Updated: Jul 14, 2021
In Part 2 of our guide to the Crypto.com app, you might have seen that we mentioned something called stablecoins when we talked about their Crypto Credit feature. And now you’re probably wondering what stablecoins are and what makes them so special in the world of cryptocurrency.
The first thing you have to remember is the definition of cryptocurrency. From our article, you will see that it is a digital currency not backed by anything that we say has value.
Now let’s compare this to the US dollar – which is a fiat currency. Back when USD was first created, it was backed by gold and silver. This has changed over the years and it is now backed by the perceived power of the country that “created” it and is controlled by the Federal Reserve. They decide how much currency gets minted/printed. But if people lose faith in that country for some reason – the value drops.
For the most part, this system works really well, and fiat currencies see only small fluctuations in their value over time. Unfortunately, cryptocurrencies don’t enjoy this same stability. Because they work with perceived value and nothing but that, their value can change drastically in a very short period. An example of this is Bitcoin, which is the original cryptocurrency and the most well-known. You would assume that this means its value wouldn’t change too much, wouldn't you?
You’d be wrong though!
As you can see in the graph below, Bitcoin’s value climbed to $10,367.53 in February of this year, and only one month later was worth just $4,944.70. It has improved since then, but that huge drop means that quite a few BTC owners took a hefty financial knock. And there is no way to know if they’ll ever recover those losses.
Such extreme fluctuations in the market are the reason many are wary of investing in cryptocurrency and accepting it as payment for whatever goods and services they may offer – because these wild fluctuations can occur in a single day. On top of that, it’s hard to be sure a cryptocurrency isn’t going to just…disappear one day, such as what happened with Pincoin in 2018.
But what many do love is the instant processing and security of cryptocurrencies. So how to combine the instant processing and payment security that cryptocurrencies give with the much less volatile fluctuations in value that fiat currencies provide?
What Exactly Are Stablecoins?
Stablecoins are a cryptocurrency because they are created digitally and are based on blockchain technology. The first two things that make them different is the fact that there is not a limited supply of a stablecoin (such as with BTC) or a fixed schedule for creating/disbursing them. The biggest difference though is the fact that they are backed by some sort of collateral.
Tying a digital and therefore effectively intangible cryptocurrency to something tangible can give token holders peace of mind because they know the price of their token is as stable as the value of the specific collateral it is tied to. Should the worst happen, cashing out quickly is easier because they know what exactly their crypto wallet is worth in terms of a known fiat currency – and so does anyone they exchange them with.
This system sounds pretty simple, but it is actually a little complicated. This is because there is a third-party custodian who is responsible for storing and managing the associated asset. And no matter how trusted they are, this centralized third party seems to bring the whole decentralized spirit of blockchain technology into question.
Some platforms have responded by ensuring that they operate with complete transparency, sharing everything from audits to daily financial records with their users, while others have been accused of multiple types of impropriety and yet consistently manage to perform incredibly well. With cryptocurrency and the blockchain still being a relatively new technology – and stablecoins even more so – no one really knows exactly how the system can and can’t be manipulated.
What form this collateral takes and how each stablecoin keeps its value in line with the asset or fiat currency they are tied to varies by the specific stablecoin. but here are a few of them.
This is the most popular kind of stablecoin and it is backed with a fiat currency, usually at a 1:1 ratio. Another term for it is fiat-collateralized stablecoin. With these, a central issuer (often a bank) holds an amount of fiat currency in reserve and issues an equivalent amount of the appropriate tokens. One of these is Tether, which claims to have a bank account with the same amount of US dollars as there are of their USDT tokens in circulation.
They are traded the same way that every other cryptocurrency is traded, using blockchain technology. However, their value stays constant and the holder can exchange them for almost the same amount of USD (or whichever fiat currency they’re backed by). The main problem with this type of stablecoin is that the holders/users have to trust that the issuer does actually have those funds in reserve somewhere.
Some fiat-backed stablecoins you may have encountered are Tether (USDT), TrueUSD (TUSD), Paxos Standard (PAX) and Gemini Dollar (GUSD).
Crypto-backed stable coins are very similar to fiat-collateralized stablecoins except that the collateral used to back the stablecoin is a cryptocurrency. They are not nearly as popular as their fiat-backed counterparts for the very reason that stablecoins were created in the first place – namely the volatility in their value.
Indeed, how can something whose value can change by hundreds of dollars in a few hours be used to back another currency whose value is meant to maintain a certain level? The best way to explain this is by using one of the most popular crypto-backed cryptocurrencies as an example. This is the DAI offered by MakerDAO, and Live Coin Watch has this description:
“DAI is a decentralized stablecoin, and is the other half of the MakerDAO system. DAI is designed to maintain parity with the 1 US $. Stablecoins enable traders to keep their money in the crypto ecosystem without being subject to massive fluctuations.”
What this means is that the value of the DAI token is pegged to the value of the USD and is backed by Ether (ETH). How the DAI maintains its value is through a series of protocols created via the Maker Smart Contract. What this smart contract does is create and destroy MKR tokens in response to the fluctuations in the value of ETH.
As you can see from the chart below, its lowest value since its creation was $0.926 and the highest was $1.063, which is impressive when you compare the value of ETH over the same period.
Crypto-backed cryptocurrencies are not as popular as we mentioned. But there are quite a few notable ones available. One of these is Synthetix (SNX), which is much less popular and doesn’t seem to have maintained its value as well over time but is also backed by Ether.
Another DeFi project that has garnered quite a bit of interest is the first Bitcoin-backed stablecoin launched by Money on Chain. It also uses a two-token system similar to DAI, with the DOC token pegged to the USD and a second token called BitPRO covering the volatility that being backed by BTC would create. While modeled after the MakerDAO, they are using the Rootstock (RSK) network to build their platform because the Bitcoin blockchain doesn’t currently support all the features of their system.
A major concern with this type of stablecoin is that the tokens could end up under collateralized if there were a massive drop in the markets. However, the Money on Chain platform apparently weathered the recent major BTC price drop quite well, despite it being the largest drop in 7 years. Other platforms were not as lucky.
These cryptocurrencies are digital coins tied to an existing asset (that is not fiat currency) with real, recognized value in the offline world. When the value of a token drops, an investor can decide whether they want to cash out their cryptocurrency or trust that the value of the underpinned asset will help return it to the level it was before.
There are several different types of asset-backed cryptocurrencies, so we’ll just give a quick overview of a few of them.
Gold and other precious metals were the only acceptable form of trade back in the day, and it remains one of the most secure assets there are available today. So it is no wonder that there are people who are finding ways to combine the security and transparency of the blockchain with the surety and long-term value of gold.
While gold tokenization projects are all the rage, we want to point out that the company issuing the cryptocurrency doesn’t have to account for all the underlying assets as they’re being managed by a third party. So they can say they have this amount of gold bars in a secure location, but there’s no real way to verify it.
Some gold-backed cryptocurrencies are Onegram (OGC), Digix Gold (DGX) and Ekon (ERC20)
According to our research, there are currently no cryptocurrencies backed by oil. However, there used to be one and it was unique for two different reasons. Firstly, it was the first cryptocurrency to be tied to a commodity, and secondly, it was created and backed by a government – the Venezuelan government to be exact.
If you haven’t heard about it before, we’re talking about the Petro. According to the Venezuelan president, one Petro token was equivalent to one barrel of oil and was created to counteract the effects of hyperinflation caused by the price of oil plummeting to record lows in 2014. Unfortunately, it didn’t take off for a number of reasons – but it did introduce a way for governments to join the crypto space.
Some other crypto assets you could look into for investment purposes are security/business-backed cryptocurrencies, diamond-backed cryptocurrencies and real estate-backed cryptocurrencies.
Among the most interesting types of stablecoin are the ones that are not backed by any kind of collateral. Instead, their price is controlled through a series of algorithms that manage their price by automatically responding to supply and demand. So if the price rises too high, the algorithm issues more coins and then reduces supply when the price falls.
This algorithm, called the quantity theory of money, is based on a model introduced by a Polish math scientist in 1517. It also happens to be a model used by multiple central banks in order to manipulate the value of its national fiat currency (we’ll let others debate the ethics behind that though), so we know that it can maintain the value of a currency – although how well it can do this in such a volatile market has never really been explored.
What this effectively translates to is that while the number of a certain algorithmic stablecoins in your crypto wallet may increase and decrease without you doing anything – they will always be equal to the same total amount of fiat currency (remember that most crypto wallets translate the balance of your crypto assets into a USD amount, unless you specifically choose a different option).
Another unique aspect of algorithmic stablecoins is the fact that they are effectively a “non-redeemable” asset because there is no physical asset underpinning them. Algorithmic stablecoins you can look into are Ampleforth (AMPL) and SteemDollars (SBD).
The Problem With Stablecoins
The biggest problem with stablecoins is that since it is almost entirely an unregulated system, there is a lot of trust involved on the part of the users/holders. The blockchain itself is completely transparent and is one of the most secure methods of making and receiving payments, but as we’ve repeatedly said – you have to trust that the creators/issuers of a cryptocurrency are legitimate.
In the case of trusted stablecoins (which is when a central authority controls the reserves and is in charge of maintaining the peg), you have to trust that they will maintain the ratio or peg that they have promised. This could be for one token to be equal to one fine ounce of gold, one USD or one Euro. In fact, you have to trust that they actually have any of the assets they claim to have underpinning the value of their cryptocurrency.
In the case of a trustless stablecoin (which is when the peg is maintained by the blockchain through a system of smart contracts), you have to trust that the entire system will be able to respond quickly enough to any extreme fluctuations in the cryptocurrency market and that it will keep its value without breaking the peg.
Until some form of universal regulation is put in place with regard to the cryptocurrency market as a whole, investors will always be dealing with the risk of unscrupulous individuals taking advantage of them in ever more creative and unexpected ways. From Exit scams to stablecoin Ponzi schemes and outright phishing scams – the entire cryptosphere is riddled with risk.
Then there is the problem of stablecoins making money laundering that much easier. While the person depositing or withdrawing funds from a stablecoin wallet has to complete a KYC (Know Your Customer), none of the other parties along the chain does.
So one person can deposit fiat currency, send stablecoins to another party who converts it to BTC or some other cryptocurrency and then sends it to a third, fourth or fifth party, and then finally it is withdrawn as “cleaned” fiat currency. And the anonymous nature of the blockchain makes this even easier to accomplish!
Cryptocurrency was originally created to get away from the regulations and controls imposed by fiat currencies, and it has succeeded in this in ways no one could have imagined. However, this same lack of regulation and control has turned the cryptosphere into the Wild West of the finance world where everyone is hoping to strike it lucky – whether by hook or by crook.
The driving force behind the creation of stablecoins is the hope of bringing a little order to a highly volatile and somewhat chaotic system. For the most part, they are managing to do exactly that. You will just have to keep a close eye on your crypto wallet and learn to read the signals in a market where the rules are still being figured out.
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