“Coins.” “Crypto.” “Bitcoin.” We hear these terms quite frequently in the world of cryptocurrency and blockchain technology; but, what exactly is a “stablecoin?” You may see the ticker USDC on your digital wallet but wonder what it really is? I know I did.
Stablecoins are an interesting subset of cryptocurrency and have ample emerging use cases. After you read this article, you may not be overlooking USDC, along with many other stablecoins, any longer.
Collateralized Crypto: The Stablecoin
Stablecoins are a class of digital currency that are collateralized by the value of an underlying asset. Essentially, they aim to resemble traditional and stable currencies. Stablecoins maintain the appeal, yet leverage the benefits of cryptocurrencies. Stablecoins allow investors access to this asset class that offers transparency, security, immutability, fast transactions, low fees, trust, stability, and privacy among other advantageous qualities. Because of its evolution as a new asset class in a technology driven economy and its benefits, demand for stablecoins has surged. In the latter part of 2020, the total value of stablecoin assets surpassed $20 billion, which equates to approximately a 300% growth rate. Furthermore, it is recorded that more than 200 stablecoins are currently in circulation or in development globally.
“Stablecoins will further become the quote currency for digital assets in the foreseeable future.” — A research arm of Binance
Stablecoins For Every Occasion
The four main types of stablecoins include:
- Fiat- collateralized stablecoins
- Crypto-backed stablecoins
- Commodity-backed stablecoins
- Non-collateralized stablecoins.
Fiat- backed stablecoins are the most common type of stablecoin. This stablecoin is collateralized or backed by currencies, like USD and EUR. Fiat-collateralized stablecoins are backed at a 1:1 ratio; for example, 1 USDC stablecoin is equivalent to $1. Essentially for every stablecoin, there is a real fiat currency held in a bank to support it. USDC is one of the most popular stablecoins for its reputation. This stablecoin is audited frequently and is backed by a very stable asset, the United States dollar. As long as the economy of the United States stays stable and does not endure too much inflation, the stablecoin USDC is guaranteed to not fluctuate and maintain value.
The second type of stablecoin is the crypto-backed stablecoin. This stablecoin is more decentralized than fiat-back stablecoins, as it is collateralized by other cryptocurrencies. Usually, the stablecoin is over-collateralized and backed by multiple cryptocurrencies in an effort to distribute risk and absorb price volatility within the collateral. The most common crypto-collateralized stablecoin is called DAI. DAI was created by MakerDAO, s smart contract platform on the Ethereum network that preserves the value of DAI via collateralized debt positions, autonomous feedback mechanisms, and incentivized external actors, according to the whitepaper of MakerDAO. Its face value is pledged to USD but backed by ETH locked up in smart contracts. Developers use this stablecoin as a stable medium of exchange to build dapps on the Ethereum blockchain.
The third type of stablecoin is the commodity-backed stablecoin. This category of stablecoin is backed by metals like gold or silver or other commodities, including oil and real estate. Although these types of stablecoins may be more susceptible to price movements, they have the possibility to appreciate in value in the future. It also opens new opportunities for investors of all social classes, as in the past these types of assets were typically reserved for the upper class. Some of the most common commodity backed stablecoins include Digix Gold (DGX), Tiberius Coin (TCX), and SwissRealCoin (SRC). DGX is built on the Ethereum blockchain and is backed by gold; 1 DGX is equivalent to 1 gram of gold, which is stored in a vault in Singapore and gets audited every 3 months to guarantee its presence. TCX is a stablecoin that is backed by 7 different metals, which are generally used in tech hardware to make items such as solar panels and electric cars. Finally, SRC is a stablecoin backed by Swiss real estate.
The last category of stablecoins are non-collateralized stablecoins, which are the most decentralized and independent form. These stablecoins are ironically not backed by anything. This category is also known as an algorithmic stablecoin and relies on a seignorage shares model to control the supply. As demand increases, new stablecoins are created to reduce the price; if the coin is trading at too low of a value, then coins on the market are bought to lower the circulating supply and introduce more scarcity, pushing up the price of the stablecoin.
The Safe Haven
Stablecoins offer many opportunities for investors and in other emerging applications. Firstly, stablecoins offer protection from market crashes and volatility. Stablecoins are generally less influenced by market conditions and offer a safe haven opportunity for investors amidst market swings. For example, if the price of ETH drops, an investor could convert their ETH to a stablecoin almost instantly on a platform in an effort to dodge major financial losses; many crypto exchanges don’t even allow fiat currencies due to strict regulations on its platform or charge a hefty fee to transfer into fiat if fiat is supported on the platform. The ease of transfer and low fees offer a plethora of possibilities to industries and individuals. For instance, many could use stablecoins to make overseas payments, since it omits the conversion into different or multiple fiat currencies, the days-long process of conversion, and sizable fees. Fast, affordable, and secure transfers are some of the advantages of stablecoins. This could be helpful for migrant workers who have to send remittances through businesses back to their international families or for payment transfers from tenant to landlord. A smart contract could be initiated to set up automatic payments for rent via stablecoins to avoid price fluctuations.
In addition to the many benefits stablecoins offer, they present the opportunity for investors to make money via interest accrued on stablecoins, lending stablecoins, and staking stablecoins. Keeping money in stablecoins on a crypto exchange is a low-risk method to make money by earning interest on stablecoin balances. Additionally, one can make money on stablecoins by lending stablecoins out to borrowers. Finally, one can earn money via staking stablecoins, which is similar to depositing money into a savings account and earning income on it.
The Other Side of the Stablecoin
Although stablecoins offer ample opportunities, there are some potential risks involved. One of the risks with stablecoins involves the asset that the stablecoin is tied to. The stablecoin is only as stable as the asset; for example, although the value of the United States dollar is stable, if the value were to change due to inflation, then the stablecoin value would be parallel. Furthermore, the stablecoin is also restricted by the same regulations of the fiat currency that it is attached to. For commodity backed stablecoins some of the same risks apply. Many stablecoin issuers don’t provide transparency about its collateral and sufficient reserves, and so this aspect to many investors is a major risk to on-board. Additionally, if the company does have the reserves, it may take a lot of time to receive the physical assets, like gold stored in a vault. For crypto-backed stablecoins, risk involves the price stability of the portfolio of assets underlying the stablecoin. Crypto-collateralized stablecoins are one of the most complex forms of stablecoins and introduces more risk associated with crypto price volatility.
Although stablecoins present some risks, its opportunities in emerging applications are infinite. It is stated that stablecoins may be the bridge to help bring cryptocurrency mainstream. Stablecoins provide global access to secure national currencies and offer a decentralized system that is secure and stable. Stablecoins may be new to your crypto vocabulary but are here to stay for the opportunities it offers. Until then, #ToTheMoon!
Disclaimer: stablecoins and cryptocurrencies are risky and volatile investments. These comments above should not be perceived as investment advice.
Jordana Cohen, Writer and Associate, Alpha Sigma Capital
Jordana joined Alpha Sigma Capital in November 2020 as writer and associate. Jordana graduated magna cum laude from Tulane University with a business major in finance and a minor in Spanish. In addition to her academic accomplishments, she has substantive experience in management and marketing endeavors through her establishment of several start-up events to fundraise for pediatric cancer research. Alpha Sigma Capital is a pioneering digital asset fund that invests in growth companies, private and public equity, mergers and acquisitions, and special situations. Alpha Sigma Capital believes in a fundamental research approach for investing and supporting the blockchain economy; and, it is rigorous in determining the value of such organizations.