What are Stablecoins?
Price stability and instant transferability
KCL Fintech Soc - Jiahui Li London 04.07.19
What are Stablecoins?
Bitcoin and Ether are the two dominant cryptocurrencies, but their prices are mostly driven by speculation, which creates huge volatility. For example, the price per bitcoin dropped from approximately $15,000 in December 2017 to around $3,000 recently. The huge volatility of cryptocurrencies hinders their adoption in the real world. Very few people would accept their salary in Bitcoin, as its purchasing power is changing all the time.
A new version of cryptocurrency, Stablecoin, was created to offer price stability while not impeding the instant transferability and security characteristics of cryptocurrency payments. The limited supply of traditional cryptocurrencies is what leads to their price volatility. In contrast, Stablecoin eliminates price volatility by pegging its value to reserve assets. Stablecoin also attempts to bring cryptocurrencies to parity with fiat currencies. There are three major types of stablecoins based on their working mechanism.
Fiat-collateralized Stablecoins is backed by a real-world currency like the U.S. dollar. There needs to be as many dollars deposited into a bank account as there are Stablecoins in circulation; that is to say, for every Stablecoin issued, one dollar needs to be deposited into a bank. When an amount of Stablecoin is withdrawn by the user, they will receive the ordered number of dollars, and the corresponding Stablecoins will be destroyed. This means that Stablecoins are just a digital representation of dollar amounts. Examples of Stablecoins include True USD and Tether. These are the simplest version of Stablecoin, but Stablecoin could never compete or even replace fiat because its value fundamentally derives from fiat.
Crypto-collateralized stablecoins remove the centralized aspect of currency by backing the Stablecoins with reserves of another cryptocurrency rather than fiat currencies. In this way, decentralization can be achieved because the system of Stablecoins does not need to rely on fiat currency, which is regulated and monitored by governments.
Stablecoins can work perfectly in a cryptocurrency system. Since the reserve cryptocurrencies are generally less stable than fiat currency, a one-to-one collateralization ratio is not suitable for Crypto-collateralized Stablecoins, since they will be as volatile as the reserve cryptocurrency, which defeats the original purpose.
For this reason, Crypto-collateralized Stablecoins are “over-collateralized”. That is, there is more than one dollar of cryptocurrency in reserve for every dollar Stablecoin, to ensure that even if the price of reserve cryptocurrency drops, there will still be one dollar in reserve. But over-collateralization may lead to inefficient use of capital, because the value of reserve required is higher than that of Stablecoins issued.
Because more cryptocurrencies are needed in the reserve, this model has higher opportunity costs than Fiat-collateralized Stablecoins. In summary, Crypto-collateralized Stablecoins are fully decentralized but less price stable than Fiat-collateralized Stablecoins.
Non-collateralized Stablecoins do not rely on any collateral in a reserve to maintain stability. By increasing or decreasing the supply of stablecoins to maintain its value, this action is similar to the central bank who either prints new money to satisfy the increasing demand or buys back money when the value of the currency decreases.
The smart contracts are created to perform the same function of a central bank, that is, monitoring the price of Stablecoins in the market and creating or buying back Stablecoins to stabilize its value. The advantage of non-collateralized Stablecoins is their total independence from other currencies. They can work perfectly without relying on other currencies or properties. However, this system completely relies on users’ faith in its stability and continual growth, just like the national fiat currency does, but without government power or collateral to back it up.
It is difficult to build faith at an early stage, especially when cryptocurrencies themselves have not been widely recognized.
The increasing adoption of Stablecoins paves way for the popularization of cryptocurrencies. If Stablecoins succeed, it may have greater impact on the world than that of Bitcoin, as Stablecoins can be used in daily transactions and will boost the usage of blockchain-based loan, derivatives and other long-term contracts.
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