Stable coins are cryptocurrencies that are pegged to another stable asset, such as the U.S. dollar or gold. It is a global currency, but not one tied to any central bank, with low volatility. For this reason, stable coins can be used for practical everyday purchases and are believed to represent what could be a catalyst for mainstream adoption. Short-term stability is critical for transactions and long-term for holding. It is believed that stable coins will possess the traits necessary to become widely used which are: price stability, privacy, scalability, and decentralization.
100% backed by fiat currency held in a reserve account with a conversion rate of 1 tether equals $1 U.S. Dollar. Very close to being a like-for-like swap between fiat and cryptocurrency, but it is centralized and not trustless. The organization has refused audits and the Tether Platform is considered fully backed only if all tethers in circulation are less than or equal to all fiat held in the reserve account. Tether has a huge headstart and a network effect as a result of being the first and demonstrating it is fairly reliable at holding its peg to the USD.
Blockchain-based stable coin pegged to the USD that is held in the bank accounts of multiple trust companies under an escrow agreement. Rather than being controlled by a single entity, the funds are managed by several banks which publish a daily accounting and are subject to monthly audits.
MakerDAO (DAI): 2015
The asset that Dai is trying to be stable relative to is the U.S. Dollar. 1 DAI equals $1, and backed by ETH. Stability is maintained through an autonomous system of smart contracts. To receive DAI, a user sends their ETH to Maker platform where they are locked up as collateral by a CDP (smart contract). If the price of ETH goes down, the system liquidates your collateral and gives it away if you don’t return the DAI you’ve borrowed quickly enough. This is done to ensure DAI always has sufficient collateralization. If the price of ETH goes up, the system becomes more collateralized and the DAI becomes stronger.
What is the purpose of stable coins?
In the crypto world, not every exchange can convert cryptocurrency to fiat money due to regulations and restrictions. By using a stable coin that is pegged to the U.S. dollar, Euro or other stable currency, an investor can sell their crypto assets for cash on an exchange that cannot deal in U.S. dollars. Stable coins hold collateral of some type and manage the supply to help incentivize the market to trade the coin at a stable value. They are a hedge against volatility.
For example, if bitcoin price is $7,500 and you trade 1 BTC for a stable coin like Tether, you would have 7,500 USDT. If the price of bitcoin dropped to $5,200 – you would still have 7,500 USDT and their worth would still be $7,500 USD. You could covert your tethers back to bitcoin at anytime.
Asset-backed coins, like Tether, are pegged to an asset so that any given moment, a token holder can exchange them for a real USD or EUR. They work much like paper money used to work under the gold standard when it was backed by something of value. An algorithmic-mechanism-backed coin, like DAI, employs a set of rules intended to match the supply of the token with demand. From an engineering perspective, asset-backed coins are easier to employ, but algorithmic stable coins possess several advantages, such as better scalability, stronger network adoption incentives, and the ability to earn profits on the creation of the stable coins. Except that they are unproven currently.
What are the challenges for stable coins?
Scalability is one of the biggest challenges because it is hard for reserve-backed stable coins to reach liquidity deep enough to support the possibilities. Investment of millions or billions in each coin will have to occur, and there is the issue of fiat currency sitting idle in bank accounts. Another problem is regulation, which means central banks may be able to act quicker. The potential is huge, but there are also technical issues to overcome. Imagine sending money to a charity and being able to track the entire process to see the money reach the recipient – every dollar of it for a minimal fee.
While it is clear that in order for cryptocurrency to have mainstream adoption, the price is going to need to stabilize so consumers can make daily transactions confidently. Nobody wants to spend $5 worth of crypto for a coffee today, only to see it sell for $4 tomorrow. By the same token, no merchant wants to sell the coffee for $4 today and see it worth $7 tomorrow, or $50 next week. Another problem is, stable coins require us to have faith in the protocol of the individual project as well as trust in the central entity holding the fiat reserves.
Stablecoins attempt to harness the benefits of cryptocurrency — transferring value digitally without an intermediary — combined with the stability of mainstream currencies. This is an evolving landscape sure to see a lot more action in the future.