What is a Stablecoin?

What is a Stablecoin?

Backed by a reserve asset, a stablecoin is designed to attempt to provide price stability in cryptocurrency markets

TL;DR: 

First introduced in 2014, stablecoins were created for the cryptocurrency markets in an effort to provide a stable crypto asset and reduce exposure to volatility. Stabilization comes from the backing of an underlying reserve asset. The options for reserve assets have expanded beyond USD to include other fiat, high market cap cryptocurrencies, and commodities. 

The total market cap of the stablecoin market is about USD $11.2 billion, having passed the USD $10 billion mark in May 2020. 

Stablecoins OKCoin supports: 

What are stablecoins?

Stablecoins are cryptocurrencies that are backed, or collateralized, with the value of a reserve asset in an attempt to:

  1. Provide price stability within the cryptocurrency market
  2. Provide crypto-based payments for global financial transactions
  3. Enable traders to move in and out of cryptocurrencies without converting to fiat currency 

Like other cryptocurrencies, stablecoins are available on cryptocurrency exchanges, but aim to peg their value to an external reserve asset, like a fiat currency, a precious commodity, cryptocurrency, or even an algorithmic reference to an external asset.

Stablecoins are built as cryptocurrency tokens using smart contracts, with 50% being developed on the Ethereum network using the ERC20 token standard.

CryptoSlate provides a full list of stablecoins by market cap and Messari tracks 12 top stablecoins on their Index.

What is a stablecoin used for? 

Investors and traders

In an attempt to lessen exposure to cryptocurrency price fluctuations, investors and traders may use stablecoins to diversify their portfolio, hedging against market volatility by purchasing a ‘stable’ reserve-backed crypto asset.

Regions where payments are unreliable

Stablecoins are also used to provide easy crypto-to-fiat transactions in areas where government regulation makes transactions complex or costly. Asset-backed cryptocurrencies leverage the same blockchain technology as Bitcoin or Ether, giving users the ability to transact peer-to-peer, securely, and privately across a transparent, global network. 

Regions with high inflation

For people living in areas where high fiat inflation devalues domestic currency, stablecoins provide an opportunity to gain exposure to a global reserve currency, via the peer-to-peer and borderless cryptocurrency market. 

Businesses and individuals

Payments and transfers can also be made more efficiently with stablecoins, giving individuals and businesses a less costly method of transacting. 

Stablecoin types

Fiat currency-backed 

  • Backed 1:1 by fiat currency, like USD or Euro 
  • The peg is referenced off-chain through a financial institution that can provide attestation for the reserve fiat currency
  • The number of stablecoins in circulation must be reflected in the number of reserve fiat currency that backs the stablecoin to provide a 1:1 backing
  • Examples: USDK, TUSD. Facebook’s Libra, not launched yet, will be backed by a basket of currencies.

Crypto-backed 

  • Backed 1:1 with cryptocurrency as collateral, like BTC or ETH
  • On-chain peg executed by smart contracts 
  • Number of stablecoins in circulation must be reflected in the number of reserve cryptocurrency that backs the stablecoin to provide a 1:1 backing
  • Public audits of the blockchain ledger can be held to confirm collateralization of reserve asset
  • Examples: WBTC

Commodity-backed 

  • Backed by a precious commodity like gold or silver
  • To be effective, the number of stablecoin in circulation must be reflected in the amount of of the commodity held
  • This type of backing is particularly challenging because there must be proof of the underlying asset, involving custody of the precious commodity
  • Examples: PAXG, XAUT

Algorithmic (seigniorage)

  • ‘Stability’ is derived from an algorithm that tracks the value of the reserve asset
  • Smart contracts algorithmically maintain a price equilibrium for a 1:1 peg of an on-chain, fiat value like USD
  • Examples: cUSD, DAI. While DAI is pegged to USD, MakerDAO’s use of CDP (collateralized debt position) in structuring use of DAI means that it will be overcollateralized with ETH and BAT. 

What are issues with stablecoins?

Maintaining a 1:1 backing can be challenging, particularly if the reserve asset is hard to obtain and custody, like precious commodities. Volatility of the underlying asset can also present issues, if price movements are significant enough to disrupt the 1:1 backing.

Centralization plays a role in the structure of stablecoins, providing oversight for the underlying asset to ensure 1:1 custody. For assets that are not digital, a party must be responsible for custody of the asset supply, confirming the number of reserve assets reflects supply of circulating stablecoins. For on-chain reserve assets, custodianship can be decentralized, though this can add complexity and other risk factors to the project including trust amongst parties and implementing a reliable structure for decentralized signing.

Regulatory restraints can also pose challenges to the launch of stablecoins; some may be deemed securities if they’re found to be an investment contract.

Stablecoins and DeFi

With about 50% of stablecoins built on Ethereum smart contracts, the network has experienced its highest rate of activity over the past year due to the substantial increase of stablecoin issuance. 

As we explained in our What is DeFi blog post, decentralized finance (DeFi) is a new ecosystem of financial services that uses public distributed ledgers to provide autonomy and privacy across a peer-to-peer network. Unlike traditional finance, DeFi services are not reliant on a central financial authority. 

The majority of DeFi applications are built on Ethereum smart contracts. The Ethereum network is undergoing an Ethereum 2.0 protocol upgrade called ‘Serenity,’ with phase 0 launching this summer and continuing over several years. EIP 1559 is a critical component of the upgrade that will improve the user experience for determining gas costs, therefore lessening transaction fees for all DeFi users, including those who hold stablecoins.

Buy and sell crypto including bitcoin, ether, stablecoins, and more on OKCoin today — sign in or create your account.

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