A beginner's guide to stablecoins

Team Luno
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5 minute read

Stablecoins have enjoyed a huge increase in popularity over the past year, with transaction volumes hitting a new all-time high in June of $54.9 billion and a market capitalisation of around $25 billion. But what exactly are they, why are people starting to use them, and why should you care?

 

What are stablecoins?

 

Stablecoins are a contemporary class of cryptocurrency whereby the value is pegged to either one external, relatively “stable” asset such as the US dollar or gold. They can even be pegged to a ‘basket’ of stable assets.

 

Unlike traditional cryptocurrencies, their price is not set by supply and demand. Rather, they employ a range of different mechanisms to ensure the price remains pegged to that asset. For example, in the case of USD Coin (USDC), for every token that’s created, one US dollar is held in reserve as collateral. This guarantees that every USDC token is backed by a US dollar and it’s redeemable on a 1:1 basis.

 

Stablecoins first arrived on the scene in 2014. The first was BitUSD, a crypto-backed stablecoin that was issued on the BitShares blockchain. BitUSD was founded by, among others, Charles Hoskinson of Cardano fame. BitUSD was collateralized by crypto and backed by the BitShares core token BTS, which was locked in a smart contract to act as collateral.

 

Since then, a number of stablecoins have been created – including USDC and, perhaps more famously, Tether (USDT). These have gained a great deal of traction in recent months and now have market caps in the billions. This is the result of a number of factors, with commentators crediting their rise to the current economic climate, the DeFi craze, and headlines around Facebook’s Libra project, among other things.

 

How do they work?

 

There are three main types of stablecoins: fiat-collateralised, crypto-collateralised, and non-collateralised (algorithmic).

 

Fiat-collateralised stablecoins maintain a fiat currency reserve, like the US dollar, as collateral to issue a suitable number of coins. There are also those backed by a commodity, like gold, silver or oil, but most present-day fiat-collateralised stablecoins use dollar reserves.

 

These reserves are maintained by independent custodians and are regularly audited to ensure the necessary compliance measures are being followed.

 

Crypto-collateralised stablecoins are backed by other cryptocurrencies. Since the reserve currency may also fall prey to high volatility, these types of stablecoins are typically over-collateralised. This means a larger number of cryptocurrency tokens are reserved for issuing a lower number of stablecoins.

 

For example, $200 worth of ether may be held as reserves for issuing $100 worth of crypto-backed stablecoins, accomodating for up to 50% of swings in the reserve currency.

 

Non-collateralised (algorithmic) stablecoins don’t use any reserves but employ a working mechanism, similar to central banks, to retain a stable price. These tokens rely on a mechanically-generated algorithm to adjust the supply if needs be, so as to maintain the token’s pegged-asset price.

 

This class of stablecoins typically uses smart contracts to sell tokens if the price falls below the peg or to supply tokens to the market if the value increases.

 

Benefits and use cases

 

The value proposition is simple. Stablecoins combine the instant processing capabilities, functionality, adaptability, and security of cryptocurrencies with the stability and trust enjoyed by fiat currencies.

 

Fighting currency devaluation and democratising money

 

Stablecoins’ inherent stability is a serious attraction for those living in countries where currencies are extremely unstable and volatile – even more so than regular cryptocurrencies. High levels of inflation are destructive, often leaving people struggling to pay for basic necessities like food and medicine.

 

In theory, stablecoins offer an escape from the effects of unstable local currencies, without people having to resort to illegal or unsustainable methods like using currencies from other countries or bartering. A currency is generally only as stable as the government that issues it, and this offers those living under unstable political regimes usable money. This is subject to the laws of a specific country, so although this may seem like a great solution to a serious issue, it’s unproven whether or not it would be viable in each specific context.

 

Remittances

 

Ever tried sending someone money from a different country? It can be an incredibly slow and expensive process, and it typically affects the people who can least afford to deal with exorbitant third-party fees, never mind the paperwork or the significant wait-time.

 

In 2018, annual global remittance flows to low- and middle-income countries reached $529 billion, an increase of 9.6% from the previous year. However, the global cost of sending money home is unjustifiably high. For example, sending $200 costs around 6.8%. Sub-Saharan Africa continues to have the highest average cost at around 9% despite the fact intra-regional migrants in Sub-Saharan Africa comprise over two-thirds of all international migration from the region.

 

Stablecoins provide a way to bypass the high costs associated with legacy institutions, to send and receive money faster, and to retain most of the monetary value.

 

Trading

 

At the moment, temporary hedging is a big motivator for individuals to use stablecoins. For example, a cryptocurrency investor might split their portfolio between stablecoins and regular cryptocurrencies, so they have a hedge against volatility and won't lose as much during market dips. Additionally, fiat onramps and offramps fees make stablecoins a viable solution for exchanges and institutional traders looking to reduce their crypto exposure without fully cashing out and having to pay withdrawal fees.

 

Decentralised apps

 

2020 has seen the rise of easy-to-use DApps and intuitive interfaces. Ethereum-based stablecoins, which constitute roughly half of all stablecoins in existence and have a total value of over $11.3 billion, are performing even better than traditional finance applications like PayPal due to DeFi apps that use them to facilitate value transfers.

 

Keeping up with the technological revolution

 

The existing financial system has its fair share of inefficiencies – notably its reliance on third parties to facilitate transfers. And everyone takes their cut. Stablecoins, and blockchain technology, in particular, allow payments to occur directly between buyers and sellers, thereby reducing the costs for both parties. Automating the transaction verification process will also result in much faster settlement times.

 

Stablecoin adoption

 

There are over 200 privately-developed stablecoins in existence today, and we’re seeing more and more financial institutions creating their own versions as a cheaper and faster means of settlement. JPMorgan, for instance, announced the creation of their very own JPM coin earlier this year.

 

While it took around five years for stablecoins to reach a supply of $6 billion, it took only four months from March to July this year for that supply to double to $12 billion. The demand comes at a time in which we’re facing extreme global market turbulence, leading many to seek greener pastures.

 

A Coinmetrics and Bitstamp report on the rise of stablecoins also likened the increase in stablecoin usage to the hyperinflation plaguing many fiat currencies since March this year.

 

The future

 

In July, the Financial Action Task Force (FATF) said that stablecoins need to comply with standards to prevent against money laundering and the financing of terrorism. This would mean exchanges, OTC desks and companies creating stablecoins would need to create and follow processes to monitor transactions and be KYC (know-your-customer) compliant.

 

Tether still retains its monopoly on the market, but questions around its legality have opened the door to rivals such as USDC. USDC has gained a fair amount of traction since March and is increasingly being used in DApps. If Facebook’s Libra project ever comes to fruition, it too will likely shake up the market.

 

As the cryptocurrency industry matures, we can expect to see a significant increase in stablecoin usage. Continued adoption from traditional finance entities will also undoubtedly bolster and normalise stablecoins’ place in our everyday lives. In November 2019, the World Economic Forum (WEF) discussed the true value of stablecoins highlighting the potential to create an inclusive and fairer financial system.

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Team Luno

On our way to the moon, we write about all things crypto. And don’t forget we’re humans too. Our blog conveys the views of Luno and the many unique opinions and characters within our team. We’ll never provide you with financial advice, and we urge you to conduct your own research before purchasing or trading any cryptocurrencies. It’s a brave new world out there, and the market can be volatile at times, so never trade with funds you can’t afford to lose. Want to let us know how much you love our blog? Tweet us @lunomoney.

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