Beginner Series

What Are Stablecoins?

Stablecoins are cryptocurrencies that are ‘pegged’ to fiat currencies like the US Dollar. These stablecoins are freely transferable just like cash, as anyone on the blockchain network can receive and send the coins. Everyone can participate, including the unbanked population. 

The management consulting company, McKinsey, estimates that the traditional financial system makes $2 trillion annually from facilitating payments. Stablecoins can cut these costs down dramatically, which could free that money to be spent elsewhere in the economy, such as on healthcare, education and scientific research. 

Already, more than AU$1.8 billion worth of stablecoins have been issued and are trading on blockchain networks. They are facilitating near-instant settlement of payments, swapping between cryptocurrencies, remittance payments, and much more. 

Contents

  • Why have stablecoins become so popular? 
  • How do stablecoins work?
  • What is the future of stablecoins?

The most used stablecoin, Tether, has a market cap of AU$90 billion as of August 2021. This makes it the fifth-largest cryptocurrency. Not far behind, with the ninth-largest market cap, USD Coin has an AU$37 billion market cap. They play an important role in the crypto economy, with multiple advantages over both fiat currencies and other cryptocurrencies. 

1. Fiat currencies aren’t crypto native

Fiat currency isn’t crypto native, which means it can’t be sent over blockchains or used in DeFi. The Australian Dollar is stuck in bank accounts controlled by centralised institutions, while stablecoins can be used in Smart Contracts on a DeFi platform.

2. Smart contracts in DeFi

Stablecoins offer a stable asset that investors can use to generate yield in the DeFi market. For example, you can deposit a stablecoin into a DeFi protocol, which then lends your stablecoins out for you to receive a yield. 

3. Trading pair for other cryptocurrencies 

For traders frequently moving in and out of different cryptocurrencies to take advantage of short-term opportunities, stablecoins make this process easy. While there would be a tiny market for people swapping RUNE for DCR directly, they are both highly liquid when using stablecoins. Moreover, some traders choose to sit in stablecoins if they think the market is headed for a downturn. 

4. Remittance payments to families

While other remittance payment systems like Western Union can have expensive fees, stablecoins are a cost-effective way for people to send money to their families abroad. As more and more cryptocurrency exchanges are established, they make it easier for people to exchange stablecoins for their local currencies or use them directly for payments. 

5. Protection from local currencies inflation

While there are many in the United States fearing that the US Dollar will inflate and lose its value, it’s still far more stable than many other local currencies. For example, the Venezuelan bolívar inflated so fast that many Venezuelans could not afford food because their savings had depleted so fast. While many Venezuelans turned to bitcoin and saw their wealth grow and some protection from hyperinflation, stablecoins offer another popular solution. As most Venezuelans cannot access US dollars through a local bank, stablecoins can be an alternative. 

6. Stable unit of account

As cryptocurrency has been an incredibly volatile asset class, there is enormous value for traders to have an asset that holds a consistent value. Moreover, they’re an effective unit of account for traders, which is appreciated at tax time. 

How do stablecoins work?

There are three types of stablecoins; stablecoins backed by real-world reserves, stablecoins collateralised with cryptocurrencies, and algorithmic stablecoins. While they are all used as fiat replacements that function in the crypto economy, and could be used interchangeably, they all work differently.

1. Real-world reserve backed stablecoins

A reserve backed stablecoin like USDC is backed by real-world assets, usually cash in a bank. That means that a stablecoin pegged to the US dollar can literally be redeemed for exactly one dollar. So if you have a million USDC stablecoins in your crypto wallet, you can redeem them for one million US dollars sent to your bank account. Popular reserve backed stablecoins include Tether (USDC) and USD Coin (USDC).

Ultimately, this means that you’re trusting the company that runs the stablecoin. You’re trusting that they have kept the stablecoin fully backed so you can redeem your stablecoins for actual dollars. Although most people don’t actually redeem stablecoins themselves, they buy and sell them through cryptocurrency exchanges like Cointree.

These types of stablecoins keep their peg using market incentives. For example, if the peg falls below $1 to 80 cents, then traders will buy the stablecoin knowing they can redeem it for $1 and pocket a 20 cent profit on every stablecoin they purchase. If the price rises above $1 to $1.20, holders sell the stablecoin as the price is above its intrinsic value of $1, again, giving the trader a 20 cent profit. 

2. Collateralised with crypto

Instead of being backed by dollars, some stablecoins are backed by other currencies like bitcoin rather than fiat (government currencies). In every other way, they work the same as reserve backed stablecoins. 

3. Algorithmic

Algorithmic stablecoins aren’t backed by anything. Instead, coins are either burned or created according to an algorithm that keeps the value pegged to the fiat currency. For example, if the market price for an algorithmic stablecoin drops from its target of $1 to $0.75, then it will burn coins until the price increases back to $1. The platform Terra (LUNA) is designed to support algorithmic stablecoins.

What is the future of stablecoins?

“The writing is on the wall: Cryptocurrencies are likely going to play a significant role in the future financial system,” reported the Harvard Business Review.

“To economists, the benefits of stablecoins include lower-cost, safe, real-time, and more competitive payments compared to what consumers and businesses experience today. They could rapidly make it cheaper for businesses to accept payments and easier for governments to run conditional cash transfer programs (including sending stimulus money). They could connect unbanked or underbanked segments of the population to the financial system,” they wrote. 

The innovation of stablecoins offers an incredible opportunity for cutting edge DeFi projects as well as for the unbanked population. It’s clear that blockchain-based stable currencies are going to be a key part of our financial system moving forward.