Introduction to Stablecoins. Use Cases and Examples
24 December, 2020
Suffering from price volatility, cryptocurrencies don’t often make the perfect fit for the needs of the general public. Stablecoins prove to be a promising alternative as they complement crypto features with the stability of established fiat currencies.
Cryptocurrencies are notoriously volatile assets. The price of Bitcoin went from 2,000 USD to over 20,000 USD in 2017 and fell back to below 6,000 USD in the following year. It has since restored its value (over 20,000 USD at the time of writing) but continues to fluctuate in price. Showing relative stability over a narrow timeframe, it is likely to remain more volatile than well-grounded national currencies and physical commodities such as gold.
Since even the top-of-the-market cryptocurrencies are not sustainable, most individuals and investors are reluctant to trust them with their holdings because of the risks involved. Crypto volatility may attract market players looking to benefit from price appreciation and trading. However, it is still a major factor preventing cryptocurrencies from being thrust into the mainstream world of payments.
Stablecoins are very likely to bridge this gap and serve as non-volatile blockchain-powered digital assets with the benefits of crypto and fiat currency combined. Read on to find out more about stablecoins, their different types, real-world applications, and examples of stablecoins currently available on the market.
What is a stablecoin?
Stablecoins marry the celebrated decentralized and secure nature of cryptocurrencies with the stability of fiat currencies and valuable commodities. As the name suggests, a stablecoin is a cryptocurrency designed to minimize price volatility by locking it to an asset or a currency with a more stable value.
The price of traditional crypto coins depends on fluctuations in a marketplace with volatile supply and demand. Crypto stablecoins are different from other cryptocurrencies, which have no inbuilt mechanism to minimize exchange rate volatility. Most of them are designed to be equal to USD, the world’s leading reserve currency. As a prominent example, Tether is a USD-backed stablecoin that is actively traded on public markets with a reliable exchange rate.
The various types of stablecoins
Stablecoins are classified as asset-backed and non-asset-backed (seigniorage). The first type can be backed by fiat, other cryptocurrencies, or commodities. Although susceptible to volatility risks of the underlying asset, the price of asset-backed coins is unlikely to drop below its value. A seigniorage-style stablecoin design, on the other hand, utilizes special algorithms to manage its supply similar to how money is issued and disposed of in a traditional banking system.
Fiat-backed stablecoins or so-called off-chain collateralized stablecoins are crypto tokens associated with the value of a specific fiat currency. They are dispersed by a central issuer that holds an amount of fiat currency in reserve proportionate to the number of issued tokens.
These tokens have their value fixed at a 1:1 ratio to a fiat currency, for example, USD or Euro. In a typical fiat-backed stablecoin scenario, the issuer might hold one million USD and distribute one million tokens worth one USD each. Users are free to trade these coins, just as they would a cryptocurrency like Bitcoin. The difference is that the holder can redeem their equivalent in USD at any time.
The centralized nature of fiat-backed stablecoins can prove to be a serious disadvantage as there is no way you can be sure the issuer holds the matching amount of backing funds in their reserve.
Cryptocurrency-backed stablecoins are very similar to their fiat-backed counterparts. They also peg their value to an asset. However, instead of fiat, other cryptocurrencies such as Ethereum are set up as collateral.
To compensate for the volatility of the underlying tokens, the amount of reserve cryptocurrency used to issue a stablecoin is greater than its value. Say, if a stablecoin is pegged to Ethereum with a market price of 10,000 USD, then an equivalent of 20,000 USD in ETH can be used as collateral to counter market fluctuations. Smart contracts are used to govern the issuance process and maintain the reserve of crypto coins.
The main advantage of cryptocurrency-backed stablecoins is their decentralized nature, with no need for a custodian to control disbursement and exchange of funds. All of the network members participate in the lifecycle of the issued stablecoins which provides higher liquidity. The monetary policy and governance are therefore in the hands of voters who take part in supporting market price stability.
Commodity-backed stablecoins are backed by other kinds of interchangeable assets, such as precious metals. The most common commodity to be collateralized is gold, but there are also stablecoins backed by oil, real estate, and baskets of various precious metals. Stablecoins backed by commodities such as precious metals are much less likely to see their value inflated than fiat-backed stablecoins.
Holders of commodity-backed stablecoins can redeem their stablecoins at the conversion rate to take possession of real assets. The cost of maintaining the stability of the stablecoin equates to the cost of storing and protecting the commodity backing it.
Non-collateralized (seigniorage-style) stablecoins
Non-collateralized stablecoins make use of a Seigniorage Shares system. These stablecoins employ algorithms to control market value. Algorithms can change the supply volume of coins to maintain their price.
The smart contracts that regulate the price of non-collateralized stablecoins have an approach similar to the central bank that prints and destroys its currency. Smart contracts sell tokens if the price falls below the peg, and supply tokens to the market if the value increases. In this way, the token remains stable and holds its peg.
Since there is no reliance on collateral, non-collateralized stablecoins are independent of any central authority. Smart contracts are, in general, more trustable, since the peg is tied to an algorithm and not to collateral. The seigniorage mechanisms are far more complex than collateralized stablecoins. However, the nature of the system requires a constant demand for stablecoins, which is not always guaranteed.
Common stablecoin use cases
Stablecoins are used in the same way as regular cryptocurrency but provide additional benefits in some situations. They are mostly applied to store funds and complete regular transactions, support peer-to-peer payments, and bring more value to cryptocurrency exchange. Stablecoins are a great asset when it comes to mitigating the side effects in the aftermath of a cryptocurrency crash.
Countering damages caused by market instability
One of the real-world applications of stablecoin is to minimize the losses caused by volatile cryptocurrencies. Traders can quickly trade the failing cryptocurrency for fiat-backed or asset-backed stablecoins to protect the value of their holdings.
Trading volatile cryptocurrency for stablecoins is similar to investing in assets like gold and storing them in treasuries in times of an unpredictable market. In the crypto world, stablecoins provide traders with a safe harbor, allowing them to reduce the risks without having to leave the crypto ecosystem.
Like other fiat currencies, with the help of stablecoin wallets, this type of cryptocurrency can be used for anything from buying morning coffee and transferring funds to family members, to overseas payments. It could be the most effective method of making international money transfers in a cheap and joined-up way.
Stablecoins allow using smart financial contracts that are enforceable over time. Smart contracts are self-executing digital contracts with rules and conditions programmed into them. They are a great fit for automating recurring payments. Transactions in stablecoins are traceable, transparent, and irreversible, making them ideal for salary and loan payments, rent payments, and subscriptions.
For example, an employer can deploy a smart contract that automatically transfers stablecoins as salary to employees at the end of the month. It is also helpful for organizations that have employees all over the world. Stablecoins reduce the high fees and the lengthy processes involved in exchanging fiat currencies.
Due to strict regulations, there are very few cryptocurrency exchanges that support fiat cryptocurrencies. However, the use of stablecoins offers a solution to this problem because they serve as a crypto-fiat trading pair. Users can trade with USD-backed stablecoins instead of actual dollars. These traits may lead to the accelerated adoption of cryptocurrency trading in the conventional world of asset exchange.
The crypto market is saturated with stablecoins each offering its own benefits. Most companies build their tokens on Ethereum and peg them to either fiat currency or other valuable assets. Let’s run through some of the most successful stablecoins out there.
Tether (USDT), formerly known as RealCoin, is one of the oldest stablecoins. It is a crypto-asset that leverages distributed ledger technology to allow individuals and organizations to store, send, and receive digital tokens pegged to dollars, euros, and yen. The Tether currency unit is issued and redeemed using the Omni Layer protocol that runs on top of the Bitcoin blockchain. Tether is designed to reduce cryptocurrency volatility by maintaining a 1:1 reserve ratio between the token and the associated fiat currency.
USD Coin (USDC)
USD Coin (USDC) was launched by Circle and Coinbase, both leading cryptocurrency exchanges and platforms with major investors. USDC is a USD-backed stablecoin running on the Ethereum blockchain. The design is based on the open-source fiat stablecoin framework developed by CENTRE, an open-source initiative established by Circle. According to the official website of Coinbase, each USDC is backed by one US dollar, which is held in bank accounts. CENTRE plans on adding tokens for the Euro and GBP.
bitCNY (BITCNY) is a market-pegged asset based on the Chinese Yuan built on the Bitshares (BTS) blockchain. These stablecoins are also available in different versions, including bitEUR and bitUSD. Backed by the BTS, the minimum collateral for bitAssets is two times (2x). For example, for an equivalent of 100 USD in bitUSD, the buyer needs to pay 200 USD-worth of BTS.
TrueUSD (TUSD) is an off-chain fiat-collateralized stablecoin that runs on Ethereum. TrueUSD does not hold any US$ in its reserves. Instead, it has partnered with registered banks and institutions with fiduciary obligations to keep funds in an escrow account.
Dai is an on-chain collateral backed stablecoin, backed by the ether (ETH) cryptocurrency. Dai is powered by Maker, the entity that created the decentralized technology that runs on top of the Ethereum blockchain. The Dai stablecoin system employs smart contracts on Ethereum that actively stabilize Dai’s exchange rate through the use of Collateralized Debt Positions (CDPs) and autonomous feedback mechanisms.
CDPs are collateralized smart contracts that allow users to generate Dai in proportion to the value of the deposited assets. A user deposits ETH into the CDP smart contract, where it is held until the debt, and its associated interest, are fully paid.
Paxos Standard (PAX)
Paxos Standard (PAX) is a regulated stablecoin launched by ItBit, a leading cryptocurrency exchange. PAX is currently one of the largest stablecoins in terms of total market value. PAX is USD-backed and runs on the Ethereum blockchain. According to the self-reported trading volume from exchanges, PAX is the second most actively traded stablecoin (after Tether) and ranks amongst the top 20 most traded crypto assets.
Paxos Gold (PAXG)
Paxos Gold (PAXG) is a crypto asset backed by real gold reserves held by Paxos, a for-profit company based in New York. Each PAXG token is redeemable for 1 troy fine ounce of gold held in custody by Paxos and its partners. Its market value is meant to mirror the physical gold it represents.
Gemini Dollar (GUSD)
Gemini Dollar (GUSD) is a stablecoin pegged to USD held in reserve at State Street Bank and Trust Company. The Gemini Dollar is built on Ethereum, meaning that token creation is the result of executable smart contracts. Smart contract execution requires a multi-signature scheme of approval for high-risk actions, which includes an offline signature for added fault tolerance.
Binance USD (BUSD)
Binance USD (BUSD) is a 1:1 USD-backed stablecoin issued by Binance in partnership with Paxos. The stablecoin is approved and regulated by the New York State Department of Financial Services (NYDFS). Binance USD runs on top of the Ethereum blockchain.
Binance GBP (BGBP)
Binance GBP (BGBP) is a token issued by Binance with the price pegged to the GBP at a rate of 1 BGBP = 1 GBP. BGBP is 100% backed by the same amount of GBP held by Binance in a bank account at all times.
Stasis Euro (EURS)
STASIS Euro (EURS) stablecoin is designed to mirror the Euro currency. EURS is fully convertible to Euros on a 1:1 basis. The fiat-to-EURS tokenization process is organized through third-party liquidity providers that constitute the STASIS network of partners. Euros received by STASIS are allocated to a reserve fund to provide 100% backing for each EURS stablecoin. STASIS has also developed a native EURS stablecoin wallet with an aim to make it a marketplace for stablecoins in the future.
BiLira (TRYB), the first blockchain-based Turkish stablecoin, grants users equal rights in the financial world of the future and connects them with decentralized finance assets. BiLira is fixed to the Turkish lira in a ratio of 1:1. Anyone who completes the KYC / AML process can own BiLira. It’s built on top of the Ethereum network following the standard methods of the ERC-20 interface.
CACHE Gold (CACHE)
CACHE is an Ethereum ERC-20 standard token customized to track physical assets such as gold. CACHE is designed to provide proof of reserve (PoR) assurance and transparency as compared to other asset-backed tokens. The defining feature of CACHE is that tokens must be 100% backed by a physical asset that is registered, tracked by RFID, photographed, and assigned to CACHE directly by commercial vault personnel using the GramChain asset tracking system.
Tether Gold (XAUt)
Tether Gold (XAUt) is a digital asset offered by TG Commodities Limited. One full XAUt represents ownership of one troy fine ounce of physical gold on a London Good Delivery bar. Holders have undivided ownership rights to gold on the specified gold bar(s). The allocated gold is identifiable with a unique serial number, purity, and weight. XAUt is available as an ERC-20 token on the Ethereum blockchain and as a TRC20 token on the TRON blockchain. The XAUt token can be transferred to any on-chain address directly from the Tether wallet where it was issued.
Petro (PTR), or petromoneda, is a cryptocurrency issued by the government of Venezuela. The Petro stablecoin is backed by Venezuelan oil and mineral reserves. Petros were 100% pre-mined by the Venezuelan government, which legally allows and encourages the use of Petro for virtually any payment, including oil trading, taxes, fees, real estate, gasoline, flights, and more.
Libra is a permissioned blockchain-based payment system proposed by the American social media company Facebook. The plan also includes a private currency implemented as a cryptocurrency. Libra tokens will be backed by financial assets such as a basket of currencies and US Treasury securities in an attempt to avoid volatility. Facebook has announced that each of the partners will inject an initial 10 million USD, so Libra has full asset backing on the day it opens.
Stablecoins can provide the stability necessary for blockchain to function and grow as infrastructure, and for cryptocurrencies to take on the role of traditional money – storing value, acting as a medium of exchange, and bringing accountability. One of the greatest benefits of regular cryptocurrency is decentralization. Stablecoins take it a step further by adding mechanisms to control and stabilize the market.
Tokens backed by more steady assets have emerged as a new tool in the digital economy and a key part of a broad market transformation covering securities, DeFi payment systems, central banking crypto initiatives, and innovative approaches to general monetary policies.
PixelPlex’s blockchain development team can help you deploy tools to manage, store, exchange, and even create your own stablecoin. Stablecoin design processes are complex but we can take on the challenges for you and bring value to your business with our expertise proven by a long history of successfully deployed projects.
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