Because of the volatility of the most popular cryptocurrencies such as Bitcoin and Ether, developers created stablecoins. Stablecoins are pegged to a fiat currency such as U.S. dollars. This ensures that payment in a smart contract won’t change over the term of the agreement. While stablecoins might be necessary today, they hopefully won’t be required in the long-term, since artificially-pegged currencies rarely survive over the long-term and increased market capitalisation tames volatility.
This article provides a simple overview of what stablecoins are, and a few of the different types of stablecoins you may come across.
If you rent an apartment and sign a lease to pay in Bitcoin, when Bitcoin quadruples in price, so does your rent. Even though Bitcoin was invented as a method for making payments, it is too volatile to be used that way.
Ether and most other popular cryptocurrencies have similar volatility. This is a problem if you want to create a smart contract for recurring payments like rent or salaries. It’s also a problem for financial services like derivatives and prediction markets. To overcome the problem, developers created the stablecoin that is always worth the same amount, such as one U.S. dollar.
There are two types of stablecoins in use, depending on the method used to make them stable: fiat-collateralised and over-collateralised cryptocurrency. A third type that is not collateralised doesn’t appear feasible given current securities regulations in the United States.
The simplest type of stablecoin is a fiat-collateralised stablecoin such as USDC (USD Coin) or USDT (Tether). Both are cryptocurrencies that are backed by the U.S. dollar. That means there is one U.S. dollar in an account for every cryptocurrency coin that exists. When someone gets rid of their crypto, they receive a wire transfer from the account that holds the dollars and their coins are destroyed.
Fiat-collateralised stablecoins are simple, completely stable, and don’t have any hacking risk since the assets are not stored on the blockchain. However, for these benefits, they forfeit decentralisation. These stablecoins depend on a third-party authority to hold the fiat money and regularly audit it. This often comes with the ability to halt trading. Another disadvantage comes from legacy currency laws in the U.S. When someone liquidates their coins, the law requires the custodian to send the dollars via wire transfer, which is expensive, or a check in the mail, which is slow.
Asset Pegged Stablecoins
The next type of stablecoin has its value pegged to a real asset, such as U.S. dollars, but it is backed by another cryptocurrency. This keeps everything on the blockchain and preserves decentralisation, but doesn’t protect against volatility. So when you want to use this stablecoin, you have to put up more than 100 percent in collateral to protect against major price variations over the course of the contract.
MakerDAO’s Dai (pronounced “die”) is an example of this over-collateralised stablecoin. When you’re done with the stablecoin, you pay back the value of the coin plus interest and you get your collateral back. over-collateralised stablecoins are completely decentralised, easy to liquidate and totally transparent. However, they aren’t as stable as fiat-backed stablecoins, the collateral provided by stablecoin owners is somewhat at risk and overcollateralisation is an inefficient use of capital.
The last type of stablecoin is not pegged to a real-world asset or backed by another asset. This non-collateralised stablecoin uses smart contracts and oracles to manipulate the supply and demand of the stablecoin to maintain a constant value, like a central bank does with a fiat currency. Basis coin was the best example of this type of stablecoin, but U.S. securities regulations forced the founders to end the project and return capital to investors.
Because of the volatility with cryptocurrencies, DeFi depends on stablecoins for smart contracts, dApps and broader financial services. Some doubt the long-term feasibility of stablecoins, since currencies pegged to real-world assets in the past have typically not persisted in the long-term. Others hope that as the market capitalisation of cryptocurrencies increases, the volatility will decrease and the need for stablecoins will go away. Until then, both fiat-backed and crypto-backed stablecoins are in use today.
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