Stablecoins: Heroes or Villains of the Blockchain?

Shining Light On These Crypto Misfits

There’s a strong argument to make that humans are wired to take sides. That no matter the topic, we enjoy nothing more than having a line drawn in the sand that demands we pledge our allegiance, one way or the other.?

Heads v Tails. Barcelona v Real Madrid. DC v Marvel.?

This is especially true with stablecoins. For every person who sings their praise another condemns their existence. Are they heroes or villains in the world of blockchain? Here we will give a brief and simple explanation of what stablecoins are and what purpose they serve.?

What is a Stablecoin?

Put simply, a stablecoin is a cryptocurrency that tries to maintain relative stability by pegging (or tying) its value to an external source. There are four different ways they can do this: by pegging their value to a fiat currency (currency-backed), a commodity such as gold (commodity-backed), another cryptocurrency (cryptocurrency-backed), or even an algorithm built into the blockchain (algorithmic).

Types of Stablecoins

1. Currency-backed Stablecoin

2. Commodity-backed Stablecoin

3. Cryptocurrency-backed Stablecoin

4. Algorithmic Stablecoin

Why were Stablecoins created?

Okay, imagine for a second that the world of financial exchange is like the animal kingdom, and that anything that can be exchanged in this world is represented by an animal. At one end of the spectrum you have animals like cows and sheep and horses; animals that live structured, repetitive lives, and whose behaviours are considered mild at best. These animals would represent things like gold or oil or the Australian dollar. At the other end of the spectrum you have animals like lions and bears and sharks; animals that are unpredictable in their behaviour and, potentially, deadly to encounter (for your investments, that is). These animals would represent cryptocurrencies.?

Now, if you’re an investor who enjoys the high risk that comes with trading cryptocurrencies then no doubt you’ll have little issue with their behaviour. But what if you wanted to use your cryptocurrency, say, for the daily purchase of goods and services? Would you muster a pride of lions to plough your fields, week in week out, or expect a bear to produce a certain amount of fur each month? Probably not. The unreliability of these animals would surely spell disaster for your enterprise. In the real world you don’t want to drive to the supermarket to find that, due to a sudden change in the value of a cryptocurrency, milk costs five times more than when you left the house. This is why stablecoins were created. The idea was to have a coin that offered all the benefits of a cryptocurrency but with the relative stability of, say, a fiat currency.?

How do Stablecoins work?

The first three types of stablecoins (from the list above)? work in a similar way so we’ll just illustrate how a currency-backed stablecoin works. In the case of a currency-backed stablecoin, for it to function its value must be pegged to a fiat currency. But, it’s not as simple as saying “one of my coins is equal to one Australian dollar.”? For the relationship to have integrity and for others to show trust in your coin you must hold an equivalent amount of the fiat currency in your own reserves. For example, if you want to release 500 coins you must hold $500 AUD as a way to vouch for the stablecoin. In the world of cryptocurrency this is known as staking. Because the value of fiat currencies tends not to fluctuate much, people are more likely to trust this type of stablecoin.?

How are algorithmic stablecoins different from the rest?

Algorithmic stablecoins, on the other hand, are different in that they are backed by an on-chain algorithm. This algorithm allows a change in supply and demand between the stablecoin and another cryptocurrency that props it up. To illustrate how they work we’ll return to Emma the farmer, who helped us explain blockchain oracles in our last article.?

On Emma’s farm is a grain silo. Inside the silo is a level which marks the optimum amount of grain for the silo to hold. Now, instead of an algorithm, imagine that Emma has a mechanism set in place to maintain this level. If Emma finds she has too much grain for the silo the mechanism releases grain until the amount drops back to the level mark. Conversely, if the amount of grain drops below the level the mechanism must add grain until the level is reached. In the real world the algorithm would burn and mint both the stablecoin and cryptocurrency accordingly to maintain this level.?

The issue with this type of stablecoin is that it is a lot more susceptible to abrupt changes in the market, changes that can’t be remedied quickly or easily. In Emma’s case, if the level moves sharply in one direction (for example, if the level were to drop drastically due to a poor harvest) it’s unlikely that she’ll be able to quickly restore the grain amount to its optimum level. In the real world, if the algorithm is unable to cope with sudden and extreme market behaviour then the stablecoin will be de-pegged, meaning it will lose its value and no longer be tied to the other cryptocurrency. This will spell disaster for the future of that coin as investors will question its integrity and effectiveness. A recent example of this was Terra’s UST stablecoin de-pegging from the cryptocurrency LUNA.?

Despite the obvious flaws in algorithmic stablecoins, flaws that will no doubt be removed in the future, there is still plenty to be optimistic about when it comes to these coins. The fact that users will only need one crypto wallet to send crypto to international bank accounts, removing the need for currency conversion (including the time and monetary costs involved with this method), is an appeal that has universal and lasting value. For now, though, it seems the jury is still out on whether stablecoins are heroes or villains. One thing's for sure is that in time we’ll have a better idea on which side to choose.?