Stablecoins

Stablecoins are cryptocurrencies that are programmed to maintain a value approximately equal to another asset.

While the most popular stablecoins are pegged to a traditional fiat currency (like the US Dollar, the Euro, or the Japanese Yen), they can also represent other commodities, such as gold or silver. Stablecoins offer transparency and ease of transfer, similar to other cryptocurrencies, with mechanisms in place to reduce volatility.

There are a few different ways that stablecoins maintain their peg to the designed asset. Some are backed by assets held in reserves while some rely on smart contracts to expand and contract the supply of the cryptocurrency based on the demand for that token.

History of stablecoins

The idea for electronic cash is not a new one. Long before Bitcoin, there were several projects that attempted to create digital money through cryptography.

The first one, B-money, was proposed by computer scientist Wei Dai in 1998 and was intended to work as an anonymous and distributed digital cash. This was followed by Bit Gold, an attempt to create a decentralized online currency created in 1998 by Nick Szabo. While both projects never saw the light of day, eCash was the first major attempt at creating an anonymous online payment using cryptography and was used by one bank in the US for three years but was dismantled in 1998 due to poor adoption.

How do stablecoins work?

Cash-collateralized stablecoins

Cash-collateralized stablecoins are backed 1:1 by an underlying currency (like USD or EUR) or cash equivalents (like US government bonds) by the issuer of the stablecoin for every minted token.

The central operator thus tracks the stablecoin’s circulation and allows anyone to mint and redeem tokens in their reserves.

Examples of cash-collateralized stablecoins: USDT, USDC

Commodity-collateralized stablecoins

Like cash-collateralized stablecoins, the value of the commodity-based stablecoin is tied to a physical (e.g.; gold or silver) or digital (e.g., Bitcoin) commodity in a 1:1 ratio held by an issuer. Generally, these also use the same IOU model as cash-collateralized stablecoins.

Examples of commodity-collateralized stablecoins: PAXG, wBTC

Crypto-collateralized stablecoins

Crypto-collateralized stablecoins are backed by cryptocurrency held in smart contracts. Often, each stablecoin minted is overcollateralized, meaning that each stablecoin token requires its holder to lock cryptocurrencies worth more than the amount they mint to ensure the stability of its $1 peg, even with fluctuations in the crypto market.

In order to redeem the underlying cryptocurrency deposited, users often have to return the stablecoins to the protocol, along with a small fee.

Examples of crypto-collateralized stablecoins: DAI

Why are stablecoins useful?

Stablecoins have proven useful in many different contexts.

First, they offer all the benefits of other cryptocurrencies, such as transparency, ease of transfer, instant finality and being borderless, while protecting users from their sometimes-high volatility. This helps when trying to purchase goods and services locally, or on a bigger scale as an alternative to the traditional SWIFT or Western Union for global payments and remittances.

Stablecoins are also useful for traders who wish to get in and out of trades 24/7 and to transfer their wealth between various exchanges to find different cryptocurrencies or arbitrage opportunities.

Stablecoins also prove useful to exchanges like Bitstamp in order to offer more fiat-crypto trading pairs that can be settled instantly.