What are Stablecoins?

October 27th, 2020

What are Stablecoins?

You may have heard about ‘stablecoins’ and wondered what the fuss is about. In simple terms stablecoins are digital versions of traditional currencies like the dollar, the value is the same $1. The reason why they were created is that people wanted the convenience of the likes of Bitcoin for digital payment, to allow people to pay for goods and transfer money. But without the downside in terms of the changing value of the crypto currencies like Bitcoin or Litecoin, which means they are not ideal for payments. Compare this to a traditional dollar where you know how it’s going to be worth tomorrow, whereas the beauty and downside of Bitcoin is that it may have risen or fallen in value even just over the course of one day. The stability of the dollar is due to the currency reserves that back the US currency, plus the intervention of the Fed which can jump in to correct the supply and demand of the dollar to control its value. In contrast, the likes of Bitcoin as decentralized crypto currencies, they lack either a reserve to control their valuation, or a central bank to take steps to control prices.

While the value of stablecoins like Tether (USDT) and USD Coin (USDC) is pegged against the dollar and doesn’t move much, their popularity has seen a dramatic rise over the past few months since April, as the pandemic began to hit home for the first time. In response to this demand, token supply has doubled in the last three months. With the overall market cap (‘capitalization’) at $21bn in mid October led far and away by Tether, with a market cap of over $15bn. Part of the reason for the upsurge in demand for stablecoins is a result of the knock on effect of the pandemic, as global investors sold off assets and sought to exchange their local currency for US dollars as a safe currency, according to the Wall Street Journal.

source: https://www.coingecko.com/en/stablecoins

To understand how Tether maintains a 1:1 USD peg Tether claims that every one of its ‘USDT’ in circulation is backed by actual dollars in their reserves. As outlined in CoinGecko, the process of how Tether is controlled by Tether Limited, is best illustrated by the flow of funds shown below:

source: https://www.coingecko.com/en/coins/tether

1:­ User deposits fiat currency into Tether Limited’s bank account.
2:­ Tether Limited generates and credits the user’s Tether account. Tether enters into circulation. Amount of fiat currency deposited by the user must be equal to the amount of Tether issued to the user (E.g.: 500 USD deposited = 500 USDT issued)
3­: User transacts with USDT. The user can transfer, exchange, and store USDT.
4:­ The user deposits USDT with Tether Limited for redemption into fiat currency.
5:­ Tether Limited destroys the Tether and sends fiat currency to the user’s bank account.

Another type of stablecoin is a crypto currency also tied (‘pegged’) to the dollar but backed by a basket of cryptocurrencies rather than dollars or another traditional currency. As outlined in the introduction, seeing as cryptocurrencies unlike dollars can rapidly rise and fall in value, this means such stablecoins require a large amount of crypto to maintain their stability. A good example from MakerDAO, which is a decentralized organisation built on Ethereum. It’s currency the DAI was created without the need to be backed by dollars, which in principle sounds simpler but in practice means “we have to trust that the custodial solution actually has the correct amount of US dollars and not creating artificial inflation” (Kerman Kohli, Hackernoon).

The rise of stablecoins over the past few months is not a short term phenomena. Backed by the economic impacts of the pandemic globally, plus the rise of DeFi use of stablecoins, they are here to stay. In addition, in a more positive aspect of this crypto currency, their popularity and stability mean they may prove especially useful in driving financial inclusion, what’s often called “banking the unbanked” of the world. Certainly for US residents looking to send money abroad to friends and family it’s an attractive option, with far lower fees too:

“For sizable populations in low- and middle-income countries (LMICs), remittances from abroad form a significant portion of their income. The total remittance amounts have been steadily growing over the last several decades to hundreds of billions of dollars as of 2019 (World Bank). As important as this source of income is for those living in LMICs, the transfer of money may involve untrusted third parties that charge hefty fees to facilitate such transfers.

“The answer may lie with the technologies of cryptocurrencies and blockchain. These could help to facilitate fast and guaranteed transfer of funds at fraction of cost currently charged by money transfer operators. In particular, the stablecoin cryptocurrencies could be the solution that will ensure cost-effective, guaranteed and timely transfer of funds from donors to recipients.” Cryptocurrency, Stablecoins and Blockchain: Exploring digital money solutions for remittances and inclusive economies’, Jan 2019 paper, Kulkarni, Schintler, Koizumi and Stough.

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