Stablecoins

What Are Stablecoins? What's the Point?

Stablecoins serve an important role in the crypto ecosystem. They have their value pegged to the US dollar, other fiat currencies, or commodities. They're not much more than digital dollars. If you want the stability of fiat currency, but want to transact on a blockchain, your best bet is to use a stablecoin.

If you want to avoid the volatility that comes with crypto, stablecoins will solve that. Unlike actual US dollars, you can instantly transfer your ETH or BTC for a stablecoin such as USDC. To reduce your exposure to volatile assets via actual fiat cash, you have to cash out which is a much lengthier process (could be days) than it is to transfer to USDC (nearly instant).

If I'm selling a product or service online, I might want to list it in USDC as opposed to ETH. With ETH's volatility, I may be losing massive percentages of profit due to a price swing. With USDC, I'm always getting the same amount in dollars, which is how most of us think: in terms of dollars. You might think why not use real dollars then? Well, if I'm using real fiat dollars then I can't transact on a blockchain. At that point, I have to use Stripe or some other payment processor to accept payments and give away 4% of my sales in fees.

Also, I know it's not stable just because it's pegged to fiat. Fiat is definitely not stable as proven by massive inflation this year alone in 2022. However, crypto is even less stable than that.

Type of Stablecoins

Fiat-collateralized stablecoins

Centralized and backed by US dollars, Euros, or even debt via government bonds. This type is by far the most popular. This is how USDC operates. Each USDC is pegged to $1 and redeemable for such.

Assuming I created a fiat-collateralized stablecoin, the idea is that for every one of my stablecoins someone mints I take that dollar they gave me to mint it and I put it in my reserves. This way, when they come back and say I'd like to redeem this stablecoin, I can give them a dollar back and destroy their token. The issuer has no concerns over a bank run or liquidity issues as the reserves are fiat.

Commodity-backed stablecoins

Centralized and backed by gold, real estate, or other commodities. In the same way that some people prefer to hold their net worth in precious metals over fiat, some people prefer their stablecoins to be backed by commodities. Digix Gold (DGX) has each token pegged to one gram of physical gold that the reserve holds in Singapore.

I know what you're thinking now: a company can mint and destroy the coins at will? Sounds too centralized for the general crypto ethos.

Yes, it sounds centralized because it is. A 1:1 backing of either US dollars, gold, or any fiat/commodity is best suited for a centralized stablecoin issuer. Luckily, there are also decentralized stablecoins.

Crypto-backed stablecoins

Decentralized and backed by BTC, ETH, or other cryptocurrencies. The volatility of the underlying asset seems counterintuitive, but just like your average DeFi loan, these tokens are typically over-collateralized. That aspect can absorb much of the volatility. Popular examples here include DAI and wBTC (wrapped Bitcoin). These tokens don't have to be decentralized but they typically are. DAI allows for users to put up collateral in exchange for stablecoins pegged to the US dollar; for an explanation of how this lending works and is safe, see this decentralized finance article. wBTC allows users to get a 1:1 representation of a Bitcoin on another network that it's not native to, such as the Ethereum network.

Algorithmic stablecoins

Decentralized and not directly backed by anything. These token prices are dictated by computer algorithms. In the same way that a liquidity pool relies on arbitrage traders (see article on liquidity mining for more details), an algo-stablecoin relies on arbitrage traders to keep the peg.

When the token goes above or below its pegged price of say $1, there is a financial opportunity to make money. If the token is trading at $0.90 then a trader or bot could buy ten thousand tokens and cash them in for $10,000, even though 10k tokens only cost them $9,000.

That's an extreme example, and the trader/bot would jump on that arbitrage opportunity when it was at 0.99 before it ever got all the way down to 0.90, but you understand the financial incentive that keeps it at the peg. The buy pressure of arbitrage traders would raise the price until there was no longer an arbitrage opportunity.

The same applies for a token above its peg. If the token is trading above peg at $1.10, the trader would go mint some from the issuer for $1 each and sell them for the 10-cent profit. That sell pressure then drives the price back down to $1.00.

If that sounds dangerous, it's because it is. Terra's UST coin is a testament to that danger, as their stablecoin de-pegged from its algorithm and crashed to zero. The token got too far from its peg too quickly and went into a death spiral toward zero. Low liquidity poses a serious threat to algorithmic stablecoins.

Other stablecoins theoretically can't go to zero because they have intrinsic value: their backing.

There are other algo-stables, such as Haven (XHV). XHV operates under a similar model to Terra, but claims to not be vulnerable to the same trading attacks that crashed the coin. XHV also brings privacy to the table, with the same cryptography that makes Monero a properly fungible and private currency.

The Future For Stablecoins

When crypto matures and becomes less volatile, stablecoins may not have as much of a demand. For the foreseeable future, they're going to remain popular and useful.

But could there be a new category of stablecoin? What if you could collateralize a stablecoin with a fully decentralized, physical asset?

Murialdo and Belof proposed a stablecoin backed by electricity in their research paper here.

Electricity is fungible, used globally, and can be decentralized. There is an intrinsic demand for its use in computational processes. Its value is relatively stable over decades. Finally, the market for electricity consumption is trillions of dollars annually.

Now electricity is also a physical asset, and can't be directly transferred over the internet, right? Electricity can't be zapped over to you freely with our current grid system, but energy can also be viewed as the communication of information, put simply.

Computing power is easy to cash in and universally holds value, and it is directly transferable to electricity.

We're so very many steps away from an Electricity-backed stablecoin (E-stablecoin) but it's still an exciting concept. I highly encourage everyone to read the research paper by Murialdo and Belof linked above.

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Shoutout to Glen for inspiring this article, happy birthday homie!