Stablecoins have become one of the most important aspects of the crypto ecosystem over the past few years. The start of a niche type of token then became quickly transferring funds between compatible crypto exchanges. This was was taken to a much larger level of adoption during the explosion in activity. This is around various decentral finance (DeFi) applications. If you’re using DeFi apps on Ethereum, BNB Chain, Solana, or some other smart contracts-enabled blockchain, it’s likely that stablecoins have become a key component of your activities. But what are stablecoins? And what is the main purpose of this special type of crypto token? Do they offer the same features as bitcoin without any of the price volatility? Much like every other alternative crypto asset, these stabler alternatives to native crypto assets come with tradeoffs.
There are a few different types of stablecoins that exist in the crypto market. However, the vast majority of stablecoin liquidity you can currently find in those backed by real-world assets. The first ever stablecoin was launch on the Mastercoin (now called Omni) protocol layer. This is build on top of the base Bitcoin. Originally known as Realcoin, this first stablecoin is now well-known as Tether USD. Other popular forms of asset-backed stablecoins include Circle’s USD Coin and Binance’s BUSD. The basic idea with these stablecoins back by real-world assets. It is to issue a token on top of a blockchain that is back by assets in the world of traditional finance. Such as dollars in a bank account, U.S. treasuries, or corporate debt.
The goal is to maintain a one-to-one price peg with a traditional, government-issued currency (usually the U.S. dollar). Of course, a peg to the U.S. dollar is only possible if the assets that are backing the stablecoin actually exist. Also, if they are able to be redeem by users of the stablecoin. Not all asset-back stablecoins are made equal, and they exist with different terms and conditions and under various regulatory regimes.
That said, there has never been a traditional stablecoin that has turned out to be running on a fractional reserve basis, meaning they do not actually have all of the assets to back the tokens they’ve issued on various blockchain networks. While there have been plenty of rumors regarding the solvency of Tether USD, the world’s most popular stablecoin has never had serious issues with liquidity, even in times of major market distress and losses suffered by the company backing the project. Then again, USD Coin has gained major ground on Tether USD over the past couple of years due to the former’s prevalent use in Ethereum-based DeFi apps.
An important distinction to make when it comes to comparisons between traditional stablecoins and crypto-native assets like bitcoin is that there are extreme differences when it comes to the level of censorship resistance offered by the two different types of digital currencies.
The key innovation with Bitcoin was that it enabled a new financial system that operated outside of the legacy banking system and could not be regulated or controlled by anyone. This means that traditional stablecoins and bitcoin are not really the same at all. Indeed, the major forms of traditional stablecoins all have backdoors implement in their respective smart contracts.
Due to these concerns around how traditional stablecoins are not as uncontrollable as bitcoin and other crypto assets, developers have been working to create more decentralized stablecoins for nearly as long as bitcoin itself has existed. These more decentralized alternatives tend to fall under two main subcategories in the form of algorithmic and crypto-collateralized stablecoins. Algorithmic stablecoins attempt to use various market indicators to regulate the supply of the stablecoin. The basic idea is to increase the supply of the stablecoin when its price is going up and decrease the supply when the price is going down.
This is not all that dissimilar to how traditional central banking works, with the obvious difference that it is intend to work in a much more decentralized fashion. These types of stablecoins are usually overcollaterize to avoid potential insolvency issues during times of market turmoil.
Many crypto enthusiasts view decentralized stablecoins as a sort of Holy Grail of crypto. However, the reality is we’re still in the early days of these developments. Additionally, there are a number of unsolved problems. Especially, when it comes to creating the best of both worlds in terms of censorship resistance and price stability. Two of the persistent issues with this type of crypto token right now are the oracle problem. Also, the sufficient liquidity for the creation of crypto-collateralized stablecoins. Especially, when it comes to making a decentral stablecoin that can function properly in all market conditions.
It would seem that more decentral stablecoins will need to develop. Especially, in order for the stablecoin vision to maintain the original vision of what crypto was originally intend to enable. Many stablecoin critics believe it is unlikely that the current state of affairs. Where stablecoin users are able to transact and conduct other financial activities without necessarily identifying themselves. This will not be allow to persist. The area of decentral stablecoins one should watch closely. However, as the many past failures in this area have shown, it’s important to remain skeptical. Skeptical of grandiose claims regarding the actual capabilities of these sorts of crypto tokens.
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