What is a stablecoin? Everything you need to know

Cryptocurrencies are currently going through an accelerated period of growth. Research from the Cambridge Centre for Alternative Finance suggests that the number of global crypto users has increased from 35 million in 2018 to 101 million in 2020.

Stablecoins make up just one part of this burgeoning ecosystem, but their influence and adoption is growing rapidly. They are now supported by more cryptocurrency service providers than ever before, with a market capitalisation of just under $ 25 billion.

These assets were first issued by fintech companies and cryptocurrency entrepreneurs, but more and more financial institutions are now also getting in on the act. These include JPMorgan Chase, which recently launched its own in-house stablecoin, the Chinese central bank and tech companies such as Facebook.

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But despite their growing prominence, they remain a mystery to many. So, what exactly are stablecoins and what role do they have to play in the future of the cryptocurrency landscape?

About the author

Artem Shaginyan is founder and CEO at LUNU Solutions

What makes stablecoins different?

In a nutshell, stablecoins are cryptocurrencies that are designed to minimise price volatility relative to a particular “stable” asset or basket of assets. Unlike traditional cryptocurrencies such as Bitcoin, a stablecoin is one that is pegged to a real-world asset like fiat money (e.g. the Euro) or exchange-traded commodities (e.g. gold).

This means they maintain a steady value against a target price, making stablecoins an attractive proposition for investors as well as providing the much-needed stability for merchants looking to participate in the crypto space.

Most importantly, it makes them more viable as an actual currency because they aren’t subject to wild, daily fluctuations in price and are useful for all the things people actually want to use money for. As such, they can enable a number of practical use cases that traditional crypto-assets simply can’t – from insurance and loans, to payments and investments.

They also substantially reduce friction by letting people use something that they’re familiar with – such as the Pound or the Dollar – as well as allowing users to cheaply and quickly transfer value around the globe while maintaining price stability. This will all be key to fostering mass adoption in the future. By increasing confidence that they are stable enough to be used as a daily medium of exchange, consumers will be more likely to trust the technology.

Ultimately, they offer users the best of both worlds: the processing speed and security/privacy of cryptocurrency payments, combined with the volatility-free valuations of fiat currencies.

How do stablecoins work?

There are three main categories of stablecoins available to users, all of which peg their units in different ways.

Fiat-backed
This is the most common form of stablecoin in the market, consisting of crypto assets that are directly backed by a government-issued currency (or commodities such as gold) with a fixed 1:1 ratio. Their value is based on the value of the backing currency.

In this setting, a central issuer or bank holds a certain amount of fiat currency in reserve and issues a proportionate number of tokens. The key requirement is that the amount of backing currency reflects the circulating supply of the stablecoin. For example, the issuer holding $100,000 dollars would equate to 100,000 tokens with the value of $1 each, which can be freely traded between users.

While they are registered with regulatory bodies such as US Securities and Exchange Commission, the off-chain nature of the system – i.e only the issuing financial institutions have complete oversight into the fiat money deposits – necessitates a certain degree of trust. There is no way for a user to be sure whether the issuer actually holds the funds in reserve, so the stability of the stablecoin’s price depends on their trust in the issuer.

Crypto-backed
In this case, stablecoins are issued with cryptocurrencies as collateral instead of being backed by fiat currencies. The main idea here is to peg them to a basket of cryptos or a cryptocurrency portfolio. Since everything is done digitally on the blockchain, the system depends on the use of smart contracts to handle the issuance of units, ensure governance and establish trust.

This creates a decentralised ecosystem that is regulated by the users themselves, as opposed to one issuer or third-party regulatory body dictating monetary policy. Users have to trust that all the network participants will act in the best interests of the group as a whole, which is one of the big draws of cryptocurrencies in general.

To acquire crypto-backed stablecoins, users lock their cryptocurrency into a contract, which then issues the token. Stablecoins must then be paid back into the same contract before their collateral can be returned, with price stability achieved through various supplementary instruments and incentives.

Algorithmic
Also referred to as non-collaterised stablecoins, these aren’t backed by any fiat currency, commodity or cryptocurrency reserve. Instead, algorithms and smart contracts manage the supply of tokens issued to maintain a stable price, mirroring the monetary policy used by central banks around the world to manage national currencies.

These smart contracts are implemented on a decentralised platform and can run autonomously, reducing or increasing the supply of tokens in circulation based on the price of the stablecoin relative to the price of the fiat currency it tracks. If the price falls below the value of the fiat currency, the token supply is reduced and vice versa.

Although they aren’t collateralised in the same way as fiat and cryptocurrency-backed stablecoins, algorithmic stablecoins may have a pool of collateral in reserve in case of black swan events.

Stablecoins in the crypto market

It has become clear that stablecoins will play a major role in the future of the cryptocurrency industry. They will help drive long-term adoption and use, primarily because they overcome a key barrier that has historically held cryptos back from being used as genuine daily currencies: the massive volatility and short-term fluctuations in value.

In the past, it has largely been a case of ‘all crypto, no currency’ as the instability of cryptocurrencies such as Bitcoin has positioned them primarily as an investment opportunity, rather than a normal currency for everyday transactions. But this is now changing thanks to the increasing prominence of stablecoins, which are helping to alleviate concerns around volatility.

As well as building trust in the technology, they will act as a bridge towards mainstream crypto adoption by helping consumers and businesses recognise the value that cryptocurrencies can offer to society. Stablecoins give users access to an asset that isn’t just for speculative investments, but also offers the price consistency needed to form the backbone of a new economy. This quality, combined with the implementation of innovative payment solutions that use stablecoins as transport currency to facilitate crypto-fiat exchange, is what will drive future crypto development.

Cryptocurrencies are certainly here to stay and it’s looking increasingly likely that stablecoins will be the answer to reducing friction, increasing stability and, ultimately, enabling the future of money in a digital world.

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