Insider Views

The evolvment of stablecoins – money of the future?

Cryptocurrencies are already well known, but the public opinion includes much skepticism concerning the high price volatility. For example, Bitcoin, the first cryptocurrency, is still considered as highly speculative by most investors. To tackle those problems, the concept of stablecoins evolved. The various types of creating a stablecoin all bear both potentials and risks to the success of the coin. Nevertheless, overall the potential outweighs the risks and creates the opportunity to replace FIAT money extensively in the long run.

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What makes a stablecoin a “stable” coin?

Cryptocurrencies are often said to be extremely volatile and speculative, which makes them inoperable for trade. Thus, the establishment of cryptocurrencies as a means of payment is hindered. The need for price stability, proper cryptocurrency accounting, payment methods, and non-speculative cryptocurrencies, leads to the concept of stablecoins. Stablecoins can briefly be defined as cryptocurrencies that are artificially stabilized or pegged to decrease volatility (see Figure 1). Technically, these coins work as a derivative of an underlying, which e.g. could be a FIAT currency (a currency issued by a government and not backed by a physical commodity) or a physical asset.1 This allows the mostly lower volatility of the assets to be transferred onto the stablecoins. Besides, stablecoins enable investors to exchange cryptocurrencies into traditional assets without leaving the crypto ecosystem.1 The currently most famous stablecoin is Tether, which is a FIAT-backed currency mirroring the US-dollar. Also, various digital versions of relevant FIAT currencies are discussed. Those require a stablecoin being pegged to the respective base currency if a blockchain-based solution is chosen.2

Theoretical price development of stablecoins

How a cryptocurrency turns into a stablecoin – stabilizing methods

To create a stablecoin the following three methods can be chosen: (1) FIAT-backed, (2) crypto-backed, and (3) uncollateralized.

FIAT-backed stabilization

The FIAT-backed stablecoin is hedged by off-chain assets, meaning, that users deposit one unit of the underlying asset and receive a stablecoin in return. Once a user returns the coin it is burned and the corresponding amount of FIAT currency is being paid out (see Figure 2). The advantage of this method is, that the coin replicates an asset, which is traded in a regulated market. Nevertheless, no deposit protection is in place and the issuer is obliged to guarantee the payback of the underlying asset.1 Since these liquid deposits pay low interest rates multiple issuers of this type of stablecoin face profitability problems.3 Examples of this stabilizing method are Tether, Digix Gold, Paxos Standard, TrueUSD, Gemini Dollar, and Stably.4

Crypto-backed stabilization

The second method, crypto-backed stabilization, technically represents the same process but with crypto-assets. This method, nevertheless, represents a soft peg, relying on a self-stabilizing mechanism, which enables investors to capitalize on arbitrage opportunities (i.e. one coin only costs 0.8 US-dollars but is worth one). The downside of this method is the need to overcollateralize the coins, since the underlying volatility may lead to a situation in which the collateral is not worth enough FIAT anymore. Therefore, the current minimum of collateralization is around 150%, which creates additional costs for users.3 Examples for this type of coin are DAI, Havven/Synthetics, and Bitshares.

Uncollateralized stabilization

The uncollateralized or algorithm method leverages an algorithm, stabilizing the coin by buying or selling the coin itself and thus increasing or decreasing the coin’s supply. This mechanism leads to a rather stable price of the coin.1 The buying of coins is processed by the issuance of crypto bonds paid for with coins, the selling by burning the coins3(see Figure 3). Since no collateral is included in this method over-collateralization is prevented, nevertheless, due to lagging corrections of the coin supply the volatility is higher.1 Not being able to sell the crypto bonds would lead to a breakdown of the peg and leave the stablecoin useless. Basis, Nubits, which both recently have been closed, CarbonUSD and Reserve are prominent examples of this type.3

Algorithmic stabilization