What is a Stablecoin and how does it work?
What is a Stablecoin and how does it work? Michael Arty Ghannoum Jan 11·5 min read
Stablecoin’s are the counter-intuitive cousin in the cryptoverse family. Attempting to be the “Fiat” in the token economies of the world, they are digital currencies who’s value is pegged to 1 of 3 types of assets; Fiat, crypto or a physical assets.
They serve mostly as platform centered coins where user stake their own crypto and redeem their stable coin value without selling the original crypto. Naturally since the earliest forms of stablecoin’s their evolution has become much more widespread and can be found in farmable staking contracts across all popular platforms, and are at the center of the crypto markets progressive growth.
Today, I will be reviewing the different assets stablecoins are pegged against and explain the economics behind their value in the cryptoverse.
Andrew Keenan, CAIA, CFA, CBP is an AVP at Credit Suisse. Contact E-mail: firstname.lastname@example.org
How does a stablecoin work?
Creating a hedge against price volatility in a crypto market is no easy feat, even for the experienced devs in the industry. The case for stablecoin’s was at first contested on account of the integrity of the teams, but is now undoubtedly a path that is synonymous with crypto’s capacity for mass adoption. Volatility is after all the biggest advantage and anxiety of the crypto market.
The idea is, that by having a token where the price is not directly correlated to the coin network , the token can maintain it’s original fiat conversion value without having to convert back into fiat. This gives your traders a practical advantage and exchanges a liquidity advantage because the value stays in the system.
To give a real life example, a bank guarantees the money you deposit, but has the capacity to lend it out x10 in Canada or x33 in the US. By keeping the dollars on the network and people paying interest back, the Bank can guarantee that you can withdraw your funds theoretically at any time. In the crypto world, a stablecoin protocol guarantees your capitals value through the creation of smart contracts on the network it operates in.
When the network is decentralized, the capital injected as collateral by the users is used to generate more of the native stablecoin in the form of a loan to another user. For example, the network Maker DAO takes collateral in ETH (Ethereum) and issues DAI as a return. No matter the price of ETH, once the smart contract is locked in the value issued as the stable coin will not decrease should the price of the ETH ever drop. Although this might seem confusing, the networks in these scenarios are using forms of arbitrage to navigate the fluctuation of the market and maintain the total value of their network. For more information check out the Maker DAO protocol, which is one of the most promising projects on the market.
When the network is centralized, like in the case of the most popular stablecoin Tether, the base pegged value is set to US dollars and accumulated in USD. Theoretically speaking, every time you buy USDT the Tether holdings company should have a 1 for 1 ratio of USD to your deposit in their Treasury. without going much further in how this is done, it is important to note that Tether has been in the ropes with the SEC and auditors for exactly this reason, and despite its multi-billion dollar market cap has not necessarily evolved in its transparency with regulators nor users.
Fiat Pegged Stablecoins
The most popular and simplest one of the bunch are Fiat Pegged stablecoins, which are inherently centralized.
In a Fiat Backed Stablecoins for example:
if the issuer banked $1,000,000 USD and issues a stablecoin in a 1:1 ratio that represents that collateral. The users on the network now have 1,000,000 units equivalent to 1 USD to trade.
In order to increase the supply, the issuer needs additional USD before creating more stablecoins and vice versa if the issuer wanted to reduce the total supply by buying back issued tokens.
In this scenario, whether the treasury has Fiat or a precious metal reserve is secondary to the fact that the total supply is dependent on the treasuries value ratio to the issued supply. More means more, less means less, direct correlation.
Trusting over the network and the governance of the treasury is a hard pill to swallow. Ultimately the user is trusting the custodian with their hard-earned crypto as well as the sale of their loan to the network at the risk of losing it all. When the early networks were being built early adoption was quite complex, and whether these protocols were being governed by algorithmic protocols dumping coins to manage the value, early adopters had heavy trenches to dig for us to arrive where we are today. Trusting centralized financial institutions is similar to the relationship with private banks in the US; unnamed shadow bags of gold passing out loans for collateral built on loans from another bag from another persons collateral. At the risk of being volatile the crypto pegged coins still maintain the traceability across chains and platforms.
Crypto Pegged Stablecoin
When value’s are pegged to other cryptocurrencies, the volatility can be double edged, wherein the stablecoins value will increase in relation to its exchange but drop in relation to the asset it is pegged to. To mitigate this risk the network will create a partial issuance of the minted coins and maintain a massive reserve to manage the circulating supply. The networks productivity is leveraged by smart contracts, as well as the types of cryptocurrencies that are accepted as a sources of collateral.
More often than not these networks will accept ETH or BTC exclusively, but are more and more open to other stable coins and key chains that have more stable networks and more promising future projections.
A step-by-step process for stablecoins would look like this:
A User creates a smart contract by offering a crypto asset, known as a Collateralized Debt Position.
Using this CDP, the crypto-backed stablecoins enters circulation to fulfill the users order.
The user can then trade that value and conduct the activity they required
In order to retrieve their collateral the user must pay back the smart contract at the agreed position.
By virtue of the volume of transactions and need on the network the capacity to lend and offer liquidity becomes much wider on these networks, and offer a more advantageous and transparent experience for users. After all, centralized authorities are a board room meeting away from hell freezing over.
With the current trend in crypto going towards Defi protocols and decentralized lending the need for these stablecoins is only going to become more significant. After all, they are the simplest way for nations to organize an e-currency without nationalizing a chain. Already we can find DAI and other stablecoins appearing as remittance networks to simplify transactions, who says it can’t hold a greater role tomorrow?
Thank you for stopping by, onto the next lesson in the cryptoverse