So what exactly are stablecoins?
A stablecoin is a cryptocurrency that has been designed to minimise volatility by being pegged 1:1 against another currency or price of a more stable asset, such as a fiat currency. Here’s a short video that explains the different types of stablecoins. These are roughly divided into three types:
- Fiat-collateralised stablecoins
- Crypto-collateralised stablecoins
- Algorithmic stablecoins (non-collateralised)
For example, USDC (USD Coin — which is a fiat collateralised stablecoin), issued by the company Circle is backed 1:1 with a dollar deposited in their bank account (or received by Circle and managed by them)*. As shown in the chart below, stablecoins have seen an explosive amount of growth over the past year, currently sitting at $90 billion dollars in market capitalisation and a whopping $233 billion in transactions on a single day. Circle alone has issued almost $15 billion in USDC. This is much lesser than its biggest competitor, which is Tether and which has a nearly $53 billion issuance. For a more detailed history of stablecoins, including some key risks, you can have a look at this article by HackerNoon)
How does the process of issuance or creation of fiat-backed stablecoins work?
In simple terms, this means a user deposits $1 USD in a bank account managed by Circle, and Circle ‘mints’ or ‘creates’ a digital version of the same coin for issuing to the user. The coin will reside and be issued as a token on a particular blockchain. For Ethereum, the common standard for creating a token is the ERC-20 standard and hence Circle mints new ‘ERC-20’ USDC tokens. For buying, I can go and buy a USDC ERC-20 token from any of the exchanges that support it. Circle also mints USD equivalents on other public blockchains, such as Solana and Algorand.
Of course, this also means that multiple public blockchains can have multiple currency equivalents of stablecoins, for example the Korean Won (KRW) stablecoin has a substantial issuance by a number of entities as well. While the hackernoon article has covered some of the key risks and other important aspects, i’d like to stress on a very important benefit to a stablecoin, particularly for software development in the crypto space and as a key pillar for a modular architecture for decentralised and open finance, so read below.
How is it different to a dollar sitting in my bank account?
One might ask — if i’ve got $100 when i open up my bank account app and $100 in USDC when i open my wallet on my crypto exchange app, what is the key difference between both of them?
After all, they both look on the screen as the same thing, don’t they?
In addition to different risks associated with both of them, the key benefit on the back-end is that open source software developers building applications on public blockchains, for the first time in history, have access to one of the most important building blocks in developing decentralised financial applications i.e. a stable currency such as a digital dollar, which has been up till now been only used by banks or consortiums of banks for transacting among themselves in a very closed and quite manual system. They can build all sorts of applications that integrate a stablecoin and serve the percentage of population that doesn’t care much about cryptocurrencies but cares about earning a better return on money lying in their bank account (And that is a significant majority).
Stablecoins open up this system by providing a unique standard on a public blockchain. It means that a very efficient internet of value is here and it means that if i hold a USDC in my digital wallet (controlled by my private keys and secured on the blockchain) then i can send it to any other person on the planet via a transaction on the public blockchain, just with the help of an internet connection and their wallet address. I also will no longer will be giving control of my funds to a bank to earn interest on it and provide me with a service, instead i can provide myself with a return on the money in addition to securing it safely. Public key cryptography is an extremely important topic here and i’ll cover it in a separate post, but suffice it is to say, it is the foundation of me holding on to my own funds in a digitally secure manner.
For open source software developers, this opens up a world of possibilities, and they can come up with some very creative ways to utilise that money in efficient ways to help me earn yield on that money, in customisable ways based on my own preferences and risk appetite, and let me be a bank of my own. It lays the foundations for creating automated digital marketplaces for lending and borrowing those dollars as well using smart contracts (covered separately in subsequent posts) and in breaking monopolies of banks and fintechs.
All of these are important aspects, but one might ask — what if the issuer goes bankrupt or continues to ‘mint’ new digital dollars without backing them up 1:1 with dollars deposited in their bank accounts? This was, for a long time, one of the key risks related to USDT (Tether) and which has now been reasonably cleared as Tether has settled a lawsuit with the New York Attorney General and confirmed that it will be getting regular audits conducted to prove that USDT is completely collateralised. Subsequent to this, Coinbase, one of the world’s biggest cryptocurrency exchanges has listed USDT after this settlement, which indicates significantly renewed confidence in it.
But ths risk still remains, and this is a risk that i would refer to as one that is more specific to centralisation i.e. someone needs to trust that a central party minting new stablecoins has a 1:1 backing with fiat currency in their bank accounts and aren’t just generating these out of thin air.
Enter the world of decentralised stablecoins: Currently these are mainly two types i.e. crypto-collateralised (such as Dai/Maker) and non-collateralised/algorithmic stablecoins (such as Fei/Tribe). These have been briefly explained in the video above, but what’s important to understand is that both approaches have different value propositions and risks associated with them, however they are transparently minted and transactions visible and auditable on a public blockchain. Algorithmic stablecoins are a very interesting yet experimental area in crypto, but these are exceptionally new and none have stood the test of time. But nevertheless is a fascinating topic for another post.
Back to crypto-collateralised stablecoins: Maker DAO on it’s website, indicates the following features of the Maker protocol and its associated Dai stablecoin:
And here is a summarisation of how MakerDAO works:
While the area of stablecoins continues to evolve, this much is certain — the volume of issuances and transactions on public blockchains will only increase in the years ahead, and hence stablecoins are a fascinating area worth revisiting as new technology developments evolve in the space.
What are your thoughts on stablecoins? Were there any aspects that i may have missed? If you’ve got any specific feedback on this post, or something wasn’t clearly explained, leave a comment below! :)
Updated 15th Aug 2021: An earlier version of this article suggested Circle backs their USDC with 1:1 cash deposits in their bank account. This was incorrect and has now been corrected. As per their latest Independent Accountant Report, Circle does not hold all of this amount in cash and instead has chosen to park a portion of this amount in investments as well.