Stablecoins 101: The Why

  • 5 mins read

Stablecoins 101: The Why

Stablecoins 101

Stablecoins are blockchain-based versions of fiat currencies, commodities, algorithms or a basket of these. They are programmable and can interact with blockchain applications often using smart contracts (self-executing agreements normally written in Solidity). Fiat currency refers to government-backed currencies that are not backed by anything – at one time they were pegged to commodities like gold. Stablecoins offer the speed and security of blockchains while attempting to remove the notorious volatility of the crypto market.

These digital assets offer investors price stability in a few different ways:

  1. Reserves: reserve stablecoins are backed by assets (reserves of fiat, fiat equivalents such as treasuries, &/or gold). Examples are USDC, BUSD, & PAXG
  2. Algorithmic: algorithmic stablecoins use algorithms (usually via smart contracts) to balance their supply based on demand. Examples include Terra’s failed UST
  3. Hybrid: hybrid stablecoins offer a mix (or basket) of assets that support its’ peg. These can include hard (commodity), soft (fiat), & algorithmic (math). Examples include Facebook;s Libra/Diem & TAL     


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Why Stablecoins?

Stablecoins are often used to buy/sale Bitcoin or other cryptos on DeFi/CeFi platforms without ever having to leave the ecosystem. As their adoption grew, they’re now used not only for native blockchain services such as staking or lending, but also to pay for off-chain goods and services.

A fiat peg means instant utility, because for an asset to be used as money, that asset is expected to act as money:

  1. a medium of exchange
  2. a unit of account and 
  3. a store of value

…. , meaning an asset has to maintain its value, so the cost of goods and services is predictable. The immediate benefit of stablecoins is that they can be a medium of exchange, bridging the gap between fiat and cryptocurrencies. Stablecoins are inherently stable assets, making them a good store of value and encouraging their adoption in regular transactions. 

Informed stablecoin holders know they hold an inflationary asset, but the immediate purchasing power over short periods of time also means stablecoins can be used to buy goods and services at predictable prices. Thus, the value of most stablecoins is pegged to the value of either a specific fiat currency such as the United States dollar or a particular commodity such as gold. Being pegged means that their price is fixed, so one stablecoin tracking the U.S. dollar should be worth one dollar.

This peg can be maintained through a number of different mechanisms. The most common method used by stablecoins is called asset backing. Asset backing refers to the total amount of stablecoin tokens in circulation with respect to the number of assets backing it. A stablecoin is backed 1:1 if, for every stablecoin in circulation, there are assets worth an equivalent amount backing it.

In the case of stablecoins backed by a U.S. dollar, it’ll keep its value as long as the stablecoin is redeemable for a U.S. dollar. However, if its value moves sharply, traders will look to profit off of price difference between markets & the lost peg.

What are stablecoins good for?

Priority #1 for every person & every business is cash flow.

Priority #2 is access to those funds  to pay the bills. Stablecoins are the only form of digital money that is immediately usable on or off-chain 24x7x365 anywhere, at any time… & that is just the first use case.

Being based on the blockchain allows stablecoin holders to take advantage of numerous opportunities. The first stablecoins were issued as fiat currency replacements on exchanges and gave investors a safe haven away from the volatility of other crypto assets.

Stablecoins can now be used to lend for rates better than those offered by traditional savings accounts or take out cryptocurrency-backed loans in the decentralized finance (DeFi) space. While stablecoins may earn higher yields than traditional savings products, it is crucial to note that stablecoin offerings do not provide any government-backed insurance.

Stablecoins have been issued on various blockchain networks that support smart contracts and are widely used throughout the DeFi space and on exchanges. Blockchain networks that support smart contracts allow applications like decentralized exchanges (DEXs) to be built on top of them. Decentralized exchanges are marketplaces where transactions are made directly between traders.

Stablecoins can also be used to pay salaries in cryptocurrency as they make it cheaper to move money across borders. Only a transaction fee to move funds on the blockchain has to be paid. Moreover, cross-border transactions are settled faster on the blockchain, taking between a few seconds to an hour, depending on numerous factors. These factors include the type of network being used, potential network congestion, the amount paid in fees and the transaction complexity. However, the traditional financial system may take days to settle cross-border transactions.

Utility is King

Stablecoins increase the mobility of crypto assets around both on-chain & off-chain ecosystems. This situation means that they possess instant utility beyond the ownership of normal cryptos simply because they reduce price volatility – and have extended reach in ready made USD markets if the USD is the peg. While traditional cryptocurrencies don’t have a fixed price and may swing wildly, a stablecoins’ low volatility helps investors maintain their funds on the blockchain while reducing risk.