In this article, we take a look at what a “stablecoin” is and what problems these currencies are trying to solve in the crypto market.
The challenge with cryptocurrencies today
A currency has multiple uses. Primarily, it is a device that is used as a means of payment to exchange goods and services. Secondarily, it must be a stable unit where you can save economic value over time. For a currency to be suitable for saving value, one should be sure that the value remains stable and predictable over time.
Today, cryptographic currencies have proven to be a bad alternative to the latter. You cannot save value efficiently when prices fluctuate by up to 20% on a regular day. In spite of this, Bitcoin is called “Digital Gold,” which refers to saving values in Bitcoin on a par with gold for a long time.
Bitcoin and Ethereum are two of the most dominant cryptocurrencies, but the value fluctuates very much. Volatility increases speculation, and so far, this adds to the mass-option and ease of use in the real world. For example, it is not appropriate to get paid in Bitcoin when the purchasing power can change within a couple of hours.
As mentioned above, the volatility of the crypto market inhibits the adoption of technology and the use of crypto terminals to what they are designed to do. What many misunderstand with cryptocurrencies is that not all of them has the purpose of replacing the existing monetary system and the traditional currencies we have today. Bitcoin, among other things, tries to solve the problem of being dependent on a third party to transfer money from A to B and that the payment takes an unreasonable amount of time. This is the case with Bitcoin, but you must not think that all currencies have this purpose.
Today, according to Coinmarketcap.com, there are over 600 tokens built on Ethereum’s network. Ethereum is a blockchain that allows developers to create decentralized applications (dApps) on their network. These applications have their own tokens, and in many cases, they are so-called «utility tokens,» which will have their own usefulness within their own ecosystem. These ecosystems and applications depend on adoption and that you use a token for what it’s actually designed for.
Imagine for simplicity that Ethereum is the Internet, and a decentralized application is an E-mail. To send an e-mail, you need a token. In today’s crypto market, any token is an object of price speculation. Who would like to use a token to send an email when you know that the value can double in brief time? And on the other hand, someone can choose to stay away from such a token since the value can sink sharply right after buying it. Here is an obvious problem for now.
The solution to this problem can be stablecoins. These are cryptocurrencies that try to solve the issues that extreme volatility in the other cryptocurrencies causes.
The market value of a stablecoin should always remain stable, and the appraisal may, for example, be linked to the dollar. For example, a coin will always be worth $ 1.
There are several methods to achieve price stability, something we will return to in the next section.
Stablecoins can help bring out the real potential blockchain technology has by making it easier to gain wider adoption. When volatility is removed, a currency becomes more appropriate to use as a means of payment and for saving the value. This makes it easier for larger companies to apply technology to make quick payments without the risk of changing the payment base. Today, for example, you may risk the price fluctuating more than what a traditional transfer fee costs, just during the short time a transfer takes.
Use of stablecoins by trading
So far, the most well-known application for stablecoins is to be a safe haven when there is turmoil in the market. For those who are speculating in cryptocurrency, it’s a long and undesirable way to go from cryptocurrency back to fiat (Dollar, Euro) when the market corrects. Then it is advisable to have a stable currency readily available. Today, the most famous stablecoin used through trading is tether (UDST). On several of the largest exchanges, including Binance and Bittrex, you can exchange cryptocurrencies directly to Tether. Equally, you can switch back to the currencies you want when you want to enter the market again.
The picture below shows how the price of Tether measured in dollars (green line) evolves over time. The yellow line shows how development in Tether has been a goal in Bitcoin.
So far, as mentioned, stack coins are primarily used for trading. Over the past year, the number of new companies wishing to fight the throne for stack coins has increased significantly. Some of the new players are Maker, Bitshares, Havven, TrueUSA, Digix Gold, Kowala and BaseCoin. Everyone primarily wants to offer a stable currency that can provide fast payment and adoption. A couple of projects also see that a stable currency will provide room for loans and long-term futures contracts.
How is the mechanism behind a stablecoin?
As you have received from you initially, a coin of a stable currency will usually be linked to the price of a stable asset. Most people assume that a coin will cost 1 dollar. Today there are three different models behind the various stacking coins, and each has their own method that keeps the price stable.
1. Centralized “I-O-U”
Here, a company issues a virtual currency that represents a claim on an underlying asset. The underlying asset is usually money stored in an account or a vault. This is the case for Tether and Digix. One coin is linked to 1 dollar, and the coin is locked at this exchange rate.
The disadvantage of this model is that the ownership of the underlying assets is centralized. This leads to a trust issue above the issuer, and one has to trust that the company owns and have the underlying values.
Earlier this year, Tether Limited, the company behind Tether, was in severe weather when it was questioned whether they actually had values that could support a 1: 1 exchange ratio with the coins they had issued.
2. Mortgages of inventory
Here you can issue stack coins yourself through existing platforms, such as Bitshares, Maker and the Port. You make part of your own stock as a mortgage through a smart contract and receive new coins. For example, you can use Maker and lock Ethereum worth $ 150 and get out Dai worth $ 100. (Dai is Maker’s token and is a stablecoin).
The downside of this method is that you have debt (to Maker) that is pledged in an asset that is highly volatile. For example, you risk risking that the price you put in Ethereum drops below the value of the inventory of Dai. The different platforms have different methods to regulate this risk. One example is that you have to put up with a mortgage that is higher than what you can borrow. As in the example where you put $ 150 in a mortgage and get $ 100.
3. No mortgage, no underlying assets
The most famous pricing mechanism we know today is based offer and demand. If the offer is given and the demand goes up, the price goes up. If demand drops, the price goes down.
The last method uses an algorithm that monitors the demand for stablecoins at all times. The algorithm regulates the offer, so the price is always stable. The price of these coins, like Example 1, is usually set at $ 1.
Which one is best?
There is no easy answer to this question. Here you have to make your own judgments and evaluate which method you are most comfortable with. 2) and 3) are decentralized, something many crypto enthusiasts appreciate.