They’ve gone through several junctures and been the subject of many debates since their beginnings, but will this new wave of popularity make 2019 the year of the stablecoin?
What are stablecoins?
A stablecoin, as the name suggests, is a cryptocurrency whose rate can theoretically be tied to a fiat currency and – as a result of this backing – it will not experience the same significant exchange rate fluctuations as other cryptocurrencies tend to experience on a daily or even hourly basis. The first mention of the term stablecoin was way back in 2014, and there have been several iterations, and many different opinions about this new asset class since then.
Use-cases for stablecoins
Stablecoins have various purposes in trading and market predictions. In trading, for example, on regular, and especially on decentralized crypto exchanges, it is necessary to have a stable tool to preserve the value relative to fiat currencies. Another function is that lower fluctuation rates make stablecoins a more reliable asset for loan rendering as well as payments or repayments.
It may also be more secure to use stablecoins as a store of value in countries where there are various fiat currency restrictions. And for cross border transfers, for example, there is a lower risk of volatility than that associated with conventional cryptocurrencies like bitcoin or Ether.
How pegging works
While most stablecoins are pegged to a fiat currency, there are other methods to achieve a stable exchange rate. The reason that most stablecoins are still pegged to fiat however, is that it remains the easiest way to ensure that the exchange rate is fully secured in the required fiat currency. If you want to get stablecoins pegged to the U.S. dollar, for example, then for every coin issued, you should keep the same amount of dollars under collateral. Some US dollar-backed stablecoin examples include TrueUSD, Gemini Dollar, and of course, Tether.
Tether claims to be backed by the US dollar despite several sources doubting the validity of this claim and continues to be surrounded by controversy. Tether was designed to always be worth $1 USD, meaning that it supposedly maintains reserves of $1 USD for every Tether produced (changed to $0.74 in March). However, neither the crypto industry nor regulators have seen sufficient evidence of a transparent audit that proves this to be the case.
As we mentioned, there are more complex ways to achieve rate stability for stablecoins. With the help of smart contracts, for example, which control baskets of cryptocurrencies, so that when a certain exchange rate is exceeded, the smart contract automatically sells off a part of the portfolio. Then, when the rate falls, the smart contract buys those cryptocurrencies back. At the same time, they have more crypto in collateral than the released stablecoins, in order to avoid “rate sagging”.
An example of this is DAI, a decentralized stablecoin on the Ethereum blockchain. Unlike stablecoins backed by fiat, DAI is backed by cryptocurrency collaterals, maintaining its stability and following global market conditions, without a centralized authority.
With DAI, the trader stakes Ether as collateral, but they must issue DAI to the amount that they have 150% collateral rate as a minimum. The rate is then evaluated by a decentralized oracle provided by MakerDAO, that is regularly fetching rates from centralized exchanges. Then, if the rate of ETH drops, for example, the trader should repay the DAI loan or add collateral. However, the trader can also choose to do nothing. In this case, they won’t be able to get their collateral back. MakerDAO will soon be launching a multi-collateral contract to issue DAI, where traders will be able to stake not only ETH, but other assets to get a DAI loan.
Other stablecoins (like Synthetix) which are algorithmically collateralized, and also “hybrid” stablecoins are now also coming to the fore. The recent release of the Facebook cryptocurrency “Libra”, deemed a fiat-backed stablecoin by the company, has opened up the debate on a greater scale as to what warrants the term “stablecoin”, and how this asset actually functions.
Less risky, but not risk-free
Stablecoins could be considered as a hedging mechanism for traders interested in cryptocurrencies, but who are in the market for less risk-averse assets. However, it should be understood that stablecoins are not risk-free instruments and carry various levels of risk for the trader or the owner, regardless of their backing.
If a stablecoin is backed with a pledge in fiat currency, for example, it bears the risk of funds being blocked in financial institutions. If this happens, the price of that stablecoin could collapse. And of course when stablecoins are backed by a portfolio of crypto assets, there is always the chance for smart contracts hacks. The other risk is that the value of the crypto assets being held as collateral may fall dramatically, which will then lead to a reduction in the cost, or potentially an almost complete zeroing in the case of a big panic in the market.
All this being said, all asset trading – traditional stock trading included – has a certain amount of risk attached to it, so it will be interesting to watch the trajectory of this new wave of stablecoins in the market in terms of trading, saving, and payment mechanisms, as major companies both inside and outside of the cryptocurrency industry embrace the latest stablecoin trend.