In the world of cryptocurrencies, where uncertainty and high volatility are an inherent characteristic of this industry, we observe that stablecoins have emerged as a solution to this instability. These digital assets, designed to maintain a constant value, offer an attractive alternative to the high volatility of the cryptocurrency market.
In this article, we will explore what stablecoins are, how they work, their different types, benefits, challenges, and impact on the financial ecosystem.
What are stablecoins?
A stablecoin, or stable currency, is a type of cryptocurrency whose value is tied to another stable asset that acts as collateral. This asset can be a fiat currency such as the dollar or euro, a commodity such as gold or silver, another cryptocurrency, or an algorithm that continuously adjusts the supply of the currency based on real-time demand.
Stablecoins are typically issued as tokens on a public distributed ledger technology (DLT), with blockchain being the most popular. They are traded on both centralized (CEX) and decentralized (DEX) exchanges and aim to minimize volatility, maintain stability, and serve as a bridge between traditional finance and decentralized finance (DeFi).
The stablecoin trilemma
The stablecoin trilemma, similar to the blockchain trilemma (security, decentralization, and scalability), presents three desirable attributes that are difficult to achieve simultaneously:
- Stability: Maintaining a constant value.
- Decentralization: Operate without a central authority.
- Scalability: Handle large volumes of transactions efficiently.
Challenges of the centralized stablecoin trilemma
Centralized stablecoins use reserves backed by collateral to maintain their parity. For example, in the case of the dollar, for every stablecoin issued, there is a corresponding dollar in a bank account backing it. This convertibility ensures that parity is maintained, i.e. that a dollar stablecoin remains equal in value to one U.S. dollar.
They typically achieve stability and scalability by being backed by tangible reserves and managed by a centralized entity. However, they sacrifice decentralization by relying on trust in a central authority to maintain reserves and ensure convertibility.
Challenges of the decentralized stablecoin trilemma
Decentralized stablecoins replace reliance on a third party with transparent and automated mechanisms that are accessible without permission and generally incentive-based. This allows anyone to see exactly how the stablecoin works and, if they wish, participate in its operation. This transparency makes decentralized stablecoins more resistant to both internal corruption and government influence.
However, they face significant challenges in terms of stability and scalability due to the volatility of the underlying assets and the complexity of automatic adjustment mechanisms.
Main categories of stablecoins
Fiat-backed stablecoins (centralized)
Fiat-backed stablecoins maintain parity with traditional currencies such as the dollar, euro, or others by basing their value on reserves equal to the total number of tokens issued. These reserves, usually deposited in highly reputable traditional banks, are under constant scrutiny by regulators and auditors hired for this purpose.
Often, the reserves backing cash-backed stablecoins are audited periodically by third parties. This process ensures that the amount of tokens in circulation matches the company’s reserves, creating confidence in the stability of the cryptocurrency.
In essence, these stablecoins act as an IOU (I owe you) for a traditional fiat currency, usually dollars. Users buy stablecoins with their fiat currency and can redeem them for their original currency whenever they want.
Cryptocurrency-backed stablecoins (decentralized)
Stablecoins backed by other cryptocurrencies, although it may seem contradictory, offer solid guarantees of stability. These stablecoins are pegged to one or more cryptocurrencies and their backing is based on excess collateral. This means that for every unit of stablecoin issued, more than one cryptocurrency must be deposited as backing.
Frequent audits and monitoring tools help maintain the price stability of these stablecoins. This decentralized approach, through the use of automated smart contracts, eliminates the need for a central entity to control issuance and supply. This provides a more autonomous and resilient version of stablecoins compared to fiat-backed stablecoins.
Asset-backed stablecoins (centralized)
Asset-backed stablecoins are backed by reserves of commodities, raw materials, and real estate that serve as their collateral. Each stablecoin unit represents a fraction of the physical asset. These types of stablecoins are widely used in trading operations, as they facilitate the entry of retail investors into transactions in gold, oil, gas, soybeans and other commodities, allowing them to trade fractions of these assets.
Commodity-backed currencies are popular because they can provide investors with a hedge against inflation and other types of economic instability. To accommodate potential market fluctuations, most commodity-backed stablecoins maintain a reserve that exceeds the total value of the coins issued.
Algorithmic stablecoins (decentralized)
Algorithmic stablecoins use algorithms and smart contracts to regulate the supply of currency in response to changing market demand. Unlike other stablecoins, they are not backed by another asset. Instead, an algorithm adjusts the supply by selling tokens when the price falls below the desired value and issuing tokens when the value exceeds the set limit. This strategy ensures that the amount of tokens in circulation changes regularly, always maintaining each investor’s share of ownership.
These stablecoins offer a more scalable solution compared to asset-backed or cryptocurrencies. However, they require a high level of technical knowledge and understanding to properly design and implement. Experts recommend that investors carefully evaluate the risks and benefits before relying on these stablecoins for financial transactions or investments.
Balancing the trilemma
The nature of a trilemma implies that all three goals cannot be achieved simultaneously at their best. For stablecoins, these objectives are price stability, decentralization, and capital efficiency. Price stability remains the primary goal of stablecoins, and in recent years both centralized fiat-backed and overcollateralized decentralized stablecoins have managed to maintain parity with some success. However, both make major concessions to one of the other two dimensions of the trilemma.
Fiat-backed stablecoins, for example, sacrifice decentralization by relying on central entities to manage reserves. On the other hand, algorithmic stablecoins require excess capital to ensure their stability, which compromises capital efficiency.
To date, various design approaches have emerged to address the trilemma and achieve the three desired properties. Some algorithmic stablecoins have been able to temporarily balance the trilemma by maintaining price stability without requiring excessive collateral and without relying on a central entity. However, market forces have exposed their weaknesses, demonstrating that the balance is fragile and difficult to maintain in the long run.
The ongoing design challenge is to find the optimal balance between these three goals to provide a truly stable, decentralized, and capital-efficient solution.
Uses of stablecoins
Stablecoins are becoming increasingly important in global finance due to their low volatility, low cost and flexibility. These characteristics make them valuable assets for a wide range of applications, acting as a hybrid between traditional cryptocurrencies and fiat currencies. Their ability to maintain a stable value makes them particularly useful for daily transactions, international payments and as a store of value, providing a reliable alternative for both individuals and businesses looking to take advantage of the benefits of cryptocurrencies without exposing themselves to their inherent volatility.
Store of value/volatility hedge
- Protection against devaluation: In countries or regions where the official currency suffers from constant devaluation or liquidity problems, stablecoins are used to safeguard savings and protect the value of assets.
- Preserve cryptocurrency values: Investors use stablecoins to preserve the value of their cryptocurrency positions during periods of high volatility or when a downtrend in the market is expected.
Global accessibility
- Financial inclusion: Stablecoins facilitate borderless transactions, providing a financial solution for people without access to traditional banking services. This allows users to participate in the global economy without geographic limitations.
Savings
- Alternative to bank accounts: Holding stablecoins in a digital wallet is easier and less costly than maintaining a savings account at a traditional bank. In addition, stablecoins can be used to earn interest and can be easily exchanged for fiat money.
- Viability in cryptocurrency transactions: Stablecoins are exchangeable for any cryptocurrency, making them ideal for fast and efficient operations with cryptoassets.
Transfers and international shipments
- Fast and cheap transfers: Stablecoins allow money transfers to be made quickly and at significantly lower costs than traditional bank fees. Transactions can be completed in seconds and at a reduced cost.
- Cross-border transactions: Stablecoins are ideal for international transfers, offering a faster, cheaper and easier alternative to traditional methods. In addition, they preserve the value of the currency and avoid losses due to mandatory conversion to the official currency of the receiving country.
Dealing with DeFi
- Cryptocurrency trading: Stablecoins are widely used on decentralized platforms to buy, sell and exchange cryptocurrencies between peers without the intervention of intermediaries or central authorities.
- Participation in funds and derivatives: They allow users to participate in investment funds, take exposure in derivatives, and access other financial products within the DeFi ecosystem.
- Lending: Users can lend their coins to earn interest or use them as collateral to borrow other assets, gaining liquidity without having to sell their cryptoassets.
- Yield Farming: Stablecoins are used in yield farming strategies where users invest in or provide liquidity to pools to earn management tokens or other rewards.
- Insurances: Some DeFi insurance platforms use stablecoins to provide a reliable and transparent means to purchase insurance coverage and pay claims.
Conclusion
Stablecoins are transforming global finance with their ability to provide stability, accessibility and flexibility in a wide range of applications. From protecting the value of savings to facilitating international transactions and empowering the decentralized economy, they represent a significant evolution in the financial world.
It is important to note that while stablecoins offer numerous benefits, users of DeFi protocols that utilize them could suffer losses if the stablecoin fails to maintain its intended price. Therefore, it is essential that investors and users understand the risks involved and carefully evaluate the reliability and back-up mechanisms of the stablecoins they choose to use.
References:
[1] Stablecoins.wtf – The stablecoin trilemma
[2] Kraken.com – What are stablecoins
[3] Bitcoin.com – What are stablecoins
[4] Techopedia – Stablecoins
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