What are Stablecoins?

1. What are Stablecoins?

Stablecoins are crypto-assets with a fixed rate or resistant to significant rate fluctuations. This class of digital assets adds low volatility (or almost no volatility) to the well-known advantages of cryptocurrencies. It can be achieved by pegging STBs to various assets (including fiat currencies, gold, SDRs, digital currencies or baskets of crypto-assets), or by reproducing on a decentralized basis some elements of monetary policy used by central banks (the concept of Seigniorage Shares).

2. What is the purpose of Stablecoins?

Stablecoins are not only excellent as a means of exchange, they can also effectively serve as a unit of account and as a means of saving, thanks to their exchange-rate stability. This can allow many people to get their paychecks in cryptocurrency without fear of a sharp decline in its exchange rate. Stable currencies can become an alternative to fiat currencies for residents of economically unstable countries with high inflation and significant currency restrictions. Also “stable coins” can be effectively used in the market of cryptocurrency loans and derivatives. In addition, Stable Coins have long been popular with traders who buy more volatile cryptocurrencies “on the low side” and then sell them at a higher price during market recovery periods.

3. What type of collateral are cryptocurrencies?

There are three main categories of “stable coins,” depending on the underlying collateral:

  • Backed by fiat currencies (examples: Tether, TrueUSD);
  • secured by digital currency or a basket of cryptocurrencies (BitUSD from Bitshares, created on the MakerDAO platform and Ether-secured Dai tokens);
  • unsecured (Seigniorage Shares).

4. How are STABLECoins secured by fiat?

Stablecoins of this type are promissory notes. Each Stablecoin corresponds to a unit of fiat currency held by a third party (e.g. a depositary bank). For example, a user deposits USD into a bank account and receives Stablecoins at a 1:1 ratio. When he wants his dollars back, the issuer will liquidate the appropriate amount of his Stablecoins and return him the required amount in that fiat currency.

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DigixDAO follows a similar pattern, except that it is backed by gold rather than fiat currency.

5. What is the peculiarity of Stablecoins secured by cryptocurrency?

Cryptocurrency or a basket of digital currencies is used as collateral for this type of Stablecoins. Such coins are usually backed by crypto-assets in a ratio greater than 1:1. Since cryptocurrencies are highly volatile, such high collateral requirements minimize the risks of insolvency of the Stablecoins issuer during market crashes.

6. How is the rate of unsecured Stablecoins supported?

Satablecoins may not be secured by fiat, cryptocurrency or any other assets.

Seigniorage Shares is a concept of cryptocurrencies tied to fiat without requiring collateral in other assets. It involves replicating, on a decentralized basis, techniques similar to those used by central banks.

For example, to maintain the price of a “stable coin,” the issuer algorithmically changes the volume of supply of such securities.

So, if the price of a “USD substitute” is above the $1 mark, the smart contract will issue additional “stable coins. It will sell them on the open market until the price falls to the target mark. On the other hand, the issuer will buy back tokens in order to support the price of the “stable coin” during periods of excessively low exchange rates. If the possibilities of supporting the exchange rate are exhausted, and the price of Stablecoins is still below $1, the issuer issues the so-called “Seigniorage Shares”. The latter give the holders of STB shares an opportunity to get the income from senorage (the issuer’s profit).

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It is not difficult to guess that the stability of such a system directly depends on the demand for such securities. This scheme can collapse if users lose confidence in such coins (especially if their rate continues to fall, possibilities of redemption of coins are exhausted, and demand for Seigniorage Shares is insignificant or absent).

Examples of such Shares include Basis and Havven.

7. What are the advantages and disadvantages of fiat-backed Stablecoins?

Advantages:

  • easy to understand;
  • one hundred percent stability (if fully secured);
  • low exposure to vulnerabilities and risks of hacking attacks on the network (because the collateral is not contained in the blockchain).

Disadvantages:

  • the need to trust a third party – the custodian holding the fiat currency;
  • requires another third party, an auditor, to verify that the volume of collateral matches the supply of tokens released to the market;
  • costly and slow withdrawal to fiat;
  • high degree of regulation.

8. What are the pros and cons of cryptocurrency-backed Stablecoins?

Pros:

  • no need to rely on a third party to provide collateral;
  • higher level of decentralization;
  • onchain transactions allow for more rapid regulation of the supply of “stable coins.”
  • higher liquidity than fiat-backed Stablecoins (only one onchain transaction is enough to redeem “stable coins” with the corresponding amount in cryptocurrency);
  • high level of transparency with no need for an external auditor (monitoring is available to everyone).

Minuses:

  • Not as high degree of rate stability compared to fiat-backed Stablecoins;
  • probability of automatic redemption into collateralized cryptocurrency in case of sharp decrease of “stablecoins” rate;
  • dependence on the viability of another cryptocurrency (or a basket of digital assets);
  • somewhat more complicated system compared to Stablecoins backed by fiat.
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9. What are the advantages and disadvantages of unsecured Stablecoins?

Advantages:

  • No need for collateral;
  • theoretically, a higher degree of decentralization and independence, since there is no linkage to any fiat currencies or crypto-assets (however, with the general decline in the cryptocurrency market, there may be a decrease in demand for Seigniorage Shares).

Disadvantages:

  • more complicated monetary mechanism;
  • the need for sustained demand for this kind of Stablecoins;
  • a high degree of vulnerability to shocks in the cryptocurrency market (so, in the event of a market crash, it may be difficult to redeem such coins);
  • the difficulty of analyzing and assessing the viability of such monetary systems.

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