying assets would drop in the real world. 

Having all of this in mind, let me ask you this - will Facebook's Libra take the best of stablecoins, minimizing their limitations and improving strengths? Or will it be just another stablecoin fighting its way through the fiat world?

Would love to hear your thoughts in the comments below??????

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About: I am a business developer, sales professional, FinTech strategist, as well as Cryptocurrency and Blockchain enthusiast. I'm highly passionate about Financial Technology and Digital Innovation, and strongly believe that it will change the world for the better. Apart from my daily job at a global payments startup where I'm leading company's expansion into Europe , I'm an active member of FinTech community and a TechFin evangelist.

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