What is a Stablecoin? The Safe Harbours of the Digital World

What is a Stablecoin?

The world of cryptocurrencies is famously known for its high volatility. A crypto asset that soars by 20% one day can plummet by the same amount the next. This dramatic fluctuation is the biggest hurdle preventing cryptocurrencies from being used for everyday transactions or as stable financial instruments. So, is there a way to navigate these turbulent waters without getting caught in the storm? The answer lies with stablecoins.

A stablecoin, as the name suggests, is a “stable” cryptocurrency. Unlike volatile assets such as Bitcoin or Ethereum, its price is pegged to a specific, stable asset, typically a fiat currency like the US dollar or a commodity like gold. This pegging mechanism ensures that a stablecoin’s value remains closely aligned with its underlying asset. As a result, users and investors can leverage the convenience of digital transactions while being protected from the risk of sudden value drops.

Why Do We Need Stablecoins?

The emergence of stablecoins addresses a fundamental need within the crypto ecosystem. We can summarise these needs in a few key points:

Escaping Volatility: During market downturns, crypto investors can convert their assets into stablecoins instead of cashing out, thereby protecting their portfolios.
Facilitating Global Transactions: Stablecoins offer a viable alternative to the slow and costly international money transfers of the traditional banking system. Their low-cost and high-speed transfers facilitate global trade.
Backbone of DeFi (Decentralized Finance): DeFi platforms offer financial services like lending, borrowing, and yield generation in a decentralized manner. The need for a stable unit of value on these platforms makes stablecoins the backbone of DeFi.
Everyday Payments: Using Bitcoin for daily purchases, like buying a coffee, is risky due to price volatility. Stablecoins, with their price stability, become an ideal medium for such payments.

Types of Stablecoins: How Is Price Stability Maintained?

Stablecoins use different mechanisms to ensure price stability. Based on these mechanisms, they can be categorised into three main groups.

1. Centralized Collateralized (Fiat-Backed) Stablecoins

These stablecoins are backed by reserves of fiat currencies like the US dollar or Euro, or by government bonds. For every stablecoin issued, an equivalent value of the underlying asset is held in reserve. The most popular examples are USDT (Tether), USDC (USD Coin), and BUSD (Binance USD).

How They Work: For example, when 1 USDC is minted, a centralised entity (like Circle) deposits 1 USD into a bank account. This guarantees that 1 USDC will always be worth 1 USD. In this system, trust is placed entirely in the central authority’s honest management of its reserves.
Advantages: They have a simple, straightforward, and generally reliable structure.
Disadvantages: As they are centralised, they are subject to banking oversight and regulations. Questions about their transparency can occasionally arise.

2. Crypto-Collateralized Stablecoins

These stablecoins hold other cryptocurrencies like Bitcoin or Ethereum in their reserves instead of fiat money. While using volatile assets to ensure stability might seem paradoxical, this system relies on the principle of over-collateralization. The best-known example is DAI.

How They Work: To create $100 worth of DAI, the system might require locking up $150 worth of Ethereum (or another crypto). If Ethereum’s price drops and the collateral’s value falls below a certain threshold, the system automatically liquidates the collateral. This mechanism helps to maintain the stablecoin’s value.
Advantages: They are not tied to a centralised authority; they are transparent and decentralized.
Disadvantages: They require over-collateralization, which makes them capital inefficient. The system’s balance can be disrupted by sudden and sharp drops in crypto markets.

3. Algorithmic (Non-Collateralized) Stablecoins

These stablecoins are not backed by any assets. Price stability is maintained through complex algorithms and smart contracts. The core principle of the system is to balance supply and demand.

How They Work: When the price of an algorithmic stablecoin falls below $1, the algorithm reduces the supply by buying back the stablecoins from the market, causing the price to rise. When the price goes above $1, new stablecoins are minted to increase the supply and bring the price down. The system works through a mechanism known as “seigniorage.” TerraUSD (UST) was the most well-known and tragically collapsed example of this type.
Advantages: They are fully decentralized and highly capital-efficient as they do not require any collateral.
Disadvantages: They are the riskiest type of stablecoin. The algorithmic mechanism can fail to cope with extreme market volatility, leading to a collapse known as a “death spiral.” This is why many algorithmic stablecoin projects have failed.

The Future and Risks of Stablecoins

Stablecoins have the potential to act as a bridge, connecting traditional and digital finance. However, this technology faces significant regulatory and security risks.

Regulations: Governments and financial regulators have begun introducing regulations to control the potential risks associated with stablecoins (e.g., money laundering, terrorist financing). These regulations will shape the future of the industry.
Security and Transparency: The transparent auditing of the reserves of centralized stablecoins is crucial for building user trust.
Systemic Risks: The failure of algorithmic stablecoins poses systemic risks that could have a domino effect throughout the entire crypto ecosystem.

In conclusion, stablecoins offer an innovative solution to the volatility problem of cryptocurrencies. Although they are called the safe harbours of the crypto world, each type has its own unique risks and advantages. Investors and users must understand these differences to make informed decisions. With the right regulations and solid foundations, this technology could grow further and play a significant role in the future of finance.