Stablecoins: The What’s What – MEW Publications
With the new integration of MakerDAO on our DApps page, as well as the growing buzz around Facebook’s Libra coin that promises to be backed by a reserve of real assets, we thought that our MEW community might have questions about the use and value of stablecoins.
Here’s our take.
First, let’s take a look at what is a stablecoin.
Stablecoins are a specific type of cryptocurrency with its value tied to something reliable and consistent, like fiat currency or physical assets of value such as silver and gold.
The DAI token is a popular example of a stablecoin. It’s pegged 1:1 to the value of the US dollar and is the currency used for MakerDAO’s collateralized loans which allow users to stake the crypto assets they already own for a more stable crypto coin.
The main benefit of stablecoins is that they provide a more reliable investment that is less affected by the volatility of the crypto market, giving crypto-newbies the option of entering the space in a less risky and more familiar manner.
Another quality of some types of stablecoins that could make them more attractive to a user from traditional finance is that they are, theoretically, recoverable. Since their value is tied to another asset off the blockchain, the coins themselves are ‘expendable’. If the blockchain is hacked or compromised, the stolen funds can be declared non-redeemable and prevented from entering the crypto ecosystem.
The flipside of this advantage is that these types of stablecoins need to be centralized — under the oversight over one entity that has control over the blockchain. Still, there are different ways stablecoins can choose to maintain their stability and alternatives that are less reliant on centralization do exist.
1. Stablecoins collateralized by crypto
Crypto-collateralized stablecoins are the decentralized solution for cryptocurrency stability. The idea may sound contradictory (isn’t avoiding crypto volatility the reason for stablecoins in the first place?), but overcollateralization and incentive alignment help bring stability while maintaining decentralization.
A good example of a crypto-collateralized coin is MakerDAO’s DAI stablecoin. DAI’s consistent value is maintained by smart contract technology, which auto-corrects based on the value of the US dollar by automatically buying and selling reserves of ETH and MKR, its governance token.
In fact, the MakerDAO ecosystem decentralizes the central bank model by distributing governance to a network of MKR token holders, and structuring incentives to support stability and solvency. Combining traditional central bank architecture with decentralized technology, MakerDAO can balance currency supply without being vulnerable to the abuses of ‘money printing’ by a centralized, non-transparent governing entity.
2. Stablecoins collateralized by fiat
Fiat-backed coins are pegged either 1:1 to a reserve of fiat currencies (Tether and USDC are examples) or, more rarely, to physical assets like gold. They cannot be considered decentralized because they rely on something that physically exists and/or is managed by one centralized entity.
For this reason, these types of stablecoins are often seen as disruptive to the development of the crypto ecosystem and cause concern in the crypto community which believes strongly in decentralization.
Although it is an attractively simple and convenient concept, some feel that this connection to off-chain assets negates one of the most important advantages of crypto: severing ties with centralized banking and promoting independence from third parties.
3. Non-collateralized (algorithmic) stablecoins
Algorithmic stablecoins have no backing collateral or reserves at all. These coins are managed through smart contract algorithms that execute functions which are, ironically, similar to what reserve banks do: removing coins from circulation when prices are too low and ‘printing’ currency when prices are too high to keep the value pegged to a chosen asset. Algorithmic stablecoins are much more rare, but Carbon Money and Steem Dollar are two examples.
Auto-correction based on market cap, circulating supply and volume means non-collateralized coins have no need for centralization or collateral. However, the mechanisms supporting these coins are very complex, and their balancing act depends on the expectation of future growth in coin value. Because of this, non-collateralized stablecoins are rare and less popular than fiat- and crypto-collateralized ones.
The uses of stablecoins extend beyond staking and loans. Some countries with volatile fiat currencies are beginning to look towards stablecoins as a feasible quick-fix for their economy. Workers in these countries will know the value of what they’re getting paid, instead of questioning the worth of their national currency or worrying about a local market crash.
Similarly, stable cryptocurrencies may provide a solution for residents of countries that impose harsh restrictions and demand financial control over their inhabitants. Crypto-technology offers relief to these individuals, and stablecoins help make that relief reliable.
Crypto-exchanges also look at stablecoins to streamline their processes. When trading crypto, there is often a lot of back-and-forth involved between currencies, because of shifting market values, cross-chain incompatibilities, and a lack of supported coins. By including stablecoins, these exchanges can create and maintain accurate crypto-swaps without having to constantly deal with regulations over crypto-to-fiat transactions.
Perhaps the most promising benefit of stablecoins is their ability to fuel the new world of DeFi — decentralized finance. The MakerDAO project is a prime example of this growing infrastructure for frictionless financial access. Without the reliability of stablecoins, financial products that meld the stability of the traditional market with the accessibility of crypto would be not be possible.
Stablecoins, whether centralized or decentralized, already make up a respectable portion of crypto transactions. With an over 130% uptick in trading volume for USD stablecoins just in the last month, and Tether already surpassing their entire last year’s volume by $200 million, there is definitely a demand for consistency in value. In practice, stablecoins may provide a more pragmatic and realistic approach to using crypto for many people. Not everyone can comfortably ride the extreme market waves into global adoption. These processes take time, and stability will likely be a key point in turning the tide.
We have only just begun to see the applications and effects that decentralized, reliable values will have on the world as a whole. As the crypto market matures and the value of more canonical, decentralized cryptocurrencies like Ethereum and Bitcoin become more stable, all crypto assets may become low-risk investments. Until then, stablecoins offer an attractive and immediate alternative.