by Daniel Taylor
April 2023
What’s a stablecoin and why would you use one?
Stablecoins: they currently account for three of the top 10 cryptos; they’ve captured some $150 billion in value; but what are they, what should you know about them and why might they be useful to you?
Stablecoin is a term you’ll often hear – in the crypto world and, increasingly, in mainstream reporting as well.
In this intro guide, let’s dive into:
- What stablecoins are (and aren’t)
- What they’re used for
- What role they play in the crypto ecosystem
- The different types of stablecoin and their risk profiles
Stablecoins: a basic definition
A stablecoin is a specific type of crypto designed to maintain as stable a price as possible. Like a pound or a dollar in your bank account, it should (let’s forget about the current economic conditions for a moment!) maintain as constant and as reliable a value as possible on a day-to-day basis. Stablecoins achieve this by pegging (tying or linking) their price to a given reference asset, often the US dollar.
The most common mechanism for achieving this, to continue our US dollar example, is to use reserve backing. In other words, for every ‘digital dollar’ issued on the blockchain as a stablecoin, there must be a ‘real-world dollar’ kept in reserve (in a bank account, or some other liquid instrument) by the issuer of that stablecoin. This makes the stablecoin a 1:1 blockchain representation of its underlying asset: in theory, $1 of the stablecoin should always be redeemable for $1 US dollar.
One way to think about it is to imagine a private bank issuing a blockchain-based chip, or token: you get a house-guaranteed digital representation of a dollar you can use and trade, and cash in for a dollar when you’re done.
While ‘digital dollar’ is a handy shorthand, it’s important to remember what a stablecoin is not: which is state money as issued by a country’s central bank. These are privately issued and guaranteed assets, and therefore come with their own individual risks, which is why it’s so important to understand the mechanisms at play (more about which later on).
What stablecoins are used for
Even so, the innovation and potential of having a blockchain-based representation of a stable asset is huge: allowing users to benefit from all the native advantages of crypto and blockchain while maintaining a degree of price stability and predictability.
Today, sending money cross-border using traditional infrastructure is slow, expensive and complex, with multiple intermediaries and conversions involved along the way.
With the blockchain technology we have today, we can send digital dollars anywhere in the world, almost instantly and for fractions of a penny – without middlemen, and using only a mobile phone.
It’s why merchants can use stablecoins to accept payments at much lesser cost, and efficiently relay value among themselves anywhere in the world. It’s how you send money to someone on the run in a war zone – or the other side of the globe. It’s how value could flow more efficiently and more effectively than ever before between all the locations and places of the world.
The stablecoin concept is big and transformative enough that it is shaking up the whole payments industry.
Stablecoins in crypto
Zooming in a little for a moment, there are a range of reasons why stablecoins have quickly become popular among crypto enthusiasts and within the crypto ecosystem.
Interestingly for those who want to trade cryptoassets, stablecoins are now used more often than traditional currencies such as the pound or dollar in trades involving purchases of cryptocurrencies such as bitcoin (BTC) or ether (ETH). Over 2021, quarterly stablecoin trading volume averaged $2.96 trillion. In short, crypto users are using stablecoins because this is where the market is for making crypto trades.
Stablecoins have also to a certain degree ‘closed the loop’ in the digital asset ecosystem. Before, a user might have ‘cashed out’ to their bank and national currency: now, in the stablecoin era, users also have the choice to trade into a stablecoin and hold stablecoin assets as a perceived ‘safe haven’ during periods of volatility – without any longer needing to leave the confines of the crypto ecosystem.
This trend has certainly been accelerated by the increasing use of stablecoins in decentralised finance (see our intro guide to DeFi here), which increasingly relies on stablecoin assets as the basis of lending, borrowing and decentralised trading activity, and therefore provides extra incentive to hold stablecoins.
For all these reasons, the stablecoin is an important category of the crypto space, and often held as part of a crypto portfolio.
Stablecoin types and stablecoin risks
What stablecoin, though, to hold – if you so choose? After all, stablecoin is an umbrella term, and encompasses various different mechanisms and approaches.
Reserve-backed stablecoins
By far the most common stablecoin type remains the reserve-backed stablecoin we discussed at the beginning of this guide, where issuers hold dollars (or other currencies, or even commodities such as gold) in reserve in return for digital dollars issued. Prominent examples of this type of stablecoin include USDC (issuer: Circle), USDT (issuer: Tether) and BUSD (issuer: Paxos) which, at the time of writing, account for around $140 billion (or 90+%) of the circa $150 billion of stablecoins in circulation.
Key to your usage of this type of stablecoin is your assessment of the integrity of the backing reserves – in other words, do you trust the issuer’s IOU? To address this question, some issuers will now issue attestations on their websites as to the breakdown and volume of their asset reserves, and provide detailed information as to how their products work.
In the current absence of any regulation or safety net relating specifically to stablecoin products, it’s particularly important to do your own personal due diligence on this issue – though it’s worth noting that this type of stablecoin will very likely be regulated soon, hopefully bringing extra customer assurances, with processes in different stages of advancement in the EU, UK and US.
Because this type of stablecoin is issued and managed by a centralised entity, users should also be aware that assets may be frozen by the issuer (e.g. in instances of suspected unlawful activity), even when held in external wallets.
Crypto-backed stablecoins
Perhaps because of such concerns, other varieties of stablecoin have aimed to solve the problem in different ways.
One such approach, of which DAI is the most prominent example, is to make use of a cryptocurrency such as ether (ETH) for stablecoin backing instead of using dollars in a bank account.
In this case, users pledge a certain amount of crypto, and receive a certain amount of DAI stablecoin in return. The whole process is governed not by any central entity, but by a system of pre-programmed actions that lives on the distributed blockchain. The issuance of the DAI itself is overcollateralised – by which we mean that to obtain $1 DAI, I must pledge significantly more than $1 of crypto collateral. This is essentially a ‘safety buffer’ to account for the volatility in crypto price – with the warning that if the price reaches below a certain ‘liquidation’ level, it will be automatically sold off to meet the debt obligation.
From this short description, it should be evident that the risks in this type of stablecoin are completely different. My main concerns are liquidation (forced selling of my collateral) because of price volatility and, as with all things crypto, trusting that the technology will work as it should.
Because they stem from blockchain-hosted computer programming rather than identifiable central entities, crypto-backed stablecoins are unlikely to be encompassed by regulation in the same way and get any of the guarantees that might come to centralised stablecoins. If something goes wrong, you won’t have any recourse. However, as part of the stablecoin toolkit, they offer a more non-counterparty dependent solution to the stablecoin challenge for those who prefer an alternative option.
Algorithmic stablecoins
Finally, speaking of things working as they should, a last category of ‘algorithmic’ stablecoins has aimed to largely remove the crypto collateral part, and leave the functioning of the price peg solely to technology and market incentive.
Following the high-profile collapse of TerraUSD in May 2022, the most famous of the algorithmic stablecoins, understandably this option isn’t top of the pops at the moment, though it will undoubtedly be subject to ongoing experimentation and innovation. We won’t say much more than that this is getting towards the very riskiest part of the crypto curve. Hopefully this breakdown leaves it clear that not all stablecoins are made alike.
In closing
Stablecoins are a relatively new and fast-evolving area of the crypto space, exploding from almost nothing In 2017 to the billions of value they capture today.
Hopefully this guide has given you a point of departure to understand what a stablecoin aims to do, some of its potential and utility, and the factors you may want to consider in using these types of assets yourself.
No doubt, there’s a lot of progress and innovation still to come: and, as ever, Zumo is here to support and help you on that crypto journey.
