How to use a Stablecoin? A Complete Guide
Stablecoins are rapidly establishing themselves as a crucial element in the crypto ecosystem and play a huge role in facilitating the mainstream adoption of crypto-based solutions.
Stablecoins combine the speed and flexibility of crypto with real-world assets eliminating high volatility. This property makes stablecoins a critical tool for value transfer in the crypto space. And with a total market capitalization of over $150 billion, stablecoins have grown into a mountain of value in the heart of digital finance, capturing the attention of both consumers and regulators alike. This piece looks at what stablecoins are and how they are used.
The traditional financial system, despite its role in facilitating the flow of value, comes with several limitations which make it susceptible to corruption and manipulation by centralized authorities at the expense of the average user. It is slow, opaque and in many cases, incurs a high cost of usage. These factors cause frictions that affect both businesses and the average user.
Blockchain technology was created to solve these problems by increasing the speed and flexibility of financial exchange through decentralized finance (DeFi). But users faced difficulties in moving their funds from fiat to crypto and vice versa. Also, the highly volatile nature of cryptocurrency assets made them unsuitable as a medium of exchange and as such are primarily used for their speculative appeal.
To effectively use crypto assets as a medium of exchange, there was a need to create a tool for bridging real-world fiat as well as capturing and protecting value against volatility. This led to the creation of a stable form of crypto assets called stablecoins.
What is a stablecoin?
A stablecoin is a cryptocurrency whose value is pegged at a fixed rate to an external asset to achieve very low volatility. Stablecoin prices are not subjected to the dynamics of supply and demand. Instead, they are usually pegged to government-issued fiat currencies such as the US dollar, a commodity like gold, a basket of assets, or backed by an algorithmic code to maintain stability which is a crucial characteristic of money.
The first notable ever created was BitUSD, which was launched in 2014 by Dan Larimer and Charles Hoskinson. BitUSD’s value was backed by BitShares token BTS as well as futures, fiat, gold, silver, and other assets. In the years that followed, a number of stablecoins have been created.
Stablecoins do experience some volatility, but very on very low levels that are usually not noticeable. To maintain extremely low volatility levels, stablecoins tie themselves to stable assets by some simple mechanisms. One popular mechanism is to peg the stablecoin 1:1 with traditional assets in a reserve. For example, fiat-backed stablecoins like USDC are pegged 1:1 to government-issued US dollars. This means that for every USDC in existence, there's an equivalent US dollar held in reserve.
Types of stablecoins
These are the most common types of stablecoins. They are stablecoins backed 1:1 by government-issued fiat currencies which are held in reserves and maintained by an independent custodian. They are regularly audited and users are subjected to Know-Your-Customer (KYC) and Anti-Money Laundering (AML) to ensure they follow the necessary compliant measures stipulated by government regulations. Examples of fiat-backed stablecoins include USDC, BUSD, and the largest by market cap, USDT.
These are stablecoins backed by using other cryptocurrencies as collateral and are usually maintained using smart contracts. This means that they are decentralized, unlike their fiat-backed counterparts. To mitigate the effects of the high volatility of the cryptocurrencies backing them, these stablecoins are usually overcollateralized. This means that to mint one of these stablecoins would require a higher amount of cryptocurrency collateral. For example, to mint, $100 worth of crypto-backed stablecoins might require $200 worth of a cryptocurrency like Ether to be held in reserve. MakerDAO's DAI is a popular example of a crypto-backed stablecoin.
Commodities such as gold are also used to back stablecoins. In the same way, fiat reserves are held by central entities that issued fiat-backed stablecoins, commodities like gold are also held in reserve and are used to back stablecoins to maintain a stable peg. Stablecoins backed by commodities also make it easier for users to invest in high-end assets like gold and silver. Therefore, the stablecoins allow for easy swapping of tokens for the underlying assets. However, it is important to note that commodities can fluctuate in price and lose value. An example of a commodity-backed stablecoin is Paxos Gold (PAXG).
Stablecoins can also rely on complex algorithms and smart contracts to maintain a stable price by effectively balancing funds held on the blockchain with supply and demand. Using algorithms, stablecoins can maintain stability and defend their peg under market conditions. There are two categories of algorithmic stablecoins;
FRAX is a hybrid stablecoin that is collateralized by crypto assets and also relies on mathematical cryptographic algorithms to maintain its peg to the US dollar. Hybrid stablecoins adopt this dual trait to guard against black swan events which pure algorithmic stablecoins are susceptible.
Seigniorage stablecoins are also non-collateralized or pure algorithmic stablecoins. These stablecoins do not have any reserves and solely rely on complex algorithmic processes and seigniorage to adjust circulating token supply based on supply and demand dynamics. This is done by destroying or inflating the on-chain supply of the stablecoins to maintain their peg. This category of stablecoins is the most decentralized but is heavily susceptible to black swan events such as a death spiral. A notable example is Terra's UST. USDD is another stablecoin project experimenting with this model.
Use cases of stablecoins
Stablecoins bring the stability of fiat currencies to the blockchain ecosystem, making them a more improved version of fiat currencies in terms of security and transparency. They allow for easier, faster, and cheaper transactions when interacting with applications built on the blockchain. These properties make stablecoins suitable for a wide range of use cases within the crypto ecosystem.
- Trading - Stablecoins act as base currencies for market makers and are the most used for price quotations on crypto exchanges and in OTC markets. For example, trading volumes on USDT/BTC are larger than USD/BTC. Stablecoins provide liquidity which allows traders to easily enter and exit trading positions on exchanges.
- Borrowing and lending in DeFi - Stablecoins are used as an on-ramp into DeFi. Typically, stablecoins are used to facilitate lending and borrowing on DeFi platforms. They are mostly used as collateral by borrowers to assess crypto funds. They also act as safe haven for investors to store their funds in down markets.
- Remittances and cross-border payments - Stablecoins are popularly used by businesses and individuals for cross-border payments. It provides an easier, cheaper, and faster alternative than traditional means. Also, most individuals living abroad use stablecoins to preserve the value of money when sending funds back home to friends and family living in countries with hyperinflation like Venezuela and Argentina.
Stablecoins are rapidly establishing themselves as a crucial element in the crypto ecosystem and play a huge role in facilitating the mainstream adoption of crypto-based solutions. In a landscape increasingly dominated by digital currency, the importance of stablecoins within financial infrastructures will significantly increase.
Currently, there are over 200 privately-developed stablecoins in existence and more financial institutions are creating their own versions of stablecoins as a cheaper and faster means of settling transactions. For example, in 2021, JP Morgan announced the creation of its own stablecoin, the JPM coin. As the crypto industry matures, there's likely to be a significant increase in stablecoin usage.
Furthermore, the continued adoption from traditional financial and corporate institutions will also undoubtedly bolster and launch stablecoins into mainstream usage.